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©International Monetary Fund. Not for Redistribution

December 1995 • Volume 32 • Number 4

A QUARTERLYPUBLICATION OFTHE INTERNATIONALMONETARY FUND ANDTHE WORLD BANK

n FINANCESDevelopmentFinancial MarketsAnticipating Capital Flow Reversals uri Dadush and Milan Brahmbhatt 3

Foreign Direct Investment in Developing Countries: Joel Bergsman and x/aofang Shen 6Progress and Problems

Privatization and the Development of Financial Markets Mahmood Pradhan 9in Italy

Progress Report on Commercial Bank Debt Restructuring IMF staff 14

Saving and the Real Interest Rate in Developing Countries Jonathan D. Ostryand Carmen M. Reinhart 16

Can Inflation Targets Help Make Monetary Policy Credible? Timothy D. Lane, Mark Griffiths, 20and Alessandro Prati

Corruption, Governmental Activities, and Markets Vito Tanzi 24

Policies for Achieving Sustainable Growth in the IMF staff 28Industrial Countries

Commercializing Africa's Roads Rupert Pennant-Rea and Ian G. Heggie 30

Can Eastern Europe's Old-Age Crisis Be Fixed? Louise FOX 34

Quantifying the Outcome of the Uruguay Round Glenn Harrison, Thomas Rutherford, 38and David Tarr

Setting Investment Priorities in Education Nicholas Burnett, Kan Marble, 42and Harry Anthony Patrinos

Why Macroeconomists and Environmentalists Need Ronald McMorran and Laura Wallace 46Each Other

Comments by Stanley Fischer 48

BooksHow Russia Became a Market Economy by Anders Aslund William Easterly 50Winds of Change: Economic Transition in Central and Eastern Europe by Daniel Gros and Alfred Steinherr Michael Deppler 50Privatization & Economic Performance edited by Matthew Bishop, John Kay, and Colin Mayer Andrew Ewing 51The Confidence Game: How Unelected Central Bankers Are Governing the Changed Global Economy Daniel Hardy 52by Steven Solomon

International Monetary Arrangements for the 21st Century by Barry Eichengreen Tamim Bayoumi 53Techno-Nationalism and Techno-Globalism: Conflict and Cooperation by Sylvia Ostry and Richard R. Nelson Robert R. Miller 53The OECD Jobs Study: Facts, Analysis, Strategies by the Organization for Economic Cooperation and Jeffrey R. Franks 54Development; Unemployment: Choices for Europe, Monitoring European Integration by the Center forEconomic Policy Research; and Spanish Unemployment: Is There a Solution? by Olivier Blanchard et al.

Letters ss_Index 1995 57

© 1995 by the International Monetary Fund and the International Bank for Reconstruction and Development/THE WORLD BANK.All rights reserved. Requests for permission to reproduce articles should be sent to the Editor. Finance & Development will normallygive permission promptly, and without asking a fee, when the intended reproduction is for noncommercial purposes.


Letter from the Editor

TJLhe past year has been an eventful one in the international financial markets.The dominant event was the sudden reversal of capital flows to Mexico at the endof 1994, which put Mexico's economy at risk, aroused fears of a "contagion effect"in other developing countries, and necessitated substantial financial support fromthe international community. Although Mexico took center stage, uncertaintyabout the direction of interest rates also created turbulence in securities markets inboth industrial and developing economies, and huge derivative-related losses insome industrial countries triggered concern about the stability of the global bank-ing system.

How developing countries can avoid an economic crisis like Mexico's, precipi-tated by large capital outflows, is the subject of an article by Uri Dadush andMilan Brahmbhatt. Countries that have stable macroeconomic policies, highdomestic savings, strong investment in the traded goods sector, and high exportgrowth—and that do not rely excessively on short-term capital flows—are lesslikely to suffer abrupt economic downturns.

Foreign portfolio capital flows to developing countries have surged over the pastdecade, but remain volatile and risky; stock markets are so shallow in some coun-tries that even a small retreat by investors can have a very large impact. By con-trast, foreign direct investment tends to be longer-term and less speculative—andmay bring additional resources to host countries, such as technologies, managerialexpertise, and access to new markets. But, as Joel Bergsman and Xiaofang Shenshow in their article, to attract such investment, many developing countries needto pursue economic reforms far more aggressively.

Mahmood Pradhan's article on the effect of privatization on financial marketreform in Italy underscores the importance of deep and efficient financial marketsfor all economies, industrial as well as developing. Corporate governance in Italyhas suffered because of the country's fragmented banking system and smallequity market; the size of the latter has also limited share ownership in companiesand hampered the Government's privatization program.

The commercial bank debt problems of developing countries remain an impor-tant issue for international financial markets. Considerable progress was madein 1994 and the first half of 1995 in resolving these problems. By end-June 1995,21 countries had completed deals that restructured commercial bank debts witha face value of $170 billion. But this progress has been uneven among developingcountries. The Progress Report on Commercial Bank Debt Restructuring indicatesthat, even though secondary market prices for debt have declined over the past year,prices for the debt of many low-income developing countries have remained signifi-cantly above their levels of mid-1993, and are potentially out of line with the abilityof these countries to service debt over the medium term. The Report suggests that,as a result, commercial bank creditors will need to show considerable flexibility inreaching agreements to resolve the debts of these low-income countries.

The liberalization and integration of international financial markets has createdchallenges and opportunities for industrial and developing countries alike. As theevents of the past year show, to reap the benefit of changes in the internationalfinancial environment without succumbing to the dangers, countries need to pursuesound macroeconomic policies and establish healthy domestic financial markets.

FINANCEDevelopment is published quarterly inEnglish, Arabic, Chinese, French,German, Portuguese, and Spanishby the International Monetary Fundand the International Bank forReconstruction and Development,Washington, DC 20431, USA.

Opinions expressed in articles and othermaterials are those of the authors; theydo not necessarily reflect IMF or WorldBank policy.

Second-class postage is paid atWashington, DC and at additional mail-ing offices. The English edition is printedat Lancaster Press, Lancaster, PA.Postmaster: please send change ofaddress to:

Finance & Development700 19th Street NW,Washington, DC 20431Telephone: (202) 623-8300Fax Number: (202) 623-4738English edition ISSN 0015-1947

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2 Finance & Development / December 1995


Anticipating CapitalFlow ReversalsU R I D A D U S H A N D M I L A N B R A H M B H A T T

HAT early warningsignals should policy-makers heed to avoida repeat of a Mexico-

type reversal of private capitalflows? Experience suggests thata combination of indicators canprovide powerful hints ofapproaching problems.

A review of the experience of developingcountries that received major private capitalinflows in the first half of the 1990s suggeststhat some of them were better able to managethese flows than others. Countries that havelargely avoided sudden reversals of inflowshave a number of common characteristics:stable macroeconomic policies; avoidance ofprotracted real exchange rate appreciation;high domestic savings; significant investmentin industries in the traded goods sector; rela-

tively restrained current account deficits; highexport growth; and relatively little relianceon short-term capital inflows. In contrast,countries that have proven to be morevulnerable to shifts in market sentiment havetended to exhibit these characteristics to a farlesser degree.

A number of lessons emerge from the expe-riences of both sets of countries that can helppolicymakers avoid sudden reversals of capi-tal flows.

Lessons of experienceLarge real exchange rate apprecia-

tion. Some of the countries that experiencedsignificant private capital flow reversals in1995—such as Argentina, Hungary, andMexico—had also undergone large and pro-tracted real exchange rate appreciation in thefirst half of the 1990s (see chart). A surge incapital inflows attracted by high returns inthe wake of a comprehensive economic reformmay contribute to some appreciation of thereal exchange rate. But prolonged apprecia-tion of the real exchange rate that threatensexternal competitiveness and puts the exter-nal sector under pressure may create the con-

ditions for a subsequent loss of confidence byforeign investors.

The experience of a number of countriesshows that this pattern need not always pre-vail. For one thing, some key reform measures,such as fiscal consolidation and trade liberal-ization, are apt to lead to real depreciationrather than appreciation. Indeed, many of themost successful reformers and recipients ofcapital inflows, particularly those in Asia,have seen only modest real appreciation oreven significant real depreciation of their cur-rencies (see table). Increases in private savingsin these countries have tended to offset theexcess demand and inflationary pressuresgenerated by large capital inflows, pressuresthat would otherwise result in real apprecia-tion. For example, Malaysia, which wasamong the countries receiving the highest vol-ume of private capital inflows relative to GDP,experienced a small depreciation of its realexchange rate. In general, the correlationbetween private capital inflows and real appre-ciation was not significant for the 16 majorprivate capital recipients shown in the table.

In contrast, significant real appreciation isoften the undesirable side effect of using the

Uri Dadush,a French national, is Chief of the International Economic Analysis andProspects Division of the World Bank's International Economics Department.

Milan Brahmbhatt,a UK national, is an Economist in the International Economic Analysis andProspects Division of the World Bank's International Economics Department.

Finance & Development / December 1995 3

w


exchange rate as a nominalanchor in stabilization programsin high-inflation countries. Ina number of countries, high realappreciation of the exchange ratein the 1990s was associa-ted with the use of nominalexchange rate anchors to curbthe momentum of high inflationbuilt up in earlier years. Of the 16countries shown in the chart, the8 countries with the largest realappreciation had a median infla-tion rate of 53 percent in the1980s while the countries withthe smallest real appreciation(mostly in Asia) had a medianinflation rate of only 9 percent.Stabilization programs based ona nominal exchange rate anchor were in effectat one time or another during the early 1990sin several of the countries showing high realappreciation, such as Argentina, Hungary,Mexico, and Poland. Persisting in this policymuch beyond the initial phase of such pro-grams, instead of switching to greater relianceon tight fiscal and monetary policies, risksundermining external competitiveness.

Declining private saving rates. Somedecline in private saving rates could, in princi-ple, result from a perceived increase in perma-nent income in the wake of successful reforms,or from an anticipation of lower taxes follow-ing cuts in government spending. The evi-dence suggests, however, that the mostsuccessful reformers, such as the East Asianeconomies and Chile, have seen increasedprivate saving rates even when thesewere very high at the outset (Corbo andHernandez, 1994).

A number of analysts (for example, Kigueland Liviatan, 1992; Calvo and Vegh, 1994)have argued that a strong initial boom in con-sumption is a typical result of nominal-exchange-rate-based stabilization programs,reflecting a fall in interest rates that is oftenan initial effect of such programs, as wellas anticipation on the part of the public thatthe program may not be sustainable. Ifthe consumption boom persists—implyingrapidly declining private savings—it canhave important consequences for the sustain-ability of the balance of payments positionand the credibility of the exchange rateanchor itself. For example, the ratio of privateconsumption to GDP in Mexico increased by 5percentage points in 1990-93, compared with1985-89 (see table). In four other countrieswith high real appreciation (Argentina,Hungary, Peru, and Poland), the increase inthe consumption share between these twoperiods averaged 9 percentage points. In con-

Exchange rate appreciation/depreciation amongmajor private capital recipients 1

(percent change, 1990-94)

Source: IMF Research Department.1Real effective exchange rate.

trast, it fell by about 1 percent in the fourcountries in the table with the least real appre-ciation. Given that fiscal deficits improved by2-3 percent of GDP, on average, in both highand low real appreciation countries, privatesavings rates must have fallen significantly inhigh appreciation countries.

Inadequate investment in the trad-ables sector. Insofar as capital flows areattracted by increased efficiency, one wouldexpect to see significant foreign and domesticinvestment directed to the traded goods sector,reflecting improved international competitive-ness. If, however, capital flows finance a con-sumption boom and/or are driven by "herdinstincts," one might expect the inflows to findtheir way mostly to the nontradables sector,where relative prices and profitability havebeen bid up by high domestic demand (someof it induced by the capital flows themselves).Although comparable data on tradables andnontradables investment are not available, itis notable that the services sector, which ismost closely associated with nontradables,expanded relative to GDP in the high appreci-ation countries but not in the low appreciationones. Real growth of the service sector in1990-93 in the high real appreciation half ofcountries shown in the chart exceeded overallGDP growth by 1.4 percent a year but only by0.3 percent a year in the low appreciation half.High real appreciation countries also experi-enced poorer overall investment growth thanlow appreciation ones (see table).

Low export growth. This is a critical sig-nal that a country's ability to service mountingforeign obligations could be called into ques-tion by investors. In theory, perfect capitalmarkets could supply virtually unlimitedcredit to a country expecting a future boom inexports but, in practice, creditworthiness indi-cators are based on the evolving track recordof export growth and the country's share in

export markets. If the countryis rated a high risk, investorswill expect commensuratelyhigh returns, and rapid exportgrowth becomes even more im-portant to sustained capital in-flows. As would be expected,export growth in the early 1990sshowed a fairly close inverserelationship with real exchangerate appreciation, averaging 7percent (in nominal dollar terms)in the high appreciation half ofcountries but 12 percent in thelow appreciation half.

Unsustainable current ac-count deficits. There is no hardand fast rule as to whatconstitutes a sustainable deficit,

though a rule of thumb can be derived fromsetting a prudent target on foreign borrowing.If, for example, the target is the commonlycited prudent upper bound on the foreign lia-bilities/export ratio of 2, then the sustainablecurrent account deficit in the long term,expressed as a proportion of exports, is equalto twice the export growth rate. Computationsof sustainable current account deficits usingthis rough rule of thumb show that they varygreatly by country. The median level for largerecipients of private capital in Europe andCentral Asia is 2.5 percent of GDP, in LatinAmerica 2.2 percent, and in Asia 8.9 percent.Among high appreciation countries, actualcurrent account deficits in 1994 averagedabout 2 percent of GDP greater than sustain-able levels. But 1994 deficits in low apprecia-tion countries were more than 6 percent ofGDP below sustainable levels—a furtherdegree of prudence no doubt reflecting thepossibility that external conditions could leadto lower export growth than the rapid paceachieved by these countries in the early 1990s.

The rule of thumb applied here gives only afirst indication. A fuller computation of sus-tainable deficits would account for other fac-tors such as the level of foreign aid, whichwould increase the sustainable deficit; thematurity and initial level of foreign liabilities;the volatility of export earnings; and theimport content of exports. Increases in allof these variables would tend to reduce theprudent liability/export ratio and the sustain-able deficit.

Growing reliance on short-term,flows. Short-term borrowing is appropriatefor short-term needs such as trade, inventory,and working capital finance, but it is inappro-priate for long-term projects, where it placesborrowers in the precarious position of havingto continuously refinance the investment.Growing reliance on short-term capital



Average Long-term Change in private Change in Average Current Deviation fromreal exchange private capital consumption- investment- annual account to sustainable currentrate change 1 flows 2 Inflation 3 GDP ratio 4 GDP ratio 5 export growth 6 GDP ratio 7 account ratio

Argentina 12.2 3.0 566.0 9.0 -1.8 8.7 -3.3 -2.1

Brazil -0.2 1.4 320.0 3.5 -1.9 5.2 -0.2 0.7

Chile 1.8 4.9 21.3 -0.8 3.0 7.7 -1.4 3.3

China -12.5 5.0 8.1 -0.9 1.9 18.5 0.1 8.2

Colombia 3.6 1.2 23.5 2.2 -1.2 11.1 -2.0 2.4

Hungary 7.1 5.3 9.0 8.9 -5.9 1.8 -9.9 -8.8

India -7.3 1.0 9.1 -1.8 0.4 8.5 -1.2 0.5

Indonesia -1.1 2.6 9.6 1.0 -1.8 12.1 -2.4 4.3

Korea -1.8 1.9 8.4 -0.1 6.0 10.5 -0.4 5.7

Malaysia -1.0 9.4 3.7 0.1 7.6 18.7 -3.2 27.3

Mexico 4.8 4.3 69.1 5.1 2.2 9.4 -8.2 -4.8

Peru 10.4 1.3 481.3 5.8 -4.0 1.5 -3.8 -3.4

Philippines 2.3 1.1 15.1 2.3 4.3 12.7 -6.3 0.9

Poland 9.1 1.0 53.0 12.4 -11.2 5.5 -3.0 -0.4

Thailand 0.1 4.6 5.8 -5.9 10.8 17.0 -5.2 7.2

Venezuela 0.2 2.0 23.0 0.5 -3.1 4.4 0.2 2.8

Sources: International Economics Department, World Bank; and IMF for real effective exchange rates. Consumption and investment ratios and goods and nonfactor service export growthare measured in nominal dollar terms,

1 1990-94.2 As percent of GDP, 1990-93.3 Consumer price index, 1980-89.4 1990-93 versus 1985-89.5 1990-93 versus 1985-89.61990-94.7 1994.

inflows (especially to finance current accountdeficits) may be a sign of strain. Although theborrower prefers long-term financing, lendersor direct investors are reluctant to complybecause of perceived risk.

