Chapter 18 Trade, Financial, and Exchange Market Reforms

1. Chapter 18Trade, Financial, and Exchange Market Reforms © Pierre-Richard Agénor and Peter J. Montiel

2. Reduction in trade barriers fosters • adjustment in relative prices, and • reallocation of resources toward the sector producing exportables. • In the long term, successful trade liberalization leads to • expansion of exports; • contraction of activity in import-competing industries; • transfer of resources from sectors producing nontradables toward those producing tradables. • More open trade regime may be associated with higher long-term rates of economic growth.

3. Trade Reforms: Some Recent Evidence. • Trade Liberalization, Wage Rigidity, and Employment. • Monetary and Financial Liberalization. • Unification of Foreign Exchange Markets.

4. Trade Reforms: Some Recent Evidence

5. Papageorgiou et al. (1990): trade liberalization in 19 countries, during 36 episodes of reform undertaken in developing countries between World War II and 1984. • Successful liberalization episodes have been characterized by their • comprehensive nature; • systematic elimination of quantitative restrictions on imports; • political stability; • prudent macroeconomic policies; • maintenance of restrictions on capital movements until trade reforms were sufficiently advanced; • significant initial depreciation of real exchange rate.

6. There is no strong evidence suggesting that liberalization was associated with sharp reductions in employment and short-run contraction in output. • Balance of payments improved significantly in most cases, as growth of exports outpaced growth of imports. • Since the mid-1980s, far-reaching trade reforms have been implemented in the developing world. • Prior to reform, extensive barriers to trade were in place in most of these nations. • Particularly interesting set of episodes took place in Latin America and the Caribbean. • In relation to different macroeconomic conditions, extent and timing of reforms differed across these countries.

7. Peru: • Trade regime prior to reform was severely distorted. • Import policy reform: • dismantling nontariff barriers such as quantitative restrictions and foreign exchange controls; and • eliminating widespread exemptions. • Export policy reform: • reduction or elimination of price and quantitative barriers to exports; and • introduction or improvement of incentives for export promotion and diversification. Table 18.1: • Indicators of trade regime before and after most recent reforms for 15 Latin American and Caribbean countries.

8. Average tariff rates were reduced dramatically. • In Brazil, number of tariff rates was reduced from 18 prior to reform (in 1990) to 9 by the end of 1993. • In Colombia, it fell from 22 in 1990 to 4 in 1992. • Dispersion of tariffs was also reduced, particularly in Colombia, Costa Rica and Ecuador. • Degree of openness increased significantly due to expansion of both exports and imports in real terms. • Many of reforms in Latin America were introduced in difficult macroeconomic context: • high inflation; • sluggish economic activity; • balance-of-payments difficulties; • scarce foreign exchange reserves.

9. Almost all the episodes of trade reform were preceded by, or associated with, significant depreciation of real exchange rate. • Figure 18.1: continuous real depreciation and expansion of export volumes in aftermath of recent trade liberalization in Chile.

11. Trade Liberalization, Wage Rigidity, and Employment

12. There are potential channels through which trade reforms may lead to contractionary effects in the short run. • Such costs may have adverse effect on sustainability of adjustment process, leading to sudden policy reversals or complete abandonment of reform efforts. • Buffie’s (1984b) model is used to study output and employment effects of trade liberalization. • Key implication: trade reform raises relative price of imported inputs and, if wages are not perfectly flexible, can lead to a contraction in output.

13. The Analytical Framework. • Fixed Nominal Wages. • Flexible Wages.

14. The Analytical Framework • Economy produces tradable and nontradable goods using three factors of production: capital, labor, and intermediate input, which is not produced domestically. • Capital stock is sector-specific and fixed. • Imported inputs are not subject to tariffs and their domestic price PJ is equal to nominal exchange rate E. • World price of traded goods is fixed on world markets, and domestic price is PT = (1+)E,  > 0 measures the extent to which import tariffs and export subsidies have raised domestic price of tradable good above its world market level.

