Structural Adjustment

1. Structural Adjustment CHAPTER 23

2. Introduction • In a fixed exchange rate regime, an overvalued domestic currency (Mexican peso or Ghanaian cedi) is associated with an excess demand for foreign currency (US dollar or EU euro) • This excess demand for foreign currency is often met by the central bank drawing down its foreign reserves • However, the drawing down process is not sustainable • Can result in a balance of payments crisis • In most circumstances, the International Monetary Fund (IMF) stands ready to assist member countries in dealing with such balance of payments crises • If this assistance involves the member country’s moving into its upper credit trances (which it almost always does), the IMF imposes policy conditionality on its loans

3. Introduction • Beginning in the 1980s, the World Bank began structural adjustment lending to countries facing balance of payments difficulties • Also imposing policy conditionality in the process • Developing countries with balance of payments crises caused by fixed exchange rates or changes in global economic conditions face structural adjustment under the supervision of IMF and World Bank • Effectiveness of these structural adjustment programs has been source of a significant amount of disagreement among international economists • Chapter develops your understanding of structural adjustment

4. Traded and Non-Traded Goods • Imagine that you are an international economist advising the Ghanaian government on their approach to structural adjustment. • Need to simplify the complexities of the adjustment processes to clarify your own thinking and to communicate with government representatives • Useful first step is to distinguish between traded goods and non-traded goods • In the Ghanaian context, you might imagine the following • Traded Goods • Petroleum • Gold • Cocoa • Food • Non-Traded Goods • Tailoring • Auto repair • Education • Health Services

5. Differences Between Traded Goods and Non-Traded Goods • Prices of traded (non-traded) goods are determined in world (domestic) markets • For Ghana the price of petroleum is a world price denominated in US dollars • The price of tailoring, on the other hand, is a domestic price, denominated in cedis • For traded goods, domestic consumption and domestic production can differ in value, causing a trade surplus or deficit • However, domestic consumption and domestic production of non-traded goods must be exactly the same in value • Can represent the supply side of this economy with a production possibilities frontier (PPF) • Depicts the combinations of output of traded goods and non-traded goods that the economy can produce given its available resources and technology • Given the available resources and technology, Ghana can produce anywhere on or inside the PPF

6. Table 23.1. Traded Goods vs. Non-Traded Goods

7. Figure 23.1. Ghana’s PPF

8. Internal and External Balance • Internal balance • All resources are efficiently employed • External balance • Consumption and production of tradable goods are equal

9. Figure 23.2. Internal and External Balance

10. Figure 23.3. External Imbalances

11. External Imbalances • If consumption is at CTD, consumption of traded goods exceeds production of traded goods along vertical axis • Implies Ghana has a trade deficit • If consumption is at CTS, production of traded goods exceeds consumption of traded goods along vertical axis • Implies Ghana has a trade surplus

12. Figure 23.4. A Current Account Deficit

13. A Current Account Deficit • If inflows on capital account begin to disappear, difficulties arise • Suppose direct and portfolio investment decline (foreign savings falls) • Still possible for Ghana to maintain its current account deficit by drawing down its foreign reserves • However, this situation is not sustainable • Can last only as long as the central bank has foreign reserves to sell

14. A Current Account Deficit • What could you advise Ghana to do? • Recognize that external imbalance problem comes from the demand for tradable goods being too high • Suggest that Ghana engage in demand reductionto reduce the demand for tradable goods • Significant limitation--demand reductions typically cannot be confined to traded goods alone • In most instances, demand falls for both traded and non-traded goods • External balance adjustment via demand reduction has been achieved at the expense of internal balance

15. Figure 23.5. Adjustment via Demand Reduction

16. Implementation of Demand Reduction Policies • Economist Francis Stewart (1995) studied the ways in which demand reduction policies have been implemented in many countries of the world and their impacts on the poor in those countries • Her conclusions • Demand restraint has unambiguously negative effects on the poor • Demand-reducing policies include • Cuts in government expenditure • Rises in taxation • Reductions in real wages and credit restraint

17. Implementation of Demand Reduction Policies • What else could you suggest to the Ghanaian government? • In principle at least, a country can achieve external balance and maintain internal balance • The key according to economist Max Corden (1986) is • To have two instruments as the demand reduction instrument is not enough • Also need a switching policy • Implemented by a change in the nominal exchange rate

18. A Current Account Deficit • Devaluation or depreciation of the domestic currency causes an increase in the domestic (cedi) prices of both imports and exports • If Ghana were to devalue the cedi, there would be an increase in the relative price of tradable goods or a decrease in the relative price of non-tradable goods resulting in • Increased incentive to produce traded goods • Decreased incentive to consume traded goods • Both effects tend to reduce the trade deficit • Ghanaian firms switch their production towards traded goods • Ghanaian consumers switch their consumption away from traded goods • A successful adjustment program must combine both demand reduction and switching elements

19. Figure 23.6. Adjustment via Demand Reduction and Switching

20. The Structuralist Critique • Structural economists argue that we must account for structural diversity of developing economies undergoing balance of payments crises and adjustment programs • Productive resources may not be mobile between sectors • For instance, certain barriers can prevent productive resources in Ghana from moving freely to the traded sector from the non-traded sector • Urban workers in the non-traded sector might face a number of barriers (e.g. culture and family ties) to relocating to rural areas to increase the supply of agricultural products • Domestic production may be highly dependent on imported intermediate and capital goods • Devaluation of the cedi raises domestic prices of these traded goods