Large currency exposures. Stabi-lization programs that use the exchange rateas a nominal anchor create a strong incentivefor domestic firms to borrow at low interestrates in foreign currency, and for foreigninvestors and domestic financial intermedi-aries to lend at high interest rates in domesticcurrency, while carrying the currency risk. Atthe same time, the maturity structure of loanstends to become shorter as both lenders andborrowers try to minimize currency risk. Theabsence of forward markets aggravates theproblem, since investors find it difficult tocover currency exposures. This behavior cre-ates powerful impediments to devaluation,even when it is clearly needed. Large currencyexposure is not so much an early signal of cri-sis as it is an indication of the disruption thatmight ensue.

Monetary tightening in industrialcountries. Capital flows to developing coun-tries may be adversely affected by monetarytightening in industrial countries. A conse-quent sharp rise in interest rates would reducethe relative attractiveness of developing coun-try assets and would also be accompanied

eventually by falling aggregate demand inindustrial countries and slower export growthin developing countries. Heavily indebtedcountries would see a large deterioration increditworthiness indicators. This scenariohelped precipitate the debt crisis of the 1980s.However, the rise in interest rates in 1994 doesnot wholly conform to this pattern. Rateincreases were moderate in comparison withthose of the early 1980s, and their effect oncreditworthiness was offset by global recoveryand a surge in world trade.

The overall picture. This list of earlywarning signals is not exhaustive. Attentionalso needs to be paid to controlling quasi-fiscal as well as fiscal deficits, the appropriate-ness of monetary policy, and political stability.Other warning signals, such as high realinterest rates to defend the currency, or sloweconomic growth resulting from currencyovervaluation and high interest rates, may belate rather than early indicators of fundamen-tal imbalance. Nevertheless, events since thestart of the Mexican crisis have tended to con-firm the value of the indicators discussed here.After a sharp pullback from most emergingmarkets in the immediate wake of the crisis,private capital flows to developing countrieshave recovered more quickly and substan-tially than seemed likely at the start of 1995.But the recovery has been most pronounced

for countries with the best early warning indi-cators, such as the East Asian countries, andChile and Colombia.

Suggestions for further reading:Guillermo Calvo and Carlos Vegh, "Inflation

Stabilization and Nominal Anchors,"Contemporary Economic Policy, Vol. 12(April 1994) pp. 35-45.

V. Corbo andL. Hernandez, "MacroeconomicAdjustment to Capital Flows: Latin American Styleversus East Asian Style," Policy Research WorkingPaper No. 1377 (Washington, World Bank, 1994).

Uri Dadush, Ashok Dhareshwar, and RonJohannes, "Are Private Capital Flows to DevelopingCountries Sustainable?" Policy Research WorkingPaper No. 1397 (Washington, World Bank,December 1994).

Rudiger Dornbusch and Alejandro Werner,"Mexico: Stabilization, Reform, and No Growth,"Brookings Papers on Economic Activity: 1(Brookings Institution, Washington, 1994),pp. 253-315.

Miguel Kiguel and Nissan Liviatan, "TheBusiness Cycle Associated with ExchangeRate Based Stabilizations," World BankEconomic Review, Vol. 6 (May 1992),pp. 279-305.


Key indicators for major recipients of private capitalpercent


Foreign Direct Investmentin Developing Countries:Progress and Problems

J O E L B E R G S M A N A N D X I A O F A N G S H E N

KHI ANY developingcountries have madenotable efforts to

\ attract foreign directinvestment in the past decade.Although total Hows to the devel-oping world have exploded, theyare unevenly distributed.Countries that have aggressivelyreformed policies have been farmore successful than countrieswhose reforms have beenhalf-hearted.

Foreign direct investment (FDI) is playing agrowing role in economic development. FDIflows to the developing world quadrupledfrom an annual average of $12.6 billion in1980-85 to $51.8 billion in 1992-93, and rose-to $70 billion in 1994. Developing countriesreceived 32 percent of total world FDI during1992-94, up from 20 percent in the first half

of the 1980s. The share of FDI in the grosscapital formation of developing countriesmore than doubled between 1986 and 1992,surpassing 6 percent in 1993.

While FDI is surging, other forms of capitalflows to developing countries are diminishing(see table). Aid has continuously declined as ashare of capital inflows since the 1960s, whenit was the most important source of externalfinance for developing countries; it nowaccounts for only one fourth of their capitalinflows. Commercial loans, a major source ofcapital flows in the 1970s, have virtually dis-appeared since the debt crisis of the 1980s.Portfolio investment, which boomed whenstock markets in developing countries caughtthe attention of investors in the 1980s, isimportant but is also volatile and risky—asdemonstrated by outflows from Mexico inDecember 1994.

Unlike other forms of capital inflows,FDI almost always brings additionalresources—technology, management know-how, and access to export markets—that aredesperately needed in developing countries.Investors are exacting, however, when it comesto deciding which countries are the most desir-able sites for investment, and the lion's shareof FDI has been going to a handful of coun-tries, mostly in East Asia and Latin America

(see chart). In 1994, 11 countries accounted forabout 76 percent of total FDI flows to thedeveloping world. Nevertheless, some smallcountries (including many island countries)have received amounts of FDI that are large inproportion to the size of their economies. ButFDI flows to many other countries, particu-larly in sub-Saharan Africa, have stagnated.

Why East Asia and LatinAmerica?

More and more developing countries havereduced barriers to FDI and improved theirbusiness climates. At the same time, multina-tional corporations are responding toincreased competition by considering abroader range of locations for their facilities.These mutually reinforcing trends have com-bined with technological changes in communi-cation, transportation, and production to make"the global marketplace" a reality for invest-ment decisions. The days of producing shoddy,high-cost products for sale in local markets arepassing; most foreign investors are interestedonly in sites where they can produce to inter-national standards of quality and price.

This globalization means that the old dis-tinction between export-oriented productionand production destined for the local market isweakening and even disappearing. Countries

Joel Bergsman,a US national, is a Manager in the Foreign InvestmentAdvisory Service.

Xiaofang Shen,a Chinese national, is an Investment Policy Officer in the Foreign InvestmentAdvisory Service.

6 Finance & Development /December 1995


that want to develop mustoffer good business conditionsboth for exporters and for pro-duction for local markets. Theemphasis may differ, depend-ing mainly on the size of thelocal market, but providingthe combination is increas-ingly important. Countries inEast Asia and Latin Americahave received the most FDIbecause they have adjustedtheir strategies to keep up withglobalization.

Some of these countries initially based theirdevelopment on exporting labor-intensivemanufactured goods to the industrial coun-tries. Recently, many have recognized thattechnological advances and intensified compe-tition have increased the capital and skillintensity of production in many industries.This means that countries can no longer counton low labor costs alone but also need high-quality, productive labor to sustain their com-parative advantages. Those that havesucceeded in attracting FDI have focused onimproving general education, industrial skilltraining, and labor and managerial discipline.Facilitating companies' efforts to upgradetechnology has also been crucial in maintain-ing their competitive edge.

The development of other successful coun-tries was initially based on import-substitut-ing industrialization. This strategy producedvaluable skills, institutions, and physicalinfrastructure, but was inherently limitedbecause of small domestic markets and theinefficiencies caused by continuing protection.These countries were either forced by eco-nomic crises or inspired by countries that suc-ceeded through more outward-looking policiesto reduce protection, privatize state enter-prises, and make their productive apparatuscompetitive internationally.

Whatever route they took, the rapid, sus-tained economic growth of the successfulcountries of East Asia and Latin America hasearned them the name "emerging markets."They are even beginning to rival the indus-trial countries as export markets because ofstrong, consistent increases in the demand forconsumer goods and services. All this hasmade them extremely attractive to interna-tional investors.

Companies interested in establishing facili-ties in emerging markets need access to qual-ity supplies of parts, components, andsupporting services. For manufacturingindustries, especially, a major force drivingsuccess is a "flexible" system of intercorpo-rate relations under which companies special-ize in different stages of production, either

Selected capital flows to developing countries(million 1993 dollars)

1960s 1970s 1980s 1991 1992 1993

Net foreign direct investmentPortfolio investmentNet commercial bank lendingGrants and official debt flows

Total

30413

3841,4662,167

3,024423

9,8399,854

23,140

12,9883,353

11,79134,366

62,498

34,47517,5051,892

59,301

113,173

44,86824,25014,54147,383

63,99986,5695,482

52,336

131,042 208,386

Sources: IMF, Balance of Payments Statistics Yearbook, various years; and World Bank, WorldDebt Tables, various years.Note: Figures for the 1960s, 1970s, and 1980s represent the annual averages for those decades.

What about othercountries?

Many other developingcountries have also embarkedon reforms, addressing the

upstream or downstream in a productionchain, and cooperate closely with each otherthrough networking and long-term buyer-sup-plier relationships. This type of system helpsintegrate foreign investment into hosteconomies and allows the latter to derive morebenefit from FDI through induced economicactivities, the transfer of technology and man-agement skills, and better access to exportmarkets. But companies need great flexibilityand highly developed skills to ensure "just-in-time" delivery of quality intermediate goodsand services, without defects. Countries thathave the conditions that facilitate these kindsof operations have become much more com-petitive in the eyes of foreign investors.

None of the countries that have attractedsignificant FDI inflows could have doneso without sustained trade reform enablingthem to keep up with the pressure of interna-tional competition. All have carried outsubstantial domestic economic reforms to en-courage private sector development. Manyhave essentially succeeded in stabilizing themacroeconomic environment, reducing pricedistortions, deregulating investment proce-dures, and increasing general economic effi-ciency—getting the "fundamentals" right forall private investment, domestic and foreign.

same issues—fiscal and mon-etary imbalances, price dis-tortions, bloated public en-terprises, and unnecessaryregulations, among others.Many have made significantprogress, winning deservedpraise from economists,banks, and international in-

stitutions, including the World Bank and theIMF. But FDI has either not appeared or, if ithas, still falls short of the amount desired.What is wrong?

One basic problem is that some countriespossess few attractions for foreign investors.One traditional attraction of developing coun-tries—cheap labor—is becoming less impor-tant in investment decisions. Economies at anearly stage of industrialization do not offer thesophisticated providers of inputs—both goodsand business services—that most foreigninvestors need to be competitive. Another fac-tor that deters investment is poor economicperformance—FDI tends to follow growth,not to lead it.

A closer look at the less successful coun-tries, however, reveals that many that arepotentially attractive to FDI simply have notcarried their reforms far enough. Foreigninvestors do not come just because someprogress has been made; to attract FDI, coun-tries must have made enough progress to meetworldwide best-practice standards.

Obstacles to entry. Many countries haveliberalized entry policies over the past fewyears. They have relaxed restrictions on for-eign ownership and entry in certain sectors,and they have also introduced "negative lists"

FDI flows to developing countries are concentrated in two regions(1990-94)

East Asia and the Pacific

Eastern Europe and Central Asia

Latin America

Middle East and North Africa

South Asia

Sub-Saharan Africa

Sources: IMF, Balance of Payments Statistics Yearbook, various years; and World Bank, World Debt Tables, various years.



to limit the types of investments that requirescreening and approval. In many countries,however, entry is still needlessly restrictedand/or arbitrarily regulated—often because ofpressure from domestic interest groups orfrom regulatory authorities with vested inter-ests in screening.

Inadequate legal protection. Mostgovernments have recognized the need forinvestment protection, and many have guaran-teed equal treatment for foreign and nationalinvestments. An increasing number of coun-tries have enacted laws forbidding expropria-tion or guaranteeing prompt and adequatecompensation in the event of expropriation. Inmore and more countries, foreign investorshave recourse to international arbitration forsettling investment disputes.

Legal reforms are still far from adequate inmost countries, however. In many cases, lawsstill implicitly allow expropriation ofinvestors' property for arbitrary reasons. Thevery poor functioning of judicial systems inmany countries calls into question the"prompt and adequate compensation"promised by law. Finally, investors are oftenrequired to exhaust domestic means for set-tling disputes before resorting to internationalarbitration. In the context of a weak domesticcourt system, this dramatically weakensinvestors' confidence.

Overvaluation and restricted accessto hard currencies. Since the late 1980s, agrowing number of developing countries havetaken steps to liberalize their foreignexchange systems. Many have devalued theircurrencies, and some have allowed marketdetermination of the exchange rate. In spite ofconsiderable adjustments, however, many cur-rencies are still overvalued, and extensive con-trols on exchange transactions are still seen asnecessary. Moreover, foreign exchange liberal-ization in many countries has been accom-plished by decree but not followed up byappropriate legislative steps, creating anatmosphere of uncertainty for investors.

Trade barriers. In the past, many devel-oping countries that had adopted an import-substitution strategy attracted FDI byoffering investors a protected domestic mar-ket. Recognizing the importance of competingin global markets, most have now reducedprotection and taken steps to promote exports.In too many instances, however, trade reformshave still not gone far enough. Some countrieshave reduced protection significantly, but stillhave too much to foster real competition athome or to provide an exchange rate that isconducive to exports. There is also awidespread problem in the developing worldwith customs services. Better trade policiesmay be negated by bureaucratic customs pro-

cedures and the obstructionist attitude of cus-toms agents. Thus, imported capital equip-ment and other inputs do not arrive atproduction sites on time; drawback paymentsdue to exporters are delayed for months oreven years; and going through the multilay-ered clearance process is very costly.

Tax distortions. To attract foreigninvestment, some countries use special invest-ment incentives, including tax holidays, taxcredits and exemptions, and reduction ofduties. However, experience shows that suchstrategies have had little, if any, impact onmost long-term investors. Tax holidays createdistortions of tax regimes; they favor newinvestors and discriminate against existingones—in some countries, they discriminateagainst domestic investors. The expiration oftax holidays causes sudden increases in taxburdens on companies. Moreover, these incen-tives are often granted through complex andbureaucratic administrative procedures thatencourage corruption. A stable, automatic taxsystem with reasonable rates and without dis-cretionary incentives is better both forinvestors and for the host country. Many coun-tries have a long way to go to reach that goal.

Getting the word out. Investment pro-motion—persuading investors to come—hasbecome widespread in recent years. Morecountries, however, need to have a carefullyplanned program of making the improve-ments achieved at home known to theworld—not so much through expensive adver-tising supplements but rather through sophis-ticated, long-term public relations campaigns.Providing effective assistance to interestedinvestors and businesslike follow-up, andhelping existing investors to solve administra-tive problems are important parts of promo-tion that are too often neglected.

Role of governmentsFor many countries that have not achieved

the expected results, the problem is thatreforms have been inadequate. Governmentsneed to persevere with reforms already underway. Intensified global competition has putcompanies under greater pressure, and theyare responding by investing only in the mostfavorable places. Countries should take this asa challenge rather than a threat if they want towin the battle for FDI.

Furthermore, policy liberalization alonemay not increase competitiveness sufficiently.Economic opening is the necessary "stick" toforce competition and shift resources to theirmost productive uses. Experience in manycountries suggests that "carrots"—public sup-port of efforts to make firms moreefficient—are also urgently needed. For exam-ple, now that international investors have

begun to be more interested in high productiv-ity than in low labor costs, government assis-tance is needed to upgrade technology andlabor skills. Access to information and techni-cal services, general education, and special-ized industrial and managerial training aremore important than ever.

"Public support" does not mean, however,that governments should do, or even pay, for itall. To the contrary, many of the support ser-vices required by industries are best deliveredby private institutions. Foreign investorsthemselves can provide assistance, motivatedby their own business interests. Private com-panies not only benefit from such a support-ing system but also can play a crucial role inthe design and operation of it, and they mustbear at least part of the cost.

The role of governments is thus becomingmore complex. Governments can no longer actsimply as monopolies providing certain ser-vices or goods, or even simply as regulators;their functions must include those of orga-nizer, coordinator, assistant, and partner. Tosucceed, governments will need to changetheir orientation and acquire new skills.Commitment, creativity, and willingness tolearn from mistakes are crucial assets that canlead to success.

The Foreign InvestmentAdvisory Service

This article is based, in part, on the experienceof the Foreign Investment Advisory Service(FIAS). Created ten years ago by theInternational Finance Corporation (IFC), FIASis now jointly operated by IFC and the WorldBank. Its mission is to help governments ofdeveloping countries to attract foreign directinvestment through improved policies, sensiblederegulation, and more effective institutions.

Governments that request FIAS's help getfrank and confidential analysis of the problemsthat concern them. FIAS's advice reflects theexperience of other countries but also takes intoaccount the political and administrative reali-ties of the client. FIAS works informally andclosely with client countries to build relation-ships of trust and understanding with them. Bynow, FIAS's clients number about 90, includingdeveloping countries all over the world, as wellas transition countries in Eastern Europe andthe former Soviet Union.

Clients pay part of the costs of FIAS's advi-sory work. The rest of FIAS's expenses areunderwritten by IFC and the World Bank, andby donations from the United NationsDevelopment Program and individual indus-trial countries.



Privatization and theDevelopment of FinancialMarkets in ItalyM A H M O O D P R A D H A N

DI TALY's financial marketshave been extensivelyliberalized in recent years.

