Stabilization and Reforms in Latin America: Where do we stand? 9783964562807

Table of contents :
Contents
Foreword
Introduction
Wine and Bottles, Old or New? Rethinking Economic Policy in Latin America Once More
Wine and Bottles, Old or New? Rethinking Economic Policy in Latin America Once More Comment on Eduardo Lizano
Good Governance after Stabilization: Avoiding a Negative-Sum Game
Good Governance after Stabilization: Avoiding a Negative-Sum Game Comment on Leonardo Auernheimer
Capital Inflows, the Real Exchange Rate and the Mexican Crisis of 1994
Capital Inflows, the Real Exchange Rate and the Mexican Crisis of 1994 Comment on Sebastian Edwards, Roberto Steiner and Fernando Losada
Regulation for a Stable Financial System : Prudential Supervision and Liquidity Management in Argentina
Regulation for a Stable Financial System: Prudential Supervision and Liquidity Management in Argentina Comment on Roque Fernández
Problems of Monetary Policy in Latin America
Problems of Monetary Policy in Latin America Comment on Helmut Hesse and Antje Heikamp
Regional Free Trade Agreements as an Alternative to Unilateral Liberalization: The Case of Chile
Regional Free Trade Arrangements as an Alternative to Unilateral Liberalization: The Case of Chile Comment on Patricio Melier
The Social Dimension of the Latin American Reform Process
The Social Dimension of The Latin American Reform Process Comment on Hermann Sautter and Rolf Schinke
Are the Latin American Reforms Sustainable?
Are the Latin American Reforms Sustainable? Comment on John Williamson
The authors

Citation preview

Hermann Sautter and Rolf Schinke (eds.)

Stabilization and Reforms in Latin America

Göttinger Studien zur Entwicklungsökonomik de Desarrollo Econömico in Development Economics 3

Göttinger Studien zur Entwicklungsökonomik

Stabilization and Reforms in Latin America: Where do we stand? Hermann Sautter and Rolf Schinke (editors)

Vervuert • Iberoamericana 1996

Die Deutsche Bibliothek - CIP-Einheitsaufnahme Stabilization and reforms in Latin America : where do we stand? / Hermann Sautter and Rolf Schinke (eds.). - Frankfurt am Main : Vervuert; Madrid : Iberoamericana, 1996 (Göttinger Studien zur Entwicklungsökonomik, de desarrollo económico, in development economics; 3) ISBN 3-89354-173-X (Vervuert) ISBN 84-88906-58-7 (Iberoamericana) NE: Sautter, Hermann [Hrsg.]; Göttinger Studien zur Entwicklungsökonomik

© Vervuert Verlag, Frankfurt am Main 1996 ©Iberoamericana, Madrid, 1996 Reservados todos los derechos Printed in Germany Printed on acid free paper

5

Contents

Foreword

7

Introduction

9

Eduardo Lizano

Wine and Bottles, Old or New? Rethinking Economic Policy in Latin America Once More Stefan

15

Tangermann

Comment on Eduardo Lizano Leonardo

45

Auernheimer

Good Governance after Stabilization: Avoiding a Negative-Sum Game

49

Günter Gabisch

Comment on Leonardo Auernheimer

67

Sebastian Edwards, Roberto Steiner, and Fernando Losada

Capital Inflows, the Real Exchange Rate and the Mexican Crisis of 1994

69

Peter Rühmann

Comment on Sebastian Edwards, Roberto Steiner, and Fernando Losada

119

Roque B. Fernández

Regulation for a Stable Financial System: Prudential Supervision and Liquidity Management in Argentina

123

Günther Engel

Comment on Roque B. Fernández

147

6

Helmut Hesse, Antje Heikamp Problems of Monetary Policy in Latin America

151

Helmut Reisen Comment on Helmut Hesse and Antje Heikamp

177

Patricio Meiler Regional Free Trade Agreements as an Alternative to Unilateral Liberalization: The Case of Chile

183

Heinz Gert Preuße Comment on Patricio Meiler

201

Hermann Sautter and RolfSchinke The Social Dimension of the Latin American Reform Process

207

Hans-Rimbert Hemmer Comment on Hermann Sautter and Rolf Schinke

242

John Williamson Are the Latin American Reforms Sustainable?

247

Bernhard Fischer Comment on John Williamson

256

List of authors

261

7

Foreword

With this third volume of the Ibero-America Institute's Gottinger study series, we continue our discussion of recent economic problems in Latin America. This book contains the revised and edited contributions presented at a Symposium held in Gottingen during November 1995. All comments, however, refer to the oral presentations. It was a great pleasure for us bringing together experts from Latin America, the United States and Germany and discussing with them new insights and experiences of economic problems related to the reform processes in Latin America. We would like to thank them all for their contributions. As usual, the organization of the symposium rested on several shoulders: A grant by the "Deutsche Forschungsgemeinschaft" provided the necessary financial support. We could count on the help of all members of the scientific and administrative staff of the Institute. Therefore, we are indebted to all of them. Special thanks go to Mrs. Margret von Schierstaedt. With her professional experience she formatted the papers and gave this volume its final appearance. Editorial assistance has been provided by Mr. Klaus Liebig. Gottingen, May 1996.

Hermann Sautter and Rolf Schinke

g

Introduction

Hermann Sautter and Rolf Schinke

The papers published in this volume have been presented at the symposium "PostStabilization Problems and Ongoing Reforms in Latin America" organized by the Ibero-America Institute in November 19g5. Since several years Latin America undergoes a process of rapid economic change. Had the eighties been called the "lost decade", at their end a process of economic reforms set in that progressively affected the most important LDCs of the Western Hemisphere. The change was so marked that in several respects it is justified to term it a "...new approach to development"1) in this part of the world. Key elements are the liberalization and deregulation of factor and goods markets, the opening-up of their economies towards world markets, and a stabilization policy aimed at attaining a sound macroeconomic equilibrium. The results obtained so far are impressive: According to ECLA data the inflation rate of all Latin American and Caribbean countries fell from their peak in 198g with a change in the aggregate consumer price index of 1213 percent to about 25 percent in 1995. While their accumulated change in GDP per capita between 1981 and 1990 was -7.5 percent that change was +5.1 percent during the period 1991 to 19952). Another indicator of success has been the return to international capital markets for some countries. "And then came the Mexican crisis"3'

and the "tequila effect" spread over to other

Latin American countries. Obviously, something went wrong with the reform process, at least in some countries. It was the objective of the symposium to discuss some of the most important weaknesses of the reform processes. In this introduction we do not aim at giving a brief description of the contents of the papers presented at the symposium. Instead, we will restrict ourselves to indicate the

" World Bank (1993, 2). a

CEPAL (1995, 51, 50). Data for 1995 are provisional.

31

Krugman (1995,29).

10

central questions raised on the conference and - tentatively- what have been the answers to them. The first question raised was: Did the Latin American reform process already pass the "point of no return", or is it just a new episode in al long history of stalled initiatives, of stop-and-go policies? The answer is not quite optimistic. In one country only - Chilehas the process gained its own dynamism, so that the "watershed" seems to have been passed. Referring to another country - Venezuela- until recently the judgment has been equally definite, but on the negative: the reform process has been a short episode or a "false start" as Williamson termed it. (Up to now it is not yet clear whether the new policy steps initiated in April 1996 will change the picture.) Referring to the majority of Latin American countries, however, the picture is not so clear. To say it in Lizano's words on page 39 of his paper: "...while the old (system) has not quite finished dying, the new is still trying to be born". The old model of unionism, populism, and paternalism and the new model of economic liberalization are overlapping. Elements of both coexist. This situation given, the second question was: Which are the next steps of the reform process? Or to ask it differently: Which are the necessary elements and the chances of an ongoing reform process? To take the chances first: they are not bad. But the challenges are tremendous. 1. Latin American countries have to create and maintain a stable macroeconomic environment. - The task of stabilizing Latin American economies is far from being accomplished. Inflation rates continue to be five to seven times higher than prevailing rates in the main industrialized countries. Insofar Latin America is not really in a "post-stabilization"-period as the title of the conference seemed to suggest. Only the first step towards a stable macroeconomic situation has been made. The next steps could be more difficult. This is especially true for Argentina which succeeded in its struggle against inflation by using the nominal exchange rate as a stability anchor. The results in terms of lower inflation rates are undebatable. But the problems created are also unquestionable: the revaluation of the real exchange rate, which deteriorated Argentina's competitiveness on international markets, and the high vulnerability of the domestic monetary system. Roque Fernández pointed to some problems related to this instrument. Obviously, monetary management has been successful in containing the "tequila"-effect. It is an

11

open question whether Argentina will also succeed in balancing aggregate demand and supply and thereby maintaining stability without borrowing it from abroad. 2. Latin America has to define its foreign trade strategy. - Unilateral liberalizations forced domestic producers to rearrange their capacities. Domestic competition has been stimulated, inefficient activities have at least partly been finished. But export growth is still unsatisfactory in many cases. This is partly due to overvalued exchange rates. Another part of the problem is the world-wide trend to create trade blocs and to discriminate against non-member countries. This situation given, should Latin American countries establish their own trade blocs and refrain from further unilateral liberalizations in order to maintain some bargaining power? This was a question raised by Meller. Is a "Pan-American Free Trade Area" a realistic option, and if not, is the accession of some more countries to NAFTA a more realistic alternative? Latin America has to find its trade strategy without falling back to its old inward-looking orientation which could be even worse if applied on a regional level. 3. Saving rates have to be increased substantially. - Even those who do not consider the saving-process as the "heart of development" will admit, that higher domestic saving rates facilitate a non-inflationary growth process which does not run into the risk of a new debt problem. As Hesse pointed out, one of the preconditions for reaching higher saving rates is monetary stability. This is also the condition for preventing capital flight and for attracting long-term capital inflows from abroad. As to short-term capital movements, several speakers expressed their reservations. If it is not possible to convert short-term into long-term investments, the advantage of being an "emerging market" is a double-edged one. This is illustrated by the Mexican experience analyzed by Edwards, Steiner, and Losada. 4. Energetic steps must be undertaken in order to combat poverty. - Lizano reminded us of Adam Smith who said: "... no society can surely be flourishing and happy of which the far greater part of the members are poor and miserable."1) Williamson spoke of "Latin America's social debt" which has to be addressed before the underprivileged revolt. May be, that they do not in a revolutionary 11

Smith (1766,96).

12

sense of the word, but, in any case, lasting mass-poverty will undermine every system of property rights and, therefore, debilitate the functioning of markets. Economic growth which already has been or will be triggered by institutional reforms has its "trickle down"-effect. This is unquestionable. But it is undebatable as well, that more is needed than just waiting for the "trickle down" to happen. Until now, the reform process did not have a strong social dimension as Sautter/Schinke

showed. This has to be changed, not only for social or political

reasons, but also for economic ones. In general, investment in human capital generates higher returns than that in physical capital. 5. Political institutions have to be modernized. - The legacy of the old political system is an obstacle to the process of economic modernization. But until now, much less has been done in reforming the state than in reforming the economy. What Latin America needs is not only a "smaller state" but a state strengthened in its capabilities to establish reliable property rights, to correct market failures and to provide public goods. Paradoxically, the stronger state may consist in a government which is based on strict policy rules and which has a much smaller scope for discretionality, as Auemheimer suggested. These are five steps which have to be undertaken in order to make the reform process an "ongoing" one. The list may be extended easily. What seems to be clear after having experienced five to seven years of reforms is the fact that the reform process needs still more time. The extent of distortions and the length of the adjustment period have been underestimated. In this sense, there is a great similarity to the German unification process. It may be true, that no country will learn very much from others and reduce, thereby, its learning costs. But learning together is an advantage by itself, and it seems, that Germany as well as Latin American countries have to learn at least one thing together- patience.

13

References

CEPAL. 1995. "Balance preliminar de la economía de América Latina y el Caribe 1995." Notas sobre la economía y el desarrollo 585/586. Krugman, Paul. 1995. "Dutch Tulips 74(4):28-44.

and

Emerging

Markets".

Foreign

Affairs

Smith, Adam. 1766. "An Enquiry into the Nature and the Causes of the Wealth of Nations." Glasgow Edition. Glasgow 1976: Oxford University Press. World Bank. 1993. "Latin America and the Caribbean: A decade after the debt crisis." Latin America and the Caribbean Regional Office. Washington, D.C.

15

Wine and Bottles, Old or New? Rethinking Economic Policy in Latin America Once More

Eduardo Lizano

1.

Introduction

A glance at the shifting tides of economic policy in Latin America reveals rapid successions of intense change. The foreign debt crisis of the 1980s gave way to astonishing transformation and resurging economic growth in the early 1990s, only to have the brakes slammed on with the Mexican debacle in 1994 and the uncertainty and pessimism it engendered. Success and failure on this continent follow one another in rapid succession, enthusiasm and wild hopes yield to disappointment and discouragement. It is no wonder that we find ourselves confused about the present and uncertain about the future. Sometimes we struggle to take one step forward, only to fall two steps back; other times we advance two steps forward and take only one step back. Advance and retreat alternate endlessly. Stop and go policies, growth and stagnation follow one after the other. Anyone who has followed the economy of Latin America is accustomed to the rapid pace of changing perceptions and opinions about promise and possibilities.

Burki

and Edwards, for example, find that economic policy makers have clearly heeded the lessons of the Mexican case, thus opening the door for a second generation of reforms. At the same time, Krugman dourly affirms that the Mexican case "marks the beginning of the deflation of the Washington consensus," which means that "some backsliding" will be inevitable.11

In an even more dramatic example, in December

1994, at the meeting of heads of state in Miami, President Clinton made reference to the case of Latin America, saying, "These reforms are working wonders ... these are remarkable, hopeful times."21 Nine days later, Mexico plummeted to the depths of financial and exchange-rate catastrophe. Thus, Latin America reveals striking breaks with the past, alongside persistent deep-rooted structural features. " Burki and Edwards (1995, 24); Krugman (1995, 24,31). 2

> As quoted by Nairn (1995, 49).

Despite all the

16

consensus and the trend toward convergence, the picture is far from clear or optimistic. So the countries are looking for a light at the end of the tunnel, trying to find an Ariadne's thread to pull the economies of Latin America out of the maze of underdevelopment and poverty. Three elements are available to clear away the undergrowth: new knowledge is being acquired, new experiences are being built up, and new events are unfolding. It has become fashionable to carry out comparative studies of countries, sectors or specific policies to extract new "lessons". Presumably, these experiences will prove useful for other countries drafting their own economic policies. The flow of new information (knowledge, experiences, events) relating economic policy to problems of development is impressive. For practical purposes, it is nearly impossible to keep up to date, given the fast pace at which this information is flowing. Even so, it is helpful to glance at some of the main publications as a sampling of a body of literature which grows more abundant with each passing day. In the 1980s, Krueger began the series of comparative studies with her three-volume work on trade and employment. In the latter half of the decade, Krueger and Bhagwati published 11 volumes for the NBER, detailing their research on foreign trade and development. Subsequently, the World Bank carried out four studies on groups of countries at the beginning of the 1990s. Different themes were considered: agricultural price policies (Krueger, Schiff and Valdes, five volumes), foreign trade liberalization (Michaely, Popageorgiou and Chaksi, seven volumes), economic policies of poverty, inequality and growth (Lai and Mynt, nine volumes) and finally, macroeconomic policies (Little, Cooper, Corden and Rajapatirana). Numerous other publications came out at about the same time to extract useful "lessons". Harberger began the trend a decade ago (Some Lessons of Economic Policy in World Economic Growth, Case Studies, 1984), followed by Joan Nelson (Economic Crisis and Policy Choice, 1990), Gerald Meier (Politics and Policy Making in Developing Countries, 1991), Perkins and Roemer (Reforming Economic Systems in Developing Countries, 1991), and the World Bank (World Development Report, The Challenge of Development, 1991), all of whom pursued this line in the early 1990s. In the years immediately following, the flow of literature increased considerably, to include Haggard and Kaufman (The Politics of Economic Adjustment, 1992); Bates and Krueger (Political and Economic Interaction in Economic Policy Reform, 1993); the

17

World Bank (The East Asian Miracle, 1993; and Adjustment in Africa, 1994); Haggard and Webb (Voting for Reform, Democracy, Political Liberalization and Economic Adjustment, 1994); and John Williamson (The Political Economy of Policy Reform, 1994). At least the following publications should be cited on the specific subject of Latin America: Corbo and Melo (Lessons from the Southern Cone Policy Reforms, 1987); John Williamson (Latin American Adjustment, How Much has Happened, 1990); Enrique Iglesias (Reflexiones sobre desarrollo económico: hacia un nuevo consenso latinoamericano, 1992); ECLAC (Equidad y transformación productiva: un enfoque integrado, 1992); Sebastian Edwards (Latin America and the Caribbean: A Decade after the Debt Crisis, World Bank 1993); and Burki and Edwards (Latin America after Mexico: Quickening the Pace, World Bank, 1995). So what has been the result of this vast outpouring? There are several different viewpoints, according to which the outcome can be considered either very useful or hardly worth the effort. Comparative studies of countries, regions and certain sectors and policies can be a very effective tool for accumulating knowledge. The "lessons" they yield can be valuable for other countries seeking answers to the question of what to do and why to do it. In this sense, the exercise resembles the accumulation of scientific and technological know-how. Nonetheless, when the question is not what to do, but rather how to do it, the "lessons" learned do not transfer readily. "Lessons" on concrete experiences of how things have been done in one particular country do not necessarily apply to other latitudes, and serious mistakes can easily be made. The decision on how to do things depends to a great extent on institutional organization, historical factors, traditions and cultural elements, none of which can be transplanted. While it may be true that knowledge is universally valid, the concrete application of this knowledge depends on the environment, which is highly varied and constantly changing. Barely two years ago, Lizano (1993) undertook a comparison of three studies published on economic policy in Latin America: the contributions of John Williamson, known as the Washington consensus, the new ECLAC position, and the thesis of Enrique Iglesias, President of the IDB. In part, the aim was also to identify other areas that could be added, to widen the consensus.

18

Now the goal pursued is altogether different. It is not working out what the consensus is at present, based on accumulated experiences and "lessons" learned with economic development and economic policies in many Latin American and non-Latin American countries. Instead, the task is to seek to articulate what the consensus should be. based on these same "lessons." Some topics will be commonly accepted points of view, while on others, there will be disagreement.

2. E c o n o m i c p o l i c y i s s u e s that call f o r c o n s e n s u s The purpose of this section is to examine a range of economic policy issues. Some are widely accepted, others are controversial, and still others will be left out of this discussion altogether. The idea is not necessarily to reach consensus, but to provoke dialogue. The emphasis will be more on asking what conditions are necessary than on thinking about what conditions are sufficient. In any case, there is serious doubt as to whether sufficient conditions can be determined at all. The thoughts expressed here are based on experience and on accumulated knowledge of the prevailing situation in the countries of Latin America in general. Because each individual country is so different from all the others, discussion cannot center on specific points, and will instead remain general. The presentation, then, should steer a narrow course between two streams: overly general arguments and overly detailed discussions.

2.1.

Macroeconomic instability

One of the most frequently recognized features of the economies of Latin America has been macroeconomic imbalance. Even so, the countries have made major progress in recent years to achieve and consolidate greater macroeconomic stability. Clearly, two observations are in order: i)

Even though much progress has been made, many countries of the region have not yet embraced macroeconomic stability as a permanent feature of their economic policy. What stability has been achieved is very precarious and will not easily withstand the brunt of normal political and electoral cycles. The job cannot long be delayed, given the serious damage that instability and macroeconomic imbalance can inflict on consumers, savers and investors.

19

ii) A number of countries, both small (Bolivia, Nicaragua) and large (Brazil, Argentina) have learned to fight runaway inflation. However, few have learned to bring moderate inflation (15 to 20 percent per year) down permanently to single-digit levels. In most countries of the continent, inflation rates continue to be five to seven times higher than prevailing rates in the main countries of the international economy. Is this inertial inflation? Structural inflation? Is it perhaps the result of deficient monetary or exchange-rate policy? The answers are not yet in. A number of important points have already become clear following a lengthy learning process that has exacted a very high social and economical price. Three need to be stated here: i)

The need for a cautious monetary policy.

The single-minded enthusiasm for

financing economic development with bank credit has accomplished nothing. If development could be financed with Central Bank printing money, underdeveloped countries would already be a thing of the past. As time goes by, it becomes increasingly clear that monetary policy should be guided with indirect instruments (open market policies) rather than direct instruments (quantitative controls). ii) The need for fiscal discipline. Excessive fiscal deficits simply lead to inflation when they are financed by the Central Bank or by turning to the capital markets for resources, thus squeezing the private sector. iii) The need to avoid price controls as a means of fighting inflation. Price controls produce poor results. After a time, usually brief, adjustments become inevitable. Truly curing inflation requires going to the root of the problem:

an imbalance

between effective demand and overall supply. This is why Latin America has learned the hard way that monetary expansion, excessive fiscal deficit and price controls are the fast lane to macroeconomic instability and stagnation. Another controversial approach is the "anchor" system, which many believe should be eliminated altogether. Goods and factor prices should be flexible to reflect relative scarcity. The same is true for exchange-rate policy. So-called macroprices such as exchange rates, interest rates and wages definitely should be stable; but their stability must ultimately be an outgrowth of national and international macroeconomic

20

conditions. Attempts to hold them fixed will achieve very little, and indeed may wreak much damage. In an economy where major imbalances persist, any program to keep macroprices fixed or "anchored" is a clear invitation to disaster, in terms of both stability and growth. Even though "anchors" are inadvisable,1) macroprices exert a very powerful influence over the condition and overall evolution of the economy, and should not be allowed to drift freely. Although "anchors" and indexing are to be refused, the countries must avoid any free-float policy for these prices. Certain goals need to be set, and certain interventions are inescapable: i)

Local interest rates should move toward convergence with rates prevailing on international financial markets, once local currency devaluation has been accounted for. This means meeting at least two basic conditions: the government must avoid squeezing the private sector to finance its deficit, and the capital account needs to be kept open, to facilitate the inflow and outflow of capital. As a result, interest-rate fluctuations will closely shadow the changes on international financial markets. If the two remain in tandem, macroeconomic imbalances will be minimized. Any attempt to control interest rates merely encourages the growth of informal financial markets, where interest rates tend to be much higher than on formal markets.

Because these informal markets operate free of any banking

supervision, the overall financial system becomes more shaky. ii)

Real wages should fluctuate in accordance with productivity gains. Programs to fix minimum wages above market levels succeed only in redistributing income from those who become unemployed toward those workers who do benefit from the wage increase. Two serious problems persist in Latin America in this connection: first, many countries collect very high payroll taxes, which artificially raise labor costs while dampening the demand for labor, without exerting any beneficial effect on real wages. Second, in nearly all the countries of the region, the wages of public employees are not subject to market mechanisms because of job security and tenure rights.

iii) Consensus on the exchange rate policy has proven more elusive, and various highly disparate opinions continue to coexist.

Several alternatives can be dis-

carded out of hand. The first is the "anchor" approach, or the fixed exchange rate. 11

For a different point of view see Bruno (1995,13).

21

This method will not work because productivity gains over several years are unlikely to offset the difference between domestic inflation and international inflation. Exchange-rate appreciation inhibits exports, thus hindering the national exports to the international economy. A second option, the free float, is also unthinkable. The exchange rate is such an important price factor that no country can afford to cut it entirely adrift and let it float freely. Even the developed countries have all felt the need for some type of intervention to influence the exchange rate. In the third place, crawling-peg devaluations cannot function as a permanent solution.

In

some cases, they have proven effective for relatively short periods. However, if they were implemented as a long-term policy, economic agents would soon anticipate this devaluation and factor it into their expectations of inflation and their financial estimates. This would cement inertial inflation, which is very difficult to counteract. A fourth approach, the "moving" band, would appear to be the best option. This exchange-rate policy presupposes a certain degree of intervention by monetary authorities within a previously-established band whose width and direction may vary in accordance with shifting economic conditions. A fifth possibility would be to adopt the Panamanian monetary system, eliminating local currency and replacing it with a foreign currency, in this case the US dollar. Such a move is under consideration in several small economies of Central America and the Caribbean. Over the medium term, it may be the most realistic option for some of them. All these macroeconomic imbalances are closely interwoven, a fact which has become more evident in recent years in many countries of Latin America, as a result of greater flows of foreign capital.

The imbalances which are most closely inter-

connected are the capital account, the fiscal deficit, the interest rates, the income of hot money, and the exchange rate. The problem, in essence, is a product of high fiscal deficits. Because these deficits need to be financed, they push up interest rates on national financial markets. This, in turn, creates a magnet for speculative foreign capital.1> Such capital movements create merely a mirage: the illusion that the exchange rate is in equilibrium. In fact, exchange rates are set by supply and demand. Speculative capital movements increase the supply of hard currency, and the 11

Hot money is attracted by the differential between local real interest rates (that is, discounting inflation) and prevailing interest rates abroad. By contrast, capital movements to finance economic development (increased production and exports) are led by expectations of profitability (when investment opportunities in a country carry an expectation of high profit). Speculative capital flows are to be avoided and discouraged in favor of capital income for development purposes.

22

resulting exchange rate is in fact lower than it would have been without the fiscal deficit.

This lower exchange rate jeopardizes export activities and encourages

imports. The exchange rate is not truly in balance if it is achieved by the income of speculative capital attracted by high interest rates resulting from a heavy fiscal deficit. This situation will not change as long as there is a high fiscal deficit. Thus, exchange rates will come into balance only when the fiscal deficit, or macroeconomic imbalance, disappears. Local interest rates will decline, speculative capital income will vanish, and the supply of foreign exchange will contract; the exchange rate will indeed be balanced. This clearly reveals, once again, that macroprices can never come into equilibrium if certain sectors of the economy continue to be out of adjustment. The various macroeconomic imbalances are inextricably locked together.

2.2.

Market size and economic opening

Over two hundred years ago, in the well known third chapter of his first book of "Wealth of Nations", Adam Smith showed that market size, labor productivity, accumulation of capital and economic growth rates are all closely linked. After three decades of protectionist economic policies, the countries of Latin America have taken a sharp turn. They reached the conclusion, undoubtedly correct, that their domestic markets offered scant opportunities for growth over the medium term. Because these economies are so small, their narrow markets actually weigh down development like a millstone. The countries of Latin America have therefore decided to open their economies and find better ways to fit into the international economy. They have slashed tariffs and swept away non-tariff barriers such as import and export quotas, multiple exchange rate systems, and the like.

Moreover, they have

launched this process unilaterally, not demanding access to other markets in exchange. The results have been encouraging. In many countries of the region, opening has brought export growth and diversification without causing dislocations of either production or employment levels. However, in some countries, such as Mexico, opening

23

has taken place alongside burgeoning domestic consumption, and the current account of the balance of payments has slipped into the red. This phenomenon can be attributed to mistakes in the opening process. When an economy is opened, tariff reductions need to be implemented simultaneously with exchange-rate adjustments. This prevents the local-currency price of imported goods from plummeting, preventing a drastic rise in demand for them. The idea is to ward off a consumption boom. In this first stage, the advantage of opening is not so much to reduce the price of imports, as to modify relations of profitability and thus encourage export activities over production for the domestic market. Factors of production are therefore reallocated toward the export sector. This first stage should trigger, not a boom in consumption, but rather an increase of investment to expand exports. As this stage is consolidated, domestic demand is no longer fully met by local production, and imports need to increase. The country begins to produce new goods (more exports), meanwhile leaving off production of other goods (expanding the need for imports). Foreign trade becomes a higher share of the gross domestic product. The opening of the economy gathers strength and a second stage takes place. Because imports are flowing freely, new opportunities become available to diversify and expand the sources of supply for consumer goods and for raw materials and capital goods for production.

This import growth does not necessarily generate problems because

exports (including tourism) are also expanding, bringing in the needed foreign currency. This is why exchange-rate policies play such a critical role as part and parcel of overall trade policy. They are an essential prerequisite, along with the dismantling of foreign trade barriers. Adam Smith notwithstanding, is it truly worth the trouble and the risks the countries of Latin America must incur to push their way deeper into the international economy? In a recent article, Krugman (1995) seriously questions whether it is. His data show that the quantitative benefits of opening are rather negligible. Nonetheless, this author appears to overlook the truism that in economics, non-quantifiable factors often carry more weight than the ones that can be measured. The fact is that the impact of international trade goes beyond merely forcing domestic producers to allocate factors of production better and opening new sources of supply to consumers. One of the greatest advantages of international trade is that it creates a culture of competition

24

and efficiency that embraces not only export activities, but all sectors of the economy as well. Indeed, opening cannot take place unless the whole economy is liberalized. This is why the countries of Latin America must boldly persist in the process of opening their economies and of penetrating the international economy more deeply. This raises a major concern. The opening process has already advanced significantly, as a matter of fact in many Latin American countries external tariffs average 10 to 20 percent. The next step is to reduce still further customs duties. Should this type of measure be taken unilaterally? Or instead, should access to external markets be a condition for reducing these duties? It is important to recognize that, in general, the countries of Latin America have very little leverage for negotiating greater access to the markets of developed countries. The solution may lie in regional integration programs within the standards of the World Trade Organization. At least to some degree, these programs provide a means of obtaining certain reciprocal access to the markets of other member countries. Indeed, if the United States can be induced to participate, either by expanding NAFTA or by creating the Free Trade Area of the Americas, then for all practical purposes, the small and medium-sized countries of Latin America will reap the benefits of access to the international market, given the size of the United States economy. This is why Latin American countries have begun to attach so much importance to the different regional integration blocks that are being formed or have already begun to operate in the continent, and are seeking ways to have the United States join with them.

2.3.

Greater supply of exports

Macroeconomic stability and market size are necessary conditions for bringing about rapid economic growth. However, they alone are not enough. A systematic effort is also needed on the supply side to increase the exportable surplus. This is the only way to meet the challenges of entering the international economy and to take hold of the new opportunities it extends. Two processes need to be set in motion simultaneously. In the first place, structural adjustment should be fostered. For several decades, a model based on trade unionism, populism and (state) paternalism (the UPP model) held sway in the great majority of Latin American countries, based on the creation and distribution of economic rents.

25

The role of structural adjustment is to eliminate or at least substantially reduce the many distortions that accumulated during this period. The price system can then work better, getting prices right both for goods and services and for factors of production. As they are allocated better, factors will become more productive.

In other

words, such a process will expand production without requiring more factors of production. The economy will operate nearer to the transformation curve. In the second place, another prerequisite is to eliminate the bottlenecks so common in underdeveloped countries, so that more and better factors of production can be available. The transformation curve will thus shift to the right. However, even if this were to be accomplished, if factors of production were allocated better, eliminating distortions, and if bottlenecks were removed so the endowment of factors of production could increase, it still would not be enough. Experience in Latin America has shown that the countries need to go one step further if they hope to trigger a substantial expansion of production, particularly for export.

Special pro-

grams need to be implemented to encourage private investment. Of course, these will vary from one country to another, depending on local conditions. These special programs should embrace many different activities, for example tourism, drawback manufacturing (maquila) and free zones. Most attract local and foreign investment by holding out concessionary incentives such as exemption from customs duties on imports, exemption from income tax for a given period, and even direct export subsidies. Experience shows how difficult it is to convince producers, both national and foreign, to displace their resources and channel them into export activities. Anticipated profits need to be substantial, and the credibility of economic policy very appreciable, in order for this to happen. The effect of these special production promotion programs is, quite simply, to create new rents and new distortions. Such programs run the serious risk of encouraging new pressure groups to take shape to pick winners, to use discretion rather than rules. That is dangerous even if done through congress. That is the main reason why the "liberalization model" is far better than the "export promotion model".

Even

so, export promotion as a form of state intervention is not so dangerous as previous forms for two reasons. First, the incentives are oriented toward promoting exports, and not supplying the local market. Thus, from the very beginning, producers need to learn to compete on international markets if they are to benefit. Second, from the

26

outset, it is understood that the incentives are given for a fixed term only, which is defined in advance. Lessons learned from the UPP model show the importance of phasing out these incentives automatically over the course of time. Also, and this is important, the new model of economic liberalization has yet to define other measures to expand exportable production over a relatively short term.

2.4.

The role of markets and prices

Without a doubt, one of the key features of current economic policy thinking in Latin American countries is that the markets and the price system play a critical role in the decisions of economic agents, i.e. in economic development. Effective markets and a functioning price system are now seen as the key for making wise decisions on how much to save, how much to consume, where to invest, what to produce and what to import. In essence, they provide essential information on relative scarcities and consumer preferences. Latin America has now shunned economic planning systems a la Allende in Chile, Castro in Cuba and the Ortegas in Nicaragua. Nor do unorthodox schemes such as Alan Garcia's program in Peru offer a realistic alternative. We also see Latin America moving away from the "inward-looking" development model practiced in the decades immediately following World War II. Industrialization, built on import substitution and heavy state intervention, spelled serious problems for the countries of Latin America. Corruption engendered by interventionism, coupled with stagnation brought on by protectionism, proved to be a disastrous combination, and income distribution became so skewed that Latin America began to post worse figures than any other continent. So the Latin American countries failed to find encouraging prospects for development from this "inward-looking" model based on trade unionism (pressure groups born under the wing of rents created and distributed by a protectionist state), populism and state paternalism. It is generally believed that an effectively functioning market for goods and factors is preferable to economic planning systems or the UPP model. However, three observations are in order. First, the decision to depend on market operations does not in any way mean that markets are perfect. Even if, in general terms, the market approach is adopted as the best option, the concept of the market and the price

27

system must never be elevated to the category of ideology. The market is a human creation and will always have imperfections. In light of available alternatives, however, it is still the best choice. Second, systematic government intervention is needed if the markets are to operate normally. Without Intervention, the markets cannot operate as they should. However, intervention must always be designed to improve markets, not to replace them or interfere with them. Third, "abnormal" situations call for direct intervention to provide protection for certain social groups or specific activities. That means interfering with the free operation of the market, but in such cases, intervention must always be transparent and temporary. Thus we see that the automatic forces of the market do not, in and of themselves, guarantee macroeconomic balance or remove microeconomic obstacles to achieving high economic growth rates. Nor do they guarantee equity. Two important facts must be borne in mind: i)

As Stlglitz recently stated, since the time of Adam Smith, market economies have brought unprecedented improvements in the standard of living. We must not, however, overlook the limitations of the market economy (public goods, externalities, economies of scale, monopolies, incomplete markets, increasing returns, income distribution). The market is not an economic cure-all. In fact, it would be counterproductive to overstate its benefits.1> The market alone cannot do everything, and very often its operation falls short of the Pareto-optimal. While efficient markets are necessary, so too is an efficient public sector. Great emphasis has been placed on the role of markets and prices in guiding the decisions of economic agents.

ii) Making the markets work as they should is a difficult and complex task. In fact, efficient markets do not just happen by spontaneous generation. As Robbins has asserted so vehemently, strong, systematic government intervention is needed to 11

The two hundred years since Adam Smith wrote his masterpiece have witnessed an unprecedented increase in living standards within capitalist economies. The fruits of this growth have, moreover, been widely distributed. I suspect that Smith would have been astonished at how effectively the invisible hand had worked, how well it had served to increase the wealth of nations." "But In the face of such achievement, he would, I think, have looked on in astonishment at those exaggerated claims - meant to be interpretations of his invisible hand conjecture- that the market economy was Nirvana on earth, that resources were always and instantaneously allocated in a (Pareto) efficient manner. Such exaggerated claims do a disservice, even to those who would like to see government play a very limited role In economic activity." Stiglltz (1991, 39-40).

28

prevent antisocial behavior and to establish an elaborate code of rules on property rights and the validity of contracts. Only in such a framework can markets do their job. 1)

Systematic intervention by the state can facilitate market formation and

ensure that markets function properly. While market failures cannot be denied, neither can government failures. Nor should one succumb to the temptation of blindly accepting state intervention as a means to achieve the Pareto optimum.21

2.5.

The role of the state

From the very first sentence of the fifth book of his Principles (On the Influence of Government), Mill states that government intervention is one of the most highlycharged issues of discourse.3) Today, nearly one hundred fifty years later, his words still ring true. The Latin American experience has been deeply traumatic, and many countries still have not left this very painful experience behind. The UPP model promoted the edification of a government structure that was usually overblown and nearly always inefficient. Numerous, highly varied pressure groups were born under the sheltering wing of the "inward-looking" development model:

industry groups, labor groups, pro-

fessional groups, bureaucratic groups, political groups.

For all practical purposes,

they succeeded in taking the government by storm and transforming it into an instrument to promote and defend their own interests.

11

"On the contrary, it assumed a strong state and a body of law restraining antisocial behavior and prescribing an elaborate code of rules relating to property and contract. And in the British version, as opposed to that presented by the Physiocrats, this code was conceived, not as some simple and rigid deduction from imaginary principles of natural law and natural rights, but rather as an historically evolving organism subject to continued revision and improvement in the light of considerations of utility ... Within this framework, Smith argued, the force of self-interest combined with the existence of markets could be trusted without central guidance to secure a division of labor involving a use of resources tending continually, where not obstructed, to produce the goods and services which were the subject of the most urgent effective demand and at the same time to provoke a continual search for means of improvement." Lord Robbins (1968, 100). A more elaborate discussion by Robbins can be found in Lord Robbins (1953, 11-19).

21

"Informational problems, including incentive problems, are no less important in the public sector than in the private ... the consequence of these remarks is to make us cautious in recommending particular government actions as remedies for certain observed deficiencies in the market." Stiglitz (1986, 257-265). A systematic analysis of government failures can be found in Krueger (1990).

31

"One of the most disputed questions both in political science and in practical statesmanship at this particular period relates to the proper limits of the functions and agency of government." Mill (1848, 785).

29

Instead of striving to safeguard the general welfare of the community, the government focused on creating and distributing rents to favor pressure groups. It had to adopt many different measures to prop up these pressure groups, and this was reflected in a vast proliferation of laws and decrees, rules and regulations, controls and prohibitions, subsidies (both explicit and dissimulated), exemptions and exonerations that can be found in exuberant abundance wherever the eye turns in the countries of Latin America.

Excessive interventionism curtails the initiatives of economic agents and

poses a serious obstacle to development in these countries.

Instead of playing a

positive role in the process of economic growth and social progress, the government gradually turned into a formidable barrier. This unfortunate trend in Latin American countries should not, however, blind us to the critical need for the government to intervene in economic affairs, and to the resulting requirement for government to be efficient. State reform and modernization have acquired paramount importance in the great majority of the countries of Latin America. Although the reasons to encourage state intervention are widely accepted, it is worthwhile to recall the following: i)

The market and the price system can operate effectively only if the state is able to enforce property rights, the validity of contracts, and the safety of persons and goods. This does not happen by spontaneous generation, but requires continual intervention by public entities.

ii) The effort to rein in monopolistic tendencies and privileges for pressure groups is also a never-ending task, and new threats arise constantly. iii) The market, a human creation, is imperfect. As was stated, it very often fails to meet its intended purposes. State intervention is often essential in cases of market failure. iv) Maintaining macroeconomic balances (monetary, fiscal and exchange-rate policies, as well as the tax system) is the number-one responsibility of the state. v) Other appropriate tasks for government agencies are to consolidate the national market, open up the economy, and obtain access to external markets. vi) Investing in human resources (education and health) is a major responsibility of the government, although not its exclusive domain.

30

vii) Infrastructure projects are another legitimate government concern. Projects can be funded through public investment, or by concession to private investors. Clearly, public-sector tasks are numerous, important and complex. They cannot be performed unless the state is efficient.1)

An inefficient state will jeopardize the com-

petitiveness of private companies and undermine the welfare of consumers.