15. Each sector's output is produced by competitive firms operating with a constant-returns-to-scale technology. • Sectoral factor demands: Lh = yh(Lh, Jh, Kh)Cw(w, h, E), Kh = yh(Lh, Jh, Kh)C(w, h, E), Jh = yh(Lh, Jh, Kh)CE(w, h, E), h = N, T refers to production sectors; Yh: sector h's output; Ch: sector h's unit cost function; w: nominal wage; : rental rate on capital in sector h. (2) h (3) h (4) h

16. Let Ph denote final prices in sector h. • Zero-profit condition yields Ph = wCw + hC+ ECE. • Equations (2) to (5) can be solved for output and factor demand levels and rental rate of capital, as a function of the nominal wage, price of imported inputs and price of final goods. • Households consume both categories of goods and hold only domestic money in their portfolios. • Assume homothetic preferences and utility function separable in goods and money. (5) h h h

17. Relative sectoral demand functions can be defined as homogeneous functions of degree zero in prices: Dh/A = dh(PN, PT), 0  dh 1, A: aggregate nominal expenditure. • It is defined by A = PNyN + PTyT – EJ - (M - Md), J: total imports of intermediate goods. • (7): A is equal to difference between net factor income and hoarding, which depends on difference between actual (M) and desired (Md) money balances. (6) (7) s s

18. Desired balances depend on net factor income: Md = PNyN + PTyT - EJ. • Nominal wages are indexed to the price level, which is defined as a geometrically weighted average of prices of traded and nontraded goods: w = w(PNE1-), w > 0, 0 < , < 1. (8) s s ~ ~ (9) 

19. Market-clearing condition for the nontraded goods market can be written as yN = AdN(PN, PT), which determines price of nontraded goods. (10) s

20. Logarithmically differentiating Equations (6)-(8) and simplifying yields, in terms of rates of change, Lh = hK(LK - KK) + J(LJ - KJ) + wL(LL - LK), j: share of factor j in sector h's total production costs; ij: partial elasticity of substitution between i and j; : devaluation rate. • Using (5) to substitute out for h in (11) and rearranging yields: Lh = Lh(h, , w), Jh = Jh(h, , w). ^ ^ h h h h h h (11) ^ h h h h ^ _ _ ? + ? ^ + ^ (12)

21. Sign of cross-price terms is indeterminate, due to possible divergence between output and substitution effects. • Since factor demand functions are homogeneous of degree zero, sum of all partial derivatives in each equation is equal to zero. • From (9), rate of change of nominal wages: w = [N + (1-)T]. • Equations (7)-(10), (12) and (13) can be solved simultaneously for Lh, Jh, w, and N as a function of T or . ^ (13) ^ ^ ^

22. Fixed Nominal Wages • Assume: nominal wages are fixed ( = 0) and imported inputs are used only in the tradables sector. • Trade liberalization: lowering of import tariffs and export subsidies coupled with nominal devaluation. • Assume: reduction in tariffs is less than rate of devaluation, implying increase in domestic price of tradables and thus of imported inputs. • If nominal wages are fixed, effect of the trade reform program on employment in traded goods sector is indeterminate: • net devaluation leads to fall in product wage, which stimulates demand for labor;

23. > < • liberalization also leads to increase in relative price of imported inputs. • Whether net effect is positive or negative depends on • pattern of substitution across factors, and • effect on gross output. • If production function in traded goods sector is separable between primary factors and imported inputs, condition that determines whether employment in traded goods sector rises or falls is given by T - JT 0, JT: share of imported inputs in production costs in tradables sector.

24. If production function is not separable and capital and imported inputs are better substitutes than labor and imported inputs, condition (14) is not sufficient to guarantee increase in labor demand and employment. • Condition for employment to rise following trade liberalization is that expansionary, expenditure-switching effect dominates • “hoarding effect” induced by relative price change; • expenditure-reducing effect induced by negative income effect; • potential fall in employment in traded goods sector. • If cross-price elasticity of demand for nontraded goods is large enough, net effect of liberalization is expansion of employment in nontraded goods sector.

25. If cross-price elasticity of demand for nontraded goods is small, net effect of trade reform on employment is likely to be negative. • Result: overall effect of liberalization on employment is ambiguous in an economy with immobile capital in the short run and nominal wage rigidity.

26. Flexible Wages • Assume: wages are free to adjust to changes in prices, and only traded goods sector uses imported intermediate inputs. • Effects of trade liberalization become even more uncertain. • Product wage in traded goods sector may rise, thus further reducing demand for labor in that sector. • In the nontraded goods sector, employment may also fall to the extent that • negative income effect associated with lower employment in traded goods sector; • possible increase in product wage compensate for expenditure-switching effect of liberalization.

27. Result: overall decline in real consumer wage may be associated with increased unemployment. • Buffie (1984b): • In a large number of cases, contractionary effects on employment may be large enough to offset the expansionary effects. • Real wage rigidity increases short-run contraction in employment, unless there is very high degree of substitutability between labor and imported inputs. • Despite of short-run adjustment costs, trade liberalization may be beneficial in the long run, since elasticities of substitution between inputs are higher than in the short run.