\ The Government's large-scale privatization program andthe European Union's single-market initiative have provided,and continue to provide, strongincentives for eliminatingmarket distortions.

Italy's relatively underdeveloped capital mar-kets and fragmented banking industry, com-pared with those of other large industrialcountries, as well as its structure of corporateownership and pattern of corporate finance,have limited the role of financial markets incorporate activity. These features of the econ-omy have posed considerable difficulties forthe large-scale privatization program initiatedin 1992 to reduce the state's share of economic-

activity. Several public banks, insurance com-panies, industrial firms, and major public util-ities were earmarked for privatization. Mostof the early privatizations were carried outthrough private placements, primarily be-cause of the small size of Italy's equitymarket (although in some cases the specificcharacteristics of the firm being privatizedmay have made this appropriate). Althoughrecent privatizations carried out through pub-lic offerings—mainly those of state-ownedbanks—have generated considerable interestamong small shareholders, structural weak-nesses in financial markets, including a lack oftransparency of corporate ownership and con-trol, have continued to hinder the broadeningof share ownership.

Since June 1993, total proceeds from privati-zation have amounted to over 15 trillion lire(about $9.4 billion), of which the stockmarket has effectively financed aboutLit 11 trillion, representing about 5 percent ofstock market capitalization. Forthcoming pri-vatizations will involve significantly largeramounts than have been raised in recentyears. The Government's 1996-98 fiscal pro-gram contains projections for privatizationproceeds of roughly Lit 10 trillion per year. By

contrast, since 1988, new capital raised on theMilan Stock Exchange—the largest of the tenItalian stock exchanges, accounting for morethan 90 percent of all equity trading—hasaveraged about Lit 6 trillion a year.

The Government's need to sell large vol-umes of shares generated by the privatizationprogram is having the beneficial effect of pro-viding an impetus for reforms to enhance theefficiency of financial markets. For instance,reforms of takeover legislation and new regu-lations concerning representation of minoritystockholders in privatized companies havebeen designed to improve the system of corpo-rate governance and to encourage wider shareownership. There have also been importantchanges in other areas, such as improvementsin the liquidity and transparency of equitymarkets and a move toward establishing auniversal banking system.

Financial marketsBond market. Italy's bond market is one

of the largest in the world and the secondlargest in Europe; its government bond mar-ket is the largest in Europe and the thirdlargest in the world. Large public sectordeficits have led to dramatic growth in the

Mahmood Pradhan,a UK national, is an Economist in the World Economic Studies Division of the IMF's Research Department.

Finance & Development I December 1995 9


European stock markets: indicators of size and turnover in 1994(million dollars)

Marketcapitalization

Market capitalization Average companyas percentage of GDP size 2

Turnoverratio (percent) 3

United Kingdom

Germany

France

Switzerland

Netherlands

Italy

Spain

Sweden

Belgium

1,210,245

470,519

451,263

284,092

283,251

180,135

154,858

130,939

84,103

118.123.034.0

108.985.917.732.166.636.9

5851,128

9831,199

894808409

1,149543

78.197.8

133.980.173.572.344.170.515.6

Sources: International Finance Corporation, Emerging Stock Markets Factbook, 1995; and IMF, World Economic Outlookdata base.

1 Total market value of all listed domestic companies at the end of 1994.2 The ratio, as of end-1994, of market capitalization to the number of listed domestic companies, in millions of dollars.3 The total value of shares traded during the period divided by the average market capitalization for the period.

bond market, and government debt nowaccounts for over 85 percent of the total valueof debt instruments traded. The market's sizeand the broad range of debt instrumentstraded there, particularly the relatively largefloating-rate market, have attracted signifi-cant interest from foreign investors. The intro-duction of an active secondary market,improvements in the settlement process, andwithholding tax reforms have also increasedthe international attractiveness of Italianbonds.

A particularly striking feature of the Italianbond market is the small amount of corporatedebt issued and traded there. In 1993, newdebt issues by nonfinancial corporationsaccounted for less than 2 percent of the mar-ket. In the past, regulatory constraints limitedthe growth of this market, and the absence ofrating agencies hindered the development ofan active secondary market. The new BankingLaw that came into effect in early 1994 virtu-ally eliminated stamp duty on corporate debttransactions, and firms that could provide agood record of profitability and a bank guar-antee were permitted to issue short-term com-mercial paper and investment certificates.These reforms did not result in an immediateflourishing of private bond markets, however,since they coincided with a period of relativelyhigh interest rates that limited new issues byprivate sector borrowers.

Equity market. In contrast to the bondmarket, the equity market in Italy is relativelyunderdeveloped, with a market capitalization,measured as a percentage of GDP, that isamong the smallest in Europe (see table).Although recent privatization issues haveattracted a large number of small sharehold-ers, household sector savings have tradition-ally been channeled mainly through banks.

and the total amount of equities held bythe domestic household sector remains rela-tively low.

Institutional investors are also underrepre-sented, compared with other European coun-tries. This partly reflects the absence, untilrecently, of a legal framework encouraging theemergence of several key types of institutionalinvestor. New investment funds have been per-mitted only since 1992, and closed-end fundsand private pension funds since 1993. Bankshave only recently been allowed to own equitystakes in nonfinancial enterprises. Mostimportant, however, the limited involvementof institutional investors reflects the structureof corporate ownership, which consists of asmall number of large business groups withextensive cross-holdings (accounting forroughly 80 percent of the market capitaliza-tion on the Milan Stock Exchange) and a largenumber of small and medium-sized firms thatare mainly family-owned.

Transactions costs in the Italian equitymarket, as in other European equity markets,have fallen significantly over the past decade,largely because of dramatic technologicaladvances in information dissemination andtrading systems but also, to a lesser extent,because of extensive regulatory reforms. Thelatter have included liberalization of access tomembership of stock exchanges, reductions intransaction taxes, and liberalization of broker-age commissions. Underlying these reformshas mainly been the recognition by manycountries of the increased competitionbetween national stock markets resultingfrom the liberalization of capital flows inEurope.

Reforms in Italy were implemented begin-ning in the early 1990s, which was relativelylate compared with those in France, Germany,

Spain, and the United Kingdom. However,after the January 1991 law that set up single-capacity stock exchange firms, Societa diIntermediazione Mobiliare (SIMs); the intro-duction of block trading in November 1991;and, more recently, the New Banking Law(September 1993), which relaxed constraintson banks' ownership of stock exchange mem-ber firms, the Italian stock market has largelycaught up with competing markets in Europe.

To improve the transparency of tradingvolumes and the information content oftransactions prices, the 1991 SIM law madeit mandatory for all trades to be conductedon the stock exchange. Before the November1991 reforms, Italian banks had for sometime acted effectively as market makers byoffering to match block trades. An importantincentive for banks to offer this service wasthe fixed commissions that existed up tothat time. Such off-exchange trading had oftenprovided scope for insider trading, especiallyfor large traders who could artificially affectprices on the exchange prior to their own off-exchange trades.

Competition from other European stockmarkets has also led to the development ofmarkets in derivative securities. In September1992, a futures contract on ten-year govern-ment bonds was introduced on the MilanStock Exchange. More recently, there has beenincreasing interest in derivative instrumentsin equities, particularly since the introductionof trading in futures contracts based on theequity price index, Indice della Borsa diMilano (MIB30), on the Italian Futures Market(MIF) in November 1994.

Corporate control and financeSystems of corporate control differ consid-

erably among industrial countries. In stock-market-based systems, such as the UnitedKingdom and the United States, control isexercised by institutional investors via largeand active equity markets. By contrast, inmany countries in continental Europe, controland finance are institution-based; banks andother financial institutions are major share-holders in nonfinancial corporations and per-form an active role in supervising andmanaging them. In stock-market-based sys-tems, investor protection—that is, takingsteps to ensure adequate performance and anequitable distribution of corporate profits—isprovided largely through potential and actualtakeovers. Typically, there are few takeovers ininstitution-based systems, and investors areprotected largely by the active involvement ofequity-holding financial institutions.

Corporate control. In Italy, neither ofthese systems of corporate control has beeneffective: control is concentrated in the hands



of a few large business groups; there are fewhostile takeovers; and, until recently, bankswere impeded by regulations from taking anactive role in corporate governance. Althoughthe greater concentration of ownership in Italydoes not necessarily imply weaker perfor-mance of its corporate sector—since majoritystockholders have greater incentives thanminority stockholders to actively monitor per-formance of corporations—the absence ofboth external monitoring and the threat ofhostile takeovers has resulted in less effectiveprotection of minority shareholders.

The corporate sector in Italy consists of asmall number of large business groups withwidespread intergroup shareholdings and alarge number of small and medium-sizedfirms that are either family-owned or have onemajority owner. Shareholdings of the nonfi-nancial corporate sector account for almost80 percent of the capitalization of firms listedon stock markets, with most of the remainderbeing held by financial institutions. Further-more, companies where a single entity owns amajority stake account for 60 percent of stockmarket capitalization. By comparison, in theUnited Kingdom, less than 4 percent of marketcapitalization is held by the nonfinancial cor-porate sector, and of the largest 200 compa-nies, more than two thirds have no singleshareholder with more than 10 percent of theequity. Ownership is more concentrated inGermany, where 90 percent of the largest 200companies have at least one shareholder withmore than 25 percent of the equity. In bothGermany and the United Kingdom, however,minority shareholdings are more significantthan in Italy.

These differences have important implica-tions for the Italian Government's privatiza-tion program. The efficiency of privatizedindustries will depend largely on effectivemonitoring and supervision of corporate per-formance, especially in sectors where exist-ing public enterprises may be transformed,at least in part, into private monopolies.Reducing the concentration of ownershipwill require particular attention to therights of minority shareholders, especiallywhere privatization is intended to lead towider share ownership.

Large business groups in Italy are typically-characterized by extensive cross-holdings ofequity stakes, both within and outside thegroup. The hierarchical nature of businessgroups distinguishes the Italian system ofcross-holdings from those of other countrieswhere cross-holdings are also extensive, suchas France, Germany, and Japan. In Italy, "par-ent" companies—those at the top of a pyrami-dal structure—have stakes in smaller firmslower down the hierarchy, but these sub-

sidiaries rarely hold equity in parent firms.Such business group interests are extensive inthe manufacturing sector, where they accountfor 75 percent of total employment. For parentfirms, control of firms lower down the hierar-chy can often be exercised with a minorityholding. The controlling group can gain at theexpense of other shareholders through trans-actions among subsidiaries that are designedto transfer profits to subsidiaries in which thecontrolling group has a larger share. Thismakes the protection of minority investors aparticularly important issue in Italy: withoutadequate protection, there is little incentive forinvestors to hold noncontrolling stakes.

Corporate finance. In comparison withother major industrial countries, debt financein Italy differs significantly in terms of matu-rity and source; most such debt consists ofshort-term bank loans. Equity finance is bothsmall and restricted mainly to large firms: forexample, the five largest business groupsaccount for 70 percent of the market capital-ization of the Milan Stock Exchange. This pat-tern of corporate finance is attributableprimarily to relatively high corporate incometax rates, favorable tax treatment of interestpayments on debt, and regulatory constraintson the amount of long-term lending by banks.

Few Italian banks have well-establishedprocedures for analyzing the risk exposuresentailed in longer-term lending. The market inwholesale corporate banking is dominated byMediobanca, which is owned mainly by largeindustrial groups. It is the only institutionactive in mergers and acquisitions and has adominant position in managing equity issuesfor large industrial enterprises and has, there-fore, been extensively involved in theGovernment's privatization program.

The regulation of Italy's banking industry-has recently been relaxed, however, and bankswill consequently be able to play a greaterrole in both corporate finance and theGovernment's privatization program. Thebanking system is moving toward the univer-sal bank model, although some restrictions onbanks' activities have been retained: they arestill not permitted to operate directly in insur-ance, mutual funds, or stockbroking. Underthe European Union directive on financialservices, however, banks will be allowed tooffer stockbroking services by 1996.

The Italian equity market is widely per-ceived to favor insiders. Small stockholderswho do not have controlling interests, espe-cially those who hold nonvoting shares, areoften placed at a disadvantage, because theydo not benefit from the transfer of firmownership. Legislation approved in 1974enabled Italian companies to issue savingsshares (azioni di rispannio) that do not have

voting rights; holders of these nonvotingshares are entitled to the same dividend paidon voting shares plus an additional 2 percentin years when dividends are paid to othershareholders, with a minimum dividend of5 percent of the par value in years when nodividends are paid to holders of votingshares. Although the number of companiesissuing both voting and nonvoting shares inItaly—about 50 percent—is not unusuallyhigh, nonvoting shares accounted for 57 per-cent of the market capitalization of the MilanStock Exchange in 1990.

Further, the premium on voting shares issignificantly higher in Italy than in most othercountries. Between 1987 and 1990, the averagepremium on voting shares, compared withnonvoting shares, was over 80 percent. In con-trast, in the United Kingdom, voting sharestraded at a premium of just over 10 percent; inCanada, of just over 20 percent; and inSweden, where voting and nonvoting sharesare extensively issued, the premium was onlyabout 6 percent. For companies with a major-ity holder, the premium was significantlylower than for companies that had a numberof large holders but no majority holder—sug-gesting that the premium reflects the privatebenefits of control, even though these benefitscannot be observed directly.

Reforms of takeover legislationThe primary aim of recent takeover legisla-

tion in Italy has been to ensure that when oneparty, or a group of shareholders acting inconcert, acquires a controlling interest in afirm, the effective takeover is transparent andthat minority stockholders are offered thesame terms for their holdings as those whosell out to the bidder. In 1992, the new lawrelating to takeover bids (offerte pubbliched'acquisto (OPA)) made it compulsory forthose intending to acquire control of a listedcompany to make a public tender offer, whichmust cover enough capital (a minimum of 10percent) to enable them to achieve control. Itis, however, intrinsically difficult to detectinformal agreements or voting trusts amonginvestors. Moreover, although the regulatoryauthority, in principle, has to be notified ofany such trusts, it is not in general obliged tomake public any information it obtains on for-mal or informal voting trusts.

The widespread existence of informalagreements among investors has raised someconcerns in the context of the privatizationprogram, particularly with regard to thepotential for core groups to acquire controlwithout the knowledge of minority holders.In response to such concerns, the OPA lawof 1992 was revised and strengthened bythe March 1994 law, which requires public



notification of agreements among investorsbidding for firms being privatized. The newlaw, however, applies only to takeover bidsfor such companies; the more general problemof defining and identifying informal agree-ments remains. These recent reforms oftakeover legislation may, in the long run, actto reduce concentration in corporate owner-ship to the extent that acquiring control ofenterprises will be more costly. Takeoveractivity should also, in principle, become moreefficient, in that transfers of ownership will bemore transparent.

Promoting equity financeThe authorities have sought to strengthen

the protection of minority shareholders byestablishing the relevant legal and supervi-sory structures. A law prohibiting insidertrading and other related insider activity waspassed in October 1991. Other measures toprotect the rights of "outsiders" include rulesfor the selection of outside directors andrules mandating postal voting in privatizedcompanies. In the recent privatization of thestate-owned insurance company IstitutoNazionale delle Assicurazioni (INA), forexample, three seats on the managementboard were reserved for directors nominatedby minority shareholders. Also, effective

February 1995, privatized companies havebeen obliged to introduce postal voting atshareholder assemblies.

The Government has also introduced anumber of measures designed to encouragesmall investors. In June 1994, it issued a decreethat would harmonize the withholding tax onshares at 12.5 percent, the same rate applied towithholding tax on bond interest payments,and shareholdings of up to Lit 100 millionwere exempted from inheritance tax.

ConclusionIn embarking on a large-scale privatization

program, the Italian Government has neededto address many distortions in domestic capi-tal markets. For a long time, the relative lackof transparency of corporate ownership andcontrol in Italy have acted to discourage shareownership. Many of the recent reforms oftakeover legislation and regulations relatingto minority representation on corporateboards should, over time, lead to improvedconfidence in the system of corporate gover-nance. To the extent that legislation wasrequired, many of the necessary reforms are inplace. There is, however, a different kind ofproblem that may not be resolved by legisla-tion. The practice of exercising control viainformal coalitions (voting trusts) among

shareholders has been extensive in Italy, inlarge part because of the concentration in thestructure of corporate ownership. The priva-tization program represents an importantopportunity for the authorities to reduce theextent of concentration by ensuring a widerdispersion of shareholding and increasing thetransparency of ownership and control.

This paper is based on a more detailed study of pri-vatization and the financial markets that isincluded in "Italy: Background EconomicDevelopments and Issues," Staff Country ReportNo. 95/36 (Washington, IMF, 1995).

Suggestions for further reading: Colin Mayer,"Financial Systems, Corporate Finance andEconomic Development," in G. Hubbard (editor.),Asymmetric Information, Corporate Finance andInvestment (Cambridge, Massachusetts: NationalBureau of Economic Research, 1990); C. Robinsonand A. White, "The Value of a Vote in the Marketfor Corporate Control," (unpublished, YorkUniversity, Toronto, Ontario, 1990); and LuigiZingaks, "T\ie Value of the Voting Right: A Studyof the Milan Stock Exchange Experience," Reviewof Financial Studies, Vol. 7 (Spring 1994),pp. 125-48.