No

matter how diligently private companies strive to modernize their factories and farms, they will never become competitive unless, year by year, the government also raises the productivity of its own activities. The cart of progress has a double yoke. The private sector and the public sector must pull together if the cart is to move forward. Neither can pull it alone. The UPP model operated well without an efficient state. It was built on an alliance between business groups and bureaucratic-political groups.

Business really never

objected to government or political requests, or demanded efficiency from the state. In any case, if the bloated, inefficient government became expensive to maintain, industry simply raised its prices, passing the additional costs along to local consumers. Tariff protectionism made this all possible. Today, with the countries of Latin America opening up to the international economy, this alliance is doomed to disappear. Under the new model, businesses can no longer transfer the costs of an inefficient government to local consumers. Instead, they need to compete with producers from other countries.

Industry groups are now

pressuring for fast, deep-running reform of the state, otherwise they will not be able to compete. It has become a matter of life or death. This is the greatest challenge facing economic policy in Latin America. How is the state to modernize? To some degree, methods have been found to make the private sector more efficient, through a combination of sticks (reducing tariff barriers) and carrots (special export-promotion programs).

However, despite the widely recog-

nized need to reconstruct the government so that the economy can grow robustly on the foundation of a efficient public sector,2) no means has yet been found to modernize for sure the state. This is without doubt the weightiest legacy of the UPP model.

11

Efficient does not necessarily mean small. While most of the countries do have oversized government sectors and excessive facilities, for certain activities such as education or financial supervision, the government in fact should be expanded.

21

Burki and Edwards (1995, 2, 6-7,17-18).

31

2.6.

Profits and wages

With each passing day, the close relationships among profits, real wages and domestic savings become more critical. Whether or not profits can rise over the medium term depends on two factors: the incorporation of innovations, or new technologies, and the size of the market. When the prospects for greater profit are good, new investment opportunities arise. If these investment projects perform well, labor will be in greater demand. Employment levels inch upward, and real wage levels begin to climb. Ultimately, then, real wages are not a function of nominal wages, but of profit trends. At the same time, however, profits are very much a function of real wages. In fact, wages are a key ingredient for creating a climate of social stability, which in turn encourages entrepreneurs to invest more. This is why union leaders, instead of dickering over readjustments in nominal wages, should demand a higher investment rate, both private and public. Business leaders, instead of fussing over nominal profits, should pay more attention to real wage trends for workers. This leads us to the age-old dilemma of the relationship between growth and distribution. It is time to consign to the history books the thesis that growth should come first, followed by distribution, along with its counterpart, which claims that distribution must come first, in order to bring about growth (Adelman 1975).1) Growth and distribution are equally important parts of a single process. Growth determines distribution, and distribution brings new growth. Because the two are reciprocal and interdependent, any sound economic policy needs to include simultaneous measures for triggering growth and promoting better distribution.

2.7.

The trickle-down theory

This, in turn, raises the hot-button issue of "trickle-down" thesis. Recently it has been said, again and again, that "trickle down" is not the answer. This view needs to be corrected. "Trickle down" really does work. In fact, it works well. Because economic n

The East Asian experience is sufficient to reject conventional wisdom of a necessary link between high income inequality and rapid growth." Birasall et al. (1994, 30).

32

growth raises the demand for labor, employment levels and real wages both rise. Some of the benefits of a higher GDP are in fact transferred to relatively low-income strata of the population.1) Economic growth also tends to improve government revenues broadening the base for tax collection. This, in turn, facilitates an expansion of public services, to the benefit of low-income groups.

Economic growth rates are

vitally important to improve living conditions for the general population.

As a matter

of fact, economic growth has in itself a social dimension. Nevertheless "trickle down" alone is not enough. Some social groups will oftentimes be left on the sidelines of economic growth, missing out on its benefits. This is the result of two basic problems. The first is a structural problem, the legacy of the UPP in Latin America, which produced negligible economic growth and extreme social exploitation, leaving poverty and inequality in its wake. It is a problem that cannot be attributed to the new economic model. The other is a more short-term, circumstantial problem, involving the costs of adjustment as the economy moves away from the UPP model and toward economic liberalization.

Structural problems have always been

cause for alarm, at least since A. Smith made his famous statement that "...no society can surely be flourishing and happy of which the far greater part of the members are poor and miserable."2' The circumstantial problem also needs to be solved, however, lest it impede the progress of economic liberalization. At present, several points appear to be beyond dispute: i)

Economic growth rates need to be bolstered as a top-priority long-term policy.

ii) The "trickle down" process needs to be improved through the adoption of specific measures; for example, labor markets can be streamlined to permit worker mobility.

" This was understood by Marshall as long ago as 1887, when he said, "In the ordinary course of things the first benefit of an improvement in the demand for their wares goes to the employers; but they are likely to want to increase their output while prices are high and make high profits while they can. So they soon begin to bid against one another for extra labor; and this tends to raise wages and hand over some of the benefit to the employed. This transfer may be retarded, though seldom entirely stopped, by a combination among employers, or it may be hastened on by the combined action of the employed." Marshall (1887, 216-217). A similar statement was made more recently in The Economist: "...in the long run, higher profits should be good news for workers as well as shareholders because they will increase investment, and hence output and jobs. Even if workers are left with a smaller share of the cake, that cake should be growing faster. Historically, when the share of profits as a percentage of GDP has been high, as it was in the 1960s, workers have enjoyed big gains in living standards." (1995,68). 21

Smith (1766, 96).

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iii) Public services need to be more productive, especially in the field of health and education. It is unfortunate that in many countries, it would be simply a waste of money to allocate more resources to such services at this time, when inefficiency and corruption rule. iv) There is a crucial need for programs to teach certain groups to fish (such as opportunities for training or distribution of assets), so these people can be incorporated into the labor market and the production process. v) At the same time, specific programs should be implemented to hand out fish (food distribution, rent subsidies for housing) on a temporary basis while affected groups are learning to fish for themselves. Some of these measures are permanent, specifically those in points (i) through (iv). Point (v), by contrast, is temporary.

The intensity and duration of each program

would depend on the magnitude of the structural problem each country has inherited, and on the social costs of transition from the UPP model to economic liberalization. This point merits further elaboration. Perhaps the greatest failure of economic policies designed to implement structural adjustment and launch the new model was that the staggering social costs of the transition were not fully understood.

This flaw was

quickly corrected, and for some years now, structural adjustment and economic liberalization programs have given due consideration to social costs. Resources and measures are generally set aside, not to prevent the social impact, because it is inevitable, but to soften the blow and offset the effects, which is certainly possible and necessary. One question remains unanswered: Why was this problem not anticipated?

The

reply is twofold. First, the economies of Latin America were much more distorted than anyone had realized, as a consequence of the UPP model. In fact, the tentacles of UPP economic policy had reached deeply into every sector of the economy. Second, the pressure groups created under the sheltering wing of the UPP wielded much more power (political, social and economic) than suspected, and had put down very deep roots. The government itself, placed to a very large extent at the service of special interests, had become hopelessly inefficient and corrupt. Policy makers sincerely believed that the transition from one model to the other would be a matter of three to

34

five years. This meant that the social costs of the process would quickly not be very high, and in any case, the benefits would more than offset any costs. The truth turned out to be very different. Resistance to change and to the new model has been fierce. Pressure groups cling to their rents and privileges as tenaciously as calves to the udder. The implementation of the economic liberalization model has turned out to be a far more difficult task than was originally believed. The process has advanced much more slowly. Today, no one is surprised to hear that the transition might last over a decade. Once this socio-political fact was accepted, it became easier to understand that the social costs of transition would be much higher than had been thought initially. This is why structural adjustment programs, and economic policy in general, can never overlook the need for measures to offset the high social costs.

2.8.

Profits and domestic savings

It is often said that the domestic savings rate, as a share of GDP, is very low in Latin America by comparison with other countries, especially in East Asia. This fact, it is claimed, stands as a barrier to development in the countries of Latin America, and therefore, one of the objectives of economic policy should be to devise measures that will substantially increase the domestic savings coefficient.1) When the thesis is stated in these terms, it could easily lead to error. The emphasis is misplaced, and the causal relationship is misstated. Several observations need to be made: i)

The methods being used at present to calculate the national accounts classify a very high proportion of the expenditures on health and education as consumption, not as savings or investment in human resources. Therefore, depending on a country's demographic structure and degree of development, it often appears that the best solution is to increase these kind of expenditures thus increasing

11

Burki and Edwards (1995,1) feel that one of the problems in Latin America is "...raising domestic savings rates". Edwards (1995, 2) asks why savings coefficients have traditionally been so low in Latin America, and Edwards (1993, 111) states that "...savings are at the heart of development: increased savings allow faster capital accumulation and higher economic growth." Obviously, this is not a new position. Already in 1955, Lewis (1955, 225-226) had stated, 'The central problem in the theory of economic growth is to understand the process by which a community is converted from being a five percent to a 12 percent saver..."

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consumption and reducing savings.

With such a method, it is impossible to

gauge the often ongoing effort to develop human capital. As a matter of fact, oftentimes for poor countries it is wiser to spend more in education and health, i.e. to increase consumption, from the point of view of national accounts, than to invest in fixed capital. Namely, in these countries the wisest decision is to invest in men, rather than in machines. ii) Figures on national savings do not account for capital flight.1) Because more than a few countries of Latin America had decades-old capital controls in place, Latin Americans resorted to numerous schemes to export capital routinely, as a daily practice. Best known are under-invoicing exports and over-stating imports. Most countries also had notorious currency black markets. If calculations could include this phenomenon, the domestic savings rate would be higher than statistics now suggest (also exports would be larger and imports would be lower). Thus, efforts to increase the domestic savings coefficient could be nullified, depending on where investments are made - whether in the country or abroad. iii) While it is important to know where domestic savings go, it is equally crucial to know how they are used. In many countries of Latin America, the capital/output ratio leaves much to be desired.

Capital productivity is low.

Over the past

decade, for example, Costa Rica has had higher investment coefficients than Chile; but Chile has consistently reported higher rates of growth than Costa Rica. With its high productivity of capital, Chile has succeeded in growing faster in spite of a lower investment coefficient. This leads to a critical insight. It is a mistake to see economic growth as a function of the savings coefficient. The causal relationship that really matters is to understand that the savings coefficient is a function of investment opportunities. In other words, the cause and effect flow, not from savings to growth, but rather from investment and profit opportunities to savings. When innovation (Schumpeter), a widening market (Adam Smith) and a satisfactory socio-political environment create the potential to increase profits, new opportunities for investment will come forth. When this happens, domestic and foreign savings provide the needed investment funds. Good opportunities for investment, and for making profits, will not be lost simply for lack of financing.

1

> Edwards (1995,1).

36

Thus, savings are not a cause, but rather an effect and a result. Attention should always be focused on creating new opportunities to increase profits and, therefore, for investment. Economic policy should take this perspective into consideration. The rest (more domestic savings, to be invested in the country of origin) will follow without much difficulty. A misunderstanding should be avoided. The real issue is not about the relevance of savings. They are important indeed to finance development. The question rather is about how to increase savings. What is essential to keep in mind is that savings depend basically on investment opportunities and not the other way around. And that investment opportunities, on the other hand, depend on the size of the market, on new technologies, and on changes in demand.

2.9.

Human resources development

If there is any one point on which economists agree unanimously, it is the critical role of education in economic development. How often it is said that in the end, a country is its people. This is not a new idea, but a long-standing belief that dates back at least to the time of the classical economists, as Blaug (1975) so eloquently shows. Civic values in general cannot flourish in a setting of widespread ignorance. There can be no economic development when great masses of the population lack primary and secondary schooling. Thus, from the strictly economic standpoint, education explains to a large extent the development phenomenon. As a matter of fact, land and capital productivity depends on the capacity of the labor force. Also possibilities for incorporating new technology require a knowledgeable work force. Studies have shown that it is often more important to spend on human resources development than on fixed capital investment. Other studies have found that innovations from developed countries can be absorbed most effectively by developing countries where secondary education is widespread (Cae, Helpman, Hoffmeister 1995). In some Asian countries, high economic growth rates can be attributed more to expenditures on education than to expenditures on science and technology (Young, 1995). Despite all this evidence, major obstacles continue to stand:

37

i)

It is politically very difficult to increase public expenditures on education to the level of six or seven percent of GDP.

ii) The structure of expenditures on education tends to be out of balance. A disproportionate amount is spent on university education, despite the fact that primary and secondary schooling have a much greater impact on development.

The

faculty and students of universities seem to have much more political clout than parents and teachers in primary and secondary schools. iii) Another problem is brain drain from poor countries to wealthy countries. This can be considered a form of capital export, as the emigrant has benefited from considerable investment before leaving the country. This export of human resources exacts a very high price in the form of food, education, and the like. The difficulty is that the training of human resources cannot be perfectly matched to the needs of the country. In the case of human resources, it is simply impossible to adapt supply to forecasts of future demand (Robbins, 1963). iv) Even though the importance of learning by doing is becoming more and more evident, entrepreneurs are still reluctant to consider the training of workers as a highly profitable investment. Thus, among the great challenges for economic policy in Latin America are to allocate a higher share of the GDP for education, to raise the profile of primary and secondary education, and finally, to improve on-the-job training programs.

2.10. Economic policy change: whereto begin? A few brief thoughts are in order, not about the substance of economic policy, but rather how to implement it. Two broad areas need to be examined. The first is the pace of economic policy change, whether through a shock approach or implementing a relatively slow-paced program. The second is the sequence in which to introduce the different measures of economic liberalization. A number of considerations are relevant. i)

It is helpful to distinguish between stabilization and structural adjustment programs. Stabilization programs are designed to correct a macroeconomic

38

imbalance between overall supply and effective demand, as reflected above all in a high inflation and an unstable exchange rate. Shock therapy is the best way to put a halt to such an imbalance. High doses of medicine need to be administered over a rather short period. A number of countries have elected this method to slam the brakes on runaway inflation, for instance Bolivia and Nicaragua. Structural adjustment programs on the other hand need much more time. They are designed, not to restrict effective demand, but to increase overall supply. New institutions may need to be created, others should be overhauled, investment should be encouraged, incentives need to be restructured, and so forth. Unless these time-consuming measures are faithfully taken, the process cannot move forward. A very important point is often overlooked: no stabilization program can prosper unless economic growth rates are restored.

In most cases, these programs

consist of curtailing effective demand. Wages fall, profits decline and government revenues slacken.

It cannot be done unless the major sectors of society

(workers, entrepreneurs and politicians) agree on the broad outlines of the stabilization program. Each of these social groups must be willing to make sacrifices, at least temporarily. This has its limits. If the economy does not rebound, if no light is glimpsed at the end of the tunnel, political support erodes and the stabilization program breaks down. This has happened repeatedly in Latin America, clearly demonstrating that stability without growth is not a viable proposition. Instead, stability needs to go hand in hand with growth. ii) What is the best sequence in which to introduce economic policy measures? There is no single way, although certain relationships are self-evident.

For

example, the capital account cannot be opened unless the commercial account is opened first and public finances are set in order. Given that point, the only danger is to avoid falling into the trap of excessive rationalism. Experience has shown that the best sequence cannot be preestablished. It is determined rather by the constantly shifting political, social and economic circumstances.

New opportuni-

ties also play a role of utmost importance. Although we could always do more than we thought possible, we can never do as much as we would have liked. The proper sequence of economic policy depends much more on the ability to create and to grasp opportunities, than on written formulas.

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3. Final c o m m e n t s Latin America is undergoing a transition from the UPP model to the implementation of economic liberalization.

In today's world, it often seems that while the old has not

quite finished dying, the new is still trying to be born. The new model has been only half-backed. Different models are overlapping in the countries of Latin America, and elements of both models often coexist, producing many of the contradictions, inconsistencies and deficiencies of economic policy. To a certain point, this is inevitable. It is a difficult, complex, time-consuming job to change one model for another very different one, regardless of whether the general orientation of economic policy is correct. The results may stem from the remnants of the old UPP model, or equally well, from application of the new model of economic liberalization. It is very difficult to analyze economic policy in Latin America today because no static comparisons can be made between situation A (the old model) and situation B (the new model). Instead, analysis must necessarily be dynamic, looking at the process of transition from A to B. 3.1. Several points about this transition are very clear: i)

The concept of economic development has widened beyond simple growth in the production of goods and services.

It now includes income distribution (equity),

macroeconomic stability and sustainability. But this is only part of the story. It is becoming increasingly clear that economic development is merely one facet of a very complex process of change, tightly interwoven with social progress and democratization. This means that economic, social and political change are all threads of a single fabric. None can progress in any significant way unless all are moving forward together. They are the legs of a tripod, which collapses if any one of them fails. All three are closely bonded together in a web of reciprocity, each one influencing and affected by the others. None of them can be neglected. Latin America has already acquired enough experience regarding the following points: -

Economic development does not require authoritarian governments or dictatorships.

40

- There is no need for concentrating income first, to be followed by a second stage for improving distribution. -

There is no need to jeopardize the natural resource endowment or the environment, that is, to achieve well-being for the present generation by sacrificing future generations.

ii)

Latin Americans have learned the hard way that no country is fated to achieve economic development and social progress. Growth is not inevitable.

Certain

communities in Latin America have struggled through endless decades of social wretchedness and economic stagnation. Only a determined, unstinting, no-holdsbarred effort can pull a country out of underdevelopment. This is why economic policy is an essential tool for understanding the patterns of development in Latin American economies. When economic policy is analyzed carefully, nearly most successes and failures can be explained. iii) Latin America has very few options. Past models (central planning, unorthodox approaches and the UPP) offer these countries no useful alternatives.

Nor are

any other realistic, non-utopian alternatives to the economic liberalization model taking shape on the horizon. Some other possibility may arise in the future, but at present, this is not happening. It would appear that there is no turning back for these countries. While allowing for the lessons learned in paragraphs (i) and (ii) above, they have chosen the path of economic liberalization, with varying degrees of success. The difficulties and costs of the transition process are undeniable, but there would appear to be no other choice. It is astonishing and even alarming to hear wistful talk about going back to the "good old days", as recently proposed by Krugman (1995). This is not really an acceptable alternative for Latin America. The old days were not particularly "good" anyway. The history books are filled with dictatorial regimes, social schism and poverty, inflation and anemic economic growth. Any talk of the "good old days" simply ignores reality in Latin America. Attempting to turn back would be a historical error of serious proportions. Latin America is far too poor to hesitate, or worse yet, to succumb to this siren song.

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iv) Latin America lacks the economic and political weight to exert any noticeably influence over the international economic policy scene. The simple fact is that Latin America is a price taker, not a price fixer, and its countries would be sadly mistaken if they attempted to think or act otherwise. Their economies are notoriously volatile, highly vulnerable to the impact of external shocks.

Economic

policy needs to be flexible above all, able to absorb external shocks and fully exploit the opportunities of the international economy. Thus, outside influences will continue to shape substantially the future for Latin American economies. Nevertheless, it is critically important to keep in mind that even more important in determining the patterns of economic growth in these countries is the domestic economic policy. These four facts paint a discouraging picture for Latin America. The countries are faced with circumstances that are indeed uncertain (as they undergo transition from UPP to economic liberalization), complex (as they pursue social change) and difficult (as they participate in the international economy as price takers). 3.2. In this setting, the major task of Latin American economic policy must be to overcome the legacy of the UPP. Two facts are particularly important: i)

The socio-political structure of the UPP needs to undergo profound change. Trade unionism, paternalism and populism have put down very deep roots in the countries of Latin America and stand as formidable obstacles to economic development, social progress and democratization. As we have already seen, interest groups born under the sheltering wing of the UPP cling tenaciously to their privileges and rents, interfering with efforts to eliminate distortions, make better use of factors of production and incorporate new innovations.

ii) State modernization cannot wait. As a legacy of the UPP, government structures are bloated, inefficient and manipulated by interest groups; but a clear precondition for the process of social change and transition to the new economic liberalization model is a modern, efficient state. Without it, the cart of progress will never budge. Clearly, then, the remaining problems are of a basically political nature. There is little doubt about what needs to be done; the difficulty lies in how to do it. The issue is not about consensus-building but much more about conflict management.

As Bruno

42

(1995, note 13) so clearly showed, countries generally fail to learn from the errors of other countries, reproducing their painful experiences instead of finding a better way. Every time a question is answered, it merely leads to new questions, and the process never ends. In fact, there may be no Ariadne's thread to show the way out of the maze of underdevelopment. It would appear instead that there is as such no track, the way is built by walking. Therefore missteps are unavoidable. Ultimately, common sense and discipline are not enough. Good luck is at least as necessary. In a world of so much ambiguity and uncertainty, good leadership is the only timely answer. There is no substitute for the skill of inspiring credibility and arousing confidence. As Lewis stated, "It is possible for a nation to take a new turn if it is fortunate enough to have the right leadership at the right time" (1955, 418).

43

References

Adelman, Irma. 1975. "Development Economics - A Reassessment of Goals." American Economic Review l_XV(2):302-309. Birdsall, Nancy, David Ross, and Richard Sabot. 1994. Inequality and Growth Reconsidered. (draft). Blaug, Mark. 1975. "The Economics of Education in English Classical Political Economy: A Re-Examination." In Andrew S. Skinner and Thomas Wilson Essays on Adam Smith. Glasgow: Clarendon Press:568-599. Bruno, Michael. 1995. "Development Issues in a Changing World: New Lessons, Old Debates, Open Questions." Proceedings of the World Bank Annual Conference on Development Economics 1994:9-19. Burki, Shahid Javed, and Sebastian Edwards. 1995. Latin America After México: Quickening the Pace. Washington: The World Bank. Coe, David T., Elhanan Helpman, and Alexander W. Hoffmaister. 1994. "North-South R&D Spillovers." IMF Working Paper No. 144. Edwards, Sebastian. 1995. "Why are Saving Rates so Different Across Countries? An International Comparative Analysis." NBER Working Paper No. 5097. . 1993. Latin America a Decade After the Debt Crisis. Washington: The World Bank. Krueger, Anne O. 1990. "Government Failures in Development." Journal of Economic Perspectives 4(3): 9-23. Krugman, Paul. 1995. 74(4):28-44.

"Dutch Tulips and Emerging Markets." Foreign Affairs

Lewis, W. Arthur. 1955. The Theory of Economic Growth. London: Allen and Unwin. Lizano, Eduardo. 1993. "Economic Policy in Latin America: Moving toward Consensus?" In Hermann Sautter, ed. Indebtedness, Economic Reforms, and Poverty. Frankfurt a.M.: Vervuert. 45-74. Marshall, Alfred. 1887. "A Fair Rate of Wages." Reprinted in A. C. Pigou Memorials of Alfred Marshall. London (1925): Macrnillan:214-226. Mill, John Stuart. 1848. Principles of Political Economy. Ashley Edition, Longmans, 1909. Nairn, Moisés. 1995. "Latin America the Morning After." Foreign Affairs 74(4): 45-61. Robbins, Lord . 1968. The Theory of Economic Development in the History of Economic Thought. London: Macmillan. . 1963. Higher Education, Report of the Committee on Higher Education. London: Her Majesty's Stationary Office.

44

. 1953. The Theory of Economic Policy in English Classical Political Economy. London: Macmillan. Smith, Adam. 1776. The Wealth of Nations. Glasgow Edition. Glasgow 1976: Oxford University Press. Stiglitz, Joseph E. 1991. "The invisible hand and modern welfare economics." NBER Working Paper No. 3641. . 1986. "The New Development Economics." World Development. 257-265.

14(2):

The Economist. 1995 (June 24). Young, Alwyn. 1995. "The Tyranny of Numbers: Confronting the Statistical Evidence of the East Asian Growth Experience." Quarterly Journal of Economics CX(3):641-680.

45

Wine and Bottles, Old or New? R e t h i n k i n g Economic Policy in Latin A m e r i c a O n c e M o r e C o m m e n t on E d u a r d o L i z a n o

Stefan Tangermann

It is a great privilege to have the opportunity of opening the discussion on this admirable paper by Eduardo Lizano. The paper is full of insights on policy developments in Latin America. It is sufficiently cautious in interpreting the results of policy reforms, and rich in suggestions for future strategic choices to be made. The paper is based on sound economic theory, and makes ample reference to the literature, including classical writings. I find very little to criticize in this paper. Hence I shall do no more than to suggest a few points on which Eduardo Lizano may want to elaborate. In particular, I shall address the four areas of fiscal discipline, stabilization of macroeconomic prices, market opening, and the role of the state.

Fiscal Discipline Lizano well makes the point that macroeconomic stabilization is the key to successful reforms, that the various macroeconomic imbalances are closely interwoven, and that fiscal discipline is a central factor in this context. However, how does one achieve fiscal discipline in practice, in a setting where tax rates are already high, and where economic reforms often need to be underpinned by more rather than less government activity? Lizano's paper suggests some areas where governments in Latin America may need to do more rather than less - including measures such as export promotion (through tax exemptions and, possibly, direct export subsidies), public investments in human resources (health and education), protection of the disadvantaged groups in society during the process of structural adjustment (e.g. food distribution, rent subsidies for housing), and public investments in infrastructure. Nearly all of these government activities require public expenditure.

46

In this situation, either other form of government spending needs to be reduced, or government revenues need to be raised, in order to keep the public deficit under control. Which types of expenditure should be cut, and where are options for raising revenues? In the same context, one may want to note that tariff reductions, as achieved in Latin America, have eroded that particular form of government revenue. As Dean, Desai and Riedel (1994) have suggested, tariff reductions in Latin America do not appear to have been restrained by "revenue dependence", contrary to some countries in Africa and Asia where this appears to have been the case. How have countries in Latin America managed to deal with this loss of government revenue, in a situation where some new policy measures require more rather than less government expenditure? And is there any tendency to fall back to higher tariffs again, for fiscal reasons?

S t a b i l i z a t i o n of M a c r o e c o n o m i c Prices One can fully agree with Lizano if he suggests that stability of macroeconomic prices such as exchange rates, interest rates and wages "must ultimately be an outgrowth of national and international macroeconomic conditions", and that therefore there is no quick fix for achieving such stability. On that basis, Lizano criticizes "anchors" and indexing, but also any free-float of these macroprices, and is skeptical about crawlingpeg devaluations. For exchange rates, a dirty-float policy, Lizano says, would appear to be the best option. It would be nice if he could elaborate on how best one should advise governments in Latin America as to which type of "dirt" and how much of it they should inject into macroprice developments. Moreover, how does one create the appropriate expectations of market participants if they know the government may change the type and amount of dirt they inject from time to time? In particular, how does one do that in a situation where, as Lizano says, "government structures are [still] bloated, inefficient and manipulated by interest groups" "as a legacy of the UPP" model? Also, in the same context, Lizano may want to elaborate on the transferability of the monetary approach adopted by Panama, whereby the local currency is effectively replaced by a foreign currency- an approach which, as Lizano suggests, "may be the most realistic option" for some of the smaller Latin American countries. In effect,

47

replacement of the domestic currency by a foreign currency could be described as the ultimate form of "anchoring". Is this really an option for more countries in Latin America?

Market O p e n i n g I can, again, only fully agree with the importance attached by Lizano to the process of market opening, and I share his criticism of Krugman's skeptical remarks. In particular, I agree with Lizano's statement that "international trade ... creates a culture of competition and efficiency" (something which, one would have thought, somebody like Krugman might particularly want to appreciate). The process of reducing barriers to imports in Latin America has been truly breathtaking, and it can serve as an example of a bold policy move many industrialized countries, not the least Europe, should study carefully. However, if I interpret statistics correctly, removal of non-tariff barriers, reduction of tariffs, and reduction of tariff dispersion has not yet in Latin America resulted in full openness as measured by the share of trade in GDP, if compared to other countries of similar size. For example, Mexico and Korea have about the same GDP, but Mexico's share of trade in GDP is only half that of Korea. The same is true for a comparison between Colombia and New Zealand. Perhaps Eduardo Lizano could comment on that situation. Is it just a legacy of the inward-looking policies of the past? And is there the probability that trade may increase in the near future?

The Role of the State Most people would presumably be happy to agree with Lizano that (i) there is an important role for the state in the market economy in general and in the development process in particular, and that (ii) the state should be efficient. However, what does Lizano mean if he says that "the market, a human creation, is imperfect... [and] often fails to meet its intended purposes"? Clearly, as Lizano rightly states there is a need for macroeconomic policies, competition policy, investment in human resources and infrastructure, for correction of externalities and for similar government activities. But

48

what else? It may be useful to be rather concrete in this context, so as to avoid wrong incentives for governments in Latin America. At the same time, how does one achieve an efficient state? This must go far beyond economic policies. As Lizano says towards the end of his paper, "good leadership is the only answer". Are there any measures one can take to create "good leadership"? Is there any role the international institutions can play in this context? Is there hope that constraints imposed by the World Bank, the IMF and the WTO can contribute to make governments in Latin America more efficient? These are a few issues on which Eduardo Lizano may want to elaborate, to make an excellent paper even better (if that is possible).

References

Dean, J., S. Desai, and J. Riedel. 1994. "Trade Policy Reform in Developing Countries Since 1985: A Review of the Evidence." World Bank Discussion Paper. No. 267. Washington D.C.

49

Good Governance after Stabilization: Avoiding a Negative-Sum Game

1)

Leonardo Auernheimer

1.

Introduction

The decades of the fifties, sixties and early seventies were, by large, periods of dismal economic policies in Latin America. The following ten or fifteen years can be called the years of attempted, but not quite successful reforms. In the nineties it seems that, aside from occasional mishaps, public opinion and political determination are finally on the side of sound policies: openness to international trade, monetary stability and smaller government. Several of the major Latin American countries have either attained monetary stability, or are on their way to attain it, and have dismantled their highly protective tariff structure. Chile is, of course, the crown jewel, not only in terms of monetary stability and trade openness, but also in terms of efficiency in the operations of the public sector. But Peru, Argentina and Mexico (in spite of the "tequila crisis" at the end of 1994) seem to be well advanced in the process. Brazil may be still too closed to call, but there are reasons to believe that finally, after many years of stabilization attempts combining the most extreme recipes, an internally consistent stabilization program has been put in effect. The remaining task, which may take several years, is (using a very general term) to reduce the "size" of government. The "size" of government has several dimensions, and it is interpreted differently by different people at different times. There is, first, the question of the budget deficit, i.e., the financing of expenditures other than with conventional taxes. Second, there is the question of the size of government expenditures, which gives an idea of the resources used in the public sector and hence not available for private sector production. The third dimension of the "size" of government is not necessarily related to the previous two, and is the loss imposed on the private sector via regulation and the imposition of distortionary taxes and subsidies, even after '' I am thankful for the insightful comments of my discussant at the Symposium, professor Gunter Gabisch.

50

international trade has been liberalized. There is a wide consensus to the effect that international trade liberalization is associated with higher efficiency and growth. 1 ' Although measures of "internal openness" are rather difficult to obtain, there should also be agreement that gains from the removal of these domestic, government imposed distortions are important. In evaluating the effect of undergoing reforms, and the precautions that need to be taken for avoiding in the future the mistakes of the past, an important question is what kind of mechanisms could have being at play for some countries to have persisted, for so long, in the wrong policies. Consider, for example, the data depicted in figures 1 to 5. figures 1 to 4 show the level of real gross domestic product (GDP) per capita in Brazil and Argentina, respectively (between 1964 and 1993 for Brazil, and between 1949 and 1990 for Argentina), as well as its annual rate of change and the trend of the latter. In both cases the trend of the rate of per capita GDP growth is negative. Consider, more specifically, the case of Argentina in the fifteen years between 1975 and 1990, a period during which real per capita GDP fell from 109.5 to 89.3 (with an index 1968=100), i.e., by almost 20 per cent, figure 5 shows what the level of real per capita GDP would have been in 1990 if the 1975 level would have either remained constant or grown at sustained annual rates 1 and 2 per cent. At the rather modest rate of permanent 2 per cent per year, it would have reached a level of 144, i.e., 60 per cent higher than the actual 1990 level. The years from 1975 to 1990 encompass a rather long period of fifteen years. As in the case of Brazil, during these years there were various external shocks, some negative and some positive, and a variety of policies. In the Argentine case, the end of a populist regime, an intent of stabilization and reform (the years of the Martinez de Hoz Ministry), the Falkland Islands debacle and the populist Alfonsin administration. The permanently negative trend in GDP through this variety of regimes is, indeed, remarkable. We hypothesize that the high level of government Imposed distortions has been a major culprit, and in this paper try to sketch the nature of the mechanism through which such policies can start, persist for some time and finally end, as it did after 1990 We will suggest that groups in the private sector would, under certain conditions, have an incentive to engage in a game of political influence, even when the game will ultimately result in all groups being worse-off. This is not only a mechanism that could have been at work in the past in countries that are now undergoing rapid reform, but " For a very complete and careful evaluation of the empirical evidence see Edwards (1993).

Figure 1 Brasil - G D P per C a p i t a 1 9 6 8 = 100

Figure 2 Brasil - GDP per Capita A n n u a l Rate of G r o w t h

Figure 3 Argentina - GDP per Capita 1968 = 100 120

•"»I 5 2 5 4 5 6 58 6 0 6 2 6 4 66 66 70 72 74 7 6 78 80 82 8 4 8 6 88 9 0

Figure 4 Argentina - GDP per Capita A n n u a l Rate of G r o w t h

53

Figure 5 Argentina: Missed O p p o r t u n i t i e s

50

55

60

65

70

ACTUAL P C GDP 1 % SUBST GROWTH

75 --•-.

80

85

90

2% SUBST G R O W T H 0% GROWTH

that could be resurrected unless strict policy rules - rather than discretion - are enacted. In simple words, the framework we have in mind is the following. Different "sectors" in the economy (two in our model), producing different outputs, can apply part of their resources (which are fixed) to exert political influence. Government imposes taxes in a manner unrelated to how those sectors behave, and distributes tax revenues as subsidies in a random manner - perhaps charging a "fee" for administering the scheme. At every period the probability of each sector to receive all (or nothing) of the subsidy is dependent on the "effort" that each sector puts into influencing the outcome. Under different assumptions concerning the power to influence and production conditions in each of the sectors, as well as the overall size of the subsidy, we compute the equilibria. We find that under certain conditions there will be an incentive for the "start of the game" and, after the equilibrium has been reached, an incentive for both private sectors to demand an end to it. We suggest that this is one more instance of the usual "time inconsistency" question, applied here to the incentives of at least one of the two private sectors.

54

Of course, this kind of framework is in the spirit of the "political economy" literature, in which so much has been produced in the last five years.1) A difference in this paper is that we do not rely on the median voter mechanism but on direct action by producers of goods. Indeed, the episodes of real income decline in Argentina, for example, occurred under a variety of regimes.2) The plan of the paper is as follows. In the next section we describe the basic framework. In section 2 we compute solutions of the model under various assumptions, and in section 3 we close with an evaluation of the results, caveats to the model and suggestions for further research. We ask the reader to keep in mind that this is preliminary work, and that the framework is meant to suggest rather to assert.

2. The Framework There are two sectors, 1 and 2, each endowed with a fixed stock of capital and labor; normalizing both labor inputs to unity, then these endowments can be written as kt, k 2 . These two sectors produce goods x, and x, according to the technologies (1)

Xi =ai[CTiki]Pi

0 0 can be considered the "fee" charged by government. Taxes are imposed on

"

For a perceptive survey of some of the issues see Tommassi and Velasco (1995). A valuable collection of papers concerning political forces in Latin America is Dornbusch and Edwards (1991). See also Alesina and Rodrick (1994).

21

It is interesting to note the current administration in Argentina, which is carrying out the most sweeping reform in decades, was initially elected in 1989 under a populist-interventionist platform.

31

A more appropriate and customary procedure would be, of course, to write this and the following functions in their general form. Since we later derive only a computational solution for which w e will use the particular forms specified here, w e introduce them directly, in the interest of brevity and directness.

55

each of the two sectors in a manner proportional to their fixed endowment.1) At every period, the total subsidy S is entirely allocated to either sector 1 or sector 2 according to the result of a lottery, in which the probability of sector /' to receive the subsidy is equal to (2)

where (3)

6j = a, [(1-cjj) k,] bi

0< b| < 1; i= 1,2.

Notice a few things. First, time is divided into fixed periods, and decisions are taken for every period. Second, in this very simple economy, the only decision each sector takes is the determination of how much of its endowed capital will be used for production and how much for affecting the probability of receiving the subsidy. This Is, of course, the choice of the coefficient a j in each case. Each of the two sectors can affect the probability of receiving the subsidy through a "production function" of influence, so to speak, specified as in (3). The two coefficients a-,, b-, are a measurement of the "power" of each of the two sectors to affect the probability of receiving the global subsidy. Notice, then, that at every period the part of capital not used in production is, from the aggregate viewpoint, wasted. One possible interpretation of this technology (but not the only one) is that the sector uses up capital in "lobbying activities". See below for some more discussion on the interpretation of this assumption. Throughout the analysis, we assume that each of the two sectors behaves as a single unit - i.e., firms within the sector, that are identical, can costlessly enforce cooperation. Unless otherwise specified, the two sectors do not cooperate with each other. At every period, each of the two sectors maximizes the expected value of total commodities generated by the sector, which is made up of the output minus taxes (both of which occur with certainty) plus the expected value of receiving the global subsidy, i.e., (4)

ECx^-ot^o, k,] P' +

- T(1 + y>Xi

¡=1,2

where q is defined as in (3), and 11

An alternative would be to assume that taxes are imposed on output, in which case the sectors would have an additional inducement to divert resources towards "influence" and away from production.

56

is the proportion of the tax falling on sector i. A maximum for (4) for each of the two sectors is reached when dE(Xi)_0 da-.

or (5)

5E( X1 ) d ai

(P1-Dk p, _ s a , b, = Starting in 1985, and with the assistance of the multilateral institutions, Mexico embarked on an ambitious reform effort aimed at achieving macroeconomic stability and modernizing its economy. These early efforts, however, did not bear fruit, as output declined and the inflation rate exceeded 150 percent per year. In December 1987 a stabilization program based on a predetermined nominal exchange-rate anchor, and supported by (largely) restrictive fiscal and monetary policies was implemented. The main components of the reform policies were a massive privatization and deregulation process, and a significant opening of the economy to international competition.

A broad social and economic agreement between the government, the

private sector and labor unions, and aimed at guiding price, exchange rate and wage increases, became a key feature of the Mexican program. Throughout the years this agreement was renewed periodically, first under the name of Pacto de Solidaridad Económica, and later as Pacto para la Estabilidad y el Crecimiento Económico - the Pacto, for short. As time passed, by the (yearly) renewal of the Pacto became a major political event, surrounded by anticipation and, at times, by anxiety. 11

The Pacto

On the Mexican debt crisis see, for example, Buffie and Sangines (1988), Edwards (1989) and Dornbusch (1989).