28. Monetary and Fiscal Liberalization

29. Restrictions on competition in banking industry: barriers to entry into banking system and public ownership of banks. • Restriction on composition of bank portfolios: • requirements that banks engage in certain forms of lending; • imposition of “liquidity ratios,” requiring banks to invest specified share of their portfolios in government instruments; • directed lending to specific productive sectors; • prohibitions from acquiring other types of assets. • Park (1991): • Draws distinction between monetary reform and financial liberalization.

30. Monetary reform: increase in controlled interest rates to near-equilibrium levels, with remaining set of restrictions on behavior of banks left in place. • Financial liberalization: more ambitious set of reforms, directed at removing at least some of remaining restrictions on bank behavior. • Full financial liberalization involves • privatization of public financial institutions; • removal of restrictions to entry into banking; • measures aimed at spurring competition in financial markets; • reduction of legal reserve requirements; • elimination of directed lending; • freeing of official interest rates.

31. Monetary Reform. • Financial Liberalization.

32. Monetary Reform • Arguments for monetary reform as a structural policy conducive to a higher growth path are due to McKinnon (1973) and Shaw (1973). • When saving instruments in formal financial system are limited to cash, demand and time deposits, raising interest rates to near-equilibrium levels may induce • increase in saving rate; • portfolio shift out of inventories, precious metals, foreign exchange, and curb market lending into formal financial system. • High real interest rates resulting from the reform would increase investment either

33. because the need to accumulate funds to undertake lumpy investments makes money and capital complementary rather than substitute; • or because of “credit availability” effect. • Many high-return projects not previously funded would be undertaken after the reform. • Reason: banks have scale economies relative to informal market in collecting and processing information on borrowers. • Proposition: • Raising controlled interest rates should raise demand for domestic time and saving deposits. • Rate of growth increases because • increase in saving raises investment; • quality of investment improves.

34. Vogel and Buser (1976): • Under financial repression, higher rate of inflation should reduce private investment, since it would be associated with lower real interest rates. • But, they found little evidence of this effect. • Inflation significantly affected demand for time and saving deposits. • Investment level depended positively on rate of accumulation of time and saving deposits : supportive of complementarity and credit availability hypotheses. Galbis (1979): • Tested McKinnon's direct complementarity hypothesis. • Found little support for the proposition.

35. Unable to find negative effects of inflation on investment levels. Lanyi and Saracoglu (1983): • increases in real deposit interest rate increased national saving rates; • real deposit interest rate had positive and significant coefficient in a regression of growth rate on deposit rate. Fry (1996): • Used pooled cross-section-time series regressions for several samples of Asian countries. • Found weak positive effect of real deposit rates on national saving, but strong positive effect on demand for money and on supply of credit. • Thus, credit supply was found to have strong positive effect on investment.

36. No evidence was found for McKinnon's “complementarity” effect. • Found two types of evidence in support of improved quality of investment: • Real deposit rates were positively correlated with ICOR (proxy for efficiency of investment). • Real deposit interest rate had positive effect on growth. Gelb (1989): • Investigates whether positive correlation between real deposit rates and growth is consistent with causation • from growth to interest rates, or • from common third factor. • Sample of 34 developing countries during 1965-85.

37. Real deposit rates had strong positive effects on both growth and ICOR, but weaker positive effects on investment ratio. • Inclusion of additional variables weakened effects of interest rates on investment, but not on ICOR. • Thus, efficiency effect on investment, and not effect on overall volume of investment, accounted for positive relationship between real interest rates and growth. • Inclusion of other measures of distortion weakened relationship between real interest rates and growth, although it remained positive. • Causal chain between real deposit rates and growth through more effective intermediation into higher-productivity investment:

38. increase in real deposit rate increased share of domestic saving intermediated through formal financial system; • this share had stronger effect on growth than level of saving itself. Dornbusch and Reynoso (1993): • Alternative interpretation of such results. • In neoclassical growth models, growth of output per capita can be written as y – n = [(I/y)(K-1/y)-1 – n], y: real output; K: capital stock; I: net investment; n: rate of growth of the labor force; : share of capital. ^

39. What matters for contemporaneous growth is average, not marginal, efficiency of capital, and this is improved slowly through improved efficiency of investment. • Their interpretation of correlation between real deposit interest rates and growth is that high inflation impedes growth through distortions induced by uncertainty. Evidence on effects of monetary reform on growth is inconclusive. • Higher real deposit interest rates are unlikely to have strong effects on saving rate. • Even though portfolio shifts toward domestic financial instruments are induced by monetary reform, this may not have large effect on volume of investment.