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Finance & Development /December 1995 13


PROGRESS REPORT ON COMMERCIAL BANK DEBT RESTRUCTURING

IONSIDERABLE additional pro-Igress was made in 1994 and the1 first half of 1995 in resolving theI commercial bank debt problems ofI developing countries. Debt- and1 debt-service reduction operations

were concluded by Bulgaria, the Dominican

gRepublic, Ecuador, and Poland. Panamaannounced in May 1995 that ithad reached an agreement in principle withits banks. Among low-income developingcountries, comprehensive buybacks usingresources from the Debt Reduction Facility forInternational Development Agency (IDA)-

Country

Table 1Commercial bank debt- and

debt-service reduction operations 1

(million dollars)

Debt Debt- and Total debt- andrestructured debt-service debt-service reductionunder DDSR reduction as a percentageoperation 2 (DDSR) of debt restructured Cost of

(1) (2) (3) = (2)/(1) reductions

Concluded agreements

Albania (1995) 385Argentina (1992) 19,397Bolivia 643

(1987) 473(1993) 170

Brazil (1992) 40,600Bulgaria (1993) 6,186Chile (1988) 439Costa Rica (1989) 4 1,456Dominican Republic (1993) 776Ecuador (1994) 4,522Guyana (1992) 69Jordan (1993) 736Mexico4 51,902(1988) 3,671(1989) 48,231

Mozambique (1991) 124Niger (1991) 111Nigeria (1991 ) 4 5,811Philippines 5,812(1989) 1,339(1992) 4,473

Poland (1994) 9,989Sao Tome and Principe (1994) 10Sierra Leone (1995) 5 148Uganda (1993) 152Uruguay (1991) 1,608Venezuela (1990) 19,700Zambia (1994) 200

Total 170,243

MemorandumPanama (1995) 2,010

3859,386

612442170

13,1983,527

4391,128

5112,602

69312

22,2141,670

20,544124111

4,3933,7011,3392,3626,332

10148152888

6,043200

75,951

100.048.495.293.5

100.032.557.0

100.077.565.857.5

100.042.542.845.542.6

100.0100.0

75.663.7

100.052.863.4

100.0100.0100.055.230.7

100.0

44.6

Pending agreements

1,002 49.8

1003,059

613526

3,900652248196149583

10118

7,677555

7,1221223

1,7081,795

6701,1251,933

12218

4632,585

22

25,212

252

Source: IMF staff estimates.Debt- and debt-service reductions are estimated by comparing the present value of the old debt with the present value of

the new claim, and adjusting for prepayments made by the debtor. The amounts of debt reduction contained in this tableexclude debt extinguished through debt conversions. Years in parentheses refer to the date of the agreement in principle.

2 Excludes past-due interest and includes debt restructured under new money options for Mexico (1989), Uruguay (1991),Venezuela (1989), the Philippines (1992), Poland (1994), and Panama (1995); the Philippines' (1989) new-money optionwas not tied to a specific value of existing debt.

3 Cost at the time of operation's closing. Includes principal and interest guarantees, buyback costs, and, for Venezuela,resources used to provide comparable collateral for bonds issued prior to 1990. Excludes cash down-payments related topast-due interest.

4 Includes estimated value-recovery clauses.5 Corresponds to the first phase of the buyback.

Only Countries and from donor countries werecompleted for Albania, Sao Tome andPrincipe, Sierra Leone, and Zambia.

As regards debt reschedulings, Russia andits commercial bank creditors agreed inOctober 1994 on a legal framework for dealingwith the country's bank debt, and paymentswith respect to interest arrears have beenmade by Russia into an escrow account at theBank of England. Algeria reached agreementin principle on a rescheduling arrangement forits commercial bank debt in May 1995.Slovenia, after a complex series of negotia-tions, reached agreement with the commercialbank creditors of the former Socialist FederalRepublic of Yugoslavia on Slovenia's share ofthe unallocated debt of the former Yugoslavia,marking an important first step in resolvingthis difficult debt problem.

Altogether, by end-June 1995, 21 countrieshad completed deals that restructured com-mercial bank debts with a face value of $170billion, obtaining roughly $76 billion in debtreduction in present-value terms at a cost of$25 billion (see Table 1).

Allocations to the options in the variousdebt packages have differed, reflecting in somecases explicit limits imposed by debtor coun-tries and the views of the holders of the debtregarding the expected future values of thedebt instruments issued in exchange for theold bank claims (see Table 2). On the whole,cost efficiency has been achieved in each debt-and debt-service reduction operation con-cluded thus far, with the cost per unit of debtreduction achieved (the buyback equivalentprice) being in line with the secondary marketprice of the bank claims at the time of theagreement in principle (see Table 3).

ProspectsThe sharp run-up in secondary market

prices of bank claims during the second halfof 1993 and into early 1994 raised concernsthat future bank debt negotiations might becomplicated by market speculation that acountry would conclude a debt- and debt-service reduction operation. As a result,secondary market prices in several instanceswere not seen to be reflective of the countries'medium-term capacity to service their debts.In addition, the up-front costs of debtoperations (especially straight debt buybacks)were bid up substantially. Subsequent devel-opments (most notably, the rise in world inter-est rates during 1994 and the Mexican crisis at



end-1994) have contributed to large declinesin the secondary market prices of developingcountry bank claims from their early1994 peaks.

With the adjustment in prices, there is lessconcern in some cases that high levels of sec-ondary market prices will make it more diffi-cult for countries to reach agreements withtheir creditors. Nonetheless, despite the gen-eral fall in secondary market prices, prices forthe debt of many low-income developingcountries have remained significantly abovetheir levels in mid-1993 and potentially out ofline with the ability of these countries to ser-vice debt over the medium term. Speculationprior to the conclusion of a debt- and debt-ser-vice reduction deal also remains a potentialconcern, as evidenced by the run-up in theprice of Cote d'lvoire's debt in advance of dis-cussions between the country and its bankadvisory committee in May 1995. Creditorswill need to show considerable flexibility inreaching agreements to resolve the debts ofthese low-income countries, possibly entailingeven steeper discounts on debt buybacks thanthose that creditors have accepted at times inthe past.

Even at very steep discounts, the totalamount of assistance that a few low-incomecountries would require to buy back theircommercial bank debt far exceeds availableresources. In these cases, Brady-type debt-and debt-service reduction operations mayhave to be considered. Key considerations instructuring such operations will be assess-ments of the country's medium-term debt-ser-vicing capacity and the resources available tofund the up-front costs of the operation. Themenu of options in such deals may entail, inaddition to steep discounts on debt buybacks,sizable discounts on discount bonds, parbonds with interest rates substantially belowmarket levels, the write-off of past-due inter-est, and the provision of less than full collater-alization of principal on bonds issued as partof the package. To meet the financing require-ments for such operations, there will be a con-tinuing need for substantial concessionalresources from multilateral institutions andbilateral donors.

This article was derived from Private Market

Financing for Developing Countries, prepared by a

Staff Team in the IMF's Policy Development and

Review Department, and published in the World

Economic and Financial Surveys series.

International Monetary Fund, Washington,

November 7.9.95.

Bank menu choices in debt-restructuring packages

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^H^^^^^^^^^^^^^^^^^^^^^^^^^^^^^HJ^^^^^^M^^^n^3T^mH l ^n^Rra^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^H^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^H

Other non-Debt-service reduction debt- and

Debt reduction Principal debt-serviceDiscount collateralized Other par New reduction

Country Buyback exchange par exchanges exchanges money options

Argentina - 34 66Bolivia 46 35 19Brazil - 3 5 3 2 5 6 2 2Bulgaria 13 60 - 27Costa Rica 63 - - 37

Dominican Republic 35 65Ecuador - 58 42Jordan - 33 67Mexico - 43 47 - 11Nigeria 62 -- 38

Philippines (1989) 1 100Philippines (1992) 28 42 17 13Poland 25 54 18 - 4Uruguay 39 - 33 - 28Venezuela 7 9 3 8 1 5 3 1

Total 2 8 3 4 3 9 5 9 5

Sources: National authorities; and IMF staff estimates.1 The agreement included new money, but was not tied to a specific amount of eligible debt.2 Weighted average.--: Not applicable.

Table 3

Buyback equivalent prices in debt- anddebt-service reduction operations 1

(percent of face value)

SecondaryDebt-service reduction market price

Debt reduction Principal at time ofDiscount collateralized Other par Overall agreement

Country Buyback exchange par exchanges exchanges package in principle

Argentina -- 25 32 - 30 37Brazil -- 26 36 19 30 35Bulgaria 25 18 - 8 18 27Costa Rica 2 16 -- - 293 18 19Dominican Republic 25 28 - -- 26 23

Ecuador - 19 29 - 24 23Jordan 39 25 41 - 35 39Mexico 2 - 33 39 - 36 44Nigeria2 40 -- 36 - 39 40Philippines (1989) 50 -- -- -- 50 50

Philippines (1992) 52 - 45 28 48 53Poland 41 14 22 -- 25 39Uruguay 2 56 -- 45 -- 53 54Venezuela2 45 35 38 25 38 46

Total4 41 27 36 21 33 37

Source: IMF staff estimates.1 The buyback equivalent price for a debt exchange is the total value of enhancements as a proportion of the total reduc-

tion in claims payable to banks, including effective prepayments through collateralization, evaluated at prevailing interestrates at time of agreement in principle. This is the price at which the debt reduction achieved through a debt exchange isequivalent to the debt reduction under a buyback at this price.

2 The calculations include estimates of value-recovery clauses.3 Weighted average of the buyback equivalent price of the series A par bond (33 cents), the series B par bond (0 cents),

and the series A past-due interest bond (119 cents).4 Weighted average.--: Not applicable.


Table 2


Saving and the Real Interest Ratein Developing CountriesJ O N A T H A N D . O S T R Y A N D C A R M E N M . R E I N H A R T

IN\AISING real interestrates has often beencited as a way to

I increase private saving,and thus provide the resourcesfor growth. But this may not bea viable approach in thepoorest developing countries, inwhich most people live at thesubsistence level.

How does private saving respond to changesin real interest rates in developing countries?The answer will influence judgments aboutthe effectiveness of a range of policies. Forexample, financial liberalizations, which gen-erate higher real interest rates, will result ingreater savings by households only if the lat-ter decide to defer consumption; in otherwords, if the sensitivity of consumption andsaving to higher interest rates is significant.Similarly, when fiscal policy shocks con-tribute to movements in domestic interestrates, their impact on the external currentaccount will depend on how responsive pri-vate saving is to changes in real rates ofreturn.

In this article, we present some evidence tosuggest that raising domestic interest rates

to stimulate saving is unlikely to be success-ful in the poorest developing countries,where consumption choices are heavily influ-enced by subsistence considerations. Indeed,the evidence suggests that the interest ratesensitivity of saving to real rates of returnrises with a country's income level. Hence,the same policies undertaken in differentcountries could produce very different out-comes, depending on the country's level ofdevelopment.

Is saving responsive?There is little consensus in the empirical

literature on the interaction between savingand the real rate of interest in developingcountries. Some studies have concluded that,for a large number of developing countries,there does not appear to be any systematicrelationship between rates of return and con-sumption/saving behavior; others have sug-gested that there may be considerableregional variation in this elasticity.

One reason may simply be the poor qual-ity of the data in general and, more specifi-cally, the fact that there is considerablevariation in the economic significance andinformational content of the data on realrates of return. Lack of sophistication anddepth in domestic financial markets or directregulation may result in interest rates thatdo not adequately reflect expectations aboutthe underlying economic fundamentals. Inmany low-income developing countries,there are few banks, and there is little scopefor true market determination of interest

rates. This feature of credit markets in theleast developed countries may itself makesaving less responsive to interest rates.

Another reason that might explain thefailure of existing studies to detect signifi-cant effects of interest rates on householdsaving in developing countries relates to thefact that—particularly in the poorest coun-tries—subsistence considerations are likelyto be a significant factor determining con-sumption behavior. Given that, to be able tosave, households must first achieve a subsis-tence consumption level, the interest rate sen-sitivity of private saving will be close to zerofor countries where a large share of the popu-lation lives at or near subsistence consump-tion levels. Indeed, a subsistence modelwould predict a nonlinear relationshipbetween saving behavior and the level ofdevelopment, with the most significantchanges occurring when countries move fromlow-income to low-middle-income status, andrelatively minor changes between middle-income and high-income countries. Of course,the interest rate sensitivity of saving could below even in middle-income countries if theincome distribution were sufficiently skewedso that a large proportion of the populationlived at or near subsistence levels.

A frequently used proxy for the impor-tance of subsistence in household budgets isthe budget share going to food. It is indeednoteworthy that food consumption accountsfor a markedly lower share of total expendi-ture in high-income than in low-income coun-tries. As shown in Table 1, food consumption

Jonathan D. Ostry,a Canadian national, is a Senior Economist in the IMF's Southeast Asia andPacific Department.

Carmen M. Reinhart,a US national, is an Economist in the IMF's Western Hemisphere Department.



Table 1

Food as a share of expenditure 1

(1990)'

Country groupings Percent

Low-incomeLower-middle-incomeUpper-middle-incomeHigh-income

55.632.130.513.0

Source: Judith Jones Putnam and Jane A. Allshouse,Food Consumption, Prices and Expenditures, UnitedStates Department of Agriculture, Statistical BulletinNo. 867.

1 Expenditure on food as a percent of total personalexpenditure. For details of the countries included ineach country grouping, see World Bank, WorldDevelopment Report 1994: Infrastructure forDevelopment, Washington, DC, 1994.

2 Data refer to averages for each country grouping.

accounts for an average of 13 percent of totalexpenditure in high-income countries and foronly 8 percent of total consumption in theUnited States. For middle-income countries,such as Mexico and Thailand, the share isoften 30-40 percent while, for the poorestcountries, the share of food is over 50 percent;it is in the 60-70 percent range in some coun-tries, such as Sierra Leone and Sudan. Thevery sharp differences in food expenditureacross countries with different per capitaincome levels suggests that subsistence con-siderations may indeed be important in under-standing saving behavior, particularly inlow-income developing countries.

There are, however, additional reasons whysaving may be less responsive to changes inreal interest rates in low-income than in mid-dle-income countries. Some have argued thatlow-income countries are characterized bypervasive liquidity constraints, which impliesthat changes in consumption will be heavilyinfluenced by changes in current income,rather than by changes in rates of return.

Savings and incomeSubsistence considerations offer two main

predictions about saving behavior. First, sav-ing rates should increase with the level of realincome at the initial stages of development,with the largest increases in the saving rateoccurring as a country moves from low- tomiddle-income levels. Second, saving shouldbecome more responsive to changes in realinterest rates as countries become richer.The first prediction follows directly from therole of subsistence consumption in the low-

income developing countries, and the fact thatthe share of subsistence in total con-sumption—perhaps proxied by the foodshare—declines as income increases. The sec-ond prediction may also be related to subsis-tence considerations, since incentives to saveover time should affect only that portion of thebudget left over after subsistence has beenachieved, that is, discretionary income.

Among countries in various income groups,the patterns of saving rates that emerge arebroadly consistent with the predictions of thesubsistence model. As Table 2 shows, privatesaving is, on average, considerably lower forthe poorest developing countries, where thesaving rate is about one half that of the high-income group. In fact, such differences alsoappear within regions. World Bank data showthat median gross domestic saving as a per-centage of GDP (1987-91 average) was 5.6 per-cent for low-income African countries and 19percent for middle-income African countries.Average gross domestic saving for bothgroups was 7.7 percent of GDP.

Furthermore, the relationship between thelevel of income and the saving rate appears tobe nonlinear, as the largest increases in savingrates occur in the transition from low- tolower-middle-income levels, where the averagepersonal saving rate rises by 5.5 percentagepoints. The average for the upper-middle-income countries is still 2.8 percentage pointsabove that of the lower-middle-income group,but there appears to be relatively little differ-ence between the average saving rates in thehigh-income and upper-middle-income coun-tries in the sample.

It is noteworthy that liquidity constraintsand precautionary motives for saving couldproduce the opposite pattern in saving rates.If poor consumers cannot borrow but facean uncertain income stream, the demandfor precautionary savingrises. Hence, the liquidity-con-straint/precautionary savinghypothesis would predict that itis the poorest consumers, whohave no access to credit mar-kets, who would save the most.

Still, there appear to bemarked cross-country differ-ences in saving rates that can-not be accounted for by asubsistence explanation. Forexample, saving rates tend to behigher among the Asian coun-

tries than among the Latin American coun-tries in the sample, despite similar income lev-els. The more equitable income distributionthat characterizes the Asian countries may bea factor behind those differences. Institutionalarrangements (such as pension funds), whichplay a more prominent role in several Asiancountries, may also be conducive to fosteringhigher saving rates.