72

eventually became a fundamental institution in Mexico's political process, supposedly encompassing a major national project.11 Between 1988 and 1994, and in spite of the reforms, the performance of the economy was rather modest. Real growth averaged 2.8 percent - significantly lower than Chile (7.1 percent) and Colombia (4.1 percent), for example-; productivity growth was almost flat until 1993; export expansion was not impressive; real wages barely reached their 1980 level; the real exchange rate appreciated significantly; private savings experienced a major decline; and poverty and income distribution continued to be a serious problem. On the positive side, fiscal balance had been attained in 1992; inflation was reduced to single digits; and the reforms had dismantled layers of protection and regulation (see table 1 for a comparative summary of key economic variables).2' During this period there was a significant contrast between Mexico's achievements in terms of reform policies - which, in any event, reportedly were not as comprehensive as originally envisioned - , and in terms of economic results. In spite of this divergence, Mexico was being praised by the media, some financial experts and academics, and the multilateral financial institutions as a major success. It is possible to argue that a Mexican "miracle" was, at least partially, invented. This enthusiasm was the consequence of a number of factors. The most important, perhaps, was the tremendous faith that many analysts had in the market-oriented reforms; if results were not there, many argued, they were around the corner. Krugman has argued that much of the hoopla on Mexico's prospects represented a "leap of faith, rather than a conclusion based on hard evidence" (Krugman 1995, 33). The U.S. administration's efforts to persuade the public and Congress of the benefits of NAFTA also contributed to the popular notion that there was a Mexican "miracle".3)

" On the Mexican reforms until 1993 see, for example, Loser and Kalter (1992) and Lustig (1992). The book by Pedro Aspe (1993) offers a professional, and highly influential, insider's assessment of the progress made by Mexico in the reform front. 2)

The selection of Chile and Colombia as comparators is deliberate: Chile is the earliest Latin American reformer, broadly recognized for its achievements; Colombia, on the other hand, has implemented limited reforms, but has maintained a solid economic record throughout the 1980s and early 1990s.

31

The Mexican experience was often cited as an example that it was possible to undertake successful structural reforms within a democratic regime. Mexico, in fact, was often contrasted to the Chilean case, where the bulk of the (truly) successful reforms had been undertaken by an authoritarian military regime.

73

Table 1 C o m p a r a t i v e Economic Indicators: Chile, C o l o m b i a , M e x i c o a. GDP Growth

1985

5.6

6.5

1988 7.3

1989 10.1

1990 2.9

1991 7.3

1992 11.0

1993 6.3

3.3

6.1

5.4

4.1

3.4

4.1

2.1

3.8

5.3

5.3

2.7

-3.9

2.3

1.0

3.4

4.2

3.6

2.8

0.4

3.8

Chile

7.0

Colombia Mexico

1986

1987

1994 4.5

1985

1986

1987

1988

1989

1990

1991

Chile

30.7

19.5

19.9

14.7

17.0

26.0

21.8

1992 15.4

1993 12.7

1994 11.4

Colombia

24.0 57.7

18.9

23.3

28.1

25.8

29.1

30.4

27.0

22.6

22.0

86.2 131.8

114.2

20.0

26.7

18.7

11.9

8.0

7.1

b. Inflation

Mexico

1985

1986

1987

1988

1989

1990

1991

1992

1993

6.9

10.1

6.7

11.6

15.9

8.8

10.0

16.7

4.4

Colombia

14.4

20.7

12.3

1.9

5.5

14.2

3.6

6.7

6.4

Mexico

-4.4

5.3

9.8

5.8

2.3

3.6

5.4

0.8

3.5

1985

1986

1987

1988

1989

1990

1991

1992

c. Growth of Exports Chile

d. Manufacturing Employment Index (1987=100) Chile

80

89

100

112

126

129

132

141

Colombia

94

96

100

101

103

104

104

105

108

103

100

99

100

100

98

97

1986

1987

1988

1989

1990

1991

1992

1993

1994

115.1

118.6

124.6

115.3 117.3

122.8

112.2

100.2

99.4

Mexico e. Average Real Wages (1980=100) Chile Colombia Mexico

95.1

94.8

104.8 110.1

119.2

101.1 117.7

103.0

120.1

119.5

116.0

73.2

72.0

71.3

77.8

79.4

Poverty f. Incidence of Poverty

84.7

92.9

Extreme Poverty

1980s

1990s

1980s

1990s

Chile

28.0

24.0

Colombia

33.8

32.7

17.0 18.7

9.0 17.7

Mexico

27.5

25.9

7.7

8.2

Source: World Bank, CEPAL and Banco de Mexico Notes: In (b), inflation refers to the change in CPI. In (c), exports include goods and non-factor services. In (d), Chilean data refer to metropolitan Santiago; Colombian data to 7 metropolitan areas; and Mexican to the urban total. In (e), up to April 1993 Chilean figures refer to non-agro workers. Since May 1993 figures refer to general hourly wage rates. Figures for Colombia and Mexico refer to manufacturing wages. Figures for 1994 are January through October. In (f), poverty is defined as the headcount Index, i.e. the proportion of people who are deemed to be poor.

74

The World Bank and the other multilaterals were not the only, and not even the most vocal, institutions promoting the image of a very successful Mexican experiment. Some investment bankers, mutual fund managers and financial reporters were even more enthusiastic; some even urged, as late as November 1994, in favor of a credit rating upgrade for Mexico.1)

A forceful example of private sector enthusiasm was

Bear, Stearns & Co's. November 1994 statement: "[W]e expect a strengthening of the peso in the coming months, creating very high dollar returns on Cetes (emphasis added)" (quoted in Fraser 1995, 35). Just a few weeks before, JP Morgan stated that "[W]e view Mexico as investment-grade risk. We do not regard Mexican debt to have predominantly speculative characteristics" (JP Morgan 1994, 7). This perception that a "miracle" was in the making, paired with a drastic reduction in the perceived degree of country risk - in Euromoney's country risk ranking Mexico climbed from position 77 in 1985 to 34 in 1991 - and a sharp decline in interest rates in the U.S., enticed investors throughout the world to move large amounts of funds into the country. Between 1990 and 1993 Mexico was to receive net capital inflows of $91 billion, more than half of the total flows into Latin America. The sections that follow deal with the evolution of the Mexican economy in the period leading to the crisis and with the developments of 1994.

The analysis concentrates on three

questions: (a) did the real exchange rate become obviously overvalued?; (b) were capital inflows sustainable?; and (c) was the Mexican policy response during 1994 adequate?

3. Real E x c h a n g e Rates and Capital Inflows Figure 1 shows the surge in capital inflows that started in 1990, as well as the real exchange rate appreciation observed since the adoption of the Pacta in late 1987.2' Throughout most of this period there was a close relationship between these two variables: capital inflows tended to go together with the strengthening of the real value of the currency. Two key and interrelated questions emerge: first, to what extent did this continuous appreciation represent a situation of overvaluation that required 11

According to a suggestively titled article ("Who Lost Mexico?") by Fraser (1995), Chemical Bank (in November 1994), JP Morgan (in October 1994) and the Swiss Bank Corporation (in December 1994/January 1995) argued that Mexico's rating should be upgraded.

21

The real exchange rate has been defined as the bilateral rate relative to the United States, which alone accounts for over 70 percent of Mexico's trade flows. Other indices, however, result in similar patterns. See Dornbusch and Werner (1994).

75

Figure 1 Capital Account and Real Exchange Rate

K. Acc. in US$billion; RER index 1990 = 100 Source: Banco de México and IMF

corrective policy actions?; and second, was the surge in capital inflows observed after 1989 sustainable? The answers given to these questions are key in interpreting the forces behind the Mexican crisis and in evaluating the appropriateness of Mexican policies after 1990 and, especially, during 1994.

76

3.1.

Inertia and Real Exchange Rates

In early 1988, three months into the Pacto, the nominal exchange rate was fixed, becoming the fundamental anchor of the anti-inflationary effort.1) This exchange-rate based stabilization program was rooted on the notion that a predetermined rate of nominal devaluation - including a fully fixed nominal exchange rate- would constrain price increases and force the monetary and fiscal authorities to behave conservatively. According to former Finance Minister Pedro Aspe, once barriers to international trade had been eliminated, it was expected that the exchange rate policy would reduce the degree of "inertial inflation", and would "place an upward boundary on the prices of tradables" (Aspe 1993, 23-24). At least until 1993, this exchange rate policy was supplemented by prudent fiscal and monetary policies.2) Between 1988 and 1994 Mexico modified its exchange rate system several times, moving first from a completely fixed rate to a system based on a preannounced rate of devaluation - with the actual devaluation set below the ongoing rate of inflation-, and then to an exchange rate band with a sliding ceiling (see table 2). This last measure was justified on two grounds: (a) it was supposed to discourage short term capital inflows; and (b) it would deal with real exchange rate corrections, in case these were needed (Banco de Mexico 1993). As figure 2 shows, until October 1993- when the NAFTA controversy heated up in the United States - the actual peso/dollar rate was extremely stable, remaining in the lower half of the band. During 1994, however, and as a result of political and other developments discussed in greater detail below, the exchange rate came under considerable pressure, moving towards the top of the band. As is well known, the attempt to widen the band in late December failed badly, precipitating the crisis. To the extent that inflation exhibits some degree of inertia, stabilization programs based on an exchange rate anchor have the danger of generating a significant real exchange rate overvaluation, loss of competitiveness, and very large trade deficits. If this situation is not corrected in time, the credibility of the stabilization program will be called into question, inviting speculative attacks on the currency.

The Mexican

authorities argued that there were three reasons why Mexico would be exempt from " During the first months of the Pacto nominal wages provided the anchor to the system. According to Vela (1993), the move to an exchange rate anchor in February 1988 was, in part, the result of pressure from the labor unions. 2)

During the early years of the program, monetary policy was guided by the dual purpose of reducing interest rates while attaining consistency with the predetermined exchange rate (Aspe 1993).

77

Table 2 E x c h a n g e Rate Policy in Mexico 1 9 8 8 - 1 9 9 4 February - December 1988

Fixed nominal exchange rate at 2281 pesos per dollar

January - December 1989

Preannounced rate of devaluation set at 1 peso per day

January - December 1990

Preanounced rate of crawl of exchange rate set at 80 cents per day

December 1990 - November 1991

Preannounced rate of crawl of exchange rate set at 40 cents per day

November 1991 - October 1992

Exchange rate band adopted. Floor is fixed at 3050 pesos per dollar, while ceiling slides at 20 cents per day

November 1992 - December 19,1994

Rate of devaluation of band's ceiling is accelerated to 40 old cents per day (0.0004 new pesos). Bank of Mexico intervened through March 1994 in order to maintain the dollar/peso rate within narrower (confidential) "inner" band

December 20 - December 21,1994

Ceiling of band increased by 15 percent

December 22, 1994 onwards

Floating exchange rate

this fate: first, the policy started from a situation of undervaluation; second, Mexico had ample international reserves; and, third, a rapid rate of productivity growth was supposed to compensate for the appreciation of the peso.1) The Mexican stabilization program succeeded in reducing inertia, but not in eliminating it. As a result, the decline in the rate of inflation was painfully slow. Following Edwards (1993), we proceed to estimate the reduced form of a model in which domestic inflation is a weighted average of the rate of inflation in tradable goods - a " Later, an additional explanation would be added to this list: NAFTA would furnish enough capital to sustain a more appreciated real exchange rate and would also provide the opportunity to rapidly Increase exports (Aspe 1993).

78

Figure 2 Nominal Exchange Rate (End of Month)

3.6 3.4

-"TV

3.2

I I I

3.0 2.8

2.6 2.4 '

2.2

11111111111111111 n 111111111111111111111111111111111 n 111111111111111111111111111

88

89

90

91

92

93

94

Source: IMF. International Financial Statistics.

function of world inflation and exchange rate depreciation - and the rate of inflation in non-tradable goods - in turn a function of domestic aggregate demand and wages. Both commercial policy and the terms of trade are assumed to be unchanged through the period of analysis. We assume that the law of one price holds (ex-ante), so that the change in the domestic price of tradable goods is equal to the expected change in the nominal exchange rate plus the expected change in international prices. (1)

Tt^ß.T^ + O - ß ) . ^

79

(2)

*T1=EM(dl+Ji-t)

The exchange rate rule consists of adjusting the nominal exchange rate by a proportion (|> (lesser than or equal to unity) of lagged inflation differentials, that is (3)

d, = (ti H - Jt',-1)

l~f f = 1, we have a typical purchasing power parity rule (often called "real target approach"), in which the devaluation rate equates (lagged) inflation differentials. The demand for non-tradables is assumed to depend on relative prices and on aggregate demand, while the supply is supposed to be a (negative) function of real wages. Thus, the market-clearing condition for non-tradables is given by (4)

Nd(Pn/Pt,Z) = NS(W/PJ

where Z stands for an index of aggregate macroeconomic policies, in particular monetary expansion beyond passive accommodation for past inflation. Finally, we assume that wages are adjusted according to past and (expected) future inflation. The parameter y represents the degree of inflationary persistence; when y = 1 there is 100% backward-looking wage indexation. (5)

w, =

+ (1 -r)-E,.i (k, )

The reduced form of the model allows us to find an expression for the dynamics of inflation. Assuming that inflationary expectations are formed rationally, that is 7t, = E(rct) + n, (where n is a random term), we can express the dynamics of inflation as a first order difference equation, (6)

Tt, = a, Tt,., + a2 tc*,., + a3 Z, + h,

where the coefficients a, are non-linear combinations of elasticities and indexation parameters.1) Coefficient a, captures the degree of inertial inflation and should, therefore, be positive. Both a2 and a3 are expected to be positive, since the former captures the effect of world inflation on tradable good prices and the latter reflects the impact of demand forces on the aggregate price level. In addition, an interactive dummy variable - the product of a dummy and the lagged value of domestic " See Edwards (1993) for further details.

80

inflation - is introduced in the estimation, in order to capture the effect of the change in exchange rate regime in 1988. It should have a negative coefficient, under the presumption that the change in exchange rate regime reduced the degree of inertial inflation. If the absolute value of the coefficient on the interactive dummy is similar to a1, then the change in exchange rate regime not only would have reduced inertia, it would have actually eliminated it. The thrust of the model is that the evolution of the exchange rate and of nominal wages is linked to past inflation, significantly so when inertia is high, and only slightly when inertia is low. Presumably, a crawling peg exchange rate regime implies more inertia than an incomes policy program in which both wages and the exchange rate are established in a forward looking manner, in terms of expected rather than observed inflation. We have considered the following quarterly variables, covering the 1980:3-1994:3 period: 7i, = Mexican quarterly CPI inflation;

= US quarterly WPI inflation;

Z, = quarterly change in real domestic aggregate demand; d.Ti,., is the product of a dummy variable and the lagged value of domestic inflation. The dummy variable is 0 until 1988:1 and 1 thereafter, to capture the change in exchange rate regime. The price indexes were obtained from the IMF tapes; real domestic demand from the Mexican National Accounts produced by INEGI. The results of estimating (6) appear in table 3.

They support those of Edwards

(1993), Vela (1993) and Santaella and Vela (1994), in the sense that the adoption of the exchange rate as the nominal anchor succeeded in reducing inertia, since the coefficient for d.rc,., is negative (and statistically very significant). However, according to the Wald test reported at the bottom of the table, even though inertial inflation was reduced, it was not eliminated.1) A limitation of the results in table 3 is that they assume that once the exchange-rate based stabilization program is adopted, the inertial coefficient will be constant although lower than before the program.

Naturally, this needs not be the case.

Indeed, one would expect that the extent of inertial forces will change through time, depending on how credible the program actually is. Moreover, in a case such as that '' In tests not reported here, we also performed a regression similar to (6), but without the interactive dummy variable. At the 99% confidence level, a traditional Chow test did not allow us to reject the hypothesis that there was a structural break in the inflation equation in 1988:2, when the new exchange rate regime was introduced.

81

Table 3 Inflationary Inertia in Mexico (OLS; 1980:3-1994:3. dependent variable is TC,) Variable

Coefficient

t-statistic

Intercept

1.930

2.663

*t-i

0.969

18.781*

d.7t M

-0.576

-7.507*

-0.591

-1.542

0.342

4.069*

Z.-1 (# signifikant at the 1 % level) RJ = 0.881 R2 adj. = 0.871 D-W = 1.990 F = 95.935 Wald Test ona, +04 =0;

= 20.807

of Mexico, where the details of the exchange rate regime changed several times after the stabilization program was adopted, we would expect a change in the process determining inflation. This can be captured by estimating equation (6) without the interactive dummy variable, using a varying coefficients technique. The results obtained are reported in figure 3, in which we have included the point estimate + / - 2 standard deviations. As expected, there was an abrupt reduction in inertia when the exchange rate was fixed with respect to the US dollar, at the beginning of 1988. The new, lower level of inertia was sustained throughout the year, while the fixed exchange rate remained in place. However, once a crawling peg was introduced in 1989, the degree of inertia began a gradual and continuous increase, only briefly interrupted when in late 1991

82

Figure 3 Inertial Coefficient

- and within the context of the broad incomes policy program - a crawling band system was put in place. One should not infer from the above pattern that the increase in inertia is necessarily the result of having changed the fixed exchange rate system to a crawling peg or band and that, therefore, inertia would have continued a downward trend under a fixed exchange rate system. The fixing of the exchange rate reduced inertia, but the sudden reduction observed during the first quarter of 1988 was not followed by additional reductions during the rest of the fixed exchange rate period. An inertial coefficient of close to 0.7 coupled with a fixed exchange rate would almost certainly had lead to a significant real appreciation of the currency. It is conceivable that the specter of this outcome reduced credibility with respect to the

83

sustainability of the fixed exchange rate, thereby fostering subsequent changes in the exchange rate regime itself. In conclusion, as many had feared, and as it had been the case a decade earlier in Chile, the process of attempting to reduce inflation while using the exchange rate as nominal anchor was indeed accompanied by a substantial real appreciation. In 1989 a number of observers argued that this trend would become unsustainable, as the country lacked sufficient foreign exchange to finance the rapidly growing trade gap. In early 1990, however, things began to turn around. The Brady debt reduction agreement was signed, and Mexico began to open its financial sector and to privatize banks. Partially as a result of this and of the perception that a miracle was taking place, the international capital market rediscovered Mexico. The resulting surge in capital inflows allowed the country to finance very large current account deficits in 1992-94. The fact that these funds were of a private nature persuaded a number of analysts, and especially senior Mexican officials, that this was a positive development, and not a cause for concern.

3.2.

Capital Inflows, Real Exchange Rates and the Sustainable Current Account

An important feature of the Mexican liberalization process is that capital controls began to be lifted very early on, and were almost completely eliminated in late 1989. Perhaps one of the most difficult issues in designing a reform program refers to the sequencing of policies. A key question in the sequencing debate has been whether the opening of the capital account should take place early on in the process, or if some form of impediments to capital mobility should be retained until the liberalization of trade has been fully consolidated. The central issue is that liberalizing the capital account would, under some conditions, result in large temporary capital inflows and in an appreciation of the real exchange rate, sending the "wrong" signal to the real sector, thus frustrating a rapid expansion of exports (see McKinnon 1982, 1991, and Edwards, 1984). The drastic increase in capital inflows in 1990-93, which in 1993 alone surpassed 8 percent of GDP, found Mexico with an open capital account and, thus, vulnerable to an inflows-led appreciation. Most of the funds flowing into Mexico after 1990 were

84

short-term portfolio flows invested in the stock market, in private sector instruments, and in government securities (see tables 4 and 5). The composition of these flows added to the vulnerability of the system as a whole. It should be recognized, however, that in the mid and late 1980s the dangers of a dramatic surge in capital inflows were far from the minds of Mexican policy makers and of independent analysts of the Latin American scene. The concern at the time was, in fact, the opposite: What could these countries do to stop capital flight, to attract new funds, and to reschedule their foreign debts? Moreover, in early 1990, even after the Brady deal had significantly reduced Mexico's foreign debt, the main concern of the authorities was to engineer a reduction of the (very high) real interest rates.11 This surge in capital inflows allowed Mexican nationals to increase their expenditure greatly.

Starting in 1990, the country experienced a consumption boom that put

additional pressure on an already appreciated real exchange rate, and contributed to the creation of a large current account deficit. A disturbing development after 1989 was the steep decline in private savings (see figure 4).2) This contrasted sharply with the experience of most East Asian countries during the early 1990s, where capital inflows resulted in significant increases in investment rates, without negatively affecting savings. Furthermore, in no other Latin American country did the current account deficit reflect such an adverse evolution of the savings-investment differential as in Mexico. Comparative information is presented in table 6. 3)

It should be noted that

the decline in aggregate savings after 1992 is closely linked to a reduction in public savings, as fiscal policy was relaxed.4) Starting in 1992 a debate began to take place regarding the possible consequences of the real appreciation that had occurred since 1988. Dornbusch claimed that "[t]he 11

See the fascinating analysis of the Mexican economic situation by the now Secretary of Guillermo Ortiz (1991).

21

It could be argued that the decline in savings (which is in part the counterpart to the increase in consumption) is quite misleading in situations in which the consumption of durable goods increases significantly. After all, the case can be made that the purchase of certain consumer durables is, to a certain extent, a similar decision to the purchase of, say, a financial asset. In the recent Mexican experience this classification problems do not seem to have played an important role, as the expenditure on consumer durables as a proportion of GDP declined from 7.2 percent in 1987 to 6.3 percent in 1993.

31

Note that while in figure 4 reference is made to gross domestic savings, table 6 considers gross national savings.

4>

This, in spite of the fact that between 1991 and 1994 there was a slight increase in the ratio of taxes (direct and indirect) to GDP. This increase, which ceteris paribus implies a decline in private savings, should be reflected in enhanced public savings, unless public expenditure is concomitantly augmented.

Finance

85

Table 4 Foreign Investment in the Mexican Stock M a r k e t (Amount outstanding at market value, billions of dollars)

December December December December December December

1989 1990 1991 1992 1993 1994

ADRs1)

Free Subscription

Neutral Fund

Mexico Fund

Total

0.4 2.1 13.7 21.2 34.0 21.2

0.1 1.4 3.0 5.1 12.9 8.1

0.7 1.3 1.8 6.4 4.3

0.3 0.3 0.5 0.6 1.4 0.8

0.8 4.5 18.6 28.7 54.6 34.4

Source: Bolsa Mexicans de Valores. "

Includes global depositary receipts.

Table 5 C o m p o s i t i o n of Domestic Public Debt (Percent of total) Bondes

Tesob.

44.6

40.0

0.7

1991

42.5

34.1

0.5

22.9

1992

44.5

27.6

0.7

27.2

1993

59.7

12.5

2.8

24.9

Cetes 1990

Ajustab. 8.9

19941

58.8

12.7

4.4

24.2

199411

47.7

12.3

18.6

21.3

19941II

33.7

11.2

35.7

20.2

19941V1»

23.2

4.8

55.3

16.7

Source: Banco de Mexico " The jump in the value of Tesobonos reflects the exchange rate depreciation.

86

Table 6 Current Account, Investment and Savings (percent of GDP)

Argentina Current Account Gross investment Gross savings Chile Current account Gross investment Gross savings Colombia Current account Gross investment Gross savings Mexico Current account Gross investment Gross savings Malaysia Current account Gross investment Gross savings Thailand Current account Gross investment Gross savings

1990

1991

1992

1993

1.2 14.0 15.2

-1.5 14.6 13.1

-3.7 16.7 13.0

-3.5 18.4 14.9

-3.2 26.3 23.1

-0.4 22.2 ,21.8

-2.5 26.8 24.3

-5.2 28.8 23.6

1.6 18.5 20.1

5.7 16.8 22.5

1.5 17.2 18.7

-4.1 21.5 17.4

-3.1 21.9 18.8

-5.2 22.4 17.2

-7.3 24.4 17.1

-6.4 22.8 16.4

-2.3 31.5 29.2

-8.9 37.0 28.1

-2.8 33.8 31.0

-3.3 33.2 29.9

-8.7 41.1 32.4

-7.8 42.0 34.2

-5.7 39.6 33.9

-5.6 40.0 34.4

Source: World Bank. Note: Savings are obtained as a residual.

87

Figure 4 Savings in Mexico (% of GDP)

Source: Authors' calculations based on IMF data.

current problem of the Mexican economy is the overvalued exchange rate" (Dornbusch 1993, 369), and in November 1992 he argued that the daily rate of devaluation should be tripled in 1993 to 120 cents per day (Excelsior 1992). In late 1992 Edwards pointed out that "the rapid real appreciation of the peso in the last few months has contributed to [a]...widening trade imbalance, affecting overall credibility" (Edwards 1994, 39). In a public document issued in November of 1992 the World Bank noted, with a tragic sense of premonition, that "[ojpening its capital account also exposes Mexico to the volatility of short-term capital movements that can transmit

88

destabilising external shocks to the economy even if domestic policies are right" (World Bank 1992, 359). This report went on to say that Mexico could "adjust to these risks [of volatile capital movements] through higher interest rates and, possibly, depreciating the peso" (359). The Mexican authorities responded to the expression of these fears by suggesting that to the extent that flows were largely private and the fiscal accounts were in surplus, there was nothing to worry about. Their position was based on a three part argument: first, they pointed out that the system had enough built-in flexibility - in the form of flexible interest rates and the exchange rate band - to deal with eventual disequilibria. Second, they argued that a rapid increase in productivity was about to take place, generating a major export expansion that would help close the current account gap; and third, that the long term fundamentals remained healthy, especially in light of NAFTA's ratification.1)

As evidence of having matters under control, the

authorities argued that non-traditional exports were doing fine, although of course lagging considerably with respect to the growth in imports. A senior Mexican official argued that whether there was a situation of overvaluation "depend [ed] on the equilibrium real exchange rate... [T]he appreciation process is a natural, and not necessarily a negative, consequence of the reform process in Mexico" (Ortiz 1994, 306). And the Governor of the Banco de Mexico told The Economist in January 1994 that the current account deficit was not a problem because it was associated with the inflow of foreign funds, rather than expansionary fiscal or monetary policy.2) The increase in capital inflows was at the center of the "equilibrium" interpretation of the real exchange rate appreciation in Mexico. Under this view, the real strengthening of the peso was fully justified by fundamentals, and should not have generated concerns or policy actions. Interestingly enough, even a year after the crisis this continued to be the "official" view from the Banco de Mexico - see its 1995 report and in its Governor's remarks at the Inter-American Development Bank conference on "Experiences in Banking Crisis Management", held in Washington D.C. on October 5-6, 1995. From a simple theoretical perspective the view that the appreciation of the real 11

See Banco de Mexico (1993,1994) and Aspe (1993).

2)

Although Mexico's remarkable fiscal adjustment following the debt crisis cannot be overemphasized, it is important to acknowledge that, upon closer scrutiny, the stance in terms of fiscal policy started to shift as early as 1989. This can only be appreciated when the traditional fiscal accounts are corrected in order to exclude from public expenditure the inflationary component of interest payments. In any event, it is still the case that a significant shift in the fiscal stance only took place beginning in the second semester of 1993. See Leiderman and Thorne (1995).

89

exchange rate was influenced by capital inflows is indeed correct. According to most theories of equilibrium real exchange rates, in order for the transfer of resources implied by a higher capital inflows to become effective, a real appreciation is required. Edwards (1989) presents a formal analysis of this case in the context of an intertemporal, optimizing, general equilibrium model. A problem with this interpretation, however, is that it fails to recognize that the rate at which capital was flowing into Mexico in 1991-93- at levels exceeding 7 percent of G D P - was clearly not sustainable in the long run. This means that at some point the magnitude of this flow would have to be reduced, requiring a reversal in the real exchange rate movement. Although there are no mechanical rules for determining the volume of capital that can be maintained in the long run, there are some helpful guidelines that analysts can follow in order to detect departures from capital account sustainability. 1)

In general,

there will be an "equilibrium" level of a country's liabilities that foreigners will be willing to hold in their portfolios. Naturally, this "equilibrium portfolio share" will not be constant, and will depend, among other variables, on a number of conditions including interest rate differentials, the perceived degrees of country and exchange risk, and the degree of openness of the economy. Moreover, when countries embark in (what is perceived to be) a successful reform program, the "equilibrium" level of the country's liabilities that will be willingly held by international investors is likely to increase, as they will be eager to take part in the country's "take-off". Assume that in equilibrium international investors are willing to hold in their portfolios a ratio k* of the home country's liabilities relative to its GDP. 2) Denoting liabilities by L and GDP by y: 3> (7)

k* = L/y = f(i,i*,S,...)

where i is the domestic interest rate, i* is the foreign interest rate, and 8 is the perceived degree of country risk. Equation (7) implies that in steady-state the net accumulation of this country's liabilities will be equal to: (8)

A L = g.L

" On the issue of current account sustainability see, among others, Reisen (1995). 21

Ideally this should be a forward-looking measure of GDP.

31

Naturally, there Is a problem of valuation. Assume, for purposes of the exposition, that L and y are measured in the same currency.

90

where g is the "long run" rate of growth of real GDP. Of course, If instead of the country's GDP an alternative benchmark is used - say, exports-, g should be interpreted as the rate of growth of that variable. AL in equation (8) is this country's capital account surplus, and is equal to the current account deficit, plus the net accumulation of international reserves. The current account, in turn, is equal to the trade account T plus the service account. The latter can be approximated by the product of the rate of return on liabilities r (for short this will be referred to as the real rate of interest on the country's liabilities), times the stock of liabilities. Denoting the current account deficit by C, it is possible to write: (9)

A L = AR + C

(10)

C =T + rL

(11)

T = (M - X)

Where M is total imports and X is exports. Assuming, as a first approximation, that the accumulation of reserves is equal to zero, the "sustainable level" of the capital account in the long run is equal to the sustainable current account. From equations (7) - (11) these "sustainable" magnitudes will be given by: (12)

L)/y = C/y = g.k*

This says that the "sustainable" ratio of capital inflows to GDP - that is, the level of capital inflows that can be maintained in the long run without violating the portfolio equilibrium condition (8) - is equal to the desired liabilities to GDP ratio (k*) times the long run real GDP growth. Moreover, from (11) and (12), it follows that: (13)

T/y = (g - r).k*

This is the well known transversality condition that states that in long run steady-state equilibrium the trade deficit (or resource transfer) can at most be equal to the difference between the real rate of growth of the economy and the real rate of interest on the country's liabilities, times k*. This equation clearly states that a rate of growth in excess of "the" real interest rate is a requirement for a country to receive a positive resource transfer from the rest of the world. In rigor, equations (12) and (13) establish upper limits for capital inflows and trade account balances in the steady state.

91

Even in the steady state it is very difficult to measure the desired ratio of the county's liabilities to GDP. However, some insight can be gained by looking at different hypothetical values of the equilibrium capital inflows to GDP ratio under alternative assumptions for k* and of the rate of growth of GDP, g. This is done in table 7. These

Table 7 S u s t a i n a b l e Capital Account Surplus g L/Y 0.25 0.40 0.50 0.75 1.00

2%

4%

.005 .008 .010 .015 .020

.010 .016 .020 .030 .040

5%

6%

7%

.0125 .020 .025 .0375 .050

.015 .024 .030 .045 .060

.0175 .028 .035 .0525 .070

numbers are very revealing. They indicate, for instance, that if in long run equilibrium foreigners are willing to hold liabilities equal to one half of the country's GDP - that is L/y = 0 . 5 - , and the rate of real GDP growth is 5 percent, the long run steady-state equilibrium level of capital inflows is 2.5 percent of GDP. "

Notice that even with a

combination of a desired L/y of 1.0 and real growth of GDP of 7 percent per year, the equilibrium capital inflows ratio is only 7 percent, below Mexico's ratio in 1994. The numbers in table 7, then, provide a first approximation to the issue of long term capital inflows sustainability.

If observed capital inflows are significantly higher than what

according to these figures is reasonable, there are causes for concern and further analysis. In the case of Mexico, this analysis clearly indicates that in 1993 and 1994 - w h e n the capital account surplus exceeded 7percent of GDP- the authorities' concern should have been how to adjust smoothly the external accounts to levels consistent with long run equilibrium. This analysis has ignored, thus far, issues related to the accumulation of international reserves. As a result, the capital account surplus is exactly matched by the current 1>

In the particular case of Mexico, in 1994 foreigners held Mexican securities - in the form of stocks and private and public bonds- in the equivalent of slightly more than 50 percent of Mexico's GDP.

92

account deficit. This, of course, needs not be the case. Assume that the central bank has a well defined demand for international liquidity. In this case, as the economy expands, the desired level of reserves will also grow and a proportion of the capital inflows will be devoted to satisfying this higher demand for reserves. This means that the sustainable equilibrium current account will differ from the sustainable capital account. While the latter will still respond to equation (12), the former will be given by: (14)

C/y = g.k* - (AR/y)

Where AR is the desired increase in the stock of international reserves. Under the assumption that in equilibrium the authorities want to hold a certain number of months worth of imports as reserves, this magnitude can be expressed in percentage form as (R/y)*. 1) Denoting the (forward looking equilibrium) rate of growth of imports as m, equation (14) can be rewritten as: (15)

C/y = g . k * - m (R/y)*y

where y is the degree of openness of the economy, measured as the ratio of imports to GDP.

Naturally, this analysis can be easily expanded to the case where the

demand for reserves is expressed as a proportion of the monetary base or other monetary aggregate. This analysis has concentrated on long run equilibrium conditions, and has ignored transitional issues. These, however, are crucially important in cases when there are large shifts (positive or negative) in the portfolio demand for the country's liabilities. If, for example, due to changes in expectations generated by a drop in the country's perceived degree of country risk or in external conditions (world interest rates, for example), there is an increase in the demand for the country's securities, in the short run the capital account balance can exceed significantly the levels defined in table 7. Once portfolio equilibrium is regained, however, the capital account balance will again revert to its long run equilibrium level. One of the most important dynamic effects of this transition is on the real exchange rate. As capital flows in there will be an increase in expenditure and an appreciation in the real exchange rate. Once capital stops flowing in, or even when the rate at which it flows slows down, the real exchange rate will be "overly" appreciated and, in order to maintain equilibrium, a massive adjustment may be required. The dynamics of capital inflows adjustment will require, then, '' Nine months worth of imports would be represented by a (M/y)* equal to 0.75.

93

that the equilibrium real exchange rate first appreciates and then depreciates. And while during the surge in inflows the real exchange rate appreciates without any impediment, when the availability of foreign capital declines nominal wage and price rigidity will make the required real depreciation difficult under a pegged exchange rate.1) Mexico's clinging to the rigid exchange rate system, the obsession with single digit inflation and a succession of negative shocks made the possibility of a smooth landing increasingly unlikely as capital flows declined during 1994. Naturally, the situation will become even more serious if as a result of external or internal developments there is a decline in the portfolio demand for the country's securities- as was the case in Mexico after December 20,1994. Under these circumstances, the capital account balance will suffer a very severe contraction - and the current account may even have to become positive - during the transitional period towards the new equilibrium. These dynamic effects of changing capital flows on the equilibrium real exchange rate, the current account and reserves accumulation can be analyzed using simple numerical simulations. In order to do this it is necessary to add some minimal structure to the model. Equation (16) specifies the nontradable (N) market-clearing conditions; (17) is the economy's budget constrain according to which the current account (C) is the difference between aggregate demand and aggregate supply; and (18) presents the balance sheet of the central bank - where, as before, R are interational reserves and D is domestic credit. The real exchange rate e is the relative price of tradables to non tradables (Pt/Pn). It is assumed that the demand for base money (B) - which has not been explicitly written - is a function of income, with income elasticity equal to one. (16)

Nd(Pt/Pn,B) = Ns(Pt/Pn)

(17)

Td + (Pn/Pt).Nd = Ts + (Pn/Pt).Ns + C

(18)

AB = AD + AR

Under the simplifying assumptions that AD=0, equations (16) - (18) imply the following dynamics for the real exchange rate: " This type of analysis has been made in relationship to the sequencing of reforms debate. See, for example, Edwards (1984).

94

(19)

(de/e) = a.(y/R).[g.k*-C(e)/y]

where a = Ti/fy-p)

Including bonds held as a result of Reverse Repos, liquid reserves do not include Argentine bond

holdinns 21 31

Reserves at the Central Bank include deposits of comA2298. Flows have been calculated from December 1 st.

Figure 1

•qen Xjbjsuo|/\| / say bn CO CD

% o o

o 0>

•Q w

_Q gì

ro 0) c

o

•D C CD

The new Charter of the Central Bank allowed an extended use of repos and collateralized loans and also gave the Central Bank greater flexibility in managing the assets of institutions that were suspended and closed.

137

dollars rose substantially and reached their highest levels during this phase. The annualized peso and dollar prime rates reached 45% and 30% respectively, although they came down gradually to 28% and 20% respectively at the end of the month. Given this deepening of the crisis the Central Bank again acted to relieve liquidity problems in the financial system. First, the Central Bank allowed private banks to count up to 50% of their holdings of cash in vault as part of the reserve requirement. Additionally, for those banks that purchased loans from institutions with liquidity problems, a system was introduced whereby some of the remaining cash in vault could also be used as official reserve. This policy injected up to a further $1 bn into the financial system. Secondly, the Central Bank stepped up the use of repos and collateralized loans which together added a further $1,3bn of liquidity. These measures then contributed up to $2.3bn in total liquidity. However this was only some 55% of the fall in deposits in this month and banks were forced to cut credit. The fall in credit in March amounted to roughly $1,4bn with banks also finding alternative sources to finance the loss of deposits (in particular from external credit lines). The fall in credit in this period was certainly significant but it should be noted that the fall only represented roughly 3.0% of the total stock of credit at the time.

Phase 3: Stabilization of the Withdrawals. The third phase of stabilization of the financial system was roughly between the end of March and the presidential elections of May 14th. During this period M3* only fell by some $255m and although total deposits fell (by $1.1bn), peso deposits actually rose. These changes can be explained by a further change in the perception of economic agents and in particular by a reduction in perceived policy risk due to the agreements reached by the IMF and the flow of funds expected to the country from the multilateral and other institutions on the back of the agreement.

Nevertheless, risks certainly

remained in large part due to the influence of the presidential elections. This explains the delay in the recovery of the monetary aggregates as many waited before replenishing their bank accounts and other investments within the country until the election result was known. During this phase, as M3* remained more or less constant, the central bank did not need to further liberalize the system of reserve requirements and the use other

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instruments to increase liquidity was fairly low.

In total, a further net increase of

$523m of repos and collateralized loans were introduced. As an additional tool to increase confidence in the banking system, particularly for small depositors, on April 18 the Congress passed a law that created an obligatory, limited deposit insurance scheme to be funded completely by the private banking sector.

Phase 4: The Recovery. The fourth phase began after the result of the presidential elections. With the IMF agreement already in place and with the knowledge that the previous administration would remain for a further four years, there was a natural reduction in policy risk. From mid-May until the end of July, investors increased their holdings of Argentine assets substantially. Total deposits increased by $3.6bn with holdings of peso and dollar deposits increasing almost in line at $1.8bn each. Total reserves of the central bank increased by $1.6bn between the election date and the end of July and prime interest rates came down to roughly 14% in pesos and in dollars 12% in dollars by July end.

4.2

The Microeconomic Management of the Shock

In this section, the microeconomic management of the shock is addressed.

The

policy stance of the Central Bank was largely to allow the private market to be the main disciplining device. Nevertheless, the Central Bank stood ready to help institutions with genuine liquidity problems through the availability of repos ('pases') and collateralized loans ('redescuentos').

In this fashion the Central Bank was able to

minimize the number of institutions that were forced to apply for suspension or closure whilst limiting the potential liabilities of the Central Bank. In part this strategy was successful because (i) different types of depositors behaved differently, and (ii) depositors discriminated between different banks, during the crisis. This implied that only a relatively small number of institutions with particular characteristics had severe problems. In the first part of this section the different behavior of depositors and the

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different experience of banks and the policy response during the crisis is briefly reviewed. With the IMF agreement in March also came agreements with the World Bank and the Inter-American Development Bank. The resources form these institutions (together with the receipts of a Government bond issue) have funded, in part, two fiduciary funds ('Fondos Fiduciarios'). These Trust funds were principally designed to aid in the process of restructuring the private and public banking sectors. In the second part of this section, further details are provided on this restructuring process.