21. The Structuralist Critique • Demand reduction can include lost productive investments • Often achieved by reducing government expenditures • However some government expenditures may be necessary to support private investment and production • In the structuralist view, public and private investments are complementary • Adjustment often takes place under negative foreign savings (capital outflows or capital flight) • Not simply a matter of regaining external balance but of generating a trade or current account surplus to accommodate a capital account deficit

22. Figure 23.7. Adjustment Under Resource Immobility

23. Structuralists’ Recommendations • Depends on the country in question—however, generally structuralists would call for • Measures to ensure that key productive investments are not sacrificed in demand reduction • Import quotas and export subsidies to reduce trade deficits in order to require lower nominal exchange rates—preventing inflation and poverty problems • Government involvement in allocating scarce foreign exchange • Foreign debt forgiveness to prevent the necessity of generating large trade surpluses

24. The Order of Economic Liberalization • Typically, adjustment programs designed by IMF and World Bank include a number of kinds of market liberalization • Exchange rate depreciation or devaluation • Reductions in government expenditures • Including reduction in public sector workforces, elimination of agricultural and industrial subsidies, and elimination of food and medical subsidies • Wage controls to reduce demand and to prevent inflation • Elimination of import quotas and export taxes • Reduction of ad valorem tariffs to “moderate” levels of 10-15% • Privatization of state-owned enterprises • Liberalization of domestic financial markets • Has been a tendency for the IMF and World Bank to call for the implementation of the above components all at once

25. The Order of Economic Liberalization—Ghana • Suppose that Ghana faces a balance of payments crisis such as that described in the previous sections • Financing the current account deficit by selling foreign exchange reserves • Central government is running a deficit • Additionally, suppose • Government owns some enterprises on which it depends for some revenue • Government restricts imports using a set of quotas • Exchange rate is fixed • How should the steps Ghana will take in alleviating the balance of payments crisis and securing sustainable adjustment be ordered?

26. The Order of Economic Liberalization—Ghana • First: Seek a means of securing central government revenue through a broad-based tax • Government accounts are in deficit • Government may be called upon to lower trade taxes and sell its enterprises • Will involve a loss of revenue sources—alternative revenue sources must be found • Possible sources are sales taxes, producer taxes, or value-added taxes • Should be broad-based and set at low rates • Increase in tax revenues will lower the government deficit and • Tend to narrow the gap between domestic investment and domestic savings • Position the government for further reforms without precipitating a fiscal crisis • Second: Depreciate or devalue the exchange rate • Begins a switching process • Imports are reduced and exports can expand • Tend to reduce the current account deficit

27. The Order of Economic Liberalization—Ghana • Third: Tariffy quotas on imports of consumer goods and remove quotas on imports of intermediate and capital goods • Causes a quota premium equal to amount by which domestic price of the good increases above world price as a result of quota • Converts quota rents into government revenue • Helps alleviate the government’s budget deficit • Removal of quotas on intermediate and capital goods will ensure that these goods are available to domestic producers • Tend to lower the domestic prices of the goods, offsetting the effect of exchange rate depreciation and addressing structuralist concerns about declining production • Any tariffs on these goods should be set very low • Fourth: Selectively begin to privatize government-owned enterprises

28. The Order of Economic Liberalization—Ghana • Fifth: Liberalize the foreign direct investment component of the capital account • Edwards (1984) concludes capital account should be liberalized only after current account is liberalized • Capital account can be divided into • Direct investment • Ownership and control of physical capital • Portfolio investment • Ownership alone of government bonds, corporate equities, corporate bonds, and bank deposits • Long-term • Short-term • Tends to be highly volatile • Makes sense for a country to begin liberalization of the capital account with direct foreign investment

29. The Order of Economic Liberalization—Ghana • Sixth: In preparation for an eventual liberalization of the domestic financial industry and the capital account, develop an effective system of bank regulation • Banks in developing countries • Predominate the provision of financial services • Pose the most serious threat to financial stability due to their inherent instability • The prevention of financial crises requires a well-developed system of banking supervision • Pay attention to capital adequacy requirements, auditing, loan policies, and degree of foreign borrowing

30. The Order of Economic Liberalization—Ghana • Rodrik (1990) argues that, where a conflict between idealized adjustment policies and the economic and political sustainability of these policies exists • Idealized policies must be compromised • Welfare benefits of liberalization policies such as privatization and the removal of trade restrictions must be weighed against potential costs in terms of sustainability • Introduced a distinction between the range and the magnitude of policy reform programs • Range relates to the number of areas in which reforms are to take place • Magnitude refers to the degree of change in any particular policy

31. Figure 23.8. Range and Magnitude in Adjustment/Liberalization

32. Adjustment and Development • Ghana has been participating in a structural adjustment process since 1983 • However, Ghana’s health and education statistics and human development overall are disappointing • What do you, as an advisor to the Ghanaian government make of this? • Adjustment involves restructuring domestic production away from non-traded goods and towards traded goods • For non-traded goods such as tailoring and auto repair, this is perhaps no great loss • For non-traded goods such as education and health services, however, the future human capital of the country is compromised • In turn, compromises long-run growth

33. Adjustment and Development • The challenge is to help the government achieve adjustment without sacrificing productive human investments that are essential for long-run growth and development • Additionally, productive government investments that are complementary to private investment must also be maintained where possible • Otherwise, adjustment will be achieved at the expense of development