The role of real interest rates in savingbehavior is more difficult to gauge. One prob-lem—which is particularly important inAfrica—is that financial markets remain thinand governments often set interest rates atnonmarket levels. Nevertheless, there is someevidence that financial saving increased as aresult of the increase in real interest ratesassociated with liberalization of financial mar-kets in developing countries, both in Africaand elsewhere. For example, increases in sav-ing rates have been associated with higherreal interest rates in Indonesia and theRepublic of Korea and, more recently, inArgentina, Chile, and Pakistan. There is alsosome evidence that reform programs inAfrica—which caused real interest rates tomove from sharply negative to mildly positivelevels—were successful in mobilizing domes-tic savings.

Empirical findingsWhen households are assumed to maximize

utility, or welfare, subject to a resource con-straint, the interest-rate sensitivity of house-hold saving depends on how easilyhouseholds can substitute future consumptionfor current consumption (technically knownas the intertemporal elasticity of substitution(IBS) in consumption). If a given change inreal interest rates induces large shifts in con-sumption, then the IBS—one of the parame-ters describing household preferences—will

Table 2

Income and personal saving rates

GNP per adult Personal saving asin 1985 dollars a percentage of GDP

Country groupings (1980-87 average) (1985-93 average)

Low-income 1,380Lower-middle-income 2,806Upper-middle-income 4,896High-income 16,161

11.216.719.520.0

Sources: IMF, World Economic Outlook, October 1994, Washington; andWorld Bank, Adjustment Policy Research Report, Oxford University Press,New York, 1994.



be correspondingly large. In our work onthis issue, macroeconomic data from asample of countries were used to evaluatethe magnitude of the IBS for householdsfrom developing countries with diverseincome levels. The low-income countriesin the sample were Egypt, Ghana, India,Pakistan, and Sri Lanka. The low-middle-income countries were Colombia, CostaRica, Cote d'lvoire, Morocco, and thePhilippines. Three upper-middle-incomecountries also were included in the analy-sis: Brazil, Korea, and Mexico.

In addition to not requiring that theIBS be equal across countries with verydifferent per capita incomes (consistentwith the subsistence model), our method-ology allowed relative prices (of importsand home goods) to enter into house-holds' saving decisions. To take oneexample, a temporary reduction inimport prices should reduce saving, otherthings being equal, because the price ofimports is a factor whose changes over time(like the changes in interest rates) affect incen-tives to consume today or in the future.

Estimation of the IBS for countries with dif-ferent per capita incomes is, however, an inter-mediate step. Ultimately, the aim of ouranalysis is to quantify the responsiveness ofsaving to policies that alter domestic interestrates, that is, the elasticity of saving withrespect to the interest rate. It is possible tosimulate how saving responds to changes inreal interest rates using our empirical esti-mates of the IBS. By estimating how the IBSvaries with income level within our sample of12 countries, we can infer values of the IBSoutside the sample (using information on theper capita income levels for other countries)and thereby simulate the interest rate elastic-ity of saving for a broad range of countries.

Our results (see Table 3) suggest that a 1per-centage point rise in the real rate of interestshould elicit a rise in the saving rate of onlyabout two tenths of 1 percentage point for the10 poorest countries in the sample. For thewealthiest countries, by contrast, the rise inthe saving rate in response to a similar changein the real interest rate is about two thirds of apercentage point. As Table 3 shows, theresults are not very sensitive to the initial levelof the real interest rate.

In general, the cross-country variation inthe responsiveness of saving to a change inthe real interest rate is wide, consistent withthe predictions of the subsistence consump-tion model and the wide variation in incomelevels in the sample of countries included inour study. As with saving rates, the relation-ship between a country's income level and theinterest elasticity of saving varies as one

Table 3

Interest sensitivity of saying underalternative scenarios 1

Initial real interest rate

Country groupings 3 percent 4 percent 5 percent

Low-incomeAverage for group 0.312 0.306 0.300Average for 10 poorest 0.177 0.174 0.171

Lower-middle-income 0.532 0.522 0.512Upper-middle-income 0.560 0.549 0.539High-income 0.584 0.573 0.562

Source: M. Ogaki, J.D. Ostry, and C.M. Reinhart, "SavingBehavior in Low- and Middle-Income Developing Countries: AComparison," IMF Staff Papers (forthcoming).

1 The data refer to the change (in percentage points) in the savingrate owing to a 1 percentage point increase in the real interest rate.For example, in high-income countries with a real interest rate of3 percent, a 1 percentage point rise in the real interest rate wouldraise the saving rate by nearly two thirds of a percentage point(0.584 of a percentage point). At higher baseline levels of the realinterest rate, the saving response diminishes slightly.

moves up the income scale. Specifically, inlow-income countries, the IBS (and hence theinterest rate elasticity of private saving) isclose to zero. In low-middle-income countries,there is a marked rise in the IBS. The IBS isfound to increase again in the upper-middle-income countries, though there is little differ-ence between this group and the high-incomecountries.

ImplicationsThe main conclusion that emerges from our

analysis is that much of the considerable vari-ation among countries in both the level of sav-ing and the responsiveness of saving to thereal interest rate can be systematicallyexplained by the country's income level.Specifically, the hypothesis that the savingrate and its sensitivity to interest rate changesare rising functions of income finds consider-able empirical support. In particular, ourresults may help to explain why the rising realinterest rates that typically accompany finan-cial liberalization have failed to elicit an appre-ciable rise in private saving in many countries.Though financial liberalization policies—andthe resulting increases in interest rates—mayhave a number of positive effects (includingincreasing both the efficiency of investmentand economic growth), the results suggestthat the direct impact of such policies onhousehold saving behavior is likely to be rela-tively small in low-income countries. Otherpolicy questions—for example, the relation-ship between government deficits and the cur-rent account of the balance of payments—willalso depend on the responsiveness of privatesaving to real interest rates, to the extent thatchanges in public saving (increases ordecreases in the budget deficit or surplus)alter domestic rates of return. Hence, our find-

ings may shed some light on the widevariation among countries in the responseof the current account to fiscal policychanges that alter interest rates.

The failure of saving to respond tochanges in real interest rates in manylow-income countries is particularly prob-lematic, since these are also the countriesthat have the least access to internationalcapital markets and foreign savings. Buteven for developing countries that canobtain foreign financing, achieving ormaintaining adequate domestic savingsis essential for sustained growth. As theturbulence at the end of 1994 in Mexicanand other emerging financial marketshighlighted, foreign financing can bevolatile and reversals can be quite abrupt.

Increasing national saving in lower-income countries may therefore requirean alternative strategy. A recent World

Bank study of high-performing Asianeconomies highlights the role of lower publicsector deficits (achieved through expenditurecuts rather than tax increases) as an impor-tant means of achieving higher national sav-ing. Reducing the level and volatility ofinflation, and promoting macroeconomic sta-bility more generally were also seen as usefulways of promoting saving. Mandatory savingprograms may also have been effective inboosting saving in some Asian countries.

In contrast, in upper-middle-income devel-oping countries, the household saving rate islikely to increase significantly as interest ratesmove up, and the response is unlikely to bevery different from what would typically beobserved in industrial countries.

References:J.D. Ostry and C.M. Reinhart, "Private Saving andTerms of Trade Shocks," IMF Staff Papers, Vol. 39,September 1992, pp. 495-517; M. Ogaki, J.D. Ostry,and C.M. Reinhart, "Saving Behavior in Low- andMiddle-Income Developing Countries: AComparison, "forthcoming in IMF Staff Papers;G.L. Kaminsky and A. Pereira, "The Debt Crisis:Lessons of the 1980s for tin 1990s," forthcoming inthe Journal of Development Economics; WorldBank, Adjustment in Africa: Reforms, Results, andthe Road Ahead, World Bank Policy ResearchReport (New York: Oxford University Press, 1994);and World Bank, World Development Report 1994,and World Development Indicators (New York:Oxford University Press, 1994).



New Occasional Papers from theInternational Monetary Find

Uganda: Adjustment with Growth, 1987-94, by Robert L. Sharer, Hema R. De Zoysa, and Calvin A. McDonald. No. 121. 1995.vii + 43 pp.This paper explores not only Uganda's recent adjustment efforts but also the country's prospects in the medium term. It provides anoverview of recent economic performance with respect to growth, saving, and investment, and providesan analysis of Uganda's external adjustment efforts. The paper surveys fiscal adjustment and theprospects for a sustainable fiscal position, public enterprise reform, and army demobilization.Available in English, (paper) ISBN 1-55775-461-6 Stock #S121EA

Capital Flows in the APEC Region, edited by Mohsin S. Khan and Carmen M. Reinhart. No. 122.1995. viii + 76pp.The developing economies of the Asia Pacific Economic Cooperation Council (APEC) have been therecipients of a considerable volume of capital inflows in the 1990s. Given the increased integration ofcapital markets, it is not surprising that monetary control became more difficult for many developingAPEC economies. Formulating an appropriate policy response has naturally been important. Each of thethree papers that make up this Occasional Paper examine different aspects of these issues.Available in English, (paper) ISBN 1-55775-466-7 Stock #S122EA

Comprehensive Tax Reform: Hie Colombian Experience, edited by Parthasarathi Shome. No. 123.1995. viii + 67pp.This paper analyzes particular areas of tax policy that have concerned the Colombian authorities duringthe 1990s, albeit comprising a comprehensive approach to tax reform over time. It is intended to allowthe reader to view in technical detail the type of analysis conducted in a representative tax reform studycarried out by the IMF.Available in English, (paper) ISBN 1-55775-464-0 Stock #S123EA

Saving Behavior and the Asset Price "Bubble" in Japan: Analytical Studies, edited by UlrichBaumgartner and Guy Meredith. No. 124. 1995. vii + 79 pp.This volume brings together various analytical studies the IMF staff has undertaken on the Japaneseeconomy, focusing on two areas of particular interest for both longer-term economic performance andrecent cyclical developments. The first is Japan's saving behavior; the second is the remarkable swing inasset prices that occurred in the late 1980s and early 1990s.Available in English, (paper) ISBN 1-55775-462-4 Stock #S124EA

I'nited Germany: The First Five Years: Performance and Policy Issues, by Robert Corker, Robert A.Feldman, Karl Habermeiei; Huri Vittas, and Tessa van der Willigen. No. 125. 1995. vii + 74 pp.This paper reviews economic and financial developments in Germany since its reunification nearly fiveyears ago and analyzes some critical issues that have featured prominently in the policy debate over thisperiod and are likely to continue attracting attention in the years ahead.Available in English, (paper) ISBN 1-55775-472-1 Stock #S125EA

The Adoption of Indirect Instruments of Monetary Policy, by a Staff Team headed by William E.Alexander, Tomds J.T. Balino, and Charles Enoch. No. 126. 1995. vi i i + 67 pp.This paper examines the experience of implementing indirect instruments of monetary policy. Theexperiences of country studies illustrate the variety of circumstances under which indirect instruments ofmonetary policy have been introduced. Case studies are presented for Chile, Egypt, Ghana, Indonesia,Mexico, New Zealand, and Poland.Available in English, (paper) ISBN 1-55775-489-6 Stock #S126EA

Road Maps of the Transition: The Baltics. Hie C/ecli Republic, Hungan. and Russia, by BiswajitBanerjee, Vincent Koen, Thomas Krenget; Mark S. Lutz, Michael Marrese, and Tapio O. Suavalainen.No. 127. 1995. v i i i + 70 pp.Four papers analyze the process of transition to a market economy in the Baltics, the Czech Republic, Hungary, and Russia throughearly 1995.Available in English, (paper) ISBN 1-55775-519-1 Stock #S127EA

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HOW can central banksbest establish the credi-bility of monetary

I policy? Devising a trans-parent framework for monetarypolicy, this article suggests,may be an effective way toachieve this.

Credibility is an essential element of monetarypolicy and can immensely increase its effec-tiveness. This is particularly true for a centralbank that is trying to bring about disinfla-tion—whether from moderate inflation ratesor from hyperinflation. If the central bank can

Can Inflation Targets HelpMake MonetaryPolicy Credible?

T I M O T H Y D . L A N E , M A R K G R I F F I T H S , A N D A L E S S A N D R O P R A T I

convince the public of its determination tobring about price stability, its task is mademuch easier, since it does not have to battleagainst the inflationary expectations, builtinto wage contracts and interest rates, thatcan make disinflation socially costly.

Building credibilityImportant as it is, credibility is elusive:

there is no obvious prescription for convincingfinancial markets and the public that the cen-tral bank is actually pursuing its stated goals.One obvious solution is for the central bank toestablish a track record: as the public watchesthe central bank pursuing consistently tightpolicies and sees inflation gradually comingdown, it comes to believe that low inflationwill prevail. This can take many years of hardslogging, though. Is there any way to acceler-ate the process—and thereby reduce the yearsof lost output and employment as the central

bank tries to achieve price stability in the faceof skepticism from the public and the markets?

The achievement of central bank indepen-dence is generally believed to enhance credi-bility, but how can the public be sure that anewly independent central bank would pursuedisinflationary policies? Perhaps one way acentral bank could build credibility is throughgreater transparency: clarifying its goals tothe public and the links between these goalsand its day-to-day policy actions—that is,establishing a monetary framework.

Intermediate targets. One kind offramework is based on intermediate targets.For example, if monetary policy is orientedtoward keeping the exchange rate within anarrow band, this framework has three desir-able properties: (1) it provides a guiding rulefor monetary policy actions over the shortand medium terms; (2) achievement of theexchange rate target is consistent with

Timothy D. Lane,a Canadian national, is Deputy Chief of theSouthern European Division I in the IMF'sEuropean I Department.

Mark Griffiths,a UK national, is an Economist in the CentralEuropean Division II of the IMF's European IDepartment.

Alessandro Prati,an Italian national, is an Economist in theSouthern European Division I of the IMF'sEuropean I Department.



the longer-term goal of disinflation (providedthat inflation abroad is lower); and (3) thetarget and its link with monetary policyinstruments are transparent to the public,enabling the authorities' performance to beassessed continuously. As an alternative,some central banks have pursued money-supply targets, which offer other advan-tages—notably, under some circumstances,they may offer a better guide to price stability,and they are not as subject to testing by themarkets—although they are neither as closelycontrollable nor as directly observable as theexchange rate.

Many central banks have now lost theirintermediate targets. Many of those that hadbeen pursuing money-supply targets in theearly 1980s found that their ability to controlmonetary aggregates and to set appropriategrowth targets for them was weakened aseconometric estimates of money demand dis-integrated—as one central banker said, "Wedidn't abandon Ml—Ml abandoned us!"Market pressures forced some European coun-tries—Italy and the United Kingdom—toabandon their exchange rate bands inSeptember 1992, while some others—Finlandand Sweden—were forced to discontinue theirpolicies of shadowing the exchange rate mech-anism (ERM) of the European MonetarySystem. Monetary policy in all these countrieslost its anchor, leading to a quest for an alter-native monetary policy framework.

Inflation targeting. Several countries—including Canada, Finland, New Zealand,Sweden, and the United Kingdom—have cho-sen to target inflation itself. This entails, first ofall, setting a target—a quantified objective forinflation over the medium term. Setting such atarget might, by itself, have little effect on thepublic's expectations; it might very well be dis-missed as a pious wish. The key issues are,therefore, how to pursue this target and how toconvince the public that hitting the target is theforemost objective of monetary policy.

Since policy actions taken now do not affectinflation for several quarters, or even years,inflation targeting is necessarily forward-look-ing; merely reacting to the inflation alreadyexperienced would be a recipe for stop-go pol-icy. Therefore, inflation targeting, in practice,uses forecasts of inflation as the central policyvariable—tightening policy if inflation is pro-jected to be above target and easing policy ifinflation is projected to be below. Inflation tar-geting enhances transparency, including pub-lic monitoring of key information variables,and is designed to build credibility morequickly than an intermediate target. Usingsuch a framework sacrifices some of theobservability that can be achieved with anintermediate target but avoids the drawbacks

involved in focusing policy on one variable.Like an intermediate target, inflation target-ing may establish a clear standard againstwhich the monetary authorities can bejudged and may help them establish credi-bility more quickly.

Inflation targeting thus involves threesteps:

• setting targets for inflation (together withconditions under which the authorities shouldaccept deviations from these targets);

• forecasting inflation conditional on un-changed policies; and

• formulating and implementing changes inpolicy in response to deviations of forecastinflation from the target—possibly, as asubsidiary element, also taking account ofdevelopments in the real economy in theshorter term.