Which Depositors Flew and From Where? A feature of interest of the Argentine banking industry is the rather high concentration of deposits by size of depositor. For example, as of December 1994 total certificates of deposits larger than $100,000 accounted for only 2.4% of the total number of certificates but represented some 52% of total deposits. An analysis of this type of data over the period of the crisis indicates that it was the large depositors that flew first out of the Argentine banking system.

For example

between the end of November and the end of December accounts of greater than $1m in pesos fell by some 21% whereas accounts of between $100,000 to $1m fell by about 10% and smaller accounts in pesos tended to fall by even lower amounts. From January to March the fall in peso deposits was more widespread across different size bands, however smaller deposits remained much more stable.

Between

November and March, the largest relative falls occurred in accounts between $0.75m to $1 m (some 44%) whilst deposits of less than $5000 fell by only about 6% Further, comparing time deposits with sight deposits it is found that the latter were much more stable over the period. From December 21 st to the end of March sight deposits fell by only 9.2% whereas time deposits fell by over 16% and comparing the period from December 21st to end of July, sight deposits actually rose (by some 4.1%) whereas time deposits remain down (by 12%). This difference in behavior is even more marked when the deposits data is deseasonalized. Typically, in the Argentine summer sight deposits fall by more than time deposits so that considering the deseasonalized data demand deposits hardly fell at all over the crisis.

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Finally, a more systematic time series analysis of the deposits data over the period of Convertibility confirms these findings.

In other words, taking account of the time

series properties of the data (seasonality and serial correlation, etc.) it is found that the volatility of time deposits exceeds that of sight deposits. Turning to the question, from where did depositors fly?', table 3 below gives a first indication of the results. The Table shows the evolution of deposits by a standard

Table 3 Evolution of Deposits by Type of Banks

Period 11

Public Wholesale Foreign

Large Small Large Cooperative Cooperative Stock

Small Stock

Last week of December = 100 December 100,0 January 101,1 February 97,2 March 87,5 April 91,1 May 92,8 June 94,7

11

100,0 73,6 56,9 44,7 41,0 33,4 36,1

100,0 105,6 105,4 99,9 99,8 102,2 101,7

100,0 92,7 96,6 80,6 73,4 79,3 89,3

100,0 91,8 76,1 61,7 53,7 37,8 35,1

100,0 100,0 99,1 93,7 99,1 83,6 92,2 68,0 88,8 63,5 89,5 59,9 95,2 57,7

Last week average

grouping of Argentine banks; by ownership (foreign, domestic, private stock bank, mutual - cooperative- bank and public) by type (retail versus wholesale) and by size. The table shows that at the start of the crisis (December to January), deposits in the public banks and the foreign banks actually rose whilst those in the other groups fell. Worst hit were the wholesale banks (the mayoristas') followed by the small mutual

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banks. The wholesale banks were also the worst hit in March losing on average more than 50% of their deposits. The large stock banks and the foreign banks fared best over this month and although they lost deposits, they were lower on average by only 7.8% and 0.1% respectively relative to their levels in December. Although the data also shows small cooperative and wholesale banks losing deposits after March, these further declines also reflect the fact that some small cooperatives became large cooperatives or small stock banks, and that other small cooperatives and wholesale banks were closed. Apart from these broad groupings, it is of interest to ask, what bank characteristics explain which banks lost most deposits? This question can be addressed with a regression analysis using cross-sectional data on the loss of deposits across banks and a set of explanatory variables. The results of such an analysis (not reported here) indicate that depositors did indeed discriminate and two variables stand out as important explanatory factors. The first is the liquidity of the bank as measured by its actual cash reserves (both in the vault of the central bank and at the bank itself) and the second is the interest rate paid on deposits before the crisis began. The latter is interpreted here as a measure of the riskiness of banks' operations.

The results

indicate that banks that had lower liquidity and that paid higher rates on deposits lost more deposits than the average.

Naturally, a regression analysis can only give a

partial explanation. However, the preliminary conclusion is that depositors did discriminate quite forcefully during the crisis and in particular punished banks that did not maintain high reserves of liquidity and that were perceived as being risky prospects 1) . As has been argued above, the Argentine authorities essentially took the view that the private market should take the largest part in disciplining the banking system during the crisis. Nevertheless, the Central Bank took an active management role in aiding those institutions with liquidity problems. The institutions that had the most severe difficulties fell into one of two categories (i) wholesale banks ('mayoristas') and (ii) the mutual banks (cooperatives). The wholesale banks typically had (i) a rather large holding of Argentine securities (e.g.: government bonds) in their asset portfolios, (ii) a high concentration of deposits (by size of depositor), (iii) substantial income from commissions from trading activities " The banks that were most severely affected also tended to be small. One explanation for this Is that depositors simply ran to large banks as they were perceived to be, too big to fail'. The regression analysis however tends to support the importance of liquidity and interest rate variables rather than size (although there are naturally correlations between the two).

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and (iv) a small deposit base relative to assets and hence depended on funding from the inter-bank market. These characteristics implied that these banks suffered the most from (i) the fall in Argentine asset prices, (ii) the low volumes of trading in Argentine markets, (iii) high interest rates in the inter-bank market and (iv) from the flight of large depositors.

The mutual banks had a relatively larger deposit base than the

wholesale banks but tended to have weaker balance sheets, paid higher interest rates and had lower liquidity relative to other banks in the system. From the start of the crisis to the end of March, the Central Bank provided extra liquidity through the increased use of repos ('pases'). This was particularly useful to the wholesale banks that had large holdings of public bonds. The Central Bank also assisted particular institutions with liquidity problems through the extended use of collateralized loans ('redescuentos'). The total stock of collateralized loans from the Central Bank increased by almost $1.5bn over the period December to March.

Bank

by bank data reveals that the mutual banks were the largest receivers of this type of assistance as a percentage of their total deposits. In April 1995 the stock of collateralized loans to this group amounted to roughly 26% of their deposits indicating a very strong intervention indeed by the Central Bank to aid this particular group.

Restructuring in the Argentine Financial Sector The restructuring of the Argentine banking sector was a process that had already begun before the Mexican crisis hit in December 1994.

Indeed, the Central Bank

through the enforcement of international standards of prudential regulation and in particular through the implementation of the Basel-style capital requirements was already forcing many banks to consider restructuring as a means to provide further capital to allow continued growth. To many observers, however, the restructuring process appeared to be have been moving at a relatively slow pace. This is perhaps largely attributable to the ownership structure of Argentine banks and in particular the high number of owner-managed banks in Argentina. The liquidity shock following the Mexican devaluation then provided a sharp stimulus to accelerate the ongoing restructuring process. In the period December to July some 43 institutions have merged and although these mergers tended to be concentrated in relatively small institutions this total included

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some 9.4% of total deposits and 7.5% of total assets of the system. Nevertheless, there is a considerable amount of restructuring left to be done. In particular, as a result of the financial shock, 10 institutions were closed and 4 were suspended still pending resolution at the time of writing. Following the agreement with the IMF in March, two Trust Funds were set up to aid in the post-shock, restructuring process. One Trust Fund will aid in the privatization process of the provincial banks. The resources for this fund may reach over $2bn and stem from loans from the World Bank and the Inter American Development Bank. As noted above the major public banks as a group did not suffer from a severe run on deposits. In this area, the issues are then somewhat separate from those of the liquidity shock. This Trust Fund will be aimed primarily at recapitalizing those provincial banks that have embarked on a privatization program. The second Trust Fund is directed at the private sector banks and the total resources of this fund may reach up to $2.5bn. These resources come from the proceeds of an Argentine bond issue (the so-called Bono Argentino; $2bn) and a World Bank loan ($500m). This Trust Fund will be used primarily to finance restructurings and mergers between banks. The principal idea behind the use of the fund is that an institution with liquidity difficulties may wish to merge with a second more liquid institution. The second institution may then apply for funds from the Trust Fund through a subordinated debt agreement. This subordinated debt may be counted as capital for the merged institution but in the event of non-repayment, the Trust Fund would then acquire an equity holding of the merged institution's assets which it could then dispose of on the open market. The Trust Fund's resources are to be used strictly on a case-by-case basis with the use of market mechanisms to suggest the appropriate form of restructurings. The Fund then provides a temporary means of recapitalizing an illiquid institution in conjunction with a restructuring. These funds should then provide a further incentive for Argentine institutions to restructure and hence speed the restructuring process.

5. P o l i c y L e s s o n s f r o m t h e L i q u i d i t y S h o c k The Argentine liquidity shock in the wake of the Mexican devaluation provides a fascinating case-study of the behavior of a banking system under severe stress within the

144

environment of a rather extreme form of non-accommodating monetary policy. As has been reported the successful management of the shock involved, at the macroeconomic level, using the flexibility that exists within the Convertibility system and, at the microeconomic level, aiding particular institutions that suffered a sharp run on deposits, in particular wholesale banks and mutual banks. The experience also highlighted the value of the policy of high reserve requirements. The relaxation of the reserve requirements in different stages of the crisis provided much needed liquidity and was an important factor that allowed Argentina to survive without a more serious banking crisis. It is estimated that the reduction in the reserve requirements injected up to $3.4bn into the financial system relative to a total drop in deposits of some $8.5bn. Nevertheless, the liquidity shock also provoked a re-examination of policies in particular with respect to liquidity management. Although the policy of high reserve requirements was seen as extremely useful in providing emergency liquidity, the structure and form of the reserve has now been redefined. First, as argued in Section 2, there is no special reason why a reserve for liquidity purposes should be held in the form of cash in the vault of the Central Bank. In theory, any liquid asset in any location should suffice. Further, the non-remuneration of reserves provokes distortions in the financial system and increases the cost of financial intermediation.

Hence for a liquidity

reserve there is a prima-facie case to allow banks to hold reserve in the form of US Treasuries or other highly liquid assets. The Central Bank in Argentina has, as of August 1st, reduced the reserve requirements for cash in the Central Bank and introduced a liquidity reserve system whereby banks may hold OECD country financial products. The custodian of this reserve is the New York office of an international bank. However, high reserve requirements, in the form of cash in the vault of the Central Bank or US or other assets, essentially takes resources out of the system lowering its lending capacity. It would therefore be advantageous to allow banks to hold reserve in the form of Argentine liquid securities (e.g.: Brady bonds). The problem with this arrangement is that in the event of a systemic shock, as experienced in the period reviewed, the liquidity of these instruments falls dramatically. One idea to surmount this problem is for banks to hold Argentine assets (e.g.: Argentine Government bonds) but also to purchase the right to sell these assets at a pre-specified price

145

(a put option) to a foreign financial institution. The put option then guarantees the liquidity of the bond position even in the face of a negative shock to emerging market assets which tends to sharply reduce the liquidity of such instruments. As part of the new Liquidity Requirements banks can indeed hold such bonds if covered by put options up to a specified limit. It is also argued above that (i) large depositors flew first, (ii) time deposits fell more than sight deposits during the crisis and (Iii) time deposits are on average more volatile than sight deposits. These results have implications for the structure of a liquidity reserve. In short it suggests that, from the standpoint of systemic liquidity, reserve requirements should be at least as high on term deposits as on sight deposits. As part of the new Liquidity Reserve, the rates for sight deposits and time deposits, up to a certain number of days, will be equalized at 15%.

6. C o n c l u s i o n s In this paper it is argued that the main objective of prudential supervision is to create a virtuous incentive system for agents in financial markets which promotes stability, rather than an incentive system which causes agents to behave in ways which may actually exacerbate problems of instability and runs from financial institutions. In this regard, procedures with respect to failed institutions are critical in shaping expectations and hence the behavior of agents before failures actually occur.

A

virtuous incentive system will reduce the probability of potential failures by reducing the incentives of agents to act in ways that are likely to reduce levels of solvency. In Argentina, the previous system of prudential regulation was to a large extent undermined by macroeconomic factors but also by a system of managing failed entities which, in effect, provided close to full insurance for both depositors and shareholders. This system has been comprehensively revised and a new streamlined system of regulation has been introduced which has changed incentive structures markedly. The new regulatory system was tested severely by the liquidity shock that hit Argentina as a consequence of the Mexican devaluation. The shock was certainly large by standard measures but in part because of the prudential regulations put in place, the financial system survived with very few failures. Those failures that did occur were

146

also limited to relatively small institutions and in general the type of endgame strategies reviewed in section 2 were avoided during the period. The experience of the financial shock that hit Argentina in 1995 also underlined the importance of regulations on liquidity. Recently, traditional reserve requirements have been transformed into a liquidity reserve which may be held in a number of forms all of which are remunerated. Furthermore, the structure of the reserve has been altered following the lessons learned during the Tequila period. The Central Bank has also recently issued regulations regarding banks' individual liquidity management.

This

calls for banks to calculate, on a daily basis, their liquidity positions with respect to assets and liabilities of different maturities. The financial shock in 1995 was in part transmitted by a sharp reduction in Argentine asset prices and a general rise in interest rates. In general, movements in these asset prices imply solvency risks for banks with duration mismatches or with risky market portfolios. Following Basel, the Central Bank is now considering regulations for capital requirements relating to interest rate and market risks more generally defined. These regulations are of particular importance given the volatility of Argentine asset prices. Finally, the successful management of the Tequila shock, as reviewed in this paper, will have important consequences for the future. The fact that there were few failures and that the liquidation process of failed institutions was conducted in a very different manner to previous such episodes will again condition expectations for the future. In turn, this will help to reinforce the prudent behavior of financial institutions and hence aid in the development of a more stable financial system.

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R e g u l a t i o n for a Stable Financial System: P r u d e n t i a l Supervision and Liquidity M a n a g e m e n t in Argentina C o m m e n t on R o q u e F e r n á n d e z

Günther Engel

President Fernández has presented a comprehensive and informative paper on the regulation of the Argentine banking system and on the management of the liquidity shock in the aftermath of the Mexican peso crisis. My comments refer to three topics: First, the nature and causes of bank runs; second, the integration of market discipline into banking regulation; third, the credibility of the Argentine currency board system.

T h e n a t u r e a n d c a u s e s of bank runs To put the Argentine liquidity shock and the appropriate banking regulation into proper perspective, it is important to make clear what kind of bank run we are talking about. If there is a run on one or more individual banks because they are badly managed and on the brink of failure, they lose deposits which are redeposited at other banks. So there is no net loss of deposits in the banking system. In the case of a systemic bank run there is a decline in total bank deposits and a net currency outflow from the banking system. Therefore, the Argentine liquidity shock seems to have been a case of a systemic bank run. There are two different types of systemic bank runs according to their respective causes, though the borderline between them is not very clearcut. The first one begins at the microeconomic level with the failure of individual banks which triggers a contagious process of more bank runs and eventually infects the whole banking system. In this case the individual banking failure is the cause of the systemic run. The other type is started at the macroeconomic level by an exogenous shock, e.g. a loss of confidence into the commitment of the authorities to convert the national currency into

148

gold or foreign exchange at some specified rate. In this case we have at once a system-wide run and the ensuing bank failures are the result of this run. Both types of systemic runs require different types of regulation for a stable financial system. In the first case, the regulations have to be directed at assuring the soundness of the individual banks. The second type calls for credible monetary institutions and for a credible and consistent stabilization policy. While the first type of systemic run, which is based on the contagion effect, is frequently cited in the textbooks, historically it has been a rather rare event. The real danger of a systemic bank run lies in an unstable macroeconomic environment. I suppose that the Argentine liquidity shock was of this second type and was triggered by a sudden distrust of the fixed peso-dollar-rate in the wake of the Mexican peso crisis. I will return to this aspect later. If historical experience tells us that, contrary to common belief, banking systems, even with very little regulation, are not particularly prone to endogenous outbreaks of systemic instability, the question is appropriate as to what kind of banking regulation do we really need and do we need banking regulation at all to assure the stability of the financial system.

The i n t e g r a t i o n of m a r k e t d i s c i p l i n e i n t o b a n k i n g r e g u l a t i o n If an economy has almost no official banking regulation the prudential supervision has to be carried out by the depositors themselves, because they have a personal stake in the fate of the banks. As the experience of the Free Banking Era in the United States shows, there will be an incentive for the provision of public information about the soundness of individual banks. In this case, banking regulation is accomplished by market discipline alone. Of course, this system will be accompanied by regular bank failures. If these are unwelcome because of the losses incurred by depositors, an official supervision seems necessary. But if there is a complete substitution of regulatory bodies for market discipline, this may have considerable drawbacks. I will give two examples. If the banking activities are regulated with respect to the risk position, this will probably entail a loss of alloctive efficiency for the financial system because regulators are hardly able to measure risk, let alone to determine the optimal amount of risk.

149

If deposits are fully insured, there will be a substantial moral hazard problem which leads to higher losses in the case of bank failures. These losses my even exceed the reserves of the insurance system which means they will have to be born by the taxpayer. Therefore, regulatory systems seem to perform quite badly without the help of some form of market discipline. I have the impression that the Argentine reforms of the last four years took this idea into account. Nevertheless, I have two critical remarks concerning the details. According to president Fernández, Argentina has revised its system of auditing financial institutions and has introduced financial incentives for auditors to perform their functions competently. I wonder what these auditors are looking at and what measures they are supposed to take if something is wrong. I think they should concentrate on controlling the banks' net worth provided there are market oriented accounting rules. If the net worth, perhaps measured by the capital-to-asset ratio, falls below a specified minimum level, the auditors or the regulators should close the bank immediately with the order either to recapitalize or to dissolve. This policy of early closure before the net worth becomes negative simulates the market discipline of an unregulated banking system and may even function better. The Argentine deposit insurance scheme, which was reintroduced in 1995, is limited in two respects. At first, it is only partial; I understand this to mean that the insured deposits are covered only up to a certain percentage. This coinsurance is apt to remove the moral hazard problem and to introduce a certain amount of market discipline, because it gives an incentive to the depositors to monitor the risk position of their banks. On the other hand, the threat that regulators will not rescue a failed bank remains credible because the depositors will have to bear only part of the. losses. This brings me to the second limitation of the Argentine deposit insurance scheme. It only covers deposits that pay an interest rate below a certain level and leaves the other deposits uninsured. This seems to me a highly questionable regulation. If a big bank is about to fail with a considerable number of uninsured deposits of high denomination, there will be a tremendous pressure on the regulators to rescue the bank. The bailout of the Continental Illinois bank in 1984 is a striking case in point. Considering the problem of uninsured deposits this bank was simply "too big to fail". Therefore,

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leaving an important part of the deposits uninsured may reintroduce the moral hazard problem through the back door.

T h e c r e d i b i l i t y of t h e A r g e n t i n e c u r r e n c y b o a r d s y s t e m As I have mentioned above, the Argentine liquidity shock to me looks like the type of systemic bank run that has been triggered by a macroeconomic shock, in this case by a sudden loss of confidence in the sustainability of the fixed peso-dollar-rate. Therefore, I wonder what role the system of banking regulation and the liquidity management by the central bank really had to play in reestablishing credibility compared to the reelection of president Menem and - what probably may have been more important- of minister Cavallo. The coincidence of the stabilization of the deposit drain and of the recovery with the time of reelection certainly is not the result of pure chance. Therefore, it looks quite possible that the succesful management only bought time before the next systemic bank run breaks out, because the fundamental problem has not been solved: the uncertain credibility of the currency board system with a fixed peso-dollar-rate. Since its introduction in 1991 the difference in inflation rates between Argentina and the United States has led to a real appreciation of the peso by possibly 30 percent or even more. Since a future reversal of the inflation difference seems rather unlikely, the sustainability of the peso-dollar-rate remains in doubt.

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P r o b l e m s of Monetary Policy in Latin A m e r i c a

Helmut Hesse and Antje Heikamp

1. P r e l i m i n a r y r e m a r k Today, a good decade after the eruption of the debt crisis, Latin America ranks among what are known as the "emerging markets". Even so, doubts are warranted - and owe a great deal to the crisis besetting the Mexican peso in 1994-5- as to whether the process of growth that was ushered in by far-reaching economic policy reforms and adjustment measures could be set on a path which is safe over the long term and considered sound. 1) In particular, it is doubted whether it is possible to raise the propensity to invest. Although the growth of national economies is based on a number of determinants, investment continues to be regarded as one of the mainstays of expansion, especially since a significant portion of technological progress is incorporated in capital goods. Owing to the globalization of the capital goods markets, too, new technologies have become accessible to all countries. The raising of the propensity to invest in Latin America constitutes one of the major economic policy challenges of the coming years. Nearly all observers agree on that point. 2 ' "A sustained acceleration in growth will require significant increases in the volume and quality of investment. Even if structural reforms boost productivity growth, there will be a clear need to increase the rate of capital accumulation beyond its current levels... Because availability of foreign funds is likely to be tight, most countries will have to rely heavily on higher domestic saving to increase investment... Savings are at the heart of development: increased savings allow faster capital accumulation and higher economic growth." 3 ' Monetary policy makers, too - indeed, in particular measure- must face up to this challenge. They must dedicate themselves to a sustained increase in the domestic saving ratio and to ensuring a steady, long-term inflow of foreign capital for investment purposes. In the following pages, we shall discuss the extent to which this can be achieved. " World Bank (1993, 138). 21

Bank tor International Settlements (1995,19) and World Bank (1995b).

31

World Bank (1993, 111).

152

2. Latin A m e r i c a in the pattern of g l o b a l i z e d financial m a r k e t s The major industrial countries are not the only ones to have deregulated their financial sectors and facilitated access to the international financial markets since the beginning of the eighties. In view of their low saving ratios and substantial Capital flight, the countries of Latin America, too, conducted radical and rapid deregulations of their financial sectors in the late eighties and early nineties, and these deregulations led to the integration of Latin America's financial markets into global financial markets.11 In this way, the close ties between domestic investment and domestic saving were greatly eased. Open economies are not solely dependent on their own savings in order to implement additional investment; by means of capital imports, they can also fall back on foreign savings. Conversely, the domestic savings of an economy that forms an integral part of the pattern of globalized financial markets are not available solely for the purpose of domestic investment; on the contrary, such savings can also be made available to the international financial markets by way of capital exports. On the one hand, high capital mobility (which was made possible by means of farreaching deregulation measures, and which is further enhanced by the resources of modern information technology) gives rise to an improvement in global capital allocation, but, on the other hand, it is accompanied by new dangers, such as the deficit countries' increasing dependence on the rest of the world and the international monetary system's vulnerability to undesirable macro-economic trends.2) Capital imports only generate growth to the extent to which the incoming funds are utilized for investment. This is why it is important to examine their implications for investment and saving. Then it becomes evident that capital imports to Latin America - as distinct from those to Asia- have hardly led to any increase in productive capacity, and hence have made little contribution to growth, since they are used for consumption, rather than for investment, purposes. Since the mid-eighties, the investment ratio in those countries of Latin America which enjoy a heavy capital influx has remained virtually unchanged at approximately 20 %; at the same time, economic growth in this group of countries has declined from an average of 2.4 % between 1983 and 1989 to an average of 2.1 % in the period between 1990 and 1993. By contrast, the up-and-coming national economies of Asia have achieved, by virtue of high capital imports, a further increase in their propensity to invest, which, at an annual average 1>

Bank for International Settlements (1995,161).

21

Hesse, Braasch (1992, 398).

153

F i g u r e 1: Savings in % of GDP

Investment in % of GDP

Source: IMF

rate of 31.4 %, was already high in the mid-eighties, to a present level of 33.5 %. The high pace of growth of the eighties, with average annual growth rates of over 7.5 %, could thus be maintained. 1) The Mexico crisis is not least a good example of the fact that inadequate domestic saving, which is insufficient to safeguard domestic investment (in Mexico the private saving ratio in 1994 came to only about 5 5 % of the private investment ratio) represents an inadequate basis of confidence, which, in globalized financial markets, may lead to an abrupt outflow of outside savings on the part of international investors and plunge the economy concerned into profound crisis.2) Furthermore, if we visualize the current high level of tension in the global capital market, domestic saving becomes even more important. The movement of the world saving ratio provides information about the supply of tight savings in the globalized 11

IMF (1994, 57).

21

Tletmeyer (1995, 4).

154

financial markets. Since the beginning of the sixties, the course of the world saving ratio can be divided into three phases. During the seventies, compared with the previous decade, the ratio increased by approximately 2 percentage points to 25 % owing to adjustment processes following the oil price crisis. Since the beginning of the eighties saving ratios have been declining world-wide. The average ratio in 1992 and 1993 was only 21.75 %. 1) The main reason for this trend is the rapid decline in saving ratios in the major industrial countries. While the saving ratio of the G-10 countries averaged about 24 % in the late sixties and early seventies, an average saving ratio of barely 20 % of GDP was recorded between 1990 and 1995.2) By contrast, the saving ratios in developing and newly industrializing countries have shown an upward trend from 19 % in 1970 to 27 % at present. That suggests that the growth of the developing and newly industrializing countries in the past 25 years has largely been generated from their own resources.3) Further tensions in the global capital market are due to the rapid increase in the demand for capital. In particular, the demand for capital of the countries in transition of central and eastern Europe and the up-and-coming national economies of east Asia and Latin America, as well as the high budget deficits of the industrial nations, represent a major burden on the global capital market. In order to finance the public sector deficits of the G-10 countries, approximately 16 % of the total savings of these countries was absorbed between 1992 and 1994. Net capital inflows to developing countries and countries in transition came to no less than 4 % of the private saving of the G-10 countries.4' The upshot of this shortage in the global capital market is high real rates of interest, which ultimately impede an acceleration of economic growth rates in many countries. In keeping with the trend in saving ratios, the movement of real rates of interest can be divided into three phases. After a global real rate of interest5' of no more than 0.5 % was recorded as recently as the seventies, a steep rise in real rates of interest to an

"

IMF (1995a, 68).

21

Group of Ten (1995, 21 b).

31

IMF (1995a, 68).

41

Group of Ten (1995, 52).

51

Calculated on the basis of the GDP-weighted yields of ten-year Government bonds from the USA, Japan, Germany, the UK, Canada, Belgium, the Netherlands and Switzerland, less long-memory inflation estimate.

155

average of 4.75 % has been observed since the beginning of the eighties. Thus, the global real rate of interest outstrips the initial level of the sixties by almost two-thirds.1)

Figure 2:

Saving Rate

World Saving Rate (in % o f GDP) and Global Long-Term Real Interest Rate (in %)

|nterest Rate

Source: IMF

3. Saving in Latin America The contribution that monetary policy makers in Latin America can make to a lasting rise in the saving ratio is dependent on the factors that determine saving in those countries. Therefore, for the time being, attention must be focused on the trend in saving and the reasons for the saving patterns observed. Latin America, which has traditionally exhibited, at the best of times, only comparatively low saving ratios, has recorded a decline in domestic saving since the beginning of the seventies. Overall saving in Latin America went down from an average of 19.8 % between 1970 and 1982 to only 15.3 % between 1983 and 1992. This means that, with "

IMF (1995a, 84).

156

regard to saving, Latin America comes last world-wide.1) The impact on the share in global saving cannot be overlooked: while Asia was able to double its share in global saving, from an average of 8 % between 1975 and 1982 to an average of 16 % between 1991 and 1993, Latin America recorded a decline in this proportion, from 6 % in the period between 1975 and 1982 to only 4.5% in the period between 1991 and 1993.2) However, it has to be borne in mind that some countries in Latin America have successfully bucked this general trend. Chile, for example, has achieved a significant increase in its saving ratio since the beginning of the eighties, namely to just over 25.3 % last year. Certainly, this favorable course of events owes much to the institutional framework, such as the creation of a privately financed pension insurance system, but the role of monetary policy, which ensures a significantly higher level of stability in Chile as compared with other Latin American countries, must not be underrated when assessing such developments.

3.1.

Reasons for a low propensity to save in Latin America

The low propensity to save in Latin America can be put down to a number of different factors. In the first place, there are structural factors, which, since they cannot easily be influenced by monetary policy, will be treated but briefly below. Secondly, there are macro-economic factors, in combating which monetary policy plays a major part. The following analysis centers on these macro-economic factors.

3.1.1.

Structural factors

One reason for the declining saving ratios in the industrialized countries is considered to be the aging of the population.3) When elderly people retire, they draw on the savings they accumulated while they were part of the work-force. Precautionary saving to build up a financial cushion for old age is discontinued. The situation in Latin America is different. There, low saving ratios are accounted for by the high proportion of younger generations in the overall population, whose ability to save is still fairly

11

Edwards (1995, 10).

21

Turner (1995, 14).

31

Hesse, Braasch (1992, 388).

157

limited. To this extent, it seems possible that Latin American national economies will "grow into" higher saving ratios.1> A national economy's degree of urbanization provides evidence of the population's standard of social security. Firstly, urban incomes are regarded as being safer than those in rural areas; secondly, social (old-age) insurance schemes in cities are more advanced than those in rural areas. Hence, there is less need for precautionary saving. Edwards concludes "that the degree of urbanization plays a significantly more negative role in Latin America than in the rest of the sample".21

3.1.2.

Absence of a "stability culture"

A lasting increase in the saving ratio in Latin America- as in other countries - calls for stable underlying macro-economic conditions that provide a long-term real value guarantee for savings. Price stability and expectations of stability are of overriding importance in this context.3) Latin America does not satisfy these stability conditions for a high level of saving. Until very recently, uncertainties over future price movements in Latin America have been sizable. Since the beginning of the eighties, price movements in Latin America, with few exceptions, have been characterized by high inflation rates, with up to four-digit figures, which have, moreover, (and that is the key factor), been subject to extreme fluctuations. Countries such as Mexico and Argentina have scored notable stabilization successes since the end of the eighties. However, they have chiefly been the result of stability imports due to pegging their currencies to the US dollar. The pent-up need for depreciation deriving from the absence of realignments, which need was relieved only in part by the Mexico crisis, implies new potential price rises that may well lead to a devaluation, in real terms, of savings, and thus act as a disincentive to save. What is more, in countries with high and sharply fluctuating inflation rates or merely with a lack of experience of stability nominal interest rates perform their allocative function to only a limited degree.4) It is probably due to this lack of experience of stability that expectations of consistently low and not very volatile inflation rates have not become generally accepted, so that future price increases may well be misjudged. If nominal interest rates imply unduly low risk premiums, the " Edwards (1995, 34). 21

Edwards (1995, 31).

31

See the Econometric Analysis in Appendix.

4)

Ogaki etal. (1995, 4).

158

danger of a depreciation of assets, in real terms, persists, that will prevent an increase in saving. Only the guarantee of secure expectations against a backdrop of long-term low inflation rates and low inflation volatility can lead to a sustained increase in the propensity to save.

3.2.

Combating inflation as a contribution by monetary policy to increasing the saving ratio

Hence, it will be a priority objective of monetary policy in Latin America to safeguard long-term stability, in the sense of low and fairly uniform inflation rates, so that the incentive to save can be enhanced by expectations of a guarantee in real terms of the value of savings. Monetary policy on its own, however, cannot ensure lasting price stability. On contrary, it is necessary for all those involved in economic activity to make stability guiding principle of their actions. In this respect, I tend to be skeptical about chances of the stability stance adopted by monetary policy spreading throughout entire economy in Latin America.

the the the the

Social tensions which would only be further exacerbated by a restrictive monetary policy are of paramount importance when accounting for inflation in developing countries. Owing to this absence of a social consensus on what is possible in terms of income distribution, distributional struggles representing social groups' desire for a larger share of the national product lead to excessive demands being made of the national product and inevitably to an increase in the price level. The "aggression theory of inflation", which was formulated in this context, says that high rates of price increases mask social tensions that would lead to revolutionary upheavals if monetary stabilization were brought about.1) Overall, it becomes evident that it will probably be a protracted process to show Latin America the way to higher saving. It takes a lot of time to ensure stability-oriented behavior and a stable balance of power, not to mention the creation of the institutional framework, such as the setting-up of a privately financed pension insurance scheme. In the medium term domestic saving alone will be insufficient to bolster the growth process in Latin America. Hence, the national economies of Latin America will remain 11

Hesse, Sautter (1977,108).

159

to be net capital importers, i.e. they will stay on the demand side of the global capital market.

4. Can c a p i t a l f l o w s c l o s e t h e s a v i n g gap in Latin A m e r i c a ?

4.1.

High capital inflows to Latin America since the beginning of the nineties

It is questionable whether the capital inflows to Latin America that have been registered since the beginning of the nineties contribute to investment, thus to a certain extent neutralizing the low saving ratios, or whether they are merely held in liquid forms, and therefore are subject to a grave danger of being withdrawn. What requirements are to be made of a monetary policy strategy which is designed to contribute to long-term capital imports that stimulate growth? The influx of foreign capital to developing countries and newly industrializing countries that has occurred since the beginning of the nineties is primarily benefiting the emerging markets in Latin America. After the region had recorded capital outflows totaling approximately US $ 116 billion in the period between 1983 and 1989, an influx of about US $ 200 billion has been registered since the beginning of the nineties. Within the region, Mexico has undergone the most radical change in capital movements, the dimensions of which highlight the country's special position as a NAFTA member state. Following net capital outflows totaling US $ 15 billion between 1983 and 1989, overall inflows of US $ 102 billion were recorded in the period between 1990 and 1994. In 1993 the influx of foreign funds was equivalent to 8 % of Mexican GDP. Mexico was therefore able to attract over 20 % of the capital flows that were accruing altogether to developing countries and newly industrializing countries, although its share in the aggregate GDP of the emerging markets was no larger than 8 %. Capital flows to Asia, by contrast, took a calmer course. The influx increased from US $ 117 billion between 1983 and 1989 to US$261 billion in the period between 1990 and 1994.1)

"

IMF (1995b, 2).

160

Capital flows to Latin America and macro-economic indicators 1977-82

1990

1983-9

1991

1992

1993

1994

Annual averages Capital flows in US S billion Overall net capital imports

26.3

-16.6

17.9

28 6

52.6

62.3

38.6

Direct investment in %

5.3 20.1

4.4 -26 5

6.8 38.0

11.2 39.2

12.9 24 5

13.8 22.2

14.8 38.3

1.6 6.1

-1.2 7.2

5.6 31.3

16.7 58 4

27 3 51.9

53.8 86.4

29.4 76.2

19.4 73 8

-19.8 119.3

5.5 30.7

0.7 2.4

12.4 23.6

-5.3 -8.5

-5.6 -14.5

3.5

1.7

-0.1

2.9

2.9

3.4

5.0

52 5 0.16

175.1 0.72

647.8 0.4921

162.5

394

908

312

-5.831

-0.7

0.1

-0.5

-0.1

-0.6

-9.160 4 '

-1.096

-17.086

-35.008

-44.566

-46.038

340.6"

264.2

269.1

2584

261.3

Portfolio investment in % Other in % Macro-economic indicators Increase in real GDP in % Inflation rate Variability coefficient11 Budget deficit as % of GDP Current account deficit in US $ million Debt service ratio51

199.66»

Sources: International Monetary Deutsch-Südamerikanische Bank 11 21

Fund,

Inter-American

Standard deviation/weighted average 1990 to 1994

31

1987 to 1989

4)

1985 to 1989

5)

External liabilities as % of export proceeds

61

1980

"

1986 to 1989

Development

Bank, World

Bank,

161

It will be of crucial importance to future trends in Latin America whether the incoming foreign capital will be available over the long term and whether it can be used to foster additional investment. The pattern of the capital inflows could provide an initial indication of the duration of the capital tie-up. The resurgence of the capital flows to Latin America was accompanied by a structural shift, too. This development reflects the process of disintermediation which is to be observed world-wide owing to the debt crisis. While capital inflows to Latin America in the eighties were determined by bank loans, these have increasingly been relegated into the background since the beginning of the nineties.1) Since 1990 a major part of the capital inflows to Latin America has been channelled through the international bond and share markets. Portfolio investment and direct investment account for 96 % of the capital inflows; today, bank lending accounts for no more than 4 %. This development has been less pronounced in other regions. The ratio of portfolio investment and direct investment in Asia, for example, came to 69 % in 1990.2) However, the conspicuously high proportion of portfolio investment on its own is not enough to infer a short duration of capital tie-up and thus an insufficient contribution to the encouragement of domestic investment. The decisive factor, rather, is whether a long-term tie-up of portfolio investment can be achieved if it is transferred from the purely monetary sector to the real sector of the economy. "Furthermore, when capital inflows surge rather than follow a stable trend, there tends to be a gap between financial saving and real Investment. This is potentially destabilising for the economy if the funds remain liquid and can be recalled quickly. Financial savings in excess of real investment can also fuel speculative pressures, inflation and undermine rather than facilitate the investment process. More attention needs to be given to the mechanisms for transforming financial savings into real Investment. From recent country experiences, there appears to be no universal formula for controlling or channelling capital flows."3)

"

Brooks-Senflleben (1993, 3).

21

IMF (1995b, 2).

3)

Bradford (1993, 52).

162

4.2.

Reasons for the high capital imports to Latin America

Consequently, the following sections focus on the prerequisites for a long-term capital tie-up. To which extent is Latin America able to satisfy these prerequisites today, and what is monetary policy's contribution to safeguarding the basis of a long-term capital tie-up in future? Studying the reasons for the heavy capital inflows to Latin America sheds light on the underlying investment motives and enables us to draw conclusions as to whether the capital will help to finance long-term growth. The heavy capital influx to Latin America has occurred against the background of general economic policy reforms, the crucial factors of which were various structural measures (liberalization of foreign trade, deregulation and privatization of the domestic market) and a restrictive monetary and fiscal policy.1) Initial successes were recorded between 1990 and 1991, thus stimulating the influx of foreign capital, which had just started to flow. For instance, the rate of price increases could for the first time be reduced significantly in 1991 (even if it still remained at a very high level, compared with other industrial countries); at the same time, the growth rate was raised to approximately 3 % again after the stagnation of the previous years.2) This favorable trend is also reflected in the region's debt service ratios. Compared with 1986, when external liabilities were four times higher than export proceeds in Latin America, foreign indebtedness was reduced to 2.6 times the export proceeds in 1990. (Prior to the outbreak of the debt crisis in 1980, however, external liabilities were only twice as high as export proceeds.)3) This made Latin American economic policy more credible, and at the same time the security and profitability of capital investment was increased. Notably domestic investors, many of whom have a better understanding of the market than foreign investors, now spearheaded a return of flight money to the region,4) thus assuming the function of a "leading indicator"5) for other investors. Success in terms of stability in Latin America thus triggered off a renewed influx of foreign capital. In addition, exogenous factors played an important role. Capital 11

Bank for International Settlements (1994, 48).

21

Calvoetal. (1993, 125).

31

World Bank (1995a, 204).

41

IMF (1995b, 7).

s>

Jaspersen, Ginarte (1993, 62).