40. While there is little evidence in favor of “complementarity” effect, “credit availability” effect is more strongly supported by data. • Interpretation of positive correlation between real deposit rates and growth is problematic beacuse • it may reflect some contribution of efficiency effect; • real deposit rate may be serving as a proxy for more general distortions. • Episodic evidence associated with specific-country cases of monetary reform does not provide clearer verdict because ceteris paribus conditions do not hold. • Consider Korean monetary reform of 1965.

41. McKinnon (1976): • Nominal deposit and lending rates had been pegged at low levels in Korea prior to the reform, yielding negative real rates in 1963-64. • Nominal rates were revised upward, in September 1965, and directed credit restrictions were reduced, thus qualifying this episode as monetary reform. • Real rates of return rose subsequent to the reform. • Ratio of broad money to GDP increased by factor of 7 between 1964 and 1969. • Private saving increased, and growth experienced strong acceleration. • McKinnon interpreted this as supporting positive effect of monetary reform on growth.

42. Giovannini (1985): • Reached different conclusions. • Most of the increase in national saving in Korea arose in public sector due to fiscal correction. • Measured increase in households' surplus after the reform was one-shot event concentrated in 1966. • Correlation between surplus and real interest rate was negative after that year. • Measured increase in saving may have been due to recording of portfolio shift out of informal market as a change in saving.

43. Financial Liberalization • Evidence on effects of financial liberalization is episodic. Villanueva and Mirakhor (1990): • Success in financial liberalization requires macroeconomic stability and strong and effective system of bank supervision as preconditions. • Success is more likely if controls on interest rates are removed gradually. • Sri Lanka and Korea moved to financial liberalization gradually, while requisite preconditions were put in place. • Without these conditions, full financial liberalization is apt to be associated with • sharp increases in real interest rates;

44. bankruptcy of financial institutions; • loss of monetary control. • Early examples of these outcomes are Southern Cone liberalizations, Philippines and Turkey. Argument is as follows: • Macroeconomic instability increases variance of and covariance among projects funded by banks. • This increases riskiness of bank portfolios. • If deposit insurance is absent or correctly priced, banks would reduce interest rates and ration credit more severely. • But with inadequately priced deposit insurance, moral hazard will induce banks to raise interest rates to attract deposits and fund high-risk projects.

45. Reason is that they face one-way bet: • if the projects pay off, bank owners reap the profits, • if they do not, government pays off depositors, with bank owners risking only their limited capital. • This can be avoided when deposit insurance is priced correctly, because • this forces banks to pay for higher risk that their portfolio choices impose on the government; • So they internalize consequences of their actions. • Same result could be ensured by adequate bank supervision. Villanueva and Mirakhor (1990): • Contrasting experiences of Southern Cone countries, Philippines, and Turkey versus that of Malaysia.

46. All of these countries moved to full liberalization of interest rates in very short period. Southern Cone countries: • In Argentina, Chile, and Uruguay, removal of interest rate ceilings and credit controls was accompanied by • relaxation of bank supervision; • extension of either explicit or implicit deposit insurance; • all in high inflation and unsatisfactory economic performance. • Financial liberalization measures were accompanied by innovative macroeconomic stabilization programs in all three countries.

47. Bank portfolios included unusual number of bad loans, • impairing bank capital, and • increasing moral hazard problems created by deposit insurance. • Lending rates rose to high real levels, distress borrowing by firms ensued, and bankruptcies became common. • Liberalization and stabilization programs collapsed in midst of a financial crisis. • Philippines and Turkey: Liberalizations in the 1980s were carried out under similar circumstances and in similar fashion and they produced similar results. Malaysia: • Although financial liberalization was carried out rapidly, there were macroeconomic stability and banking supervision.

48. Transition to liberalized financial system was smoother, with mild increase in real interest rates and no widespread bankruptcies. Sri Lanka and Korea: • Both undertook liberalization from initially unsatisfactory macroeconomic performance. • But Asian countries removed restrictions on interest rates gradually while pursuing macroeconomic stability and stronger prudential regulation over banks. • Greater flexibility was permitted only after supervisory mechanism strengthened and macroeconomic stability was achieved.

49. Unification of Foreign Exchange Market

50. Attempts at imposing exchange and trade restrictions in developing countries have led to emergence of illegal markets for foreign exchange. • Costs of this: • high volatility of exchange rates and prices; • creation of incentives to engage in rent-seeking activities or divert export remittances from official to parallel market; • loss in tax revenue. • These costs have led policymakers to seek ways to unify official and parallel markets for foreign exchange. • Exchange-rate unification has objectives as • absorption and legalization of parallel market;