Inflation targeting in practiceIn countries that have adopted inflation tar-

gets, such targeting did not cause any sub-stantial change in the goals of monetarypolicy but did entail an increase in the trans-parency with which policy was presented tothe public. For instance, in the UnitedKingdom, periodic inflation reports were pub-lished, providing an inflation forecast basedon an array of indicators. For several centralbanks, inflation targeting has also broughtgreater accountability; most radically, thetenure in office of the Governor of the ReserveBank of New Zealand depends explicitly onwhether inflation targets are achieved. Someother features are common to most or all of thecountry cases this article discusses: inflationtargets are set for a time horizon of 2-3 yearsahead, based on the estimated lags in theeffects of monetary policy; and the inflationtargets are set as a range 2-3 percentagepoints wide, which reflects recognition of theimprecision of monetary control of inflationwhile giving the authorities a relatively well-defined goal. In most cases, the targets werenot adopted unilaterally by the central bank,but instead with a joint commitment by thecentral bank and treasury—although, in mostcases, the momentum to establish clear targetscame from the central bank.

In some countries (Canada and NewZealand), there is an explicit contingency pro-tecting the central bank from blame for miss-ing the target for reasons truly beyond itscontrol. At the same time, contingencies arelimited to avoid excessive accommodation ofinternal or external shocks—avoiding, forinstance, accommodating the inflationary con-sequences of excessive wage increases or fis-cal laxity. In other cases (Finland and theUnited Kingdom), an inflation measure is usedthat excludes such influences on the inflation

rate as mortgage interest or indirect tax pay-ments. (See box for further information oninflation targeting in New Zealand, Canada,and the United Kingdom.)

It is still too early to assess how inflationtargeting has worked in practice. Up untilnow, however, it has seemed to be a usefulapproach that might help build credibilitythrough greater transparency—provided it iscombined with a genuine commitment, on thepart of the central bank, to price stability thatis accepted by the government and by thepublic. It is a potentially promising approachthat should be considered by other countriesthat have no workable intermediate targets.

Issues in implementationApplying inflation targeting in other coun-

tries would require that several issues beaddressed. The solution to these issuesdepends on considerations that may differacross countries.

Time horizon. The horizon over whichthe target is pursued affects both the target'sattainability and its role in holding the centralbank accountable. Here, two elements are key:first, current monetary policy affects inflationwith a long lag; and second, monetary policynow affects inflation not just at a particulardate in the future, but over a longer period.This implies that inflation targets need to beforward-looking and cover a significant periodof time. Pursuing inflation targets for a rollingaverage of, say, the following two years wouldleave the authorities some scope for adaptingmonetary policy to changing economic condi-tions, as well as finding the appropriateadjustment strategy.

Form of target. Should the target be setas a range, as in most of the countries dis-cussed, or as a single number? A range ismore likely to be credible than a given figure,since there is virtual certainty that the centralbank will miss any absolute target. It is alsodesirable for the sake of accountability, sincethe range states the magnitude of deviationthat is considered tolerable. If a range isadopted, there is also the question of its appro-priate width, with a trade-off between havingtoo wide a range—which does not provide ananchor for expectations and provides a lessclear guide for policy—and too narrow arange—which would make outcomes outsidethe range more likely, thus making credibilityharder to achieve.

In some countries, there may be concernthat a target range may not provide an ade-quate focus for expectations and contracts. InItaly, for instance, the Government alreadyannounces official inflation targets, which areused as the basis for norms for governmentexpenditures as well as for wage contracts

Finance & Development /December 199b 21


Inflation Targets in New Zealand, Canada, and the United KingdomThree countries that have adopted inflation target-ing are New Zealand, Canada, and the UnitedKingdom. New Zealand's adoption of thisapproach was the most thoroughgoing. The 1989Reserve Bank Act defines the primary function ofthe Bank as formulating and implementing mone-tary policy with "the economic objective of achiev-ing and maintaining stability in the general levelof prices." This objective is made operationalthrough Policy Targets Agreements (PTAs) nego-tiated periodically between the Governor of theReserve Bank and the Minister of Finance. Thus,the Government retains power over monetary pol-icy objectives, while the Bank is given the free-dom it needs to meet these goals. Failing to meetthe target can lead to the Governor's dismissalbefore the end of a normal five-year term.

The PTAs are explicitly contingent on eventsbeyond central bank control (including majorchanges in indirect taxes, government-adminis-tered prices, the terms of trade, or a natural disas-ter), as well as the direct effects of mortgageinterest rates on consumer prices. In such circum-stances, the Reserve Bank is allowed to breach theinflation target, as long as it presents a plan thatensures that any overshooting of the inflation tar-get is temporary. Progress is monitored in the

Reserve Bank's Monetary Policy Statements,which are issued at least every six months andplaced on Parliament's agenda.

In Canada, price stability was made the opera-tional goal of monetary policy in February 1991,when the Minister of Finance and the Governor ofthe Bank of Canada jointly announced inflationtargets. This decision marked the culmination ofwidespread debate on the merits of price stability.The targets set a gradual downward glide forinflation. The 12-month rate of consumer priceindex (CPI) inflation was to be kept within a 2-4percent range by the end of 1992,1.5-3.5 percentby mid-1994, and 1-3 percent by the end of 1995.The 1-3 percent target has since been extendedthrough the end of 1998. Progress is monitoredregularly and, in particular, in the Bank ofCanada's Annual Report. As in New Zealand, anexception is made for the effects of changes inindirect taxes: the Bank of Canada would adjustthe inflation target to accommodate the "first-round" effects, but would counteract any "second-round" effects associated with increases in wagesintended to preserve after-tax real wages.

The United Kingdom's adoption of inflation tar-gets was prompted by sterling's departure fromthe exchange rate mechanism of the European

Monetary System. The Chancellor of theExchequer announced that retail price inflationexcluding mortgage payments (RPIX) would bekept within a 1-4 percent range and brought intothe bottom half of that range by the end of thecurrent Parliament (April 1997 at the latest).Monetary policy transparency was enhanced: theBank of England's quarterly Inflation Report pre-sents a comprehensive assessment of inflationarypressures, as well as the inflation forecast onwhich it bases policy advice. Since the Treasury isofficially responsible for UK monetary policy,such advice is regularly presented at the monthlymeetings of the Chancellor and the Governor ofthe Bank of England. The UK Treasury publishesa monthly monetary report containing back-ground material for these meetings, and sixweeks after each meeting is held, the minutes aremade public.

In all three countries, inflation declined afterinflation targets were first announced. (See chart.)More recent experience has been mixed: in recentmonths, inflation has been rising in all threecountries, although it has remained well belowthe levels reached before the inception of infla-tion targeting.

Selected countries: inflation performance, 1989-95(percent)

Source: IMF, International Financial Statistics.Note: Vertical lines show the dates of announcement of the first inflation targets in (a) New Zealand, (b) Canada, and (c) the United Kingdom.



nationwide. These targets as yet have nodirect bearing on monetary policy. There areconcerns that, if Italian monetary policyadopted inflation targeting using a targetrange around the official inflation objectives,wage settlements would be based on the topof the range, in the belief that this was themost likely outcome within the range. Thismay be a temporary difficulty, but it shouldnot be an insurmountable obstacle to inflationtargeting. The present incomes policy is not apermanent feature of the Italian economy. Inthe longer term, what will matter is whetherthe trade unions and general public reallybelieve that the inflation target is likely tobe achieved.

Contingencies. Another question iswhether the inflation target should be madecontingent on shocks affecting the economy,as, for instance, in Canada and New Zealand.There is also a good theoretical case for mak-ing a commitment contingent on events thatcan be readily observed: the central bank candeal with adverse shocks with less loss ofcredibility if it explicitly adjusts the targets todeal with such shocks, rather than simplyallowing slippage without explicit justifica-tion. Valid contingencies, subject to which thetargets could be revised might, for example,include oil price shocks or other uncontrol-lable changes in the terms of trade. However,it is important to put some restrictions on theuse of contingencies. One would be (as inCanada) to restrict the adjustment of the tar-get to cover only direct effects of the shockand not any secondary pass-through to wages.A second would be to give at most partialaccommodation for contingencies, such asadverse fiscal and wage developments, thatmay be influenced by monetary policy, sincefull accommodation would introduce a moral-hazard problem which would limit the centralbank's ability to brake inflation.

Modeling. Another issue in implementinginflation targeting is the design of the modelused to forecast inflation. If monetary policyis to react to deviations of inflation from thetarget, the direction, extent, and timing of thisreaction are key—and these depend criticallyon the model of the economy used by the cen-tral bank. Paradoxically, given most centralbanks' responsibility for price stability, theeconometric models used by many centralbanks provide little analysis of the monetarytransmission mechanism, which would indi-cate when and how monetary policy affectsinflation. For example, the Bank of Italy'smainstream quarterly econometric modelallows almost no influence of monetary policyon inflation for a given exchange rate, and theexchange rate is taken as external to themodel. These shortcomings should be reme-

died, insofar as is possible, to increase themodels' usefulness in guiding monetary pol-icy in pursuit of inflation targets or, indeed,any macroeconomic objectives.

To a certain extent, though, modeling diffi-culties are inherent: it is difficult, even in prin-ciple, to pin down the monetary transmissionmechanism within an econometric structure,given the potential multiplicity of channelsthrough which monetary policy may have itseffects and the importance of expectations indetermining its impact. This considerationsuggests a role not only for building biggerand better macroeconometric models but alsofor consulting a range of different models,especially simpler models such as reduced-form, VAR, or P-star models. Simpler modelsfrequently imply a tighter link between mone-tary policy and inflation than can be traced inmore complex models.

The policy cycle. A clear monetary pol-icy framework should specify the cycle of pol-icy decisions and announcements—what isdecided, when, and by whom; and what infor-mation is released. A monetary frameworkcould, for instance, specify a timetable as fol-lows: targets would be announced annually.Official inflation forecasts could then be madethree or four times a year, as in those countriesthat have already adopted inflation target-ing—a compromise between very frequent,and therefore costly, forecasts and policy re-evaluations, with perpetual shifts in course,and very infrequent forecasts, which wouldnot allow the authorities to revise policy in thelight of new information.

Information variables. Combined withthe inflation forecasts would be projections ofa set of economic variables whose value overthe coming months is predicted by the samemodel used to forecast inflation. These mightbe divided into three categories: for the first setof variables, the closest thing to intermediatetargets in this approach, monitoring rangescould be set at each forecasting round for thefour-month horizon until the next round.Money and credit aggregates—for example,Ml (currency plus checking account deposits)and the public sector borrowing require-ment—would seem to be good candidates forinclusion in this category. Monitoring rangesfor these variables would be set to be consis-tent with projections derived from the samemodel generating the inflation forecasts thatare the ultimate target of policy. Bands, orranges, around this target would be set wideenough to be attainable but narrow enough toprovide some guidance to policymakers—thatis, for the monitoring ranges to be relevant, itshould sometimes happen that variables gooutside their monitoring ranges, occasioning apolicy adjustment. These monitoring ranges

might be announced to the public, in part togive the latter a benchmark against which toevaluate the central bank's performance inpursuit of its stated inflation objective.

A second set of variables would consist ofindicators that would be monitored weekly ormonthly. For these variables, the central bankwould set a reference level associated with theinflation forecast judged to be consistent withthe attainment of the inflation target. De-viations of indicators from their reference lev-els would then be a focal point in the monthlyreview of policy. Indicators might includemoney and credit aggregates other than thoseselected as intermediate targets.

A third set of intermediate variables wouldconsist of indicators that can be monitored ona continuous basis; a short list would includethe exchange rate and current (short-term)and forward interest rates. These indicatorswould be incorporated in day-to-day andminute-to-minute policymaking, and wouldprobably not be announced to the public. Oneway of incorporating these short-term indica-tors would be in the form of a monetary condi-tions index, which would assign weights tokey indicators for use in policymaking. Use ofthis index would imply that a sign of easing inone variable—for example, a depreciation ofthe currency or a rise in forward interestrates—would signal the need for a rise inshort-term interest rates to permit the centralbank to maintain the same overall stance vis-a-vis the inflation target. However, this couldnot be done mechanically, since the appropri-ate response depends on the nature of theshock affecting the exchange rate for a giveninterest rate.

ConclusionBuilding credibility in the absence of an

obvious nominal anchor, such as an exchangerate target, and, often, in the face of uncertain-ties about fiscal and monetary policies is a keytask facing the architects of monetary policyin many countries. If a policy oriented towardprice stability can overcome the skepticism ofthe markets and the public, this will limit theadverse effects on interest rates, output, andemployment. A formal monetary frameworkbased on inflation targeting is one approachthat may be worth considering.

This article is based on the authors' paper "AnInflation Targeting Framework for Italy," IMFPaper on Policy Analysis and Assessment No. 95/4(March 1995).



Corruption,Governmental Activities,

and Markets

C ORRUPTION distorts therole of government andis costly to society.

I Governments can mini-mize the opportunities forindividuals to engage in corrup-tion by reducing the role of thestate in the economy.

Corruption comes in many shapes and forms.It is very difficult to define and, at times, evenmore difficult to identify. Here we shall simplydefine it as the intentional noncompliancewith the principle of "arms-length relation-ship," which states that personal or familyrelationships ought not to play a role ineconomic decisions by private economicagents or government officials. This principleis essential for the efficient functioningof markets.

The term corruption comes from the Latinverb rumpere, to break, implying that some-thing is broken. This something might be amoral or social code of conduct or, more often,

an administrative rule. For the latter to be bro-ken, it must be precise and transparent.Another element is that the official whobreaks the rule derives some recognizable ben-efit for himself, his family, his friends, his tribeor party, or some other relevant group.Additionally, the benefit derived must be seenas a direct quid pro quo for the specific act of"corruption." This simple description revealsseveral potential difficulties.

First, there must be evidence that a particu-lar rule has been broken. This requires that allthe rules be precisely stated, leaving no doubtabout their meaning and no discretion to pub-lic officials. But what about cases where rulesare not precise or where bureaucrats arespecifically given some discretion? For exam-ple, legislation in many countries has left thegranting of tax incentives or import licensesto the discretion of officials. It is up to them todecide whether an investment or import is"essential" or "necessary" to the country.These officials are often the sole interpretersof what those terms mean. Thus, in a way,they are in a position of monopoly, since theycan grant or deny these permits and the per-mits cannot be obtained from other sources.

But are rigid rules the answer? Over theyears, there has been a lot of controversy

V I T O T A N Z I

among economists on whether economic pol-icy should be guided by precise rules orwhether it should have an element of discre-tion. Evidently, the greater the element of dis-cretion, the greater the possibility that itmight be used to someone's (rather than thepublic's) advantage. Thus, the simplest courseto prevent corruption might be to create pre-cise and rigid rules. But, of course, some rulesmay be created just to give some governmentofficials the power to benefit from their appli-cation. Often, it is precisely the excess of rulesthat creates a fertile ground for corruption.Furthermore, if rules are too rigid, they cancreate obstacles to the smooth functioning ofthe economy or a particular organization.

Second, when social relations tend to beclose and personal, it may be difficult to estab-lish a direct link between an act that could beassumed to reflect corruption and a particularpayment for it (see box). An employee whouses his official position to favor acquain-tances—say to help them get a valuablelicense, a government contract, or a govern-ment job—may be compensated with animmediate or explicit payment (clearly abribe). Alternatively, he may be compensated,at a much later time, with a generous gift to hisdaughter when she gets married, or with a

Vito Tanzi,a US national, is Director of the IMF's Fiscal Affairs Department.



good job offer for his son when he completeshis studies. In other words, there may not beany direct, explicit, and immediate compensa-tion for the favor. The payment may be delayedin time and, when made, it may appear com-pletely unconnected with the favor received. Inmany cases, the "corrupted" and the "corrup-tor" may never even have discussed the pay-ment. It would simply be understood that afavor granted today creates a presumption oreven an obligation for a reciprocal favor tomor-row. In other words, it contributes to thegrowth of the giver's "social capital." In somesocieties, a "shadow market" for favors devel-ops with demand and supply and with implicitprices. This market often does not use moneybut trades in what could be considered theequivalent of lOUs. Implicit prices forfavors—and, possibly, even for futurefavors—are established. In this market, itbecomes very difficult to separate genuinefavors from those that are close to being bribes,and it is thus difficult to clearly identify bribesand punish those who receive or pay them.

This takes us to the third and final diffi-culty. In societies where family or other kindsof relationships are very strong, and espe-cially where existing moral or social codesrequire that one help family and friends, theexpectation that the public employee will rou-tinely apply arm's-length principles in his rela-tions with friends and relatives is unrealistic.

In these societies, the type of ideal bureau-cracy advocated by Max Weber will provevery difficult to install. In the Weberian ideal,bureaucrats would work within a set of princi-ples in which there is no place for personalrelations or cronyism and, above all, therewould be no confusion of public with privateinterests. Life in the real world, however, islikely to be very different. Centuries-old andwidely accepted social norms will often provemore powerful as guides to behavior than newand often imported rules based on arm's-length, impersonal, and universal principles.When this reality is ignored, disappointmentis likely to follow. This explains why somereforms imposed in developing countries, pro-moted by foreign advisors and which mayimplicitly require or assume arm's-length rela-tionships, often do not survive the test of time.