163

inflows, broken down by regions, show that as early as 1990 approximately 6 0 % of capital imports to Latin America were due to capital exports from the USA.1) Interest rate reductions in the United States since the end of the eighties on account of the slackening of economic activity2) and the stock market crash facilitated capital flows to Latin America, led to a reduction in debt service and thus improved the solvency and creditworthiness of Latin America, so that the way was paved for renewed foreign borrowing. Furthermore, interest rate cuts in other industrial countries led to a decrease in the return on capital investment in those countries. The positive interest rate differential in favor of Latin America, which was additionally fostered by higher interest rates on account of the restrictive monetary policy stance in Latin America, constituted an inducement to invest in Latin America.3) In addition, the advance of institutional investors and the associated professionalization of investment behavior are key factors in the increase in capital imports to the emerging markets in Latin America. The portfolio managers of institutional funds manage an increasing share of global savings4' and disseminate world-wide the capital that has been entrusted to them, taking advantage of minute yield differentials. This gives rise to a higher degree of international diversification of portfolio investment. At the same time, the share of funds lodged in developing and newly industrialized countries by institutional investors increased.5) In order to limit exposure, the players in international financial markets continuously analyze investment countries' credit rating. On account of the professionalization of investment behavior, policymakers in the countries of Latin America are exposed to the critical scrutiny of the markets to a greater extent than they used to be. If confidence in the stability-oriented monetary and economic policy stance is shaken even slightly, the funds quickly withdraw large capital sums from the countries concerned. The massive capital outflow from Mexico and the nose-dive of the Mexican peso show what grave implications a macro-economic policy that has forfeited credibility can have for the affected national economy and for the stability of the international financial system. The reduction of the " Calvoetal. (1993, 127). 21

The Federal Funds Rate declined from 9.8 % in April 1989 to 2.9 % in November 1992.

31

Calvoetal. (1993,118).

4>

The investment amounts that are managed by the most important institutional investors (pension funds, insurance companies, mutual funds) of the major industrial countries were estimated at approximately US $ 13 billion in 1993. IMF (1995b, 4).

51

"In 1987 about $ 0.50 of each $ 100 of foreign portfolio investment from industrial countries was invested in emerging markets, but by 1993 more than US $ 16 out of each incremental US $ 100 of foreign investment was invested in emerging markets." IMF (1995b, 4).

164

danger of capital withdrawals and the long-term tie-up of capital imports call for macro-economic stability. It is primarily monetary policy that has to respond in this context. An anti-inflation policy which is geared to the long term and facilitates low inflation rates of little volatility offers effective protection against an erosion of the value of capital inflows owing to depreciation or inflation. On the whole, it transpires that not only the raising of the saving ratio but also the long-term availability of foreign capital hinges on domestic stability. "When the predominant factors have been external, capital inflows have tended to be short term and highly reversible and to produce domestic overheating. When internal structural reasons have predominated, not only has there been no overheating but capital inflows have contributed to achieving macroeconomic stability and have tended to be sustainable."1) As a reason for the heavy capital inflows to Latin America, external factors are obviously much more important than in Asia. According to econometric analyses, the explanatory value of external factors for Latin America is put at between 30 % and 60 %, while that for Asia is estimated at only 20 % to 25 %.2)

5. M o n e t a r y policy g e a r e d to quality control The prime objective of monetary policy in Latin America in the next few years will be the building of confidence by means of a consistent anti-inflation policy, so that foreign capital is available over the long term to finance domestic growth. Not only must monetary policy stabilize the expectations of domestic savers, it must also stabilize those of foreign investors. It is thus to a great degree torn between the requirements of internal and the requirements of external stabilization. The room for manoeuvre available to a central bank for pursuing a successful anti-inflation policy depends crucially on the prevailing exchange rate system. This consideration is to be examined in greater detail below. The focus of interest is Argentina's currency board system and Chile's crawling peg, with a margin-of-fiuctuation construction and a basket of currencies. Both systems constitute antipoles, and are under discussion in the current period of reorientation of monetary policy in Mexico and other countries of Latin America in the aftermath of the peso crisis.

11

Dehesa (1994, 9).

21

Dehesa (1994,15).

165

5.1.

Fixed-exchange-rate systems from the point of view of quality control

In many countries of Latin America, defining a nominal exchange rate anchor was one of the key elements of the anti-inflation programs introduced in the eighties. The aim was to provide clear guidelines for monetary policy, to contribute to reassuring the financial markets and to take advantage of a certain bonus of confidence that was meant to prevent the implementation of excessive wage demands and the emergence of a wage-price spiral.1) It is tempting for countries with a high rate of inflation to peg their exchange rate to a stable currency as this ensures a comparatively speedy transition to lower inflation rates. However, it also poses a serious problem, since it leads as a rule to the appreciation of the currency in real terms. In spite of declining inflation rates, there is still a positive inflation differential vis-à-vis the US dollar as the benchmark currency. This trend is reinforced in periods of heavy capital inflows, when the monetary expansion due to the liquidity influx from abroad results in price increases that thwart the stability imports that were made possible by the pegged exchange rate.2) Latin America witnessed a real appreciation of approximately 40 % in its currencies' external value in the period between 1987 and 1994. The associated decline in international competitiveness is reflected in the course of foreign trade. In the period between 1990 and 1994, the region's import volume rose by 80%, while the increase in exports in the same period came to only 35 %.3) Growing current account deficits as a result of the real appreciation signal a pent-up need for depreciation to the international financial markets. Doubts as to the ability to maintain parity may lead to abrupt withdrawals of capital on the part of international investors, who seek to avoid imminent losses on account of depreciation. The currency board system, which has been in use in Argentina since 1991, is the most prominent example of a fixed-exchange-rate regime in Latin America. This system is characterized by a one-to-one pegging of the Argentine peso to the US dollar and the 100% covering of central bank money by the central bank's monetary reserves. Moreover, the Argentine monetary system of the past few years is characterized by the completely free movement of capital; there are restrictions neither on capital imports nor on capital exports. Nor are there any cash deposit requirements " Bank for International Settlements (1994, 48). 21

Brand, Rohm (1995, 23).

31

Turner (1995, 12).

166

or, say, any minimum deposit periods for non-residents' investments. The increases in reserves due to high capital imports were translated into roughly corresponding rises in the monetary base, so that a continuous remonetization of the country, which had been demonetized by hyperinflation and the subsequent currency reform, was possible. The successes of this system of fixed exchange rates in the fight against inflation are impressive. For example, the hyperinflation of 1989-90 was curbed within a short period of time, and a year-on-year inflation rate of 4.2 % was achieved as early as 1994. If we look at the period since the introduction of the currency board system, consumer prices nonetheless increased by a total of approximately 61 % from 1991 to the first quarter of 1995. Correspondingly, Argentina has experienced a sharp appreciation of its currency vis-à-vis the US dollar in real terms. The associated deterioration in international competitiveness led to a renewed increase in the current account deficit, to approximately US $ 8.6 billion in 1994, after a current account surplus totaling about US $ 4.5 billion had been recorded as recently as 1990.1) The Argentine system is therefore, as has become manifest, able to score short term successes in combating inflation since it imports price stability from the anchor country USA. However, it seems doubtful whether this stability can be safeguarded in the long run. One must not overlook the fact that the currency board system puts nominal exchange rate stability before the objective of price stability. Massive capital imports for a long period, which a stability oriented monetary policy has to stimulate in order to compensate for insufficient domestic savings, induce an expansion of monetary reserves. Because of underdeveloped sterilizing facilities, these inflows cause a growth in the monetary base. As the Argentine central bank has relinquished control 11

Since the introduction of the currency board system the Argentine peso also appreciated in real effective terms. Between the beginning of 1994 and August 1995, the real effective exchange rate of the peso depreciated by almost 8 percent. This paralleled the depreciation of the US dollar vis-à-vis the DM and the Yen. During the period April 1991-January 1994 the real effective exchange rate of the peso had appreciated by 34 percent, so that all in all the appreciation effect dominated. This partially compensated the preceding depreciation of the Argentine currency since 1980. However, according to the judgement of the IMF, merely half of the cumulative loss of competitiveness was offset by efficiency gains and changes in taxation. The current account surplus in the first half of 1995 (about 1 billion US-$ after a deficit of about 2.9 billion US-dollar in the first half of 1994) suggests that the competitiveness of the Argentine economy is adequate at present. But this development can also be explained as a short-term consequence of the liquidity crisis In Argentina which followed the crisis of the Mexican peso. The weak performance of imports in the first half of 1995 (-5% with respect to the first half of 1994) is a result of the "credit crunch'-induced recession. At the same time the good performance of exports in the first half of 1995 (+47% with respect to the first half of 1994) reflects the change of relative prices in favor of the exports which is a result of the slackening of the domestic demand and the thereby reduced price inflation.

167

over the monetary base and thus over monetary growth heavy durable capital imports contain the seed of a mushrooming of the domestic money stock and of a resurgence of higher inflation rates. In other words, these lead not only to a further real appreciation of the currency (which reduces foreign investors' confidence that Argentina will be able to maintain the one-to-one pegging to the US dollar over the long term) but, at the same time, discourage domestic investors. Thus, it is unlikely that the currency board system will enable monetary policy makers in Argentina to make a significant contribution to durably increasing the saving ratio and stabilizing net capital imports. Keeping up the currency board system and maintaining massive and long-term capital inflows in order to support long-term financing of economic growth, the Argentine central bank will have to face an insoluble conflict between domestic and external stability.

5.2.

More flexible exchange rate systems from the point of view of quality control

By introducing more flexible nominal exchange rate systems with the aim of stabilizing a currency's real external value, it is possible to mitigate a deterioration in international competitiveness, but only at the cost of ongoing higher relative inflation rates. On account of their forgoing stability imports, by pegging the domestic currency to a stable nominal exchange rate anchor, capital investors therefore face a greater risk of their assets being eroded through inflation or depreciation. Unlike the situation under a fixed-rate system, in this case the capital investors bear the exchange rate risk themselves. The associated uncertainties may lead to a slowdown in speculative capital inflows. By contrast, the influx of longer-term capital investment might be increased, since maintaining the real external value impedes a deterioration in international competitiveness, thus ensuring sustainable current account deficits. To this extent, long-term capital investment appears predictable. The possibility of controlling domestic monetary growth is another advantage of more flexible exchange rate systems. The Chilean currency standard, which provides for the management of the real effective exchange rate within fluctuation bands, is a comparatively more flexible nominal exchange rate system. The central rate is fixed in such a way that the inflation

168

differential vis-à-vis foreign countries is offset; in addition, with the aid of a basket of currencies, shifts between the exchange rates of the US dollar, the Deutsche Mark and the yen are taken into account, with the weighting of the individual currencies being roughly in line with the pattern of Chilean foreign trade, thus permitting the management of the effective exchange rate. Different monetary aggregates constitute the nominal anchor of the system. In the event of capital imports, they are managed in keeping with inflation by sterilizing reserve increases. In order to fend off short-term capital imports, Chile has introduced strict capital controls. For example, a cash deposit requirement of currently 30 % (previously 20 %) has been in effect since 1992 on funds raised abroad. At the same time, there are minimum lodgment periods for certain categories of capital imports.1) Overall, it has become evident that in Chile, owing to the comparatively low real appreciation, "the current account deficit has been kept within reasonable magnitudes. This shows that the external situation is also in equilibrium. Regarding this issue, it is important to stress that, in the last decade, in Chile the exchange rate has not been used for anti-inflationary purposes. We had a bad experience in the early eighties with that type of policy and so we avoid it, especially if it means a large appreciation of our currency. The main instrument used for stabilization purposes has been, and will continue to be, tight monetary and sound fiscal policies."2' Because of the absence of a nominal exchange rate anchor, Chile nonetheless continues to record comparatively high price increases although, since 1990, it has seen a decline in the rate of inflation from 27.3% to 8.9% in 1994, thanks to the stability-oriented policies of the central bank. The key factor has been that the inflation rates have been subject to markedly smaller fluctuations, not least on account of their low initial level, as compared with other countries in Latin America. Hence, by Latin American standards, the Chilean central bank enjoys a relatively high level of confidence, which forms the basis for a higher level of saving and a long-term tie-up of foreign capital. This was why Chile (in view of the additional support provided by the institutional framework, including a privately financed pension insurance system and restrictions on capital movements) was able to achieve the highest saving ratio in Latin America in 1994, at 25.3 %. With a ratio of direct investment to total private capital inflows amounting to 57 %, Chile is likewise near the top of the table among Latin American countries. "

IMF (1995b, 83).

21

Zahler(1995, 23).

169

6. Conclusions Monetary policy in Latin America can make a contribution - even if only a limited one - to a sustained increase in the domestic saving ratio and to ensuring a steady long-term influx of foreign capital for investment purposes. To perform this task, the central banks of Latin America must pursue a strict and lastingly credible antiinflationary course in order to create stable underlying conditions and dependable expectations for domestic and foreign savers. However, it is very difficult for monetary policy to achieve this objective if it is forced, in the struggle over the distribution of income, to finance excessive demands on the national product in order to avert social tensions. In addition, monetary policy in Latin America is caught up in an almost insoluble conflict between domestic and external adjustment requirements. Heavy capital imports, which are necessary for the long-term financing of economic growth, make the central banks' task of combating inflation more difficult if there is too massive an influx of capital. Short-term stability imports can be achieved by pegging the domestic currency to an anchor currency, but in the process monetary policy risks losing control over the course of the money stock and prices. It is questionable whether lasting successes can be scored in this way, insofar as dispensing with exchange rates as an instrument of adjustment requires massive modifications on the part of the real sector of a national economy. Real appreciations of currencies cause a decline in international competitiveness, resulting in increasing current account deficits and high levels of unemployment. Only if a strong government assists monetary policy makers in this situation by opting - credibly- to maintain the parity and if it can master the associated social tensions, can a decline in confidence on the part of international investors be prevented. Failing that, this system of exchange rates, too, is threatened by an abrupt capital outflow on account of renewed concern over the future erosion of assets. More flexible exchange rate arrangements, by contrast, give higher priority to maintaining international competitiveness. Under this currency standard it will be possible to tie up capital in the long term only if the central bank enjoys the public's confidence on account of the fact that it has pursued a successful independent stability be translated into expectations of price stability.

170

Appendix The thesis that price stability and stability expectations influence domestic saving is examined below. The analysis focuses on the empirical relations between the saving ratios and the logarithmic inflation rates of Argentina and Chile. The study on the exchange rate systems of these countries on the previous pages induced this country-choice. The saving ratio is expressed in terms of gross saving in percent of Gross Domestic Product (GDP). The data are taken from the System of National Accounts of the "World Economic Outlook". The inflation rate is expressed in terms of the relative change in consumer prices. This time series is taken from the "International Financial Statistics" of the International Monetary Fund. The consumer prices are chosen as price indicator since the propensity to save depends on the consumption behavior and, therefore, the relation between consumer prices and savings is closer than that between saving and the deflator of GDP. Both variables are expressed in annual rates. The examined period goes from 1970 to 1994. The charts below show the development of the saving ratio and of the logarithmic inflation rate in Argentina and Chile. In Chile, the inflation rate steadily declined during the late 1970s. Afterwards, during the 1980s, the saving ratio increased for a longer time. The opposite process occurred in Argentina. At the beginning of the 1970s, Argentina realized the highest saving ratio of all Latin American countries. Between 1970 and 1990 the inflation rate rose (with large fluctuations) as a trend. At the same time the saving ratio declined as a trend. The relation between the logarithmic inflation rate and the saving ratio is now investigated separately for each country by means of simple regression. Let a(L) and fi(L) be lag polynomials (in the lag operator L) and fi0 be a constant. Let SX be the saving ratio and PLX be the logarithmic inflation rate in country X. Finally let v be the residual of estimation. The following equation is estimated by ordinary least squares: a(L) SX= p

0

+f}(L) PLX+ v

Lagged values of the saving ratio are also used as an explanatory variable, according to the thesis that the adaptation of the saving ratios to a change in the rates of inflation is a long-term process.

171

Figure 3:

Percentage Change in Consumer Prices in Argentina and Chile

0

-I—l—I—l—l—I—I—I—I—I—l—(—l—I—I—I—I—l—l—I—I—I—I—l—l—l 70

72

74

76

78

80

82

84

86

88

90

92

Year

Figure 4:

Gross Domestic Saving in % of GOP in Argentina and Chile

Year

94

172

Both countries s h o w a negative relation between the current saving ratios a n d the t w o y e a r s lagged inflation rates. 1 ) The results of estimation are represented in the table below.

intercept

SX,

Argentina

11.03

0.79

Chile

10.46

0.75

coefficient of:

R2

LM-Test for a u t o c o r r .

-1.32

0.93

0.93

-1.46

0.82

0.24

PLX.2

All coefficients have a level of significance of at least 0,05. The coefficient of determination (R2) is 0,93 for Argentina and 0,82 for Chile. Normal distribution and homoscedasticity of residuals have been tested, in order to assure validity of usual tests. The order of integration of the saving ratios and of the logarithmic inflation rates has been investigated by means of the augmented Dickey-Fuller test. Both saving ratios are stationary with trend and drift. The logarithmic inflation rate of Chile is stationary and that of Argentina is stationary with drift. The residuals of estimation are not autocorrelated.21 An Aitken-estimation has been performed for Argentina, in order to get rid of first order autocorrelation.31 A dummy for the period 1981-1982 has been introduced for Chile, in order to smoothen a structural break. T h e negative relation between the current saving ratios a n d the inflation rate is c o n firmed w h e n real g r o w t h is c o n s i d e r e d as a further explanatory variable a n d w h e n all the three variables are treated as jointly dependent. A vector autoregressive (VAR) s y s t e m of o r d e r t w o is then estimated. The saving ratio, real g r o w t h a n d the logarithmic inflation rate are taken as e n d o g e n o u s variables in this case. T h e impulser e s p o n s e - f u n c t i o n s of the saving ratio c a n be calculated t h r o u g h inversion of the s y s t e m . 4 ) T h e s e impulse-response-functions s h o w the r e s p o n s e of the saving ratio to an i n d e p e n d e n t o n e point c h a n g e in the logarithmic rate of inflation, in real g r o w t h a n d in the saving ratio. 5 ) T h e following VAR system is estimated a n d inverted:

[SX, PLX, D(YRXL)]' = CQ +C(L) [SX, PLX, D(YRXL)]' + u YRXL is the logarithmic real i n c o m e of country X. DfYRXL) is its real g r o w t h , C0 is a vector of constants, C(L)

is the matrix of the coefficients of l a g g e d

variables a n d u is the vector of residuals. [SX, PLX, D(YRXL)j

endogenous

is the t r a n s p o s e d vector

" Current and one year lagged inflation rates had no significant coefficient. 2) The critical value for the LM-test is 3,84 (for a level of significance of 0,05), that is higher than our test-statistic. 31

It must be noticed that an Aitken-estimation is consistent only at the margin. The number of observations we have at our disposal may not be enough to ensure the accomplishment of this propriety. Hansen (1993, 121).

41

Sims (1980).

5)

They are calculated by solving the system as a function of orthonormal shocks.

173

Figure 5: Impulse-Response-Function of the Saving Ratio in Chile (SC) to One Standard Deviation Shock

Figure 6: Impulse-Response-Function of the Saving Ratio in Argentina (SA) to One Standard Deviation Shock

uPAL uD(YRAL) USA

The system describes the saving behavior with a high R? (0,88 for Chile and 0,92 for Argentina)." Also the order of integration of real growth rates has been investigated by means of the Dickey-Fuller test. The variables are stationary with drift. 11

The FP for the regression with the rate of inflation as dependent variable is 0,62 for Argentina and 0,91 for Chile. Real growth is probably also dependent on other variables. For this reason is R2 for the regression with real growth as dependent variable not high enough (0,42 for Chile and 0,21 for Argentina).

174

of endogenous variables. The impulse-response-functions of the saving ratios of both countries are depicted below. uX shows an independent change in the variable X. A temporary one point growth in the logarithmic inflation rate causes a fall in the saving ratio in Argentina and in Chile. In Chile this variable reaches its lowest level after five years, with a multiplier of -1,57. The saving ratio of Argentina reaches its lowest level after six years, with a multiplier of -2,77. The negative influence of the rate of inflation on the saving ratio is stronger in Argentina than in Chile, probably because of the higher price volatility in this country. 1) If the rise in the rate of inflation is only temporary, then the fall in the saving ratio is also temporary. If the shock to the rate of inflation is permanent, then the fall in the saving ratio is also permanent. The saving ratios of both countries reach their new equilibrium after about 30 years. A temporary rise in real growth leads to a transitory increase of the saving ratio. This variable peaks three years after the shock, with a multiplier of 2,05 for Chile and 1,02 for Argentina. Correspondingly, a permanent rise in real growth raises the saving ratio permanently. In this case the speed of adjustment to the new equilibrium is similar to that after a change in the rate of inflation. According to all the estimation results, the thesis of a negative dependence of the saving ratio of a country on lagged values of its inflation rate is not rejected.

" Due to a positive correlation between the rate of inflation and price volatility, the coefficient of the rate of inflation also catches the influence of price volatility.

175

References

Bank for International Settlements. 1994. 64th Annual Report. Basle. Bank for International Settlements. 1995. 65th Annual Report. Basle. Bradford, Colin J. 1993. "Introduction: The Nexus between Capital Flows, Investment and Economic Policy." In Colin J. Bradford, ed. Mobilising International Investment for Latin America. Paris. OECD Development Centre:51-52. Brand, Diana, and Thomas Röhm. 1995. "Ursachen und Konsequenzen der mexikanischen Währungskrise". Ifo-Schnelldienst 48 (7):20-29. Brooks-Senftleben, A. 1993. "Private Capital Flows to Latin America: An Overview of Recent Trends and some Thoughts on Sustainability and Future Prospects." Diskussionsbeiträge Nr. 62. Göttingen: Ibero-Amerika Institut für Wirtschaftsforschung. Calvo, Guillermo et al. 1993. "Capital Inflows and Real Exchange Rate Appreciation in Latin America". IMF Staff Papers 40(1): 108-51. Calvo, Guillermo et al. 1995. "Capital Inflows to Latin America with Reference to the Asian Experience". In Sebastian Edwards, ed. Capital Controls, Exchange Rates and Monetary Policy in the World Economy. Cambridge: Cambridge University Press:339-82. Dehesa, Guillermo de la. 1994. The Recent Surge in Private Capital Flows to Developing Countries. Is it Sustainable? Madrid: Asociación Española de Banca Privada. Edwards, Sebastian. 1995. "Why are Saving Rates so different across countries? An International comparative analysis." NBER Working Paper No. 5097. Group of Ten. 1995. Saving, Investment and Real Interest Rates. A study for the Ministers and Governors by the Group of Deputies. Rome. Hansen, Gerd. 1993. Quantitative Wirtschaftsforschung. München: Verlag Vahlen. Hesse, Helmut, and Bernd Braasch. 1992. "Weltkapitalknappheit: Ursachen, Konsequenzen, wirtschaftspolitische Folgerungen". In Egon Görgens, and Egon Tuchtfeld, eds. Die Zukunft der wirtschaftlichen Entwicklung - Perspektiven und Probleme. Bern: Haupt:385-403. Hesse, Helmut, and Hermann Sautter. 1977. Entwicklungstheorie und-politik, Entwicklungstheorie. Tübingen: J. C. B. Mohr (Paul Siebeck).

Band I,

IMF. 1994. World Economic Outlook- Prospects and Policy Issues. Washington, D.C. IMF. 1995a. World Economic Washington, D.C.

Outlook

-

Prospects

IMF. 1995b. International Capital Markets. Developments, Issues. Washington, D.C.

and

Policy

Prospects

and

Issues. Policy

176

Jaspersen, Frederick Z., and Juan Carlos Ginarte. 1993. "External Resource Flows to Latin America: Recent Developments and Prospects". In Colin J. Bradford, ed. Mobilising International Investment for Latin America. Paris. OECD Development Centre:55-77. Ogaki, Masao et al. 1995. "Saving Behavior in Low- and Middle-Income Developing Countries: A Comparison." IMF Working Paper No. 95/3. Sims, C. A. 1980. "Macroeconomics and Reality." Econometrica 48:1-48. Tietmeyer, Hans. 1995. "Globale Finanzmärkte und Währungspolitik". In Deutsche Bundesbank Auszüge aus Presseartikeln Nr. 65:1-5. Turner, Philip. 1995. "Capital Flows in Latin America: A New Phase." BIS Economic Papers No. 44. Basle. World Bank. 1995a. World Debt Tables 1994 - 1995. Washington, D.C. World Bank. 1995b. World Development Report 1995. Washington, D.C. World Bank. 1993. Latin America and the Caribbean. A decade after the debt crisis. Washington, D.C. Zahler, Roberto. 1995. "Chile: Growth with Stability". In Deutsche Bundesbank Auszüge aus Presseartikeln Nr. 46:20-23.

177

P r o b l e m s of Monetary Policy in Latin A m e r i c a C o m m e n t on H e l m u t H e s s e and A n t j e H e i k a m p

Helmut Reisen

The title of the paper by Hesse and Heikamp (henceforth:

HH) is somewhat mis-

leading, since the paper does not deal with problems of monetary policy In Latin America in a narrow sense. It does not, for example, discuss the scope for and the costs of sterilized intervention or various techniques of reserve requirements nor does it state the constraints imposed on monetary policy by the region's degree of financial openness and by the health of its domestic banking system. The HH paper takes a much more topical approach. It discusses two challenges to monetary policy in the Latin American context: -

First, the scope for monetary policy to help stimulate domestic savings;

-

Second, its potential to help attract long-term capital inflows for investment.

The approach taken by HH is motivated by the observation that Latin America saves too little to sustain capital accumulation and economic growth and that the international mobility of net capital flows is too limited to make up for the domestic savings shortfall. Moreover, Latin America has a (largely unexplained) tendency to consume net capital imports, in contrast to Asia which invests them.

Subsequent to the recent

financial turmoil in Mexico, such an interpretation is now mainstream; this is no small feat, because mainstream thinking now rejects the Lawson doctrine that current account deficits and large exchange rate appreciations are no cause for concern as long as they are determined by private-sector decisions. Yet, the mainstream interpretation is on weak analytical ground: -

First, does saving cause growth or does growth cause saving? Theoretically, the link from savings to growth may be more straightforward, since higher savings raise the growth rate of output by increasing capital accumulation. Recent causality tests, however, have emphasized the link from growth to saving; the causation

178

is in line with East Asia's experience where increases in saving rates have tended to lag a few years behind increases in GDP growth rates. The computation of standardized beta coefficients for various saving determinants Indicates that GDP growth is the most important variable for explaining cross-country differences In private savings (Edwards, 1995). -

Second, to what extent is saving translated into Investment?

In Latin America,

where capital mobility is less restricted than in most Asian economies, an Increase in national savings could be reflected in a reduced current account deficit rather than in higher domestic investment.

The Feldsteln-Horloka puzzle of a close

association of national savings and Investment remains far from resolved at both theoretical and empirical levels. -

Third, is capital accumulation sufficient to guarantee long-term growth? SchmidtHebbel et al. (1996) conclude in a recent survey that such simplistic notion is clearly untenable.

In addition to physical capital accumulation, two other key

ingredients sustain long-term growth.

First, the accumulation of human capital

and technical Inputs which are treated as consumption in conventional national accounting. Second, the efficiency of physical investment; "white elephants" will not sustain growth. So much for the background to the paper by HH. They then go on to lend relevance to their subject by maintaining that price stability and expectations thereof play an "eminent" role in determining national savings. Such a claim, for which no evidence is provided in the paper, is hard to swallow. My scatter diagram visualizes for the period 1980-92 (the only period for which reliable data on savings are available) that the correlation of savings and inflation rates is nil. The sizable Latin American countries, in particular, save ca. 18 to 25 per cent of their income, whatever the inflation rate. None of the recent comprehensive studies on developing-country savings (Edwards, 1995; Masson et al., 1995) finds any significant impact of inflation on savings. What is more, no other monetary variable (such as M2/GDP or the real interest rate) is found to explain significantly national saving rates. Do not confuse the degree of financial Intermediation with the level of national savings. A country's saving rate Is essentially determined by non-monetary variables.

In declining order of importance:

by the

sustained GDP growth rate, by government savings (because Ricardian equivalence does not hold), and by age dependency (Edwards, 1995).

179

180

To be sure, low rates and low variability of inflation will certainly not do harm to savings in Latin America. This will imply further disinflation that will not come without cost.

HH emphasize rightly that overvalued exchange rates imply only temporary

gains for disinflation, a point which has been stressed and formalized by Larrain and Reisen (1995). Because of entrenched expectations and indexation derived from the region's past inflation record, inflation will persist unless price disinflation is helped by wage disinflation or real exchange-rate appreciation.

Usually, wage disinflation

requires excess unemployment above the natural rate of unemployment and real appreciation that will widen the output gap, the difference between actual and potential output. To the extent that disinflation has been achieved, like in Argentina and Mexico, by the transitory rate-of-change effect of rising unemployment and of an appreciating currency, such disinflation is hardly sustainable. Eventually, the economy will have to move back to the natural rate of unemployment and to a sustainable level of currency valuation. Only the cumulative unemployment above the natural rate (the level effect) and the sustainable appreciation of the fundamental equilibrium exchange rate (e.g. through productivity gains) will be reflected in a sustainable gain in disinflation. The problem of monetary policy in Latin America today is to determine the optimal rate of inflation and the optimal speed of disinflation towards such rate. Under almost unrestricted capital mobility, it is wise not to be overambitious and single-minded with inflation targets in the low-level single-digit rate. Recent experiences in much of Latin America and Asia provide a case for targeting money and real exchange rates simultaneously (Reisen, 1993a). The second issue discussed by HH concerns the attraction of long-term capital by means of monetary policy. Comparing Argentina and Mexico with Chile in my first Amex Prize Essay, I had predicted financing difficulties for Mexico (but also for Argentina): "Some countries - notably, Mexico, Argentina and Peru - are heavily dependent on short-term capital inflows vulnerable to quick reversal in the event of change in investor sentiment. Note that the structure and maturity of capital inflows depend on the exchange rate regime. As long as a peg to, say, the US dollar is credible it allows investors to exploit nominal domestic-foreign interest rate differentials in short-term interest rates; the peg is apt to raise the "hot money" share in capital inflows." (Reisen, 1993b, 131).

181

Chile, but also Colombia and Israel, have escaped a financial crisis a la Mexico and Argentina by adopting crawling exchange rate bands with little intramarginal intervention (unlike Mexico), aided by selective capital inflow controls. Crawling exchange rate bands constitute a partial resolution of the basic trade-off between competitive exchange rates and inflation control once fiscal discipline and central bank independence are installed. The central parity rate, combined with a domestic inflation target, becomes the key nominal anchor, while the band width allows the accommodation of shocks through market-determined variations of the nominal exchange rate. Under high capital mobility, however, conflicts between the inflation target and the exchange rate target will arise when a restrictive monetary policy is needed to defend the exchange rate band despite no inflation pressures or when domestic inflation pressures require a restrictive monetary policy stance which causes subsequent appreciation pressures.

In these instances, a variety of further policies - fiscal policy, reserve

requirements, foreign exchange controls- will have to assist the exchange-rate regime. With integrated capital mairkets, Obstfeld (1995) sees no comfortable middle ground any more between either a pure float of the currency or an irrevocable currency union. That middle ground will be more comfortable as long as capital accounts are not fully open, as there is a general lack of access to foreign funds and as governments retain influence on their domestic financial institutions (Frankel, 1994).

182

References

Edwards, Sebastian. 1995. "Why Are Saving Rates So Different Across Countries?: An International Comparative Analysis." NBER Working Paper No. 5097. Frankel, Jeffrey. 1994. "Sterilization of Money Inflows: (Reisen)?" IMF Working Paper 159.

Difficult (Calvo) or Easy

Larraín, Guillermo, and Helmut Reisen. 1995. "Disinflation with Unemployment in Latin America: Sustainable?" In D. Turnham et al., eds. Social Tensions, Job Creation and Economic Policy in Latin America. Paris: OECD. Masson, P.R., T. Bayoumi, and H. Samiei. 1995. "International Evidence on the Determinants of Private Savings." IMF Working Paper 91. Obstfeld, Maurice. 1995. "International Currency Experience: New Lessons and Lessons Relearned." Brookings Papers on Economic Activity 1995(1):119-220. Reisen, Helmut. 1993a. "Capital Flows and Their Effect on the Monetary Base." CEPAL Review 51 (December): 113-122. . 1993b. "Integration with Disinflation: Which Way?" In R. O'Brien, ed. Finance and the International Economy: 7. The Amex Bank Review Prize Essays. Oxford: Oxford University Press. Schmidt-Hebbel, Klaus, Luis Servén, and Andrés Solimano. 1996. "Saving and Investment: Paradigms, Puzzles, Policies." The World Bank Research Observer (forthcoming).

183

Regional Free Trade Agreements as an Alternative to Unilateral Liberalization: The Case of Chile "

Patricio Meiler

1. Introduction Multilateralism and free trade are the key concepts that generate worldwide consensus. For a small country, a truly multilateral free trade environment is considered to be a first-best world. Chile has pursued an autonomous trade strategy which has produced a successful expansion of exports. The opening up of the Chilean economy was achieved through a far-reaching unilateral trade liberalization process, which formed one component of an overall reform package where free-market price incentives, comparative advantage and private sector entrepreneurship all played leading roles. A sharp real devaluation of the exchange rate also had an important effect on the successful expansion of Chilean exports. The first section provides the main features of the Chilean export boom. If what has been done up to now has produced excellent results, then why should Chile change its small-country go-it-alone trade strategy, and try to become a member of preferential trade groupings? This issue is discussed in section II. Section III examines the Latin American perception of NAFTA, the Uruguay Round and bilateral trade agreements.

2. Main F e a t u r e s of Chilean Export Boom The role of exports in the Chilean economy has undergone a fundamental change as a result of the structural reforms implemented during the 1970s. There are various '' The author appreciates the comments of Heinz Gert Preusse, Hermann Sautter, and other participants at the Symposium.

184

elements which led to this change: (1) During the 1970s, trade reform, i.e., the unilateral opening-up of the economy (unilateral tariff reduction and the removal of nontariff barriers) eliminated the anti-export bias of Chile's industrialization strategy based on import substitution. (2) During the 1980s a significant real devaluation was carried out and sustained for a relatively long period (more than 6 years), and this gave clear and consistent incentives to the exporting sector. (3) The prevailing economic climate of free markets, open economy, privatization, deregulation and reduction of bureaucracy enhanced the overall efficiency of the economy and stimulated the private sector to turn itself into the economy's main productive agent. However, there are certain measures, in addition to those already mentioned, that have contributed to specific export sectors. For example, state investment in research and human capital related to the fruit and fishing sectors; Decree Law 701 which gives direct subsidies (75%) to the costs of forestation, and special subsidies to small-scale exporters1). The level of exports was less than US$ 500 million in 1960 and slightly above US$ 1,100 million in 1970. In 1980, exports attained a record level, close to US$ 4,700 million, and even exceeding the yearly average over the subsequent six year period (1981-1986). From 1985 onwards, exports have shown sustained growth, rising from US$ 3,804 million (1985) to more than US$ 11,500 million (1994); preliminary estimates provide a figure of US$ 15 billions for 1995. Measured in constant purchasing power terms (1994 US dollars), the level of exports in 1994 was 2.6 times greater than the level in 1985 and 6.5 times higher than in 1960. In the 1960s the annual average rate of growth of exports (3.2%) was below that of GDP (Gross Domestic Product). This situation was reversed from 1974 onwards when in general the yearly growth of the exporting sector began to exceed the growth of GDP (see the respective yearly figures in table 1). Specifically in the period 1985-1994 exports display a yearly growth rate of 10.3% while GDP was expanding at 6.2% per year. This type of figure suggests that exports were probably the engine of growth in the Chilean economy 2 '. The greater weight exports have acquired in the Chilean economy can easily be seen in the trend of their relative share of GDP. Indeed, the share of exports in GDP (measured in terms of constant 1986 relative prices) varied around 12% in the period 11

For a more extensive discussion of these issues see Meller (1995).

2>

For a more detailed discussion of this topic see Garcia, Meller arid Repetto (1995).

185

Table 1 Growth of Chilean Exports: 1 9 6 0 - 1 9 9 4 (Five-yearly averages)

Period

1960-65 1965-70 1970-75 1975-80 1980-85 1985-90 1990-94

Average annual growth Exports

Gross Domestic Product

4.2% 3.0% 5.6% 15.3% 1.8% 10.8% -9.1%

3.8% 4.7% -2.3% 6.8% -0.4% 6.5% 7.2%

Source: Central Bank of Chile.

1960-1975. This percentage exceeded 20% by 1980 and was above 25% in 1985. In the 1990s the relative share of exports has been fluctuating around 35%. In the period before 1970 the prevailing perception was that Chile's comparative advantages lay basically in copper concentrates; i.e., "it was thought to be very difficult to export anything other than copper." Indeed, the relative weight of copper in the total export basket stood at more than 70% in the period 1960-1975. Since 1979, the relative share of copper has fallen below 50%, and in the 1990s it has been lower than 40% of total exports. A breakdown of non-copper exports gives the following values for 1994: forestry products (including cellulose, wood, furniture, etc.): US$ 1.623 billion; agricultural products: US$ 1.095 billion; marine products (including fishmeal): US$ 1.327 billion; non-copper mineral products: US$ 950 million. In addition there were more than US$ 2.3 billion of other goods exports (table 2) 1) . " For a deeper review of the success (and failures) of some specific Chilean export products see Metier and Sàez (1995).

186

Table 2 C o m p o s i t i o n of C h i l e a n E x p o r t s : 1960-1994 (million US$) Year

Mir eral procJucts copper

1960 1970 1980 1990 1994

341.8 839.8 2,152.5 3,910.2 4,242.0

noncopper 85.1 110.6 619.4 729.3 949.5

Sea products1)

Agricultural products

Forestry products

Others

Total

0.3 1.4 290.8 862.1 1,327.5

23.5 30.1 281.2 899.4 1,094.9

2.0 10.2 591.3 869.9 1,623.1

37.3 119.6 735.5 1,309.4 2,301.9

490.0 1,111.7 4.670.7 8,580.3 11,538.9

Source: Central Bank of Chile. Note: In 1990 there was a change In the classification system, for which reason the entries are not entirely comparable. 11 Fishmeal is not included in the figures for 1960. In 1960 and 1970, seafood products are not included.

The Chilean export basket in the first half of the 1990s displays a significant preponderance of natural resources (NR) and processed natural resources (PNR). There can be no doubt that copper occupies an outstanding place in total exports and will continue to do so for at least the next ten years. Nevertheless, the trend of "other exports" ("others"), corresponding to exports not directly linked to the country's natural resource endowment, should also be highlighted. Chile's exports go to a wide variety of markets: she does not have a natural trading partner. The European Union, which took more than 40% of Chilean exports in the period before 1980, has seen its share reduced to about 26% in the 1990s. NAFTA and Latin America (excluding Mexico) each represent about 20% of total exports today, while the Japanese market takes 16% and the Asian region about 14% of Chile's exports.

187

Finally, there is a special indicator, which in our judgment illustrates the significance acquired by the exporting sector in the Chilean economy, as well as providing suggestive evidence regarding its sustainability and future expansion. This indicator is the number of Chilean exporting firms, and their notable expansion in a relatively short period of time (table 3). In 1986 there were about 200 firms exporting between US$ 1 million and US$ 10 million, and another 235 exporting more than US$ 10 million. In the space of just four years, these figures more than doubled: in 1990 there were 526 firms exporting more than US$ 10 million and 431 exporting between US$ 1 million and US$ 10 million.

Table 3 N u m b e r of Firms by Export Value: 1 9 8 6 - 1 9 9 0

Value of exports More than US$ 100 million More than US$ 10 million Between US$ 1 million and US$ 10 million

1986

1990

4 235 193

8 526 431

Source: Central Bank of Chile, unpublished data.

3.

3.1.

C h i l e a n T r a d e Strategy Alternatives

Introduction

Before 1974 Chile had a highly restrictive foreign trade regime which included quotas, prior import deposits, licenses, foreign exchange budgets, prohibited import lists, and special regimes relating to particular regions, particular industries, and public firms, as

188

well as quite high nominal tariffs. In the five year period, 1974-79, all non-tariff barriers were eliminated and the average (highest) nominal tariff rate was reduced from 105% (750%) to a flat tariff structure of 10%. This 10% flat tariff structure was kept until 1982. During the 1980s, to confront the economic situation generated by the external debt shock, nominal tariffs were increased by stages to 35%. Having a flat tariff structure (10%) provided the authorities with an easy-to-use tool, complementary to the exchange rate, to respond to external disequilibrium. Furthermore, it provided additional fiscal revenues with which to finance the fiscal deficit. The second unilateral liberalization process of the 1980s was much slower than that of the 1970s: it took almost six years to reduce nominal tariffs from 20% (June 1985) to 11% (January 1991)1). Since the 1982 Balance of Payments crisis, the main tool used to confront external disequilibrium has been the exchange rate. During 1982-84 real devaluations were carried out in order to reestablish the real exchange rate at the level prevailing prior to 1979 (when a fixed nominal exchange rate was established). However, due to the requirements of large external debt service payments, the 1982-84 devaluations were not enough, and additional real devaluations were implemented during and after 1985. These large real devaluations provided a very significant stimulus to export expansion. In short, during the 1970s trade reforms followed the neutrality principle of equalizing incentives across goods. Given the prevailing anti-export bias of that time, these measures were favorable to exports; however, towards the end of the decade there was an appreciation of the exchange rate. During the 1980s there was a clear shift towards exports using domestic currency depreciation as a general measure (there were also certain special subsidies to minor exports as well as specific State measures). Thus, over the past two decades, Chile has implemented two unilateral and nonselective trade liberalization processes: a radical one (1974-79), and a more moderate one (1985-91). Probably the most important difference between the two episodes has been that, whereas in the first liberalization after an initial devaluation the real

" In the first unilateral liberalization process, nominal tariffs were reduced from 22% (1977) to 10% (1979) in less than two years.

189

exchange rate appreciated, in the second one, tariff reduction was accompanied by a sharp real devaluation of the peso". In summary, the main features of Chilean trade strategy up to 1993 have been the following: (i) A far-reaching unilateral trade liberalization process, (ii) An export market diversification strategy which has meant the absence of a natural trading-partner relationship. (iii) The small country assumption, or the importance of being irrelevant, i.e. Chile could always find a niche in foreign markets. The previous sections show that this trade strategy, in which Chile has taken its decisions autonomously, has been very successful in achieving export growth. If something has had positive results, why, then, should it be changed? Why is Chile interested in establishing trade agreements with different commercial partners? This key issue is explored in this section.

3.2.

Changes in the Region's Trade Regimes

There are two sequential features characterizing the changes observed in Latin American (LA) trade regimes during the 1990s. First, most LA countries have implemented a unilateral trade liberalization process, i.e., each LA country has decided to reduce its tariff and non-tariff barriers independently of what the rest of the world has done. Theoretically, it is convenient for a given country to carry out unilateral tariff reduction even if there is no reciprocity from its trading partners. This is due to the fact that lower cost imports will displace inefficient domestic production, thereby increasing consumer welfare and the efficiency of domestic resource allocation. In other words, even when the rest of the world has tariff (and non-tariff) barriers, a specific country can increase its level of welfare (and domestic efficiency) by unilateral tariff reduction, without the requirement of reciprocity. This proposition is theoretically valid when the specific country's tariffs are relatively high and those in the rest of the world are very low. In short, there have been deep changes in the LA trade regime. The sharp unilateral external liberalization process that most LA countries have implemented could be " There are three sources of deviation from a uniform import tariff structure in Chile: a) The adoption of a number of price bands for agricultural products (wheat, sugar and oil seeds); b) the differential tariff preferences given to countries that are members of ALADI (some of them subject to import quotas); and c) lately, entry into various FT As and economic complementary agreements with specific countries, implying a deviation from a uniform tariff structure, both in terms of specific products and Import origin.

190

observed by a comparison of tariffs and quantitative restrictions (QR) figures for the 90s with the 80s (second half) shows the following (tables 4 and 5):

Table 4 Present d e c a d e (1990s) tariffs and quantitative r e s t r i c t i o n s in Latin American countries

Country

Tariffs & Surcharqes

(%)

Argentina Bolivia Brazil Chile Colombia Costa Rica Ecuador Mexico Peru Uruguay Venezuela

Tariffs

Surcharges

0-22 5-10 0 - 40 2) 11 0-20 1 -40 5-35 0-20 15 - 25 10 - 20 0-20

10 1 - 2 -

0-16 0-18 -

0-5 -

Source: GATT, IMF. 1>

This percentage corresponds to all tariff categories.

21

The mean tariff is 14% in 1993.

Quantitative Restrictions (Q.R.) (import % affected by Q.R.)

4

D

2 11> 0 141) 1 151> 2 5 0 10

191

Table 5 Past d e c a d e (1980s) tariffs and quantitative restrictions in Latin American countries

Country

Year

Tariffs & Surcharaes

(%)

Argentina Bolivia Brazil Chile Colombia Costa Rica Ecuador Mexico Peru Uruguay Venezuela

1986 1984 1985 1984 1984 1985 1984 1984 1989 1982 1988

Tariffs

Surcharges

0 - 100 0-60 812) 0-35 612) 0 - 220 0 - 290 0 - 100 0 - 117 0-75 0-80

0-14 0 - 2

Quantitative Restrictions (Q.R.I (import % affected by Q.R.)1)

-

5-15 0-18 13 - 100 1 - 30 3-19 3 - 147 0 - 74 2 5

60 90 34 3 ' 0 93 4> 1 38 3> 38 1004) 0 656)

Source: IMF, Issues and Developments in International Trade Policy, 1992. 11 Q.R. include import restrictions through exchange control. In general, Q.R. correspond to nonautomatic requirements to import permits. 21

Average value of all tariff categories.

31

This percentage corresponds to all tariff categories.

41

In this case Q.R. corresponds to prohibitions.

51

Q.R. through allocation of foreign exchange.

(a) Maximum nominal tariffs have been reduced from a three digit level to around 20%. There has been a clear change of perception in LA; during the 60s through the 80s, tariffs lower than 20% were considered to be too low, while now, tariffs higher than 20% are considered to be too high.

192

(b) Most LA countries had surcharges prior to 1990; these surcharges have been significantly reduced or eliminated during the 90s. (c) A large percentage of LA imports were subjected to QR prior to 1990; QR play now a null or minor role in most LA countries. In short, LA is now a more open region and has become export-oriented. Comparing years 1980 and 1993, the export/GDP share has increased in most LA countries; moreover, in seven LA countries this share-increase has been larger than 50%. However, the 1993 level of almost all LA countries export per capita ratio is below US$ 700 (per year). South-Korea has an export per capita ratio higher than US$ 1,500 (per year); this ratio is much larger in the case of Taiwan, Hong-Kong and Singapore. The second LA feature is related to the surprising proliferation of (bilateral) free trade agreements (FTA) during the 1990s; in the 1990-94 period no fewer than twenty six have been signed bilateral (table 6). In addition, the decade has seen the creation of important subregional preferential trading areas like NAFTA and MERCOSUR. The 1990s could therefore be called the decade of the FTA in Latin America. Chile has entered into numerous bilateral FTA and/or economic complementarity agreements. At the same time, Chile is negotiating FTAs with MERCOSUR and the European Union (EU), it is in line for admission into NAFTA and has already been admitted into APEC. Why does Chile not stick to its previous unilateral liberalization strategy? The present tariff level is still 11% so there remains some margin for reduction. Why has Chile changed its previous unilateral tariff reduction (UTR) strategy and is now very actively pursuing the establishment of FTAs instead? Let us examine a crucial assumption used in the UTR strategy, namely that domestic exports face low or zero tariffs and non-tariff barriers (Wonnacott and Wonnacott, 1981). In fact, in the UTR analysis the source of efficiency and welfare gains is based only on the replacement of inefficient domestic production by lower cost imports; no consideration is given to the possibility of increasing exports. In a world of FTAs, if an excluded country wants to increase its exports to a given FTA, how useful would it be to follow a UTR strategy? If the lowering of domestic tariffs increases the competitiveness of domestic exports beyond the level of tariff preferences prevailing among the

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Table 6 Free T r a d e A g r e e m e n t s in Latin A m e r i c a . 1990-94

1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.

Argentina-Brazil Bolivia-Uruguay Argentina-Colombia MERCOSUR Chile-Mexico Chile-Argentina Argentina-Bolivia Bolivia-Peru Argentina-Venezuela Argentina-Ecuador Bolivia-Chile Chile-Venezuela Chile-Colombia

Source:

1990 1991 1991 1991 1991 1991 1992 1992 1992 1993 1993 1993 1993

14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26.

NAFTA Brazil-Peru Mexico-Caricom Mexico-Costa Rica Bolivia-Brazil Mexico-Bolivia Chile-Bolivia Chile-Ecuador Colombia-Venezuela-Mexico Venezuela-Caricom Colombia-Caricom Brazil-Venezuela Bolivia-Paraguay

1993 1993 1993 1994 1994 1994 1994 1994 1994 1994 1994 1994 1994

BID (1995).

members of the FTA, then the UTR strategy is a useful one. However, In general, if an excluded country wants to become a member of an FTA, how helpful would it be to reduce tariffs before starting the negotiation process?1). Indeed, if the excluded country reduces its tariffs and non tariff barriers to zero, why would the FTA members be interested in bringing that country into the tariff-free club? Exports have become the engine of growth in thé Chilean economy, so Chile would like to keep expanding them. Given the widespread proliferation of preferential trade agreements, the first-best strategy for improving market access for domestic exports is to become a member of those agreements. It is usually stated that the first-best option for a small country is a multilateral free-trade world. However, a better option would be to enjoy preferential trade access, so that the small country can play the 11

It is assumed that the domestic tariff level Is relatively low, i.e. around 10% to 15%.

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"hub and spokes game". By taking advantage of its good economic and political image, this is precisely what the recent Chilean trade strategy has been aimed at. Furthermore, the small size of the Chilean economy (GDP around US$ 50 billion with US$ 15 billion of exports), and the absence of a natural trading partner are positive factors in this approach. Hinojosa et al. (1995) have examined the economic impact of alternative scenarios of trade liberalization and regional integration in the Western Hemisphere, using a CGE (computable general equilibrium model) specifically considering the relationship between NAFTA, Chile, and MERCOSUR. This interesting study has several results, but for the purposes of the present discussion we will only mention two: (i) A Western Hemisphere FTA "is the first best outcome for most of the countries in the region as well as for the region as a whole, both in terms of real GDP and total trade" (33). (ii) In Chile's case, "joining NAFTA and MERCOSUR is slightly preferable even to full hemispheric free trade, in allowing Chile to becoming a regional hub and enjoy the trade diversion effects of continued protection among its various spoke partners" (31). Chile's situation could be representative of most small LA countries. On the other hand, if Chile is excluded, it will be "negatively affected by the formation of both NAFTA and MERCOSUR" (31)1>. In short, the foregoing discussion explains recent replacement of Chile's UTR strategy by a strategy of actively seeking membership of every possible preferential trade arrangement. In addition to market access and preferential trade benefits, FTA membership provides an insurance against possible future reversals (increasing protection) in the trade policies of the FTA members. As a result, domestic agents can make investment plans with a longer time-horizon.

4. An O v e r a l l View of Latin A m e r i c a n P e r s p e c t i v e of NAFTA, and the Uruguay Round Latin American (LA) trade regimes have experimented deep changes. But while LA is becoming interested in multilateralism and free trade in the traditional way, world events like economic bloc formation and increasing protectionist forces in Developed Countries (DC) seem to be moving in a different direction. Moreover, a highly " For the advantages and disadvantages to Chile of entering into NAFTA and MERCOSUR see Labcin and Meller (1995).

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integrated trade world is introducing a new set of issues; it seems that almost everything will be included in trade policy, and therefore, to avoid distortions and noneconomic advantages, country harmonization should prevail.

4.1.

Latin American Perception of NAFTA

There is wide consensus that three regional blocs are being formed:

the EU

(European Union), NAFTA (North American Free Trade Area) and the Yen bloc. There does not exist a LA strategy, and there is skepticism about LA regional integration (Meller 1992). The alternatives for a LA country not belonging to a trade bloc would be the following: (i) To try to get into one bloc (Mexico); (ii) to form your own bloc (Mercosur); (iii) to take advantages of being small and staying alone (Chile). The existence of blocs have trade creation and trade diversion effects upon LA exports.

In the EU, Eastern Europe exports could displace LA exports, while in

NAFTA, Mexico will play that role with respect to the rest of LA. Most LA countries are very interested in being admitted to NAFTA. There are several reasons: (i) To have access to the large U.S. market, (ii) To avoid an increase in U.S. trade barriers in the future, due to domestic protectionist pressures, (iii) NAFTA is a high class club; everyone likes to be a member of an exclusive club. In this case, NAFTA membership provides a sort of "seal of approval" of macro and development policies, and of "good and reliable" government and institutions. Moreover, all this will attract foreign investment and will generate optimistic expectations stimulating domestic investment,

(iv) The U.S. Government has formulated the invitation to

generate the Hemisphere free trade area. There has not been an equivalent invitation neither from the EU nor Japan. With the exception of Mexico, many empirical studies point out that there are small static trade gains (or losses) for most LA countries if they are incorporated into NAFTA; this result is due to the fact that LA exports face already low tariffs in the U.S. (GSP and low tariffs for natural resources). If NAFTA acts as a seal of approval for attracting foreign investment, Mexico will generate investment diversion. The seal of approval argument is implicitly used to stress the fact that dynamic effects are more important than static effects in the computation of trade gains.

Magnitudes of

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Mexican benefits from NAFTA fluctuate between 1% GDP and 7% GDP, considering static and dynamic gains respectively (Brown 1992). In short, the effects of NAFTA upon the Mexican economy cannot be generalized for LA. In spite of that, it is advantageous for any individual LA country to be admitted to NAFTA; however, it should be kept in mind that the admission to NAFTA will not constitute the automatic solution of LA economic problems. Furthermore, there are several doubts with respect to NAFTA: (a) Given the income per capita differentials, the inclusion of Mexico in NAFTA will generate unforeseen adjustment problems in the three countries; then, graduality will be suggested to minimize the adjustment costs. Then, how long will it take for the next LA country to be admitted to the NAFTA club? Moreover, besides Mexico, does there really exist in the U.S. the interest and political will to establish free trade agreements (FTA) with other LA countries? What are the economic incentives for the U.S. to set an FTA with LA countries (with the exception of Mexico and Brazil)? In other words, the benefits and costs for the U.S. to set FTA with most LA countries (with the exception of Mexico and Brazil) are small, and there will be an important domestic opposition within the U.S.; then, it is not obvious which one will be the counteractive domestic U.S. political force (Saborio 1992). (b) What is the admission system to NAFTA for the incorporation of new members? This discussion has not even started. Will NAFTA be exclusively restricted to LA countries or can Asian countries, and others, apply for admission? In short, the NAFTA initiative has generated high expectations in LA. In order to avoid frustration, it has to be shown in the short run, that NAFTA will go South beyond Mexico.

4.2.

Latin American Perception of the Uruguay Round

Trade views at GATT have changed through time 1) . In the period prior to the Uruguay Round, GATT dealt only with policies affecting directly trade in goods; the policy tools where the discussion was focused were tariff and non-tariff barriers at the border. 11

For good reviews on this subject see Low (1990), Tussie (1993), Paiva Abreu (1994).

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The main guiding principle was that foreign goods should be treated equal to domestic goods. Furthermore, DC accepted the existence of positive discrimination with respect to LDC; i.e., DC tolerated that LDC would benefit through the MFN (most favored nation) clause from DC (reciprocal) external liberalization agreements. During the Uruguay Round debate, and under a more trade integrated world, all domestic policies are being considered to have trade effects; i.e. all economic policies are becoming to be trade policies. Then, everything done at the national level is beginning to be under international scrutiny; there is a clear shift from goods to policies. Furthermore, DC have in general no more tolerance for LDC positive discrimination in order to avoid free riders. In fact, it has been pointed out that during this Uruguay Round debate the LDC "weren't trying to trade off their liberalization against concessions elsewhere. The blockades came from the DC. The real problems of protectionism are increasingly to be found in the DC" (Sutherland 1994, 29). Many LDC have been highly successful in expanding exports and diversifying their export basket going to DC markets. Therefore, the LDC are very interested in an adequately functioning world trade system; more specifically there are many LA countries now supporting multilateralism and free trade. On the other hand, there is growing protectionism in DC and in some cases accompanied by discretionary regionalism (EEC). There have been structural changes in world trade and technology; an important outcome has been the low capacity of DC economies to generate jobs for (low) skilled and unskilled labor. This fact has produced increasing unemployment and social tensions in DC. An argument used to explain the rising DC unemployment phenomenon is related to "social dumping"; DC workers are being displaced by LDC workers who are paid subsistence wages, i.e., lower labor costs explain the relative competitive advantage of LDC. But, it is being suggested that "social dumping" should not be allowed; trade has to be "fair" to the interests of the DC workers (Steil 1994). This type of argument is analogous to the one used by the EEC for having the CAP (Common Agriculture Policy) which provides large subsidies to ensure a "fair" standard of living to EEC farmers 1 '. The DC have national laws protecting fundamental workers rights and outlawing compulsory or child labor. Should global agreements on trade and investment have to " The CAP costs US$ 1700 per year to an average European family.

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contain minimum international labor standards? Even though one could favor this specific issue (outlawing compulsory or child labor), the main difficulty is related to the following matter: In more general terms, DC pressure is transforming trade negotiation into policy and institution negotiation. Laws, institutions, and LA government regulations have now become "distortions" to trade. To obtain increased access to DC markets, LA regulation will have to move closer to DC regulation (Tussie 1993; Agosin and Tussie 1993).

4.3.

Latin American Excluded Countries

Latin Americans have been characterized by being fond of rhetorics; for thirty years there has been a lot of talk about Latin American integration and not much has happened. On the other hand, U.S. Americans have been characterized by being very pragmatic. It looks that we have learnt from each other. LA learnt pragmatism from the U.S. and the U.S. learnt rhetorics from LA. US rhetorics has stated from 1990 that there would be a Western Hemisphere Free Trade Area from Alaska to Tierra del Fuego; NAFTA is only the first step toward that goal. LA pragmatism doubts that NAFTA will go beyond Mexico. A key question raised by U.S. economists is related to Brazil acceptance of NAFTA rules for admission. A Brazilian would ask a symmetrical question: Would the U.S. accept MERCOSUR rules for admission? In other words, the key issue for the future is the type of relationship that will be developed between NAFTA and MERCOSUR. How to reduce the potential for future tension? How to reconcilíate both blocs positions? It has been argued that there will be two types of LA countries. The members of a bloc and excluded countries, i.e., a two tier country situation. The existence of two blocs in the Western Hemisphere is a positive situation for excluded countries; there will be some competition for attracting new members. So far, there is a formal NAFTA invitation to join a free trade area; however, given the fact that the rules for admission have not been established, is like having a closed door.

On the other side,

MERCOSUR provides an invitation to a customs union where the rules for admission are stiff.

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There is another possibility for excluded LA countries; bilateral free trade areas between neighbor countries. In other words, pushing bordered trade could have a significant economic and political effect upon LA countries. It is said in LA that each LA country has excellent relations with all the other LA countries with which it does not share a common border. Therefore, this new fact, joint ventures between LA neighbors will have important political and economic implications. Improving the movement of people, goods and investment across LA border countries would increase the size of domestic markets and could provide a dynamic stimulus to national and foreign investment.

Furthermore, it could help to economic

decentralization; development poles will be located away from the big urban capital. Many successful bordered trade arrangements could eventually help to the Western Hemisphere free trade area objective.

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References

Agosin, M., and D. Tussie, eds. 1993. Trade and Growth: Policy. New York: St. Martin's Press.

New Dilemmas

in Trade

BID. 1995. "Integración económica en las Américas." División de Integración, Comercio y Asuntos Hemisféricos. Washington, D.C. Brown, D. 1992. "The impact of a North American Free Trade Area: Applied general equilibrium models". In N. Lustig, B. Bosworth, and R. Lawrence, eds. North American Free Trade. Assessing the Impact. Washington, D.C.: Brookings Institution :26-68. Garcia, P., P. Meiler, and A. Repetto. 1995. "Exportaciones como motor de crecimiento: evidencia empírica para Chile." In P. Melier, ed. El Modelo Exportador Chileno: Análisis de su Evolución y de sus Efectos, (forthcoming). Hinojosa-Ojeda, R., J. Lewis, and S. Robinson. 1995. "Convergence and divergence between NAFTA, Chile and MERCOSUR: Overcoming dilemmas of North and South American Economic Integration." Paper presented at the VI Forum National of the Instituto Nacional de Altos Estudos. Rio de Janeiro, Brazil. Labán, R., and P. Meiler. 1995. "Trade strategy alternatives for a small country: The Chilean case." In R. G. Lipsey and P. Melier, eds. Western Hemisphere Trade Integration: A Canadian-Latin American Dialogue. Macmillan, (forthcoming). Low, P. 1990. "The GATT system in transition: The relevance of "traditional" issues." Ensaios N s 1. Rio de Janeiro: Departamento de Economía. PUC:September. Meiler, P. 1995. "Chilean export growth, 1970-90: An assessment." In G. K. Helleiner, ed. Manufacturing for Export in the Developing World. London: Routledge:21-53. . 1992. "América Latina en un eventual mundo de bloques económicos." In A. Butelmann and P. Melier, eds. Estrategia Comercial Chilena para la Década del 90. Elementos para el Debate. Santiago: Ediciones CIEPLAN:23-68. Meiler, P., and R. E. Sáez (eds.). 1995. Auge Exportador Desafíos Futuros. Santiago: Dolmen Ediciones-CIEPLAN.

Chileno:

Lecciones

y

Paiva Abreu, M. 1994. "O Brasil na rodada Uruguai do GATT: 1982-1993." Texto para Discussao N°311. Rio de Janeiro: Departamento de Economía. PUC:January. Saborio, S. et al. 1992. The Premise and the Promise: Washington, D.C.: ODC. Steil, B. 1994. 3(1):14-20.

"Social correctness is the new

Free Trade in the

protectionism." Foreign

Americas. Affairs,

Sutherland, P. 1994. "Trading places." World Link (March):28-31. Tussie, D. 1993. "The Uruguay Round and the trading system in the balance: Dilemmas for developing countries." In M. Agosin and D. Tussie, eds., op. c/'f.:69-90. Wonnacott, P., and R. Wonnacott. 1981. "Is unilateral tariff reduction preferable to a customs union? The curious case of the missing foreign tariffs." American Economic Review 71 (4):704-714.

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Regional Free Trade Arrangements as an Alternative to Unilateral Liberalization: The Case of Chile C o m m e n t on P a t r i c i o M e l i e r

Heinz Gert Preuße

Patricio Meller's paper presents an illuminating picture of Chilean trade policy from the early reform period to the present. And it is far more than just an elaboration on the Chilean case. This is because most of the problems that Chile has faced - and is still facing - have to be tackled by any other small developing country in the region and beyond. In this comment I will concentrate on just one important issue - the pros and contras of a reorientation of Chilean trade policy towards regional markets. Chile has practiced a straight forward unilateral liberalization strategy during both reform periods. By now, it is undoubtedly an open economy, and it has become an extremely successful one. It is all the more astonishing, therefore, that this approach is challenged now by a call for a new trade policy with a stronger emphasis on regional markets and bilateral agreements. Is it economic rationale which mandates the call for this change of policies (because Chilean comparative advantage is changing due to the country's dynamic development, for example) or is it the intriguing dynamics of a word wide growing protectionism which reigns the new thinking? In Meller's paper both arguments show up. He first emphasizes the need to participate in MERCOSUR, because future comparative advantage of Chile could expected to be with products for which the markets are in Latin America. In particular, he expects that the growth potential of resource based exports will soon approach its limits. Thus, Chile will have to look for other fields of export activities. Exports in manufactures

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other than refined natural resources are seen as such a promising new source of export growth. Drawing on past experience Meller shows that these kind of exports have found their markets predominantly in the neighbouring countries until recently. He concludes that its future expansion will also be concentrated on Latin America. Participation in MERCOSUR appears to be an important goal of Chilean trade policy, from this point of view. Second, there appears to be a strong belief in Latin America (and Chile in particular) that market access to western economies (and possibly to MERCOSUR) will become more and more restricted, as regional FreeTrade Agreements (FTA) mutate to inward looking regional trading blocks. Market access, therefore, becomes a vital motive on its own for participation in such a trading block. Meller presents these arguments in order to explain the new attractiveness of regionalism in Chile. Although he warns against the negative allocational effects of regionalism and bilateralism, he does not question the validity of the assumptions of this scenario itself. In the following I will try to elaborate a little bit on this point. As far as future Chilean comparative advantage is concerned, I am not convinced that a growing part of manufacturing exports (other than resource based) will find its markets in Latin America. The reason is that this would mean a considerable extension of intra-industry trade within a less developed region. The expansion of this kind of trade, however, depends on sophisticated markets with a relatively high degree of product differentiation. Trade based on conventional comparative advantage (factor endowments), in turn, is still more promising with countries where factor endowments are different. That is, by and large, the more industrialized world. Another point is, that the emphasis put on regional trading partners implies that the neigbouring markets reveal a considerable growth potential. There is little doubt that MERCOSUR might become such an attractive market for Chilean products somewhere in the future. A crucial condition for this to happen is, however, that the integration process of the region will in fact take place along the proposed lines.

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To say it differently: participation in MERCOSUR may exhibit substantial costs for Chile, if the reforming economies fail - either in their national reform programs or in the construction of MERCOSUR. From my point of view it is far from sure that both these conditions hold. For one thing, stabilization and growth policies within the region are still fragile. In Brazil, for example, the reform process has just begun. Such important steps as a comprehensive tax reform, privatization, a more independent status of monetary authorities and the complex task of restructuring of industries towards an open environment are still waiting for a realization. Its implementation will be a test for the political capacity of the new president and the viability of his reforms. As a consequence of the actual situation the macro economic imbalances are still high between the MERCOSUR member states and this has strong effects on bilateral trade balances. These effects add to the obstacles of a successful integration which are already arising out of the high degree of heterogeneity among the participants of MERCOSUR. The astonishing rates of growth of intra-regional trade of recent years should not make us forget these obstacles to the formation of a truly common market. To make things worse, the political views on the concrete implementation of a common concept of international trade policy are differing substantially between the member states. In Brazil, protectionist interests are relatively well organized, while Argentina, Paraguay, and Uruguay are more dedicated to free trade. The majority of the votes of the members is with the latter, for sure, the center of political power, however, is with Brazil. And the impact of Brazilian trade policy is, indeed, felt quite strongly, intra-regionally as well as against outsiders. -

Recently, the Brazilian government, for example, tried heavily to influence locational decisions of multinational enterprises within MERCOSUR,

-

it increased tariffs unilaterally by 70 % on 109 tariff groups in March 1995,

-

and it succeeded in a dispute with the partner countries over the level of external protection of computers, telecommunications and capital goods.

Integration theory shows that the treatment of external competitors is a critical aspect of any regional trade union, because only open regions qualify for the perceived

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positive effects of integration. Chile should not ignore all these questions before it decides to enter MERCOSUR. This brings me to my last point, the perceived need to secure access to FTAs. Meller states that Chile's recent engagement in bilateral trade agreements has been stimulated by a growing fear of staying outside of discriminatory regional blocks. This is not a new motive for an active participation in a FTA. And it surely becomes the more attractive, the more multilateral Free Trade comes under pressure. Mexico's eagerness to join NAFTA has been a case in point. However, there have been major changes taken place on the international scene since then. First of all, the successful completion of the Uruguay Round and the foundation of a World Trade Organization (WTO) are a clear indication of a growing awareness of the merits of multilateral free trade. This is not to say that the foundation of the WTO by itself will stop neo-protectionism. But there is a much higher probability now, that the majority of the trading nations are willing to keep markets open. Second, the proliferation of bilateral agreements in Latin America, which has been emphasized by Meller, has its complement in the spread of regional agreements world-wide. Thus, the European Common Market was followed by NAFTA and both probably gave an important stimulus to form APEC, MERCOSUR and other new groupings. This observation might be seen as further support for the thesis of growing regionalism. It may also be interpreted, however, as a development that will end up in a situation that makes regionalism redundant. In fact, the majority of the member states of the diverse regional groupings clearly favor an open trade regime and they comply to the principle of multilateralism. It is because of this basic political common, that the regional agreements have not ended up as inward looking fortresses until today. On the contrary, in the recent past, some quite surprising ideas about the formation of inter-regional FTAs have come into political discussion. APEC is such an agreement by its very nature (CERTEX, ASEAN, NAFTA). The 'Enterprise of the Americas Initiative' of 1994 may be seen as another. Some months ago, US trade diplomats launched the idea of a FTA between the European Union and NAFTA. And at about

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the same time, discussions on free trade began between the European Union and MERCOSUR. The chances for these proposals to be realized may be weak at present. What has to be recognized, however, is, that all these new initiatives are strengthening the idea of world wide open markets. In fact, what would show up, if inter-regional FTAs between Europe, North- and South America and Asia were to materialize, is free trade among any major Free Trade Area or Customs Union - and this is exactly the case of multilateral free trade. To summarize: The necessity to secure entry to foreign markets by joining a regional integration area should not be exaggerated. There are stones on the road, for sure, which hinder the free flow of goods among nations and regional markets, and these stones are not without harm to the international trading system. In some cases they may even be disruptive, as in the case of agricultural trade which has been and still is important in the case of Chile. But by no means these stones form the wall of an insurmountable fortress up to now - neither in the European Union nor in the United States or NAFTA. On the contrary, after the successful completion of the Uruguay Round, the probability has increased that some of the stones will be removed rather than used to construct such a wall. What follows from my point of view are two major lessons: 1. Small countries like Chile are well advised to realize that there is no acute need to join a regional party at any cost, just to secure market access. 2. For Chile, the balance between costs and benefits of a participation in MERCOSUR should be checked with particular emphasis on the potential costs of its failure.

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The Social Dimension of the Latin A m e r i c a n Reform Process

Hermann Sautter and Rolf Schinke

1.

Introduction

Referring to their rigorousness, the economic reforms in some Latin American countries are exceptional. There is hardly any developing country in Africa and Asia which shows a comparable decisiveness to open its economy, to liberalize domestic markets and to abolish governmental interventions as Argentina and Bolivia for example. These corrections in economic policy oriented towards efficiency and growth are accompanied by an astonishing ideological conversion. The old belief in governmental possibilities and responsibilities is being replaced by the new belief in free markets. Sometimes it seems that the same fervor, which formerly was supporting governmental dirigisme, is now pushing forward liberal reforms. In short, Latin America seems to have learned the lessons of the "lost decade". It is worthwhile to distinguish the two aspects just mentioned of the reform process: the pragmatic and the ideological one. On a pragmatical level, there are good arguments for competitive markets, undistorted prices, a stable money supply etc. Theory as well as empirical evidence shows, that an efficient resource allocation as well as a sustainable growth process cannot materialize as long as the price system is distorted and markets are highly regulated. Beside these arguments, there are ideological ones in favor of a market system. Markets correspond to the vision of free people in a free society. This does not mean, that economic competition would not be possible within an authoritarian political regime, but it does mean, that in the long run democratic rules cannot be maintained the economy being intensively controlled and economic self-initiative being continuously suppressed. Insofar market oriented economic reforms have their ideological and political value beside all their economic advantages. One should, however, not overstretch this point. Economic reforms are mainly realized by economic motivations. The expectation is, that deregulation will stimulate

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economic growth. It should materialize not too far in the future. The new trust in liberal markets may not be strong enough to survive a long period of austerity. What is even more important: The expected economic gains should not be restricted to the upper income-groups, if political support for market-oriented reforms is to be maintained. In other words: The economic growth should have its social dimension. This is a necessary condition for the reform process being politically acceptable. Irrespective of this political reasoning, one has to mention another point. Economic growth is not an end in itself. It should facilitate human development of all members of society. There is a growing international consensus in this respect, as demonstrated, for example, by the positive response which was given to various "Human Development Reports". To put it differently: Economic growth must be justified by ethical criteria. Let us go a step further and consider a special type of ethical reasoning. In his "Theory of Justice" 1) , John Rawls develops what he calls the "difference principle". It means that any economic measure may be considered as ethically justified only in case of improving the economic situation of the most impoverished parts of the population irrespective of possible improvements in the economic welfare of the already well-to-do. Applied to the ongoing reform process in Latin America, this principle says, that reforms are ethically justified if they reduce absolute poverty. One might consider this criteria as a radical one, but in some respect it is very moderate. It does not ask for a more equal income distribution. Even a growth process that leads to increasing distributional inequality would be ethically legitimate as far as it improves the situation of those below the poverty line. Neither the Rawls-criterion asks for poverty reduction as the only goal of economic reforms. Therefore it may be acceptable even for those who do not share all the premises of Rawls' philosophy. The politicians in Latin America probably do not, but at least verbally, some of them express their decisiveness to give poverty reduction a high priority within their reform programs. The social dimension of these programs in terms of their poverty reducing-capacity shall be discussed in this paper. Section 2 deals with the extent of poverty in Latin America. Section 3 discusses the capacity of a reactivated growth-process to reduce poverty, and section 4 refers to social policy institutions which may be used for poverty reduction. More specifically, our question is, how the reform process should be " Rawls (1971).

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extended to these institutions, considering the pragmatical as well as the ideological dimension of reforms, namely improving economic efficiency and facilitating selfresponsibility. Part 5 summarizes the ideas presented in the foregoing sections.

2. T h e e x t e n t of p o v e r t y in Latin A m e r i c a Poverty has many dimensions. Let us just mention four of them: -

the individual (what are the personal experiences of poor people?),

-

the social (how many persons are poor and what is the degree of their poverty?),

-

the temporal (how long do poor people stay poor?),

-

the geographical (is poverty more an urban or a rural phenomenon?).

Every attempt to measure poverty along these dimensions must start from an adequate definition of the problem. One can define poverty as an insufficient level of income given the basic needs of individuals or families, given the pervasive pattern of goods and services which are available for meeting these necessities, and given the prevailing pattern of consumer prices. This is the widely used income approach. Its centerpiece is the poverty line, defined as the minimum of income for meeting basic needs. Unnecessary to say, that the definition of needs, the selection of goods, and the survey of price data gives rise to many controversies. An alternative way to define poverty is represented by the social indicator approach. Following this approach, some quality of life indicators are selected and measured by index numbers, as for example the provision of calories per capita, the primary (or secondary) school enrollment ratio, or the life expectancy at birth. Choosing the income-approach, one has a strong argument for growth stimulating measures, as poverty-reduction defined in terms of narrowing income-gaps is positively related to higher income levels. This point will be elaborated in the next section. However, if one chooses the social-indicator-approach, the argument for growthgenerating strategies is not that strong. Empirical evidence shows that some Latin American countries have been able to improve their social indicators even in periods

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of economic deterioration.1) "Two possible conclusions can be drawn: (i) that the poor were hurt and these indicators do not show it, hence the indicators are problematical; or (ii) that the indicators are valid and that the poor were not hurt. Conclusion (i) seems the more warranted one."

2)

To state it differently: when using

the income-approach, the success of economic growth in reducing poverty is statistically more visible than by using the social indicator-approach. The following considerations are based on the income-concept. Income is the most comprehensive variable defining someone's possibilities to improve his quality of life. Further, the income-approach implies the value-judgement that it is up to the individual (or to the family) to decide about the adequate means for meeting needs. Finally, with respect to the income-level, one describes possibilities, but one does not predetermine, how these possibilities should be used. There are several estimates of the degree of poverty in Latin America based on this approach. The most common indicator hereby used is the headcount-index, expressing the number of poor persons or families in relation to total population. Available poverty surveys differ in the statistical methods, the definition of relevant units (persons or families), the geographical coverage etc.. Data comparability often lacks. Figure 1 and table 1 (annex) show some results published by the International Labor Office. The numbers are based on calculations done by national planning authorities and statistical offices, by ECLA, FAO, ILO, World Bank and others. With all the caution advisable, one can get the following conclusions: 1) The incidence of poverty differs widely between Latin American countries (compare for example Argentina with Guatemala or the Dominican Republic). 2) As in every developing country, rural poverty is more aggravated than the urban one. Given the relatively high degree of urbanization in Latin America,31 the national values of the headcount-index are lower than the rural values, but the total number of poor people may be higher in urban than in rural areas.

11

Fields (1992, 70).

21

Fields (1992, 70).

31

71.5 % of total population in Latin America lives in urban areas. The percentage varies between 90.5 % for Venezuela and 28.3 % for Haiti. (Data for 1990. Source: Inter-American Development Bank [1991], table A-2, p.272)

211

Figure 1

Poverty In Latin America (late 1980s/1990s)

iI -

Dominican Republic Guatemala 0%

!

!

;

!

i i

i I

20%

40%

60%

(Based on table 1 in the annex)

80%

100%

212

3) Where data are available, they show some decline during the 1970s and with the exception of Colombia an increase of poverty during the 1980s.1) This reflects the economic deterioration during the "lost decade". In seven out of nine countries for which comparable data are disposable, the incidence of poverty was higher at the end of the 1980s than at the beginning of the 1970s. The increase in poverty during the 1980s gives rise to an additional comment. Obviously some part of the formerly non-poor have experienced a substantial income decline during this period. Evidently, informal or formal safety-nets were either nonexistent or could not protect these people from becoming poor. The question remains open, how far the new poor will benefit from a recuperated process of economic growth. If their stock of human capital was left untouched by the economic crisis, they will be able to participate in an economic upswing to be expected from institutional reforms. However, their human capital may have depreciated in the meantime. In this case, impoverishment may show a certain "ratchet effect": It becomes difficult for the new poor to recuperate economically when overall economic activities will be reactivated. Empirical evidence does not allow to say something about this dimension of poverty. Suffice it to say, that the obvious weakness of safety-nets makes reforms in the social security system an urgent task. We will come back to this point in section 4. Data are not detailed enough to analyze the situation of the chronic poor. Any deterioration of their social and economic status cannot be reflected by the commonly used headcount-index. Only the calculation of poverty gaps could give some idea of this dimension of poverty.2) More sophisticated indicators - as for example the Sen-index which allows for the income distribution among the p o o r - would be preferable, but there are no corresponding data, neither on poverty gaps nor on Sen-indices or comparable indicators. Economic reforms are intended to reactivate economic growth. Both, the chronic and the new poor may benefit from growth. Insofar, the economic reform process has a social dimension in itself. To what extent does growth decrease poverty?

11

Following alternative statistical data, one gets a much more dramatic picture for Argentina. As to Burki/Edwards (1995, 8), who use data from World Bank and ECLA, the headcount-index for Argentina increased from 16.2 (1980) to 51.1 (1986).

2)

Poverty gaps are defined as the (aggregate) difference between the income of poor families or persons and the poverty line.