In these societies, the cost of the correctiverole of the government in the market is likelyto rise. Economic relationships within the pri-vate sector will also be affected, thus render-ing more difficult the establishment of awell-functioning market economy. To arguethat the personal relationships that come to beestablished between public sector employeesand individuals who deal with them reflect a"corrupt" society may be correct in a legalisticsense, but it misses the point that these rela-tionships simply reflect different social andmoral norms.

Economic consequences

The instruments that make corruption pos-sible are many. Important examples include:(a) administration of government regulations(such as the issuance of licenses and permits,and zoning and other sorts of regulations thatmay have great economic value); (b) fines foralleged or actual violations of legal norms;(c) control over government procurement con-tracts; (d) control over public investment con-tracts that can favor some areas or contractorsover others; (e) tax incentives, subsidized cred-its, and multiple foreign exchange rates; (f)controls over hiring and promotions; (g) con-trols over the assignment of entitlements andother benefits (disability pensions, scholar-ships, subsidies); (h) controls over access tounderpriced public services (such as electric-ity, telephone, and water); and (i) tax adminis-tration decisions (auditing, determination ofpresumptive income, etc.).

These examples are far from exhaustive.The greater the use of these instruments bya country, the greater the potential forcorruption. Control over these instrumentscan give government employees great power,which—given the right social environment,the right incentive systems, and weak anduncertain penalties—may allow them toextract large financial advantages (rents) forthemselves or for their families and friends.

Corruption: in the eye of the beholder?On January 25,1992, the Economist reviewed a paper by Prakash Reddy, anIndian social anthropologist who, reversing the common pattern of Westernscholars going to study developing countries' social behavior, obtained aresearch grant to study a village in Denmark. He spent a few months in thisvillage and registered his impressions of the relations among its inhabitants.Professor Reddy was amazed to observe that the villagers hardly knew oneanother. They rarely exchanged visits and had few other social contacts.They had little information on what other villagers, including their neigh-bors, were doing and apparently little interest in finding out. According toProfessor Reddy, even relationships between parents and children were notvery close. When the children reached adulthood, they moved out, and afterthat, they visited their parents only occasionally.

Professor Reddy contrasted this behavior with that prevailing in a typicalIndian village of comparable size. In the latter, daily house visits would becommon. Everyone would be interested and involved in the business of theothers. Family contacts would be very frequent and the members of theextended families would support one another in many ways. Relations withneighbors would also be close.

This story has implications for the concept of arm's-length and, in turn, forthe role of corruption. Arm's-length relationships in economic exchangeswould be much more likely to prevail in the Danish village than in the Indianvillage. In the latter, the concept of arm's-length relationships would seemstrange and alien. It would even seem immoral. The idea that, economicallyspeaking, one should treat relatives and friends in the same way as strangerswould appear bizarre. Relatives and friends would simply expect preferentialtreatment whether they were dealing with individuals in the private orpublic sector.

If a government were established in each of the two villages, with eachhaving a bureaucracy charged with carrying out its functions through theinstruments described earlier, it would be far easier for the Danish bureau-crats to approximate in their behavior the Weberian ideal than for the Indianbureaucrats. In the Indian village, the attempt to create an impersonalbureaucracy that would operate according to principles in which there is noplace for personalism, cronyism, etc., would conflict with the accepted socialnorm that family and friends come first. In this society, the governmentemployee, just like any other individual, would be expected to help relativesand friends with special treatment or favors even if, occasionally, this behav-ior might require bending, or even breaking, administrative rules anddeparting from universal principles. The person who refused to provide thishelp would be seen as breaking the prevailing moral code and would beostracized.

The Indian and Danish villages represent polar or extreme cases of howindividuals may interact within a community. Whether Professor Reddy'sdescription of them is accurate or not, they provide convenient polar cases.Most societies probably fall somewhere between these two extremes, withNorthern European and Anglo-Saxon countries closer to the Danish villagemodel, and many other countries closer to the Indian village model. TheAnglo-Saxon concept of privacy is probably just a manifestation of arm's-length relationships. Many developing countries would probably be closer tothe model represented by the Indian village. Sadly, the very features thatmake a country a less cold and indifferent place are the same ones thatincrease the difficulty of enforcing arm's-length rules that are so essential formodern, efficient markets and governments.



When civil servants appropriate, for theirown use, the instruments that the governmenthas at its disposal to influence the economyand to correct the shortcomings of the privatemarket, they reduce the power of the state andits ability to play its intended, and presumablycorrective, role. Assuming that governmentpolicies had been, or would have been, guidedby the traditional criteria that justify govern-mental action, corruption distorts the endresult in the following ways.

It distorts the allocative role of government:• By favoring taxpayers who, because of

the special treatment they receive from taxinspectors, are able to reduce their tax liabili-ties. The loser will be the market, which willfunction less efficiently.

• Through the arbitrary application of rulesand regulations. This may be particularlyimportant in the allocation of subsidized cred-its and import, zoning, and other permits. If,for example, these instruments had beendeveloped to assist genuine "infant industries"but ended up assisting others, the correctiverole of the government would be distorted,and, once again, the functioning of the marketwould be damaged.

• Through the allocation of public works orprocurement contracts to enterprises that wincompetitive bids not because they can do thejob at the lowest cost but because of their con-nections and the bribes they pay.

• Through the arbitrary hiring and promo-tion of individuals who would not have beenselected or promoted on the basis of fair andobjective criteria. The selection of these indi-viduals will damage the economy not onlybecause of the poor decisions and the numberof mistakes they make but also because of theresulting labor-market distortions—discour-aging more able but less well-connected indi-viduals from pursuing particular careers.

• Some individuals will try to get jobs not inthe areas in which they might use their partic-ular ability for productive use but in areas thatprovide scope for taking advantage of theirspecial positions. Such behavior, termed "rentseeking," will be stimulated by corruption.

Corruption distorts the redistributive roleof the government in myriad ways. If the wellconnected get the best jobs, the most prof-itable government contracts, the subsidizedcredit, foreign exchange at overvalued rates,and so forth, government activity is less likelyto further the goals of improving the distribu-tion of income and making the economic sys-tem more equitable.

Finally, in all its ramifications, corruption islikely to have negative implications for thestabilization role of the government, if thatrole requires, as is often the case, a reductionof the fiscal deficit. This will occur because

corruption will most likely raise the cost ofrunning the government while it reduces gov-ernment revenue. The allocation of disabilitypensions to people who are not disabled, thegranting of government contracts to peoplewho pay bribes to obtain them and thus raisetheir costs, and other corrupt practices thatdistort spending decisions increase the totalcost of providing government services. By thesame token, government revenue falls whenpotential tax payments are diverted or arenever collected. In some developing countries,the effective tax burden—that is, the ratio ofall tax-related payments made by taxpayers tonational income—may be significantly higherthan the official tax burden because some pay-ments end up in the pockets of tax inspectors.

Overall, corruption has a corrosive effect.The belief that everyone does it is likely tolead to a situation where many people, if noteveryone, will do it. As with tax evasion, imi-tation will prove to be a powerful force.

Policy implicationsSeveral factors determine the extent to

which corruption plays a significant role in acountry: (a) the role of the state and the rangeof instruments it uses in fulfilling that role;(b) social characteristics of the society (forexample, the extent to which arm's-lengthrelationships prevail in social and economicrelations); (c) the nature of the political sys-tem; and (d) the penalty system for acts of cor-ruption that are uncovered.

Especially in societies where arm's-lengthrelationships are unlikely to be enforceable(because of the close and continuous contactsamong closely knit groups of citizens who tendto personalize most relations), the larger therole of the state, the greater the probability thatits instruments will be used by public officialsand civil servants to favor particular groups inaddition to themselves. When this happens, thecost of government rises while the ability ofgovernment to correct the shortcomings of themarket falls. In other words, the effective con-trol that the government has over the economyis reduced. In this situation, the best policy fordecreasing corruption will be to reduce oppor-tunities to engage in it by scaling down thegovernment's role in the economy. Both thedemand for, and the supply of, corruptive prac-tices can be contained by a sharp reduction ofthat role in all its aspects, such as spending andtaxing activities and, especially, issuing andenforcing economic regulations.

When corruption in the Weberian sensecharacterizes modern states, it can be reducedby increasing penalties on those who engagein it; by increasing the transparency of therules, regulations, and laws; and by strength-ening controls on civil servants. However, in

more traditional societies, this option, whilestill worth pursuing, is not likely, by itself, togive very positive and, especially, permanentresults. History is full of examples of cam-paigns against corruption (and against taxevasion) that started with great fanfare butdid not accomplish much over the long run.By the same token, one should not officiallysanction corruption by, for example, reducingthe wages of civil servants on the assumptionthat they are getting payments under thetable. Unrealistically low wages always invitecorruption and, at times, lead society to con-done acts of corruption. This is why repres-sion of public sector wages, if carried too far,is never a good policy.

Because social intimacy creates the environ-ment that promotes corruption, a policy thathas been effective in some cases (for example,tax administration) in reducing corruptionis that of forced and periodic geographicalmobility for civil servants, to remove themfrom the region where they have their closestsocial or family relations and prevent the for-mation of new relations. Some forms of socialrelations take time to develop, so that, for awhile, after a government official has movedto a new region or taken up a new function,such relations will not play a large role in thecontacts between bureaucrats and the citizenswho depend on them. Thus, periodic mobility,especially in a large country, could effec-tively reduce bureaucratic corruption.

ConclusionEconomists have developed elaborate and

elegant theories about the workings of marketsand the role of the public sector in those mar-kets. A normative role has been assigned to thegovernment to correct market failures. In recentyears, public choice economists have stressedthat, in addition to market failure, political fail-ure could result when political actions or theactions of civil servants are influenced by objec-tives other than the need to correct market fail-ures and to promote the public interest.

The more that real-life bureaucraciesdiverge from the Weberian ideal—the morethey are permeated by corruption—the lesscontrol the government will have over its pol-icy instruments and the less able it will be tocorrect the imperfections of the market. Inother words, the less legitimate and justifiedwill be the corrective role of the government.A scaling down of that role is likely to reducethe scope of corruption.

This article was derived from the author's paper,"Corruption, Governmental Activities, andMarkets," IMF Working Paper No. 94/99,August 1994.



THE INTERNATIONAL MONETARY FUND PRESENTS

International Monetary CooperationSince Bretton Woods

This comprehensive history, published jointly by the IMF and OxfordUniversity Press, was written to mark the fiftieth anniversary ofinternational monetary cooperation. From the establishment of thepostwar international monetary system in 1944 to how the frameworkfunctions in a vastly expanded world economy, historian Harold Jamesdescribes the tensions, negotiations, challenges, and progress ofinternational monetary cooperation. This narrative offers a global perspective on theevents and decisions that shaped the world economy during the past fifty years, xiii + 752 pp. 1996.

Available in English, (hardbound) ISBN 0-19-510448-X US$45.00.

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Crisis and Reform in Latin America:From Despair to Hope

Tells the story of Latin America's reforms from 1982 to 1994. Starting with the debt crisis of1982, it shows how a new consensus—spurred by failing traditional policies and pioneeringcountries—has emerged as nations have begun to stabilize their economies, open up to interna-tional trade, privatize and deregulate firms, and improve social security, all while seeking toreduce poverty and provide a social safety net.

Devotes particular attention to the recent Mexican currency crisis, the implications of the crisisfor Latin America, and the challenges facing the region in its aftermath and in the long term.

In the economic history of Latin America, unfortunate events have seemed to repeat themselvesendlessly. But the region's recent reforms are beginning to break this melancholy circularity. Inspite of the Mexican crisis, there are rays of hope in the story of reform told here—a story thatwill engage business people, policymakers, teachers, and students alike.

Published for the World Bank by Oxford University Press. 372 pages.ISBN 0-19-521105-7. Order # 61105 • $22.95

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Policies for AchievingSustainable Growth

in the Industrial CountriesROSPECTS for sustained economic

I growth in the industrial countrieslare generally good, especiallyI because inflation rates haveI remained well contained—in many

cases, close to their lowest levels since theearly 1960s. However, large budget deficitsand high structural unemployment rates arehobbling economic expansion in many coun-tries, according to the IMF's World EconomicOutlook, October 1995 (WEO). To fosterstronger, sustainable growth, industrial coun-tries should pursue fiscal consolidation andlabor market reforms more boldly.

Benefits of bolder adjustmentLowering fiscal deficits would reduce

demands on world saving and stimulate pri-

vate investment, and making labor marketsmore flexible would lower structural unem-ployment rates and contribute to fiscal consol-idation. Today's climate of growth withsubdued inflation (see chart) provides anexcellent opportunity to pursue these policyefforts more vigorously, which would improveproductivity and raise real incomes.

Unsustainable pension plans, rising health-care costs, distortionary subsidies, and overlygenerous indexing schemes have contributedto fiscal deficits in a number of countries.Governments need to restrain spending;some may also need to increase tax revenues.These efforts at fiscal consolidation shouldhelp stimulate private investment and otherinterest-sensitive components of demand.Industrial countries that successfully tackle

Long-term interest rates and consumer price inflationin the major industrial countries

Recent swings in long-term interest rates contrast with generally subdued inflation

Source: IMF, World Economic Outlook, October 1995.1 GDP-weighted average of ten-year (or nearest maturity) government bond rates for Canada, France, Germany, Italy, Japan,

the United Kingdom, and the United States.2 Percent change from four quarters earlier.


P


their budget deficits should be able to easemonetary conditions gradually withouttriggering more rapid inflation, and long-terminterest rates should decline. Labor marketreforms should include the reduction of pay-roll taxes and unemployment compensationbenefits and elimination of other labor marketrigidities.

If governments manage by the year 2000 tobalance their budgets and reduce structuralunemployment rates by 1-2 percentage points,the outlook would be considerably brighter, asshown in Table 1. Long-term interest ratescould drop by 1-2 percent; short-term interestrates would also likely decline as monetarypolicies reflected the improved fiscal environ-ment. Investment would therefore be stimu-lated, and the capital stock would grow faster,improving productivity and tending to reduceinflation. This tendency toward lower infla-tion, even with higher output, would be re-inforced by more flexible labor markets, bring-ing about a decrease in unemployment rates,which would improve fiscal positions. GDPwould be permanently higher. The short-termcosts of fiscal consolidation would be small,the long-term gains substantial.

Costs of policy slippagesA less attractive outcome, shown in Table 2,

is possible, however, if policymakers overreactto the recent softening of growth by inappro-priately relaxing both fiscal and monetarypolicies. Signs of sluggish growth havealready led to monetary easing in some coun-tries; there is also a risk of fiscal backslidingin several countries. The benefits of thisapproach would be fleeting, while the long-term costs would be high. GDP might rise atfirst, but inflation would soon pick up, requir-ing severe monetary tightening, while largerbudget deficits would boost long-term interestrates. Investment would thus be dampened.Higher interest rates in the industrial coun-tries could provoke capital outflows fromdeveloping countries and slow economicexpansion worldwide.

A switch to more expansionary policies isnot justified by the current economic outlookfor the industrial countries. The risk of reces-sion or persistently sluggish growth in NorthAmerica or Europe is small, and Japan shouldbe on the path to recovery in 1996. There arefew signs of inflationary pressures. By puttingtheir fiscal houses in order and improvingthe functioning of their labor markets, theindustrial countries could, in the next fewyears, embark on a path of stronger and moredurable economic growth.

Table 1

Benefits of policy reform in the industrial countriesSoft landing: balanced government budgets in five years

and reduced structural unemployment rates(percentage deviation from baseline unless otherwise noted)

1996-97 1998-99 2000-2001 Long run

Real GDPCapital stockInflation (GDP deflator) 1Unemployment rate

-0.40.20.50.2

1.50.9

-0.5-0.6

1.22.1

-1.0-0.9

2.35.5-

-1.0

Short-term interest rate 1 -0.3Long-term interest rate 1 -0.1Real long-term interest rate 1 -0.1

General government balance/GDP 1 0.8Government debt/GDP ' -1.7

-1.2-1.9-1.5

1.9-4.5

-2.2-1.9-2.0

3.4-9.3

-0.4-0.4-0.4

0.9-17.9

Contribution to real GDPReal government spending 1

Real consumption 1

Real investment 1

Real net exports 1

-0.6-

0.2-

-1.41.51.3-

-2.21.41.90.1

1.31.00.1

Source: IMF, World Economic Outlook, October 1995.Note: The simulation assumes that a gradual reduction in public debt stocks is achieved through cuts in real spending and

nondistortionary transfers. The fiscal consolidation is enough to achieve fiscal balance by 2000 but is not credibly viewed aspermanent until 1998. In addition, it is assumed that revenue-neutral cuts in unemployment compensation and labor taxesreduce the natural rate of unemployment by approximately 1.5 percent in Europe, more than 2 percent in Canada, and 1percent in the United States.