213

3. Poverty reduction by e c o n o m i c growth Deregulation, liberalization and privatization can mobilize private economic activities. The premise is, that individuals are motivated and capable to intensify their work, to save more and to increase their innovative efforts. One can discuss each of these motivations and capabilities. But let us take these preconditions for successful reforms as given . Market-oriented changes of economic institutions, then, will set free private dynamism, and this will nearly inevitably materialize in an expansion of productive capacities. In short: The reform process may be expected to stimulate economic growth.11 Overall economic growth will increase the demand for labor which is the main resource at the poor's disposal. Given the pattern of output and the relationship between the growth of output and labor, demand depends on the technical characteristics of the production process. For convenience's sake let us consider a macroeconomic production function of a Cobb-Douglas-type where output (Y) is produced by inputs of labor (L) and capital (C) and where a constant rate (w) of technical progress (T0 = the original level of technical knowledge) is exogenously given:

Y, = T 0 e w L , a C , 1 3 with a and p the respective production elasticities. In terms of growth rates we get:

Y= w + a L +P C Let us assume the following parameter values which seem to lie within realistic ranges: a = 0.6,; p = 0.4, C= 0.03(0.04; 0.05), w= 0^2(0.03). In order to materialize a labor absorption-rate in correspondence with the growth rate of labor force (L= 0.025), the range of the necessary output-growth rate (Y) is between 5 % and 7 %.2) In order to absorb the actually unemployed, output should grow even more rapidly for some years. It is obvious, that only under optimistic assumptions, outputgrowth will reach such levels. To state it differently: Growth rates of labor-absorption

11

As to its ecological dimension, the whole set of economic and legal incentives will be decisive for this growth being sustainable. There is much to say about this aspect of economic recuperation. Here, we cannot elaborate this point further. Instead, we shall restrict ourselves on discussing the social dimension of reforms.

21

This corresponds to the empirical findings of Fields, who showed that poverty declined when yearly growth rates of per capita-income is above 3 % (Fields [1989,175]).

214

in correspondence with the increase of labor-supply require output-growth rates, which are not easily realized. Let us take as given for a moment a homogenous quality of labor. Then outputgrowth rates of at least 5 % would reduce poverty by giving the poor productive employment. Thereby it is supposed, that the poor are supplying the uniform type of labor which is prevailing in this model-economy. The statistically measured degree of poverty reduction will depend, of course, on the location of the poverty line and on the income-distribution below this line. Any given increase of all per-capita incomes by the same percentage will lower the headcount-index the more, the higher poor incomes are concentrated just below the poverty line (compare the reduction of the headcount-index in figure 2 and figure 3) 1) . Stated differently: The more concentrated is the income distribution just below the poverty line, the more pronounced poverty Figure 2 P e r c e n t a g e of population

" A comparable graph is presented in World Bank (1990, 47).

215

Figure 3 P e r c e n t a g e of population

reduction will be. The corresponding reductions of poverty gaps are reflected by the shaded areas in figure 2 and figure 3. Given the same proportional increase of income, the remaining gap will be higher, of course, in case of a lower concentration of the poor around the poverty line (figure 3). A similar line of reasoning holds, when one compares countries with different income levels. Given the same poverty line and a S-shaped distributional curve, it needs lower growth rates to reduce the headcount-index in low-income countries than in highincome countries, given the already lower poverty levels in rich societies (figure 4). Taking into consideration all these arguments, it is impossible to make any general judgment on the effectiveness of growth in reducing poverty, that is the strength of the much debated "trickle down"-effect. This does not mean that growth is irrelevant. It is intuitively clear that increasing overall growth rates will also improve employment possibilities of the poor, but the extent of this effect depends on many economic, social and political conditions.

216

Figure 4 P e r c e n t a g e of p o p u l a t i o n

Having pointed to these theoretical and statistical arguments, it suggests itself to ask for the empirical relationship between income and poverty. The hypothesis is, that increasing per capita-income (PCY) will reduce poverty levels (in terms of the headcount-index, INDEX). Unfortunately, one cannot test this hypothesis in a combined cross-section and time-series analysis, since data for different countries are not comparable. Therefore, separate analyses have to be made for those seven countries, where sufficient data are documented for (Bangladesh, Brazil, Chile, Costa Rica, India, Indonesia, Malaysia). The headcount-indices documented for these countries refer to urban and rural areas as well as to the national territory. Therefore, the regressions have to include Dummy-variables

(DURBAN = 1 in case the poverty

index refers to urban areas, DURBAN = 0 in case of other observations; DRURAL and DNATIONAL are defined correspondingly.) Since the observations in the underlying statistical surveys refer to households or individuals, another dummy has to be added (UNIT = 1 in case of data referring to households and UNIT = 0 in case of

217

observations relating to individuals). Using household data a necessary assumption is that the size of households does not change over time. The equation to be estimated reads as follows:1) LINDEXtj = ao + a: LPCY85ti + % DURBAN + a3 DRURAL + a4 DNATIONAL+ 85 UNIT+Uti The symbols are defined as follows: LINDEXti

Log of observation i in year t of the percentage of households or individuals in total population living below poverty line

LPCY85,

Log of GDP per capita in constant domestic prices of 1985 in yeart

DURBAN, DRURAL, DNATIONAL, UNIT

Dummies as defined in the text

Before estimating this equation, we tested for Granger causality between the variables LINDEX and LPCY85. The result was, that one can reject with a high degree of confidence the hypothesis that LPCY85 will not cause LINDEX, whereas in no case the opposite hypothesis could be rejected. Based on these results, the OLS-technique was used in calculating regressions for each of the countries selected. It was expected that the regression coefficient of LPCY85, has a negative sign. Further we expected that in cases where the DNATIONAL dummy was excluded the coefficient of the urban dummy would show a negative sign whereas that of the rural dummy was supposed to be positive. In cases where the urban dummy has been excluded the expectation was that the remaining area dummies (DRURAL and DNATIONAL) were positive with DRURAL > DNATIONAL. In three cases, however, it was necessary to exclude two of the dummies for lack of statistical significance (usually DRURAL and DNATIONAL). In these regressions, we expected a negative coefficient of DURBAN as the intercept will reflect both the influence of the dummies excluded and that of the intercept itself. These signs were inferred from the observation that in many LDCs rural poverty indices were higher than those in urban areas. Graphical analysis suggested a logarithmic relationship between income per capita and poverty. 11

Note that in the regressions one of the regional dummies has to be dropped to avoid multicollinearity problems.

218

The results are given in table 2. In every case the sign of the income variable corresponds to expectations1'; its coefficient is significant at the 1 %-level in all cases with the exception of Brazil2'. As it is shown, the income elasticities of povertyreduction vary between -0.45 in case of India and -3.50 in the case of Bangladesh. The lowest coefficient of determination is that for India, the highest is shown for Malaysia. The R2-levels are not quite high, but considering data-quality and diversity of underlying methods, the corresponding expectations have been moderate. Interpreting these results, one has to take the fact into account, that poverty lines shifted the in cases of Bangladesh, India and China. Following Ravallion,3) the coefficient of the income variable is underestimated when poverty lines increase with growing incomes, which is true for these countries. Two conclusions may be drawn from these results: reduce poverty levels, and

(i) Rising per capita incomes

(ii) the effectiveness of growth in decreasing poverty

differs widely from country to country. The second conclusion indicates, that there is a wide range of possibilities to make the growth process as effective as possible to reduce poverty. To mention just a few of them: -

Skill-levels as well as physical capabilities of poor people can be improved, giving them better employment chances.

-

Final demand can be shifted towards those goods, the production of which demand exactly those factors poor people can supply. In case of low-skill labor being the typical factor-content of tradables, a devaluation is one of the possible measures to bring about such a pro-poor oriented change of output pattern4) (the price effect of devaluations on the consumer level may, of course, counteract the poverty-reducing allocation effect).

-

Factor price-distortions favoring capital-intensive techniques can be corrected.

11

Expectations of the signs of the dummy variables have not been met in the case of Brazil.

21

In the case of Malaysia serial correlation could not be excluded. We suspect this was due to misspecified dynamics. Running the same regression with lagged per capita income the hypothesis of no serial correlation could not be rejected.

31

Ravallion (1995, 412).

41

This argument is elaborated in: Schinke (1995).

219

-

Labor market regulations impeding higher growth rates of labor absorption may be abolished.

Each of these possibilities deserves to be discussed in detail, which is not possible in the present context. We shall restrict ourselves to discuss another point in the next section: the appropriateness of social security institutions for decreasing poverty and the need of reforming these institutions. Even the most pro-poor oriented growth policy cannot eradicate poverty if growth is not supplemented by certain measures of social policy. In every society there are the old, sick and disabled, who cannot participate actively in the process of income earning. They need some protection, which may be offered by traditional and informal as well as by formal and publicly organized institutions. Given the high degree of urbanization in Latin American countries, the effectiveness of traditional and informal safety nets is limited. There is a need for formal safety nets. Do they exist in Latin American countries? How far have existing institutions to be reformed in order to reduce chronic poverty and to protect against new poverty? This is a second aspect of the social dimension of the reform process beside the first one already discussed, namely the poverty reduction by economic growth triggered by reforms of economic institutions.

4. P o v e r t y r e d u c t i o n by r e f o r m e d s o c i a l s e c u r i t y i n s t i t u t i o n s The first question to be answered in this section is: Which are the social security institutions established by Latin American countries, and which are their deficits in terms of protecting people from becoming poor and in terms of reducing the already existing poverty? (4.1.) The second question is: How far is the ongoing reform process extended to social security institutions, and are these reforms sufficient for realizing their economic and social goals? (4.2.)

4.1.

Existing social security institutions and their deficiencies

The main institutions established in industrialized countries in order to cover social risks do also exist in Latin America. Already in the 1920s and 1930s, some countries

220

- Mesa-Lago calls them pioneer countries1) - created social insurance systems for sickness and maternity, old age, invalidity, death, work injury and unemployment.2) In these countries, the foundation of social insurances was a response to the action of influential pressure groups, as for example the armed forces, railway workers or other public employees.3) In the course of time, nearly all occupational groups in the formal sector in the economy got their own subsystem of social insurance. As a consequence, the whole system got highly fragmentary. This is one of the main problems of these pioneer countries. In the 1940s, some other nations - the "intermediate countries"4' - created a general agency for social insurance, avoiding to some extent the problems of the pioneers, and in the 1950s and 1960s the "latecomers"5' concluded the process of institutionalizing social security following hereby different principles than those applied in the pioneer and intermediate countries. As a result of this development, one of the main characteristics of Latin American systems of social security is their diversity. Two sets of institutions are the centerpiece of all systems: sickness-maternity programs with their linkage to public health care, and old age insurances. They absorb the bulk of expenditures.6) We, therefore, shall restrict our further comments on these two programs. Sickness insurance and public health care have two main tasks to fulfill which are relevant in our context: poverty prevention and poverty reduction. First, people are protected from becoming poor insofar as health care is provided, the costs for medical treatment are covered and sickness benefits are paid which compensate for the income loss during periods of illness. Old age insurances also have a povertypreventive function. Second, by improving the physical capacity of people as one of " Mesa-Lago (1991,181). To this group belong Argentina, Brazil, Chile, and Uruguay. As to the history of implementing social security programs and the early start of Latin American countries see: MesaLago (1992, 69). 21

See for an overview: Social Security Program Summaries, in: inter-American Development Bank (1991, Appendix 1, 221-269).

31

This point is stressed in: Mesa-Lago (1978).

41

Mesa-Lago (1991, 182), counts the following countries to this group: Mexico, Bolivia, Colombia, Costa Rica, Ecuador, Panama, Paraguay, Peru, and Venezuela.

51

As to Mesa-Lago (1991, 182), the following nations are the "latecomers": the Central American countries (excluding Costa Rica and Panama), the Spanish-speaking and the English-speaking Caribbean nations.

61

In 1983, 90 % of total expenditures was concentrated on pension and sickness-maternity programs (Mesa-Lago [1991, 183]).

221

the central conditions for participating in the income-earning process, these programs help the poor to overcome their unsatisfactory income level. How far do existing institutions correspond to these functions? The fact is, that formal social security systems in Latin America have not been established for the poor who - by and large - are identical to those working in the informal sector. Rather, these systems are oriented towards the needs of the middle class including workers in the formal sector. Having in mind the political process of implementing social security institutions, this pattern is not astonishing at all. Typically, the chronic poor do not constitute a strong political pressure group. Their scarce resources are completely absorbed by their daily struggle for life; they hardly can afford to engage themselves in collective actions. Moreover, the group of the poor is very heterogeneous and very large. For each member, any success of common political initiatives has the character of a "collective good". Following the "logic of collective action",1' it is not to be expected that the political process will produce institutions which correspond to the specific needs of the poor. This is reflected in the coverage of social security systems in Latin American countries (figure 5 and table 3). Statistics on this subject are generally deficient. Therefore, figures should be interpreted with some cautiousness. However, they are reliable in the sense of showing a very low degree of protection in the least developed countries. The overall coverage in Latin America is 61.2 % for both the total population and the economically active population (differences in individual countries are due to different degrees of protection for dependent family members). Excluding Brazil, which has more than half of all the insured individuals in the region, the overall coverage is only 43 %. As a general rule, coverage is the lower, the higher the importance of the informal sector is, which includes the main part of the poor. To state it differently: "Those below the poverty line in Latin America are not normally protected by social security."2) Coming back to our question, one can say that formal sickness insurances usually do not improve poor people's capacity to overcome their unsatisfactory income situation. Neither the public health services give the poor substantial assistance. These services are usually organized by the health ministries, and they include primary health care, 1)

Olson (1965).

21

Mesa-Lago (1991,187).

222

Figure 5 Total Population C o v e r e d By S o c i a l S e c u r i t y (1985-1988) Dominican Republic Honduras Guatemala Ecuador

0%

20%

(Based on table 3 in the annex)

40%

60%

80%

100%

223

prevention, nutrition and care for children and pregnant women. The problem is, that these services are chronically underfinanced. Their share in total public health care resources is much lower than the corresponding share of insurance programs. To give an example, in the 1980s, services of the Colombian health ministry - the only available for the non-insured- covered 8 2 % of the population, but the ministry receives only 3 8 % of total health revenues, whereas social insurances covered only 1 8 % of population and received 62 % of revenues. 1) In short, the whole health system is biased in favor of the non-poor. It is highly deficient in helping the poor to improve their capacities and thereby to overcome poverty. It even cannot prevent the poor from further income deterioration. The same, of course, holds for old age insurances as the poor are generally not covered by these programs. How effectively can social security institutions prevent the non-poor insured people from becoming poor? This depends, beside other conditions, (1) on the administrative efficiency and

(2) the financial stability of insurance programs. As to both

aspects, there are severe deficiencies. Referring to the first point, administrative problems are illustrated by high costs of maintaining the social security organizations. On the average, these costs amount to 18.5 % of total social security spending compared with a share of 2 % to 4 % in developed countries. 2 '

The difference is partly due to the institutional fragmentation

mentioned before. The multiplicity of agencies makes it impossible to exploit potential scale economies. To take an example, in the 1980s, Colombia had 300 different programs for pension, health care and family allowances, and Bolivia had 12 major funds, 20 complementing funds and 5 programs for health services. 3) Moreover, the administration of health stations, hospitals and pension programs suffers from serious organizational deficiencies, as it is illustrated, for example, by low hospital occupancy, an irrational allocation of resources between social insurance programs on the one side and the services of the health ministry on the other side and by the lack of personal accounts in the pension systems. Given the limited amount of resources, administrative inefficiency makes it difficult - or even impossible- to protect as rapidly as possible for insured people in case of need.

"

Mesa-Lago (1991, 206).

21

Mesa-Lago (1994, 73).

31

Mesa-Lago (1991, 203).

224

This inefficiency has an additional consequence, and this refers to the second point, financial instability. Large administrative costs blow up total expenditures, and this contributes to the financial deficits of Latin American social security programs. There are many other factors to be mentioned in this context. One of them is an irrational incentive structure. To illustrate this point by an example: When 100 per cent of the pension is paid if the insured contribute to the insurance system during the last three or five years of their working life, then with this rule, it is self-damaging for the individual, to fulfill his own payment obligation during the whole working life. But this exactly makes the system financially unsustainable. There are many other examples of such a "rationality trap" caused by economically wrong incentives. What is individually rational makes the system to collapse. Other factors contributing to the financial deficits which have become notorious for Latin American social security programs are: low revenues of pension funds due to inefficient investment of resources, worsening actuarial balances, high inflation rates and declining revenues from payroll taxes during the economic crisis in the 1980s. The deteriorating financial situation made it impossible to provide the contractual services during the period of highest need. During the 1980s, pension payments have been delayed and devalued, in many cases health services have deteriorated, investment in facilities and equipment has declined, supplies of medicine have been cut etc. Argentina offers an extreme example for this failure of social security nets, and the increased poverty indices in this country (see table 1) reflect this. When the Argentine Supreme Court decided in favor of hundreds of pensioners who filed suit seeking retroactive pay, the country faced a national crisis.1) To summarize, Latin American health services, sickness insurances and pension systems neither help the already poor to overcome their poverty nor can these programs efficiently prevent the non-poor from becoming impoverished. The systems are administratively inefficient and they produce high financial deficits. Reforms, therefore are overdue. This need of reforms has been debated for a long time. What is new in this debate, is the stress on deregulation and privatization which corresponds to the ideological dimension of the ongoing reform process.

"

Mesa-Lago (1991,189).

225

4.2.

Reforms of social security institutions

Stimulated by their engagement for a free market economy, some Latin American countries also scrutinized their social security systems as candidates for privatization. This is understandable, considering the ideological drive of the reform process. But one should not neglect the pragmatical aspect of this process, and in this context the limits and failures of markets should be taken into account. For pure economic reasons, markets may be inefficient institutions in providing health care and in protecting against old age poverty. The main reasons are1) : First:

Health services may be considered public goods or merit goods.

Second:

Asymmetric information can lead to adverse selection and to the breakdown of markets.

Third:

Moral hazard may distort markets.

Forth:

Under certain conditions, (private) funding systems may be inferior to (public) pay-as-you-go-systems (PAYG).

These points deserve some explanation. ad 1) This is the traditional argument which was always recognized in health care programs. Primary health care for example has external economies converting it into some kind of public good. There is no country, therefore, leaving this sector completely for private markets. As to merit goods, the point is, that individuals cannot always recognize the utility-increasing capacity of certain goods. To take an example: The poor and illiterate may be unable to evaluate the utility of some medical treatment. The first best solution in this case is improving the educational level of people. Given the natural restrictions in this process, public provision of the relevant health services may be considered a Pareto-improving second best solution. ad 2) Insurance companies cannot distinguish high- from low-risk individuals. Calculating a premium based on average risk leads either to adverse selection and the breakdown of markets or to inefficient market solutions.2) In any case, bad risks may get insured only in case of some kind of public intervention.

" The following considerations are mainly baised on: Barr (1992). 21

Barr (1992, 750 ff).

226

ad 3) Moral hazard arises when injured persons can influence the probability of losses at a cost lower than the expected gain from insurance, without the insurer's knowledge. This is another example of asymmetric information. A special problem is that of the external moral hazard which is well known in social security as the "third party payment problem". To take an example: The third party in the relationship between patient and doctor is the insurance company. Contractual parties are attempted to explode costs to the detriment of the insurer. ad 4) If adequate growth rates are permanently higher than market interest rates1), introducing a PAYG system gives a better support to all generations than a funding system does. As PAYG finance cannot be organized by bi- and multilateral contracts, it needs governmental coercion.2) In addition to these efficiency arguments, there are - of course - distributional arguments in favor of governmental activities. It may be politically difficult to get a more equal distribution of productive resources which indirectly determines income distribution. It seems to be more feasible to influence directly the income distribution by providing a minimum income for the poor. Given some consensus in society referring to the desirable minimum income, public transfer payments are the efficient solution since private transfers are not provided to the collectively desired extent. The reason is the collective good-character of transfer payments. However, the failure of markets in producing efficient and distributional^ desired outcomes is not a sufficient argument in favor of governmental interventions. State failure can even be worse than market failure. It is necessary, therefore, to define very carefully the criteria for governmental activities in the social security system. There is no blueprint which could be applied to every country. Each country has to find its own solution considering the degree of formalization in its economy, the already existing institutions (giving rise to some kind of "path-dependency" of institutional reforms) and the efficiency of public administration. In the following we shall make some comments on the ongoing reforms of the social security system in Latin American countries. The "

More precisely: If

(1 + r) < (1 + h) (1 + g),

then PAYG systems give better results than funding systems, (r = interest rate, h = growth rate of wage rates, g = population growth rate) (Seidel, C. (1988)). 21

Spremann (1984).

227

underlying question is how far these reforms make it possible to improve administrative efficiency as well as economic stability, and to what extent they are oriented towards poverty reduction and poverty prevention. Health care and sickness insurance. - One can distinguish three types of reforms: (1) improvement of the dominant public system, partly by facilitating its collaboration with the private sector, (2) establishment of partially substitutive private systems, and (3) creation of supplementary private systems.1) There are no cases of full privatization. The limits of private markets which are demonstrated by the experiences of industrialized countries have also been respected by Latin American countries in spite of their impressive fervor for liberalization and privatization. The first type of reforms can be illustrated by Costa Rica.2) Already in 1979, a universal health service was established with a clear division of functions between the Costa Rican Social Insurance Fund (Caja Costarricense de Seguro Social, CCSS) and the health ministry. This was an important step towards a more rational allocation of resources. In the 1980s and 1990s, efforts have been made to reduce costs and to overcome organizational deficiencies. Hereby, the decentralization of services and the collaboration of the public system with the private sector played an important role. Referring to this collaboration, various programs have been launched. In one of them, several hundreds of enterprises hire and pay doctors for their employees, and the insurance fund (CCSS) supplies laboratory services as well as drugs. In another program, the CCSS and the health ministry make contracts with cooperatives or self-managed organizations. The fund pays a monthly sum per user, and the ministry pays a monthly lump-sum. The private organizations provide primary health care, curative medicine, milk to pregnant women and undernourished children. Introducing these private elements into sickness insurance promoted self-responsibility and costconsciousness by part of the insured and this contributed to the financial consolidation of the system. In short: The organizational effectiveness and the financial stability of the system have been improved, and this facilitated its capacity to prevent insured people from impoverishment. What about the changes of coverage and the capacity of sickness insurance and health care to assist poor people in their endeavor to overcome poverty? Interrupted 11

Mesa-Lago (1994, 93).

2)

The following comments are based on: Mesa-Lago (1994, 95 ff).

228

by the economic crisis in the 1980s, total coverage increased from 38.4 % in 1970 to 85.4% in 1989. Even if some of the poor, especially those in rural areas, are not covered by curative medical services, they are reached by preventive services and primary health care. Costa Rica, therefore, offers an example of a reform process, which started long before the current movement of economic transformation in Latin America. The country demonstrates the political decisiveness to follow what we may call a "human-capital approach" of economic development. The success is impressive. From 1960 to 1990, infant mortality declined from 76 to 13.7 per 1000, and life expectancy increased from 63 years to 75.8 years.1) The poverty rate is among the lowest in Latin America (see table 1).2) Chile is an example of the second type of reforms, that is the partial substitution of the social insurance by private organizations. In 1981, the government allowed the establishment of private sickness insurance companies (Instituciones de Salud Previsional, ISAPRES). Since then, about 35 of these institutions have been founded. They cover 19 % of the total population, and they participate with 40 % in total financial resources of the national health system. This is a reflection of the fact, that about one half of ISAPRES-members belong to the richest 20 % of the population.3) The insured can choose between various possibilities: They can pay to the provider of health services and get an agreed-upon percentage reimbursed by the company; they can buy vouchers from their ISAPRE to pay the provider, who gets reimbursed by the ISAPRE; and they can receive direct services from an ISAPRE which has the necessary facilities. In short, the private system offers several options, it is organized in a competitive way and it covers mainly the upper- and upper-middle class. Formally, the ISAPRES are open for the whole population. Practically, however, the larger part of the population is excluded by relative high copayments (on average 25 % of total medical costs) and by prohibitive conditions for the insurance of bad risks.4)

" Mesa-Lago (1994, 96). 21

Argentina, Uruguay, Venezuela, and Costa Rica show poverty rates of around 20 % and below (table 1). Among these countries, Costa Rica has the lowest income per capita (US-$ 1960 compared with US-$ 2970, 2910 and 6050 for Uruguay, Venezuela and Argentina; World Bank [1994], figures for 1992). Given the economic potential as reflected by per capita incomes, Costa Rica demonstrates the best performance in terms of poverty reduction. This reflects the known political engagement of Costa Rica in favor of social development.

31

Mesa-Lago (1994, 94); Witte (1994, 85). The figures mentioned in the text are based on these publications.

41

Practically, the old, the poor and the chronic sick are precluded from ISAPRES by long waiting periods, high copayments and by excluding chronic illnesses from insurance (Witte [1994, 86]).

229

The majority of the population1' is covered by the public social insurance scheme "Fondo Nacional de Salud" (FONASA). It offers two subsystems of insurance: the first is a standard package for those who pay the regular contribution of 7 % of the wage income or no contribution at all (about 40 % of total population). In this case, insured people do not have any choice between providers of medical treatment. They depend on the public facilities. The second subsystem offers a free choice between the various providers ("Systema de libre Election") and it covers those, who can afford to make copayments. In this system the insured belong by and large to the middle class. As to the financial structure of the whole public system, contributions of insured cover only 50 % of total expenditures, 40 % are financed by governmental transfers and 10 % by additional payments of members of the second subsystem. Moreover, there is a cross-subsidization from the second to the first subsystem. Referring to the administrative efficiency, the partial substitution of the social insurance scheme by the ISAPRES does not seem to have improved the situation substantially. In 1981, in the ISAPRES, costs of administration and sales absorbed 40.5 % of total expenditure. This share declined to 18.9% in 1991, but it is still quite high.21 Neither the public system seems to be very efficient.3) What is even more important in this context, is the hidden subsidization of the private sector by the public system. Preventive medicine is completely covered by FONASA. Moreover, the facilities owned by the public system charge lower than market prices for services provided for ISAPRES-members, and the government offers tax reductions for employers who pay allowances for their employees' contributions to the ISAPRES.4> The private sector, therefore, is subsidized by the public system and the government in general, whereas the ISAPRES do not contribute at all to the costs of FONASA. In some sense this corresponds to the inversion of the "principle of solidarity". With respect to poverty prevention and poverty reduction, it is obvious, that this is not the problem of those insured in the private scheme. They do not belong to the poor and they are sufficiently protected against health risks. This cannot be said, however, about those insured in the standard public scheme. Governmental transfers have 11

72 % of the population are covered by FONASA, 5 % by the armed forces and 4 % are not covered at all (figures relate to 1991) (Mesa-Lago [1994, 94]).

21

Mesa-Lago (1994, 94).

31

Witte (1994, 87).

41

Witte (1994,86).

230

been reduced, partly as a consequence of decentralization of responsibilities without a corresponding redistribution of public resources. 11 have deteriorated.

2)

Therefore, FONASA services

In short, the reform of the sickness insurance and health care

system does not seem to have improved the poor's access to health services and therefore their physical capabilities to overcome poverty. Obviously, this reform did not have a strong social dimension. However, this may change under the democratic regime which replaced the authoritarian one which initiated the reform. 3 ) Finally, reforms consist of supplementing public services by private systems. This is the third type of reforms mentioned before. The Dominican

Republic

represents an

example thereof. In this country, the coverage of social security is extremely low; with 10.2 % it is the lowest in Latin America (see table 3). 4) Considering the large informal sector, it is impossible to improve services by merely extending the coverage of social insurance. The solution found in this country consists in establishing health maintenance organizations, known as "igualas". For a monthly premium they provide a comprehensive health care to its members. Special arrangements are being negotiated between the "igualas" and associations of microenterprises in the informal sector which are willing to enroll members and to collect fees. In this case, the predominant task is not to improve the effectiveness of an existing social security system, but to provide a minimum health care to the majority of the population by creating new institutions. Until now, the success is limited. Only about 7 % of the population is included in the system of "igualas". 6) These are three examples which can be considered as representative of the reform process which is going on in the Latin American institutions of sickness insurance and health care. Private organizations, profit oriented ones as well as non-profit organizations, play an important role in this process. In some cases they may have contributed to an improved cost effectiveness. But the Chilean example shows that privatization is no guaranty for cost reduction. Wherever the efficiency of social security institutions has been improved, the insured are the winners. They are prevented more effectively from the risk to become poor. But there is still much to do in order to provide better " Stahl (1994, 309 f). Mesa-Lago (1994, 94).

21 31

As to the new agenda for FONASA see: Oyarzo/Galleguillos (1995).

41

Following Mesa-Lago (1994, 95), only about 4 % of the population are covered by health services.

51

Mesa-Lago, Carmelo (1994, 95).

231

health services to the already poor and thereby helping them to overcome their indigence. Pension systems. - These systems have to prevent the insured from old agepoverty. Only administratively effective and financially viable insurance schemes can reach this aim. As it was shown in section 4.1., these two conditions are far from being fulfilled in Latin America. Which are the reforms undertaken in various countries in order to make pension systems more effective? Three types of reforms can be distinguished i( :

(1) public schemes are maintained but substantially modified;

(2) public schemes are closed and supplanted by fully funded private schemes; (3) mixed schemes are developed whereby the public system is reformed and supplemented by private companies. Costa Rica represents the first type, that is the continuation and modification of the public system. Minimum ages for early retirement were increased; the required contributions were set so as to discourage retirement at an early age; privileged systems for civil servants were supplanted by the standard program of the "Caja Costarricense de Seguridad Social" (CCSS); administrative costs were cut; control measures were introduced in order to diminish evasion and payment delays. In short, the country made some efforts to get a more rational incentive structure, to eliminate the institutional fragmentation, to restore actuarial balances and to improve administrative effectiveness. This was done without privatization. Obviously, there is scope for reforms within the public system, given the political decisiveness to do so. Chile represents the Latin American or even worldwide model of the second type of reforms, that is the creation of substitutive private pension funds. They began to operate in 1981 on the basis of a strict equivalence between contributions and pensions. The government made it very attractive for the insured to change from the public scheme, which formerly had been universalized to some degree, to one of the private funds, known as "Administradoras de Fondos de Pensiones" (AFPs). Contributions made to the old system have been recognized in case of the insured's change to the new one. Moreover, the conditions of remaining in the public insurance system were made as unattractive as possible. An additional pull-factor which motivated the insured to leave the old system was the relative high level of pensions paid by the 11

Mesa-Lago (1994, 90), distinguishes between four types. His "mixed schemes" and his "supplementary pension schemes", however, are very similar. Therefore, they are taken together here. A thorough analysis and an overview on the ongoing reforms in various Latin American countries gives: Uthoff/Szalachman (Eds.) (1991,1992).

232

private funds which was made possible by the economic upswing of the Chilean economy in the middle of the 1980s. It is not surprising, therefore, that within only one year nearly 70 % of insured moved to the AFPs.1) For all new entrants to the formal labor market, the AFPs offer the only possibility to get old age insurance. For a long transition period - about 50 years- the old and the new scheme will work side by side, the one being based on the PAYG method, the other on full capital funding. In 1988, the private scheme had 84 % of total number of active contributors and only 4 % of total number of pensioners. Given this relationship, a substantial surplus was just unavoidable. The public sector had only 16 % of the active contributors and 96 % of the pensioners. A huge deficit was as unavoidable as the surplus in the private system. There is a debate on the sign and the amount of the consolidated balance of the entire system since various subsidies paid by the state can be estimated in different ways.2) In any case, the deficit in the public pension sector will last for some more decades, and it is still unclear how the state will finance it: with taxes, public debt, a reduction of other expenditures or some combination of all these possibilities. After having reached their maturity, the private pension funds cannot produce any surplus of savings, as savings of contributors will be matched by dissavings of pensioners. The new system has a clear advantage in terms of promoting self-responsibility. Insured can choose between various options and they know, that their own pension depends on their individual contributions. Insofar, privatization led to a more rational incentive structure which facilitates economic efficiency. In terms of poverty prevention, however, the funding system needs its own safety net which is provided by the state. The level of rents paid by the AFPs depends on the revenues of the funds invested. All macroeconomic fluctuations are reflected in the financial situation of the private funds. They cannot promise, therefore, to pay at least some minimum rents. It is the government, which gives this guaranty.3) For those who paid their contributions for at least 20 years, the state covers any difference between individual pension entitlements and the minimum pension. Insofar, the insured are prevented from old age poverty, provided the government keeps to its promises and the minimum rent corresponds at least to the poverty line. 11

Mesa-Lago (1994, 116); Stahl (1994); Witte (1994); Queisser (1993).

21

Mesa-Lago (1994,127).

31

This may create some "moral hazard" on the part of the AFPs.

233

Old people who are neither insured by the public nor by the private scheme, are entitled to get "Pensiones Asistenciales" (PASIS). These are purely needs-tested payments which are restricted to 300,000 recipients. 1) In 1991, the PASIS were fixed at an amount which equalled 12 % of per capita income. 2 ) Considering this low level, those who are not insured at all (mainly the self-employed in the informal sector) and those who are not sufficiently insured (less than 20 years of contributions) do not receive pensions which protect them from old age poverty. They depend on informal safety nets and on additional public payments, as for example the "Subsidio Unico Familiar". 3) The Chilean Reform, therefore, has its strength in promoting self-initiative and economic efficiency, but referring to its effectiveness in preventing

poverty, this

reform can hardly be considered a model. The third type of reform consists in creating mixed schemes that involve a combination of a reformed public scheme working on PAYG-bases and a fully funded scheme that could be either public, private, or a combination of both. Argentina

is an example

for this approach. Entitlements in the public system have been revised in order to regain financial feasibility. In addition to that, private schemes have been established, partly following the Chilean example. As the new pension insurance law entered in force only in July 1994, until now there are practically no experiences with this reform. As these examples demonstrate, institutional reforms which are going to transform the economy of Latin American countries, are also changing their social security systems. The same principles are working on both sides: strengthening self-initiative and self-responsibility, sharpening the economic calculus and diminishing governmental interventions. The scope for liberalization, however, is limited in the sphere of social security. One cannot avoid to recognize market failures when it comes to provide insurance against typical social risks. Moreover, distributional arguments set limits to a full deregulation. In practice, therefore, the reforms consist in some mixture of modified public systems and new private schemes. Even in Chile, the country which showed the most comprehensive liberalization of the social security system, the state still plays a decisive role.

'' Queisser (1993,223), quoting Gillion/Bonilla (1992): Estudio de la Privatización de un Régimen Nacional de Pensiones. El Caso Chileno. Doc. 18/OIT/Departamento de Seguridad Social. 21

Queisser (1993, 223).

31

Queisser (1993, 225).

234

As to the results of these reforms, there is some success in solving the old problems of institutional fragmentation, organizational deficiencies, an irrational incentive structure, actuarial imbalances. In terms of administrative efficiency and financial stability, the reforms led to an obvious progress. This will help those who are sufficiently covered by public or private schemes. They are better prevented

from becoming

poor. But there is still the large number of those, who are not sufficiently

covered

by

any insurance scheme. By and large, the institutional reforms did not improve their situation substantially. Assisting the chronic poor was not an important dimension of the reform progress. Neither the social emergency funds, which have been established in many countries during the last five to eight years, are tackling this problem. They are mainly oriented towards cushioning the structural adjustments. 1 )

5.

Summary

The social dimension of the Latin American reform process was the topic of the preceding considerations. Following Rawls, the litmus test for any economic transformation is the social and economic improvement of the most impoverished parts of the population. Referring to country-specific poverty lines and following the income approach, this part varies between about 1 0 % and 8 0 % of the population in Latin American countries. Recuperating the economic growth process - the declared goal of institutional r e f o r m s - will help these people insofar as it improves their chances to get employed and to earn higher incomes. The extent of their participation in economic growth depends - among other f a c t o r s - on the pattern of output-growth, the factor-content of newly produced goods, and the factor supply of the poor. All these factors can politically be influenced. What is economically efficient in this context, is to a large degree also effective in terms of poverty reduction. How different the performance of developing countries was in giving economic growth a social dimension, is shown by some regression results. The poverty elasticity with respect to income per capita varies between -0.45 and -3.50. In every society, however, there are the old and sick who cannot participate directly in the economic process. Informal safety nets are not as important in highly urbanized Latin America as they are in Africa or in Asian countries. Preventing these people, therefore, from becoming poor and improving their capacities to overcome poverty 1)

Sautter/Schinke (1994).

235

depends on the effectiveness and coverage of social security institutions. The fact is, that in Latin America these institutions had been highly ineffective and their coverage restricted. Potential scale economies had not been exploited, X-inefficiencies of existing agencies led to a cost-explosion, and in many cases an irrational incentive structure produced a financial disaster. Reforms, therefore, had been overdue. They have been debated for a long time. The current transformation of Latin American countries towards liberal market economies gave a new impetus to this debate. In various countries, reforms have been initiated which are based on the same principles as those underlying the economic reforms: self-responsibility is being promoted and the private sector has been activated. This improved the effectiveness of the whole system of social security. The winners are those who are covered by either public or private insurance schemes. They are prevented more effectively than before from becoming poor. The chronic poor are typically not covered by social insurances, and the ongoing reforms did not help these people substantially. In some countries, progress has been made in extending the coverage of public and private schemes, but by and large this was not the main goal of institutional reforms. Therefore, much remains to be done. The social dimension of the ongoing reforms needs an energetic extension.

236

Appendix

Table 1 Poverty in Latin America ( m e a s u r e d by the h e a d c o u n t - i n d e x Country Argentina (1970, 1980, 1986) Brazil (1970, 1980,1987) Chile (1970, 1987) Colombia (1970, 1980, 1986) Costa Rica (1970, 1981, 1988) Cuba (1988) Dominican Republic (1978, 1988) Ecuador (1975, 1980) El Salvador (1978, 1980, 1990) Guatemala (1978, 1985, 1989) Haiti (1977, 1980, 1980-86)

)

Coverage2'

Unit3»

1970s

early/mid 1980s

late 1980s/1990s

N

H

8

8.7

13

N

P H P

39.3 17

24.4

35.9

N N N

H

45

38.6

37.9

N

H

24

22.2

24.5

R

P

R R U R U R U

P P P P P H H

44.6

35 43 65 40 32 20

N R R N

P P

Honduras (1970, 1990)

N

H

65

Jamaica (1977, 1985)

R N

P P

80

Mexico (1970, 1984)

N

H

34

Nicaragua (1978)

N

P

20

R U R N R

P H P P

Panama (1970, 1980, 1986)

1)

71 78

P

78 40 76 57.4 95

61.4 79.9 76 77.5

5.9 29.9

52 29

36 67 41 51.9

237

Table 1 P o v e r t y in Latin A m e r i c a - Continuation Coverage21

Unit3'

1970S

R U N

P P P

50 19 35

Peru (1970, 1979, 1986)

N

H

Uruguay (1970, 1981, 1989)

N

Venezuela (1970, 1981, 1986)41 (1982, 1987)s>

N N

Country Paraguay (1978)

early/mid 1980s

late 1980S/1990S

50

46.1

51.8

H

25

22

26.6

H H

25

22 33

26.6 53.7

Source: Tabatabai, Hamid/Fouad, Manal (1993): The Incidence of Poverty in Developing Countries. An ILO Compendium of Data. Geneva. " Percentage, in a given population, of persons or households with income (or expenditure etc.) below poverty line. 21

N = national, Ft = rural, U = urban

3)

H = household, P = person

41 Data from: Altimir, Oscar. 1992. The Extent of Poverty in Latin America. World Bank Staff Working Paper No. 522. Washington, D.C. ECLAC. 1990. Magnitud de la pobreza en América Latina en los años ochenta. LC/L. 533. 31 May. Santiago, Chile. 51 World Bank. 1991. Venezuela Poverty Study: From Generalized Subsidies to Targeted Programs. Report No. 9114-VE. Washington, D C.

.. Data not available.

238

Table 2 P o v e r t y and Per C a p i t a - I n c o m e D e p e n d e n t V a r i a b l e : LOG ( H e a d c o u n t Index) 1> ( t - s t a t i s t i c s in p a r e n t h e s i s )

Bangladesh 2 '

Brazil2'

China 2 '

Costa Rica2'

India 2 '

Indonesia 2 '

Malaysia

33.1 (10.28)

19.86xx (2.29)

12.67*xx (5.49)

38.02xxx (5.85)

7 42xxx

(5.93)

24.18xxx (11.10)

20.85 xxx (14.19)

DURBAN

0.30xxx (3.05)

-2.40xxx (-9.51)

-0.12xxx (-2.82)

-0.30xxx (-3.60)

0.91 xxx (-11.79)

DRURAL

roo 1 0 " (11.65)

c

0.63xxx (5.85)

0.26 xxx (3.36)

0.52 ^ (5.38)

DNATIONAL 1.11xxx (4.23)

UNIT xxx

Q 2 6 «X

(3.30)

-3.50 (-8.97)

-1.80* (-1.91)

-1.59 (-4.40)

-3.12xxx (-4.02)

-0.45xxx (-2.87)

-1.58xxx (-9.47)

-2.10xxx (-12.03)

Ff adj.

0.54

0.7

0.75

0.66

0.27

0.66

0.89

SE

0.17

0.25

0.70

0.23

0.13

0.27

0.21

F

54.33

23.28

58.61

20.31

8.00

48.08

114.29

47

30

59

40

38

50

45

LPCY85

Obs

xxx

Sources: Tabatabai (1993) for headcount index and dummy variables. International Monetary Fund. International Financial Statistics for calculation of GDP per capita. "

or comparable index on household basis.

21

Estimation with heteroskedasticity-consistant standard errors.

* Significant at the 10 per cent level. ™ Significant at the 5 per cent level. Significant at the 1 per cent level.

239

Table 3 Total and economically active population covered by social security Economically active population

Total population

Country

1980

1985-88

1980

1985-88

Argentina Bahamas Barbados Bolivia Brazil Chile Colombia Costa Rica Dominican Republic Ecuador El Salvador Guatemala Honduras Jamaica Mexico Nicaragua Panama Paraguay Peru Uruguay Venezuela

69.1 85.3 79.8 18.5 87 61.2 30.4 68.3 11.6 21.3 11.6 33.1 14.4 80.9 42 18.9 52.3 14 37.4 81.2 49.8

79.1 85.9 96.9 16.9 n.a. 79.2 30.2 68.7 10.2 25.8 n.a. 27 12 93.2 40.2 31.5 59.8 n.a. 32 73 54.3

78.9 n.a. n.a. 25.4 96.3 67.3 15.2 81.5 n.a 9.4 6.2 14.2 7.3 n.a. 53.4 9.1 49.9 18.2 15.7 68.5 42.2

74.3 n.a. n.a. 21.4 n.a. n.a. 16 84.61) 4.2 13.4 n.a. 13 10.3 n.a. 59.7 37.5 57.4 n.a. 22.2 67 49.9

Latin America

61.2

n.a.

61.2

n.a.

Source: Mesa-Lago, Carmelo. 1991. Social Security in Latin America. In: Inter-American Development Bank. Economic and Social Progress in Latin America. 1991 Report. Washington, D.C. p. 179-216, p. 186. "

Includes indigent coverage (welfare or noncontributory).

240

References

Altimir, Oscar. 1992. "The Extent of Poverty in Latin America." World Bank Staff Working Paper. No. 522. Washington, D.C. Barr, Nicholas. 1992. "Economic Theory and the Welfare State: A Survey and Interpretation." Journal of Economic Literature XXX (6):741-803. Burki, Shahid Javed, and Edwards, Sebastian. 1995. "Konsolidierung der Reformen in Lateinamerika und der Karibik." Finanzierung und Entwicklung 3:6-9. ECLAC. 1990. "Magnitud de la pobreza en América Latina en los años ochenta." LC/L. 533. 31 May. Santiago, Chile. Fields, Gary S. 1992. "Changing Poverty and Inequality in Latin America," In Pestieau, Pierre, ed. Public Finance in a World of Transition, Supplement to Public Finances/Finances Publiques 47:59-76. . 1989. "Changes in Poverty and Inequality in Developing Countries." World Bank Research Observer 4:167-186. Inter-American Development Bank. 1991. "Economic and Social Progress in Latin America." 1991 Report. Washington D.C.: Inter-American Development Bank. Mesa-Lago, Carmelo. 1994. Changing Social Security in Latin America. Boulder and London: Lynne Rienner. . 1992. "Comparative Analysis of Asia and Latin American Social Security Systems." In Getubig, I. P., and Schmidt, Sönke, ed. Rethinking Social Security. Reaching Out to the Poor. Kuala Lumpur: Asian and Pacific Development Centre. 64-105. . 1991. "Social Security in Latin America." In Inter-American Development Bank "Economic and Social Progress in Latin America." 1991 Report, pp.179-215. Washington D.C.: Inter-American Development Bank. . 1978. Social Security in Latin America. Pressure Groups, Stratification Inequality. Pittsburgh: University of Pittsburg Press.

and

Olson, Mancur. 1965. The Logic of Collective Action. Cambridge (Mass.): Harvard University Press. Oyarzo M., César, Galleguillos B., and Sylvia. 1995. "Reforma del systema de salud Chileno: Marco concepcional de la propuesta del Fondo Nacional de Salud." Cuadernos de Economía 32(95):29-46. Queisser, Monika. 1993. Vom Umlage- zum Kapitaldeckungsverfahren: die chilenische Rentenreform als Modell für Entwicklungsländer? München et al.: Weltforum-Verlag. Ravallion M. 1995. "Growth and Poverty: Evidence for Developing Countries in the 1980s." Economic Letters 48:411-417. Rawls, John. 1971. A Theory of Justice. Cambridge (Mass.): Harvard University Press.

241

Sautter, Hermann, and Schinke, Rolf. 1994. "Los costos sociales de las reformas económicas. Sus causas y posibilidades de amortiguación." Contribuciones XI(1):7-30. Schinke, Rolf. 1995. "Poverty and Indebtedness in Latin America: The Influence of Changing Prices of Tradables and Nontradables." In Sautter, Hermann, ed. "Indebtedness, Economic Reforms and Poverty." Göttinger Studien in Development Economics. No.2, Frankfurt/M.: Vervuert. Seidel, C. 1988. "Das Sozialversicherungsparadox." WiSt 6:??? Spremann, Klaus. 1984. "Intergenerational Contracts and their Zeitschrift für Nationalökonomie 44:237-253. Stahl, Karin. 1994. "Chile: Vlll(2):299-313.

ein

sozialpolitischer

Modellfall?"

Decomposition."

Nord-Süd

Aktuell

Tabatabai, Hamid, and Fouad, Manal. 1993. "The Incidence of Poverty in Developing Countries. An lio Compendium of Data." Geneva: International Labour Office Uthoff, Andras, and Szalachman, Raquel, ed. 1991, 1992. Systema de Pensiones en América Latina. Santiago (1991); volúmen 2, Santiago (1992). Verlag??? (prüft Liebig/9.4.96) Witte, Lothar. 1994. "Lateinamerikanische Sozialversicherung zwischen Staat und Privatisierung." In Dirmoser, D. et al., eds. "Lateinamerika - jenseits des Staates?" Analysen und Berichte No.18:64-104. World Bank. 1994. World Development Report. Washington, D.C. . 1991. "Venezuela Poverty Study: From Generalized Subsidies to Targeted Programs." Report. No. 9114-VE. Washington, D.C. . 1990. World Development Report. Washington, D.C.

242

The Social Dimension of The Latin American Reform Process C o m m e n t on H e r m a n n S a u t t e r a n d Rolf S c h i n k e

Hans-Rimbert Hemmer

(1) First of all, I want to congratulate both authors. They have delivered a carefully conceptualized and performed paper which clarifies many aspects of the Latin American reform process with special importance for the poor. By having done that, they made my job as leading discussant not easy: The outstanding quality of their presentation offers only a few chances for critical comments. Nevertheless, I will try to find some. Starting point for my comments is table 1 of their paper which shows strongly diverging success of the listed countries with respect to poverty alleviation during the late 80's/early 90's. Taking the shown figures as granted, a first question arises with respect to the identification of poverty changes. For the measurement of poverty two lines of arguments can be used: • •

the income approach compares individual income with a poverty line; the social indicator approach deals with the consequences of poverty in the context of the fulfilment of selected basic needs.

With respect to the growth process both aspects have to be considered: generation of income for the poor and access of the poor to goods and services included in the basic needs basket. However, differences between these approaches may occur: the income aspect does not include those public goods which have to be offered for poverty reduction but are not; on the other hand individuals with sufficient income do not always fulfil their basic needs and those of their families but use their income otherwise. Alcoholism and addiction to narcotics occur quite frequently within the poor; they are consequences of poverty as well as part of their causes. Sautter/Schinke (acceptably) leave out these details; they concentrate their analysis on the income approach and its dependence on the economic growth process as it prevails in Latin America.

243

(2) But then Sautter/Schinke show clearly different results with respect to the listed Latin American countries. These divergencies cannot be explained by differences in their economic growth rates alone: additional factors must be taken into consideration. Sautter/Schinke focus their analysis on two main causalities: •

first, increased economic production creates additional employment;

•

second, employment generation contributes to poverty alleviation.

Both interrelationships can be accepted - but to which extent? (3) In order to understand the success of poverty alleviation of the Latin American growth process better, I will draft a system of determinants of income generation. On the micro level of individuals and households, income generation depends on •

the (personal) availability of resources which could be used productively;

•

the extent of use of these resources; and

•

the remuneration the owner of the resource is finally able to receive. This remuneration depends upon •

the physical production results of the resource in its effective use;

•

the monetary value of this production result;

•

the share of that value to be given to the owners of the complementarily used resources; and

•

the real income value of the remaining monetary net income of the resource which is determined by the existing system of relative prices.

Finally the primary income position resulting from this package of determinants can be modified by private or social security transfers, including the access to public and private goods usable free of charge. The resulting income describes the capabilities of different individuals or households to be non poor. The final poverty results, however, depend in addition as well from the peoples willingness to be non poor, given a sufficient income. An analysis of the poverty results of the Latin American growth process that is based upon the income approach has to show how these different determinants of poverty

244

are influenced by the growth process in the short run as well as in the long run if the result is to be more than just a statistical description. (4) Sautter/Schinke argue this way: Given the willingness of the poor to improve their situation the authors state that market-oriented changes of economic institutions will release private dynamism. This will inevitably materialize in an expansion of production capacities. As a result the demand for labour being the only resource at the poor's disposal will increase. Under the condition of a Cobb-Douglas production function of the traditional type (differentiating between capital and labour as factors of production, with an exogeneously determined rate of technical progress and constant returns to scale) this argument holds - but does it in reality? Some doubts should be mentioned: •

The argument that labour is the only resource at the poor's disposal is not firmly true in rural areas. Insofar a distinction should be drawn between rural and urban areas. Small scale farmers have some land, however with a very poor quality. Especially the rural poor often suffer from an insufficient access to the formal credit market. As long as this access is not improved - and the same is true with respect to other factor and product markets- the poor have no chance for an improvement. These problems cannot be identified within a Cobb-Douglas production function in which structural rigidities on a sectoral as well as on a regional basis cannot be considered properly.

•

A Cobb-Douglas function that differentiates between capital and labour but neglects the distinction between physical and human capital seems to be a little bit naive. It does not take into account the findings of the New Growth Theory, explaining economic growth with endogenous technical progress under the conditions of increasing returns. This theory is not only relevant for industrialized countries in Europe, North America and East Asia but also for many countries in Latin America which have remarkable potentials within their R&D industries. It can also explain the existing phenomenon of jobless growth; the Cobb-Douglas function cant. But within a jobless growth economic growth doesn't contribute to more employment and accordingly poverty alleviation.

(5) Sautter/Schinke analyze the aspect of the poverty reduction possibilities of economic growth by discussing different types of output-growth ratios. This

245

discussion, however, is more of a descriptive rather than analytical type. The question of the determinants of the different curve types shown by the authors remains unanswered. Insofar the discussion of the empirical relationship between income and poverty cannot be taken as a substitute for the required discussion of the influence of different growth types on the micro determinants of poverty. There still remains the urgent need for a more detailed analysis about how different growth types performed in Latin America influence the above listed determinants of poverty on the micro level - the ability to reduce poverty as well as the poor's willingness to be non poor. Sautter/Schinke attempt to deal with these interrelationships cannot be taken as sufficient from an analytical point of view. (6) Missing this analysis, the role of the reformed social security institutions for poverty reduction soon reaches its limits of explanation: As long as the role of the main poverty determinants and their modification during growth is not analyzed in detail, the role of social security systems can only be discussed partially. The analysis presented to us has its highlights in the transfer system though it neglects to a large part its influence on some determinants of primary poverty. Due to the fact that transfer systems may improve the resource endowments of the poor they also have an impact on the generation of income by productive activities. These possibilities should be analyzed more in detail than is actually done. Some of the relevant interrelations - the restitution of the ability to work for ill workers taken as an example - are mentioned by the authors but unfortunately neither analytically elaborated nor quantified. Is this caused by a lack of data? Undoubtedly, the emphasis of further research should be in this area. (7) On the other side, an often neglected aspect of poverty alleviation is shown very clearly: the role of institutions and their needed alteration during development. As this alteration again depends upon changes of the macroeconomic and macrosocial framework of the poor, the dependency of poverty alleviation from such institutional reforms at the macro level can be derived from Sautter/Schinkes analysis. Insofar the paper presented to us does not only give an interesting empirical insight into the Latin American growth process but also shows important areas for further research.

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Are the Latin American Reforms S u s t a i n a b l e ?

11

John Williamson

1.

Introduction

I interpret the question assigned to me as asking whether the policy reforms adopted in Latin America over the past decade will appear to historians to have been a false start, a hiccup or a watershed. The answer is already clear in two countries. In Venezuela they were a false start, and the ancien regime has been restored. In Chile they were a watershed: one can feel confident that the country is securely on the path of catch-up growth, with broad public acceptance of the new model and an adequate rate of national savings to sustain a "miracle-level" growth rate of 6 percent or more 2 ' that will give the country industrial-country living standards within a couple of decades. Other countries have experienced fast growth for two or three years, but this was rather clearly bounceback growth rather than catch-up growth. Their ability to make the transition to the latter is still in doubt. The organization of the paper is very simple. I commence by defining what I mean by a false start, and I then argue that other countries are unlikely to follow Venezuela in trying to break away from the set of policies that have, for better or worse, become known as the "Washington consensus" (Williamson 1990). I then proceed to discuss whether that means that other countries are likely to follow Chile in consolidating reforms sufficiently deep and comprehensive as to place them too on the path of catch-up287287 growth, or whether instead they will meander from one crisis to the next.

" Reproduced with permission from the Institute for International Economics. Copyright© 1996 by the Institute for International Economics. All rights reserved. 21

It seems to me that people have generally used the term "economic miracle" to describe a rate of growth of 6 percent per annum or more sustained for at least 5 years, rather than to refer to a growth rate too high to be explained by the growth of inputs using conventional growth theory (the usage of Paul Krugman (1994)), so I use the term In the former sense.

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2. M o r e False Starts? By a "false start" I mean that a country's political leaders consciously decide that they no longer wish to follow the market-friendly, outward-oriented, macroeconomically responsible policies that have been adopted in Latin America over the last decade. They will make such a decision only if they have an alternative paradigm in mind. What alternatives are available today? The alternative chosen by Venezuela was to return to the policies of the 1970s. This is an option that was surely more appealing to Venezuelans than it would be to other Latin Americans, since the 1970s, with their high oil prices, were a golden age to Venezuela. One of the sins of Carlos Andrés Pérez in 1988-89 was to fail to convince the Venezuelan people that his reforms were necessitated by changes in the world economy, so that they went on hoping that if only good (non-corrupt) guys ran the government they would be able to revert to the status quo ante. The extent of their self-delusion is shown by their willingness to riot whenever the price of petrol is raised to more than about 100 (US) per gallon. No other Latin American country has a comparable golden age capable of inspiring collective delusion. No other Latin American country has been as poorly served by its politicians in failing to explain the facts of life. Every other Latin American country has the fate of Venezuela to stand as an awful warning of the price of allowing itself to be deluded. Countries do learn by observing what is happening elsewhere in the world, and particularly by what is happening elsewhere in their own region, and the contrast between Chile and Venezuela is sufficiently vivid to inoculate other countries against the temptation to revert to populist macroeconomics and anti-market microeconomics. What about the possibility of a socialist revolution? After all, many of the social ills that prompted the Russian Revolution in 1917 are present in Latin America today, more acutely than anywhere else. The income distribution in Latin America is the most unequal in the world and has been worsening: the World Bank estimates that growth needs to be above a threshold of about 3.4 percent per year in order to prevent the number of poor increasing. Land reform has never happened and does not look like happening. Further crises arising from over-indebtedness are possible as long as the current enthusiasm for emerging markets is sustained and other governments do not

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follow the lead of Chile and Colombia in seeking to repel excessive capital inflows. All these factors would suggest that future social explosions are possible. However, the probability that any social explosions could lead to a new government that embraced a socialist economic model seems to me minuscule. In 1917, or even at the time of the Cuban revolution in 1959, the underprivileged of the world had access to an ideology that was at the same time morally inspiring ("from each according to his abilities to each according to his needs", in contrast to the appeal to selfinterest on which capitalism is based), inspired by hatred of the exploiters, and promising a practical program for the exploited to better their lot in a new society. The ranks of the underprivileged contained a full quota of the capable and the entrepreneurial, who were not filtered out into the elite by universal education. None of these conditions are fulfilled today. Socialism simply did not work: it turned out that organizing a society in which people would work for altruistic motives was possible only under emergency conditions, and the alternative motive force of fear made for a much less attractive society than one guided by self-interest, certainly where that is tempered by a little moral restraint. That failure is now a part of the common wisdom of mankind, and knowledge of it cannot be eradicated. And in most countries the able poor get a chance to rise, and then pursue their own self-interest rather than that of the class from which they came. Socialism is a non-starter. Paul Krugman (1995) argues that the Mexican crisis exploded the emerging-market bubble of the first half of the 1990s, in which the markets poured money into countries that had embraced the Washington consensus1> in the expectation that policy reform would produce economic miracles, and the countries enjoyed a boom on the basis of the resulting capital inflows rather than of improved fundamentals. It is true that the markets had unrealistic expectations of how much could be achieved how quickly by policy reform, but it already seems clear that Krugman's pessimism as to the extent to which the markets would withdraw in the wake of the Mexican crisis was wrong. This pessimism led him to conjecture that many countries would seek an alternative to "Washington consensus" policies as the perception grew that these had failed. Like me, he argued that a return to either import substitution or the Communist alternative are non-starters. He concludes his article (Krugman 1995, 44):

" His summary of Williamson (1990) as "free trade and sound money" is a little too crude for my taste, but that is another matter.

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"But it seems strangely unimaginative to assume that because there are no other popular paradigms for policy in circulation, nobody will be able to come up with a rationale for policies that are very much at odds with the Washington consensus. Indeed, there are already audible rumblings about emulating a supposed Asian model. Developing countries should try, some people say, to be like Japan (as they imagine it) rather than America. The intellectual basis for such ideas is far weaker than that for the Washington consensus, but to suppose that bad ideas never flourish is to ignore the lessons of history." What would an attempt to emulate an Asian model amount to? It certainly would not involve abandoning the new dedication to macroeconomic discipline. In fact, it would reinforce the commitment to exporting and make it much less likely that macro discipline failed in one key dimension, that of ensuring that exchange rates remain competitive.1> It would imply a welcome focus on increasing savings, perhaps at the cost of biasing the financial system against the provision of consumer credit. The most dubious consequences would be attempts to design industrial policies in place of efforts to deregulate, and a resolve to use the financial system to steer credit toward favored sectors. Given the quality of the bureaucracy in Latin America, these changes would probably not be helpful; but they hardly amount to a wholesale retreat from the reforms of the last decade. The only other doctrine on the horizon capable of inspiring a fundamental reordering of society is greenery.

There is, however, a deep split in the green movement

between those who wish to develop an alternative to capitalism and those who want to reform it. Since no one has yet developed a practical program that offers a green alternative to capitalism, and the costs of such a program would surely lack widespread appeal (I say that as one who would probably be more willing than most to bear my share of them), I doubt that the former group will win control of the movement, and if they did they would have no chance of gaining power. The green movement matters, but as a force to reform capitalism rather than to replace it. I am therefore unable to identify a potential cause that seems at all likely to induce a deliberate rollback of the main policy reforms of the last few years. In retrospect, my principal unease as to the veracity with which I reported the consensus in Washington is that I said it favored a "competitive exchange rate". I fear this was wishful thinking: the town is full of people who think it Immoral if exchange rates do not float or who want the exchange rate to be used as a nominal anchor.

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3. H i c c u p or Watershed? By a "watershed" I mean that the policy reforms succeed in pushing Latin American countries into a phase of rapid catch-up growth that continues until they have achieved industrial-country living standards. By a "hiccup" I mean that they mark yet another twist in the tangled history of Latin American policymaking, neither reversed (that is the false start scenario) nor initiating a decisive breakthrough. I suppose that my vision of the growth process owes more to Rostow (1960) than it is currently respectable to admit. I have always found the concept of a "take-off" that is possible once certain preconditions have been satisfied and that will be followed by a "drive to technological maturity" during which compound interest will work its benign influence until technology and living standards have caught up with those in the most affluent countries intuitively appealing.

(Rostow's drive to technological maturity is

what I refer to by the more concise term "catch-up growth".) Rostow's preconditions involve profound changes in traditional society.

Either ex-

tractive industries have to develop or agriculture has to modernize so as to provide the foreign exchange to buy the imports necessary for modernization. The government has to become sufficiently effective to build up social overhead capital (infrastructure). A new entrepreneurial elite that seeks modernization has to emerge and displace the traditional land-based elite, and must acquire the power to redirect the surplus income derived from land ownership and wasted on "prodigal living into the hands of the productive men who will invest it in the modern sector and then regularly plough back their profits as output and productivity rise" (Rostow 1960, 24). Reactive nationalism, as well as the profit motive, has frequently played a central role in motivating the transition and placing authority in the hands of those willing to uproot traditional societies in the cause of modernization. A difficulty with the Rostovian vision is that all these things happened in Latin America in the middle decades of the twentieth century, and by the 1960s it looked as though the region was safely past the take-off stage. (Remember that in the 1970s Brazil and Mexico ranked alongside Korea and Taiwan as the leading "NICs".) Then came the debt crisis, and within a few years conventional wisdom came to look upon Latin America as a region where growth had stalled and only fundamental policy reforms could get it going again. Rostow's drive to technological maturity does not emphasize

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the possibility of the process stalling as a result of misguided policies, yet that certainly seems to have been what happened in Latin America. If the policies that caused growth to stall are reversed, then an amended version of the Rostovian vision holds out the hope that catch-up growth will indeed be possible and can carry the region into the age of affluence. While there is scope for debate on exactly how one should classify the policies that caused growth to stall, my own taxonomy would identify four culprits: macroeconomic populism, inward orientation, a bloated public sector, and inadequate savings.

I take it that these are sufficiently

familiar villains to make elaboration superfluous. Between them, they led to a slowdown in the supply-side rate of growth as the first easy stage of import substitution was exhausted and unrealistic hopes were placed on the public sector, but this lower growth potential was not accompanied by a corresponding cutback of ambitions, which led to excessive foreign borrowing and, in the fullness of time, to the debt crisis. The policy reforms that have been undertaken virtually throughout Latin America in the last decade, with major backsliding only in Venezuela, were directed to remedying the policy weaknesses identified above, except that they paid little attention to raising savings, which was addressed only by the effort to restore fiscal discipline. In this they were like my "Washington consensus", which reflected all too accurately the lack of emphasis on the issue in Washington at that time. Only Chile, with its pensions privatization and the tough decision to finance the transition to a fully funded scheme by raising taxes to pay off the existing pension rights acquired under the previous pay-as-you-go scheme, did anything major to raise private savings. Several other countries - Argentina, Mexico, and Peru - have recently attempted to follow the Chilean precedent, although so far in a rather half-hearted way. What are the risks that these reforms will not succeed in igniting a process of catch-up growth? (1) Several years ago Dornbusch (1990) argued that it was a mistake to assume that successful stabilization could be relied on to crowd in investment spending. He pointed to Bolivia as a country whose brave stabilization of 1985 had not been rewarded by renewed growth. We now have more years of data on Bolivia, and are therefore in a better position to evaluate whether the danger of stagnation to which he pointed was a semi-permanent problem. It turns out that the average growth rate over the period 1990-94 was fractionally over 4 percent per year,

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about 1.2 percent in per capita terms. This is still well short of an economic miracle, but it is a lot less depressing than the average of under 1.5 percent per year (implying negative per capita growth of over 1 percent a year) of the previous 4 years that motivated Dornbusch's concerns. It provides at least some support for the view that a market economy can be relied on to return to growth in due course if the government provides a stable macroeconomic environment, the basic institutional infrastructure of a market economy, and a reasonable set of incentives to act entrepreneurial^. (2) A second set of concerns, highlighted by Nairn (1995), is that Latin America will fail to move forward on the next set of reforms that are needed if it is to achieve anything close to its potential. These are institutional reforms: examples cited by Nairn are building the equivalent of a Securities and Exchange Commission, organizing well-targeted social programs to compensate the poor, and providing adequate regulation of the banking system. They tend to involve strengthening the state. If one goes back to Rostow, this was a crucial part of what he saw as necessary in order to achieve take-off. But it is not what has been central to the reforms of recent years, where the emphasis has instead been on cutting back a bloated state, and hence there is a danger that it may be neglected by the current generation of policymakers.1'

It is as difficult to imagine much in the way of

growth without adequate state institutions as it is to envisage much sustainable growth in a non-market economy. (3) The Western Hemisphere is notorious for having low savings, and this is not just because many governments allowed the fiscal accounts to slip into deficit. Savings rates in Latin America are about half those in East Asia, and they are inadequate to sustain growth rates of more than 4 to 5 percent. (4) That shortfall cannot be compensated by borrowing more on the international capital market without running a severe risk of renewed debt difficulties like those Mexico and Argentina have encountered last year,

perhaps the world capital

market will indeed remain over-eager to lend to emerging markets, and that would permit Latin American countries to over-borrow for a time and to some extent compensate for their low savings. But the danger is that this would punctuate '' To my discomfort, the Washington consensus has sometimes been interpreted as a "neoliberal" manifesto propagating the nonsense that a smaller state is better: I intended it more as a distillation of what was fit to survive from "neoliberalism" at the end of its era of dominance.

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periods of progress with a succession of crises, which are certain to slow down the long-run growth rate. In these circumstances it would be better to limit capital inflows and accept lower investment and a corresponding reduction in the growth rate, rather than to risk crises as a result of an excessive buildup of external debt. (5) Then there is the Krugman danger that Latin American countries will try to ape East Asian practice without having the relatively competent and uncorrupt bureaucracies that allowed East Asia to get away with more interventionist policies. As already argued, I do not see this as likely to lead to a wholesale repudiation of the policy reforms of recent years, but it could delay progress. (6) Finally, there is a danger of social explosions, for the reasons discussed above. These may be unlikely to involve the capture of government by the rebels, but local explosions on the model of Chiapas can still be economically damaging. They divert public spending into unproductive military uses, they can undermine the security of property rights that is essential to investment spending, and they can destroy the livelihoods of those who participate in them, not to mention their neighbors. While I believe there is a good chance that the region as a whole, if not each of its component countries, will succeed in making the breakthrough into catch-up growth, this benign outcome is far from a certainty. I do not worry too much about explicit repudiation of the Washington consensus reforms, but I do see a real danger that these will not be complemented by the other actions that are essential to settle down into catch-up growth: strengthening public-sector institutions, stimulating savings, keeping out excessive capital inflows, resisting siren calls to imitate East Asia in the dimensions where there is no institutional capacity to do so, and addressing Latin America's social debt before the underprivileged revolt.

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References

Dornbusch, Rudiger. 1990. "Policies to Move from Stabilization to Growth." Proceedings of the World Bank Annual Conference on Development Economics. Washington, D.C.: World Bank. Krugman, Paul. 1994. "The Myth of Asia's Miracle." Foreign Affairs 73(6):62-78. . 1995. "Dutch Tulips and Emerging Markets." Foreign Affairs 74(4):45-61. Nairn, Moisés. 1995. "Latin America the Morning After." Foreign Affairs July/August. Rostow, Walter W. 1960. The Stages of Economic Growth: A Non-Communist Manifesto. Cambridge: Cambridge University Press. Williamson, John. 1990. Latin American Adjustment: How Much Has Happened? Washington, D.C.: Institute for International Economics.

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Are the Latin A m e r i c a n Reforms S u s t a i n a b l e ? C o m m e n t on John W i l l i a m s o n

Bernhard Fischer

Introduction It is extremely difficult to comment on such an excellent and well-balanced paper. Therefore, I cannot establish a basic "Gottingen dissent" to the answers John Williamson has delivered to the question whether Latin America's reforms are sustainable. The Washington consensus could certainly not be understood as a sufficient condition for a sustained recovery in Latin America. But nevertheless expectations of the outcome of major stabilization and liberalization efforts in terms of short-term welfare gains have been (too) high and the critical role of what John Williamson has labeled as "complementary factors" has obviously been underestimated. The sustainability of policy reforms will critically depend on whether their results will meet expectations in the public in terms of higher living standards within a certain period of time. Let me therefore elaborate a little bit more on some potential constraints which could hinder a catch-up growth a la Rostow in most Latin American countries, keeping aside country specific challenges and capacities to deal with. First, I will refer to the widespread institutional uncertainty in many Latin American countries. Second, I will focus on the critical role of social and physical infrastructure for a sustained development process and identify shortcomings in many Latin American countries with this respect. Third, I will briefly discuss a hitherto rather neglected threat for the sustainability of economic reforms in Latin America: the fragility of its financial systems.

Weak Institutions In the debate on the sustainability of policy reforms in Latin America reference is frequently made to the need of institutional reforms which were not a prominent part of the Washington consensus. Among the reforms suggested are:

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•

the establishment of institutional anchors for past reforms (for example, tax reforms and the creation of

independent central banks in order to prevent a

reversal from fiscal consolidation); •

a further deepening of democratic institutions and the decentralization of state power to allow a more participatory development;

•

the creation of a more predictable legal environment and of enforcement mechanisms to guarantee property and other rights;

•

a strengthening of the management and administrative capacity for policy formulation and implementation;

•

the provision of institutionalized mechanisms of communication.

These reforms are intended to reduce institutional uncertainty which is blamed to restrict savings and investment (Borner, Brunetti and Weder 1990). I will not deny that in the past lack of credibility, lack of checks and balances and a climate for rent seeking societies have shortened time horizons, favored consumption rather than investment, and created a breeding ground for corruption. But from a pragmatic point of view it has to be kept in mind that many of these institutional aspects cannot be dealt with overnight and that institutional deepening is extremely difficult to implement in a fragile political environment and in societies where a basic social consensus is lacking.

I n a d e q u a t e Social and Physical Infrastructure For decades, governments in Latin America failed to develop the institutions needed to handle their population's basic problems because they concentrated most of their resources on managing their countries' economic assets. Today, Latin America is - leaving aside Africa- the region with the worst income distribution in the world. Poverty is widespread and it has increased during the past decade (World Bank 1990). Among other causes this was attributed to the regressive distributive consequences of the social policies that have been adopted in the past decades (Hausmann 1994). The potential of socio-economic instability arising from increasing inequality and the bankruptcy of social security systems is a serious threat for the

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business climate, in particular for foreign investors. Only to the extent that governments succeed in reducing poverty and making income distribution more equal will countries be able to sustain politically further structural reforms. An important pillar for a strategy to reduce poverty and unequal income distribution is the accumulation of human capital, in particular by improving the coverage and quality of education. There is a broad consensus that investing in people is a conditio

sine qua non for

development. The critical importance for broadly accessible education and training systems for economic development has been demonstrated by the experience of the dynamic Asian economies. Improving access of the broad mass of people to essential services is vital to enhance their chances for further participation in productive, income-generating processes. Investment in human capital is also essential for improving Latin America's competitive edge. Only a better educated labor force together with more flexible labor markets will allow companies to change their product mix in response to rapid shifts in comparative advantage. Orientation towards long-term objectives such as restructuring sectors in order to achieve sustainability or buildingup capacities through processes like education requires long-term time horizons for policy makers and investors which are still absent in many Latin American countries. Investment in physical infrastructure was also critically neglected in Latin America during most of the 1980s and the early 1990s. As a result the region now faces a serious deficit in power generation, roads, water supply, and telecommunications. According to World Bank calculations, approximately 60 billion US $ will have to be invested in infrastructure every year between now and the year 2000 to make up for past neglect and to provide the region with the infrastructure stock needed for an export-led growth strategy (World Bank 1994). The volume of infrastructure investment required during the rest of the decade is substantial, representing approximately 4.5 per cent of the region's total GDP. The bulk of the increase in investment in infrastructure will have to c o m e from the private sector - both domestic and foreign. However, given Latin America's low average saving ratio it is difficult to imagine that foreign capital will be easily ready to fill the gap, in particular as long as policies that reassure foreign institutional investors on sovereign risk and stock market illiquidity are lacking (Fischer and Reisen 1994a).

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F r a g i l i t y of D o m e s t i c F i n a n c i a l S y s t e m s Severe banking crises in four big Latin American economies (Venezuela, Mexico, Argentina and Brazil) in 1994 have pointed to the failure of governments to draw enough attention to the importance of sound financial markets for sustaining policy reforms in other areas. Bank failures have been responsible for deepening recession in some countries, threatening governments' anti-inflation strategies and jeopardizing economic restructuring programs. A solid financial system not only plays a central role in linking savers and investors, thereby promoting investment and growth. A well functioning financial system can also serve as an important shock absorber and thus reduce volatility of both monetary and real economic variables (IDB 1995). However, in Latin America financial markets are dominated by short-term instruments, reflecting investors short-term preferences to invest in highly liquid assets. Therefore, there is a permanent risk of financial crises stemming from the refusal of banks to roll-over maturing debt and of a high exposure of lenders to interest-rate risk. Furthermore, non-performing loans and political interference make the banking sector in many Latin American countries fragile. A further deepening and widening of domestic capital markets may be essential to promote long-term savings (Edwards 1995) and to ensure sustained private capital inflows (Fischer and Reisen 1994b). From a development point of view a critical issue still remains to be solved: How can a financial system efficiently be used to channel private capital inflows into productive investment, and, in particular, how can this foreign money be made available to finance productive purposes of poor people? John Williamson has mentioned Chile as an outstanding example in Latin America for having undertaken major actions to raise private savings. I am not so convinced whether the privatization of pensions per se was a critical factor for a higher level of private savings. However, the creation of an institutional investor base has certainly strongly influenced the rapid growth and development of the government and corporate bond market as well as of the equity market (Fischer 1995). Unfortunately, conditions in other Latin American countries are not so promising for a successful repetition of Chile's experiment. First, a strong government and administration are needed both for the implementation as well as for the regulation and supervision of a private pension scheme. Second, the costs of transition - partly financed by higher taxes in the case of Chile - would be tremendously high in countries with widespread poverty,

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such as Brazil. Third, in the years after the establishment of the private pension scheme, the Chilean economy experienced extraordinarily high rates of growth and thus very attractive returns for pension fund investment which are unlikely to be achieved in other Latin American countries.

Conclusion In concluding, weak institutions, insufficient social infrastructure, bottlenecks to finance an adequate physical infrastructure as well as relatively vulnerable financial systems constitute - at least in the short to medium term - major constraints for a spectacular economic recovery in many Latin American countries. Since results from policy reforms in the past were already disappointing in terms of income growth for large segments of the societies, future policy reforms may be even more difficult to be accepted by the public if democratic deepening continues. These are serious threats for the sustainability of reforms in Latin America.

References Borner, Silvio, Aymo Brunetti, and Beatrice Weder. 1990. Institutional Obstacles to Latin American Growth and Proposals for Reform. Basel. Edwards, Sebastian. 1995. "Why are Saving Rates so Different Across Countries? An International Comparative Analysis." NBER Working Paper. No. 5097. Fischer, Bernhard, and Helmut Reisen. 1994a. "Pension Fund Investment from Ageing to Emerging Markets." Policy Brief No. 9. OECD Development Centre. Paris. . 1994b. "Financial Opening. Why, How, When." Occasional Papers No. 55. International Center for Economic Growth. San Francisco. Fischer, Bernhard. 1995. "Institutional Investors and Capital Market Development. Challenges for Latin America." HWWA-Diskussionspapier Nr. 29. Hamburg. Hausmann, Ricardo. 1994. Sustaining Reform: What Role for Social Policy? InterAmerican Development Bank. Washington. D.C. (mimeo). Inter-American Development Bank (IDB). 1995. Economic and Social Progress in Latin America. 1995 Report. Washington, D.C. World Bank. 1990. World Development Report 1990. Washington, D.C. .1994. World Development Report 1994. Washington, D.C.

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The authors

Leonardo Auemheimer Professor, Department of Economics, Texas A&M University, College Station, Texas, USA. Sebastian Edwards Professor, Chief Economist, The World Bank, Latin America and the Caribbean Region, Washington, D.C., USA. Günther Engel Professor, Department of Economics, Georg-August-Universität Göttingen. Roque Benjamin Fernández President, Central Bank of the Republic of Argentina, Buenos Aires, Argentina. Bernhard Fischer Head, Department of Development Economics, HWWA-lnstitut für Wirtschaftsforschung, Hamburg. Günther Gabisch Professor, Department of Economics, Georg-August-Universität Göttingen. Antje Heikamp Land Central Bank in Bremen, Lower Saxony and Saxony-Anhalt, Hannover. Hans-Rimbert Hemmer Professor, Department of Economics, Justus-Liebig-Universität Giessen. Helmut Hesse Professor, President of the Land Central Bank in Bremen, Lower Saxony and SaxonyAnhalt, Hannover.

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Eduardo Lizano Professor, Academia de Centroamérica, San José, Costa Rica. Femando Losada The World Bank, Latin America and the Caribbean Region, Washington, D.C., U.S.A. Patricio Meiler Professor, CIEPLAN, Corporación de Investigaciones Económicas para Latinoamérica, Santiago, Heinz Gert Preuße Chile. Professor, Department of Economics, Eberhard-Karls-Universität Tübingen. Helmut Reisen Head of Research Division, Development Centre, OECD, Paris, France. Peter Rühman Professor, Department of Economics, Georg-August-Universität Göttingen. Hermann Sautter Director, Ibero-America Institute for Economic Research, and Professor, Department of Economics, Georg-August-Universität Göttingen. RolfSchinke Ibero-America Institute for Economic Research, Georg-August-Universität Göttingen. Roberto Steiner The World Bank, Latin America and the Caribbean Region, Washington, D.C., U.S.A. Stefan Tangermann Professor, Institute of Agricultural Economics, Universität Göttingen. John Williamson Senior Fellow, Institute for International Economics, Washington, D.C., USA.