1 In percentage points.-: Indicates zero.

Table 2

Costs of policy slippages in the industrial countriesHard landing: easing of fiscal and monetary policies

(percentage deviation from baseline unless otherwise noted)

1996-97 1998-99 2000-2001 Long run

Real GDPCapital stockInflation (GDP deflator) 1

Unemployment rate

0.8-0.21.9

-0.6

-0.5-0.80.9

-0.2

-1.0-1.5-0.10.4

-1.7-5.3--

Short-term interest rate 1

Long-term interest rate 1 0.9Real long-term interest rate 1 0.5

General government balance/GDP 1 1.4Government debt/GDP 1 0.5

1.21.01.2

-2.54.5

1.40.60.7

-2.18.8

0.30.30.3

-0.59.9

Contribution to real GDPReal government spending 1

Real consumption 1

Real investment 1

Real net exports 1

0.60.4

-0.3

1.0-0.5-1.0

1.0-0.9-1.1-0.1

1.0-1.6-1.0

Source: IMF, World Economic Outlook, October 1995.Note: The simulation assumes that the growth rate of money increases by approximately 2 percent a year in 1996 and

1997 before returning to its baseline rate of growth. It is also assumed that fiscal policy is eased so as to increase debtstocks by about 10 percent of GDP, phased in gradually over five years. It is assumed that these policy changes are knownin 1996 and consequently are reflected in expectations. The estimates for the long run represent the permanent effects ofthe shocks.

1 In percentage points.--: Indicates zero.

This article is based on the World Economic Outlook, October 1995, prepared by IMF staff.



R U P E R T P E N N A N T - R E A A N D I A N G . H E G G I E

| HYnot bring roadsinto the marketplace,

I put them on a fee-for-\ service basis, and

manage them like a business?

mRoad transport is the dominant form of trans-port in sub-Saharan Africa. It accounts for 80to 90 percent of the region's passenger andfreight movements and provides the onlyaccess to most rural communities. By the endof the 1980s, Africa had nearly 2 million kilo-meters of roads, after a surge of constructionduring the 1960s and 1970s by African gov-ernments and foreign donors seeking to meetthe region's enormous need. Little was done tomaintain these roads during the 1980s andearly 1990s, however, and years of neglecthave left them badly damaged.

This situation is not peculiar to roads.Buildings, ports, dams, and irrigation schemeshave all suffered from the same kind of neglect;

the importance of maintenance has been over-looked in budgets in favor of other political pri-orities. In 1988, in an attempt to reverse thedamage to road networks, which constituteone of Africa's largest assets, the World Bankand the donor community launched the RoadMaintenance Initiative (RMI) (Box 1).

Because the neglect of roads and otherphysical infrastructure has such deep roots,the RMI has taken a fundamental, long-termapproach: procedures cannot be changed untilattitudes have changed. The task of changingattitudes begins with two steps. First, thecosts of inadequate maintenance must beestablished; second, the group with the powerto decide how much should be spent on roadsneeds to be enlarged to include the people whoactually use the roads.

The cost of neglectThere have been many studies to identify

the costs bad roads impose on an economy. InAfrica, where congestion is rarely a problem,even in cities, these costs are more likely to berelated to the damage suffered by vehicles anddelays resulting from the need to drive slowly

because of potholes and other road-relatedproblems. A study carried out by road haulersin Zambia in 1992 estimated that potholedroads boosted vehicle operating costs by atleast 17 percent a year. Neglect is also expen-sive at an aggregate level. In 1993, the RMIestimated that Kenya's $40 million shortfall inroad maintenance expenditure increased vehi-cle operating costs by about $120 million peryear. The lesson: when roads are poorly main-tained, a $1 increase in road maintenancereduces road transport costs by up to $3.

Poor road maintenance also results inincreased long-term costs of maintaining theroad network. Over a 15-year period, thesecosts are about one third higher when roadsare rehabilitated infrequently than they wouldbe with regular road maintenance.

In many African countries, responsibilityfor roads is divided among half a dozen min-istries and a number of local governmentagencies. Roads are managed like a social ser-vice instead of as part of a market economy.There is no clear price for using them; roadexpenditures are financed from general taxrevenues; and the agencies that manage roads

Rupert Pennant-Rea,a UK national, is a consultant. He was Editor of the Economist, 1986-93, andDeputy Governor of the Bank of England, 1993-95.

Ian G. Heggie,a UK national, is Principal Infrastructure Economist and Task Manager for theRoad Maintenance Initiative in the World Bank's Africa Technical Department.He was Special Adviser to the UK Transport Minister in 1979-80.


Commercializing Africa's Roads


are not subjected to rigorous market disci-pline. Management objectives are vague.Managers have few incentives to cut costs andare rarely penalized for poor performance.

Funds allocated for maintenance are wellbelow what is needed. In most countries, theyare less than half of estimated require-ments—and, in some, less than a third. Thereare two main reasons. First, road users payvery little for use of the road network. Second,funds are allocated as part of the annual bud-get process—maintenance is at a disadvan-tage here, since it can always be postponed.

The people who know most about the costsof neglect are not government officials, butroad users, who have to cope every day withthe deteriorating condition of Africa's roads.By creating road-management boards toinvolve road users in the decision-making pro-cess, the RMI introduced an important com-mercial element that had been strikinglyabsent: the customers' point of view. It turnedout that customers were keen that moreshould be spent on maintaining the road net-work. And this was not idle talk—they wereprepared to pay more themselves. They hadonly one proviso: whatever form their extrapayment took, it should be earmarked formaintenance. And users also wanted to beinvolved in choosing the means to this end,helping to decide how much to pay and over-seeing how the road agencies and road fundsspent their budgets.

The theme that permeates every aspect ofthe RMI program is that of a more commercialapproach—the language of customers, mar-

The Road MaintenanceInitiative

The RMI was launched by the United NationsEconomic Commission for Africa (UNECA)and the World Bank in 1988, under the aus-pices of the Sub-Saharan Africa TransportPolicy Program, in an effort to identify theunderlying causes of poor road maintenancepolicies and develop an agenda for reformingthem. The program is administered by theWorld Bank's Africa Technical Departmentand is financed by the Governments ofDenmark, Finland, France, Germany, Japan,the Netherlands, Sweden, Switzerland, and theEuropean Union. Finland, France, Japan, andNorway provide senior staff members to workon the program.

Cameroon, Kenya, Madagascar, Tanzania,Uganda, Zambia, and Zimbabwe joined theRMI in 1990-91. Other countries that are alsocurrently receiving assistance from the pro-gram include Benin, Ghana, Lesotho, Malawi,Mozambique, and Togo.

kets, tariffs, procurement practices, and valuefor money being applied to the maintenanceand management of roads. Many of the bene-fits of the marketplace can be replicatedwithin the RMI framework, even though theRMI is not a privatization initiative (it does notenvisage transferring the ownership of roadsfrom the state to private companies). Instead,what the RMI is promoting is a public-privatepartnership.

Four building blocksThe RMI framework is comprehensive, so it

cannot be easily or quickly put in place. Thekey concept is commercialization: bring roadsinto the marketplace, put them on a fee-for-

Fuel levies are closely related to variableroad maintenance costs1

Source: Ian G. Heggie, Management and Financing of Roads.1 an Agenda for Reform, World BankAfrica Technical Series, No. 275 (Washington, 1995).

Note: Diesel fuel levy at $0.09/liter.1 Based on data from a selection of developing countries that do not have any extremes of climate.

service basis, and manage them like any otherbusiness enterprise. However, since mostroads will remain in government handsfor some time to come, commercializationrequires changes in four important areas:

• involving road users in the managementof roads;

• securing enough money for road mainte-nance, year after year;

• ensuring that all parties know what theyare responsible for; and

• establishing a system for managing roadprograms, with clear accountability.

The four are interconnected. The financingproblem cannot be solved without the strongsupport of road users. But this support cannotbe won without steps to ensure that resourcesare used efficiently. And resources will not beused more efficiently until ways are found tocontrol monopoly power and constrain roadspending to what is affordable, and manage-rial accountability is increased. Furthermore,managers cannot be held accountable unlessthey have clearly defined responsibilities.These building blocks have far-reachingimplications and could be applied to other sec-tors in Africa.

Economic, fiscal perspectivesDoes the concept of commercialization make

sense from an economy-wide viewpoint?It is impossible to dispute the economic case

for spending more on maintaining Africa'sroads. Road maintenance and rehabilitationprojects typically produce economic rates ofreturn well over 35 percent. The harder ques-tion is how the money should be raised.

As a general fiscal rule, earmarking of taxrevenues is undesirable. It can lead to a seri-ous misallocation of resources, with certaintypes of spending being boosted merelybecause they have a supporting base of ear-marked taxes while others languish becausethey have no convenient sponsor and aredenied access to the earmarked revenues.

To avoid the earmarking trap, road pro-grams must be financed as much as possibleby user fees rather than by taxes. This distinc-tion is not purely semantic. User fees linkwhat is available for spending to what is beingdemanded and can be calibrated so that indi-vidual customers pay only for what they con-sume. The cost of a road is not just the price ofits initial construction. Maintaining it througha long life is just as important and needs to beproperly costed into any calculation. If userspay according to how much of the road



The Sub-Saharan Africa Road InformationNetwork (SSARIN)

they "consume," the financingarrangements are qualitativelydifferent from a conventionalbudgetary model in which gov-ernments raise general rev-enues and spend them on achosen menu of programs.

On a spectrum of financingoptions, with user fees at oneend and taxes at the other,roads can fortunately bepushed far toward the user-feeend. License fees can be higherfor heavy vehicles than for cars.Fuel levies are closely related tovariable road maintenancecosts (see chart). And tolls areeven more precisely linked touse, though they are harder toadminister. Revenues earnedfrom these three financingmechanisms, which together would constitutea road tariff, could be funneled directly into aroad fund for spending on maintenance aswell as on new construction. This type offinancing makes it possible to impose thevaluable discipline of a hard budget constrainton road agencies. Road-management boards,which set the road tariffs, ensure that roadagencies can spend only what road users arewilling to pay and, hence, what road fundscan supply. Agencies will thus be forced to beresponsive to the needs of road users and willbe unable to overspend.

Both these notions are consistent with thebroad principle of commercialization. But it isa principle that needs extending beyond theissue of macroeconomic probity, importantthough that is. Being commercial is usuallyassociated with the most micro aspects ofbehavior, such as incentives given to individ-ual staff members. Here, too, the RMI uncov-ered some serious weaknesses in the way roadprograms were being run. For example, itfound that, in 1993, engineers in Zambia couldearn eight times more in the private sectorthan in the public sector. Not surprisingly, theroad agency had only 11 professional andtechnical staff members—and 85 vacancies. Itis difficult for road agencies to correct theseflaws, so long as they are seen as inflexiblebureaucracies offering uncompetitive salaries.The problem of uncompetitive salaries isparticularly troublesome in AnglophoneAfrica.

The RMI also uncovered flaws in the wayroad funds were set up and financed.

The RMI program found that sharing experience on best practices was one of thebest ways of introducing new ideas and building consensus. Initially, RMI staffregularly visited participating countries and gave presentations on experiencegained under the RMI program in other countries. This was supplemented bystudy tours, newsletters, and annual meetings between RMI staff, country coordi-nators (individuals in participating countries formally designated to head a localsecretariat), and members of the donor community with an interest in roads.

The sharing of experience turned out to be so successful that the countries par-ticipating in the RMI program decided to formalize it by setting up a simple, fax-based information exchange network. Each country wishing to join the networkmust have two things: a working fax connection and a designated country coordi-nator.

SSARIN currently has more than ten members. I. Kimambo, the RMI countrycoordinator from Tanzania, is Secretary of the Network, which is managed by asmall committee consisting of the Secretary and the country coordinators fromKenya and Uganda. SSARIN reports on progress every six months in the Sub-Saharan Africa Transport Policy Program newsletter published by the WorldBank's Africa Technical Department and is planning to start a newsletter of itsown. Since fax connections in Africa are problematic, the management committeeis exploring the feasibility of connecting SSARIN to the Internet.

users getting value formoney? At the heart of theRMI's agenda is the creationof a surrogate form of marketdiscipline to ensure that roadsare managed like a business,not a bureaucracy.

Because the credibility of these funds de-pends on their being genuinely independent ofday-to-day pressures on government finances,the RMI encourages African countries to setup special boards to manage road funds, witha majority of non-official members represent-ing road users and the business community,an independent chairman, clear terms of refer-ence, and independent outside audits. Thegoal is to avoid the fate of the Central AfricanRepublic's fund, which was raided by theGovernment in 1993 to pay the salaries of civilservants and other unrelated expenses.

It is also possible for road funds to raisemore money than should ideally be spent onroads. This is what happened in the 1980s inSouth Africa, whose road fund was receivingas much as one third of the pump price of fuel.The fund built up a big surplus. This led toconcern that the roads department might goon a spending spree, which eventually led tothe fund's being abolished in 1989. MostAfrican countries are still far from sufferingproblems of excess revenues, but SouthAfrica's example demonstrates the dangers ofan inflexible system for raising revenues. Toavoid this, all road funds set up under the RMIprogram have built-in mechanisms for regu-larly adjusting the road tariffs.

A road fund managed by a representativeroads board offers many other advantages.Road users, accustomed to market disciplinein the private sector, expect clear lines ofresponsibility and sound business practices.They are concerned by two questions, in par-ticular: who is being paid for what, and are

Sharing experienceOne of the strengths of the

RMI program is the way ithelps countries learn fromeach other. Disseminating thelessons learned in differentcountries was originally doneby word of mouth andthrough study tours, but theprocess has now been formal-ized into an informationexchange network (Box 2).Donors, too, are deeply

involved in supporting the RMI program, andoften have experiences to share. The world'stwo biggest economies, the United States andJapan, have road funds financed by earmarkeduser fees. New Zealand also has a road fundand has gone further in commercializing itsroads than any other country in the world.Finland, Japan, New Zealand, and the UnitedKingdom have road boards that participate inthe management of roads. By pooling theirknowledge, all countries involved in the RMIprogram can find cost-effective solutions morequickly than they could through conventionalbilateral contacts.

This is the justification for the WorldBank's role in administering the RMI pro-gram. Although the Bank has long been asso-ciated with large investment projects, itsfuture may now lie less in the construction ofnew roads than in providing technical assis-tance and facilitating sustainable maintenancepolicies. Under the RMI, the Bank is acting asan impresario, helping others to make thingshappen. That task may not make headlines,but it is important—and the RMI's approachseems to be working.

This article is based on a more extensive study byIan G. Reggie, Management and Financing ofRoads: An Agenda for Reform, World BankTechnical Paper No. 275, Africa Technical Series,Washington, DC, World Bank, 1995.

32 Finance & Development /December 199b


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Can Eastern Europe's Old-Age Crisis Be Fixed?L O U I S E F O X

N THE transition econ-

\ omies of Eastern andCentral Europe, the high

I tax rates required tofinance existing pension systemsare impeding efforts to promoteeconomic growth and improveresource allocation. This articleexamines the difficult choicesinvolved and suggests ways inwhich a better balance betweenincome security and long-termfiscal sustainability mightbe achieved.

The transition from central planning to amarket orientation in the former centrallyplanned economies of Eastern and CentralEurope (ECE) has not been easy. Since theBerlin Wall fell, these countries have faceddeclining incomes, inflation, and unemploy-ment. One of the biggest obstacles to restoringstable growth and increasing saving andinvestment has been persistent fiscal deficits,caused in part by rapidly growing expendi-tures on pension benefits.

Eastern and Central Europeans spendmuch more on pensions than their incomesor demographics would predict (see chart).These expenditures have been rising rapidlysince the transition began, with an increasingshare of these countries' falling GDPs beingcaptured by pensioners. In many countries,pension expenditures are the largest singleitem in the government budget, accountingfor about 15 percent of GDP in Polandand Slovenia, and 10 percent in Bulgaria,

Hungary, Latvia, and the Slovak Republic.Unlike in Organization for EconomicCooperation and Development (OECD) coun-tries and middle-income developing coun-tries—where funded, privately managedprograms cover a growing share of thework force—ECE countries have only public,pay-as-you-go (PAYG) pension systems fi-nanced entirely by payroll taxes from theirworking populations (see Estelle James,"Averting the Old-Age Crisis," Finance &Development, June 1995; two related articleson pension reform that appear in the sameissue; and Kathie Krumm and others,"Transfers and the Transition from CentralPlanning," Finance & Development, Sep-tember 1995). Under central planning, thestate was able to finance these expendituresthrough high tax rates. In market economies,however, these high tax rates are dysfunc-tional and increasingly inequitable. How didthis crisis come about?

Louise Fox,a US national, is a Senior Economist in the Municipal and Social Service Division, Country Department IV of the World Bank's Europe & Central AsiaRegional Office.


I


Pension spending in selected transition, OECD,and middle-income economies

Sources: Louise Fox, "Old Age Security in Transition Economies," World Bank, Policy Research Department WorkingPaper No. 1257, February 1994; World Bank, Averting the Old Age Crisis: Policies to Protect the Old and PromoteGrowth, Oxford University Press, New York, 1994.

1 1991.

Under central planning, the command econ-omy promised cradle-to-grave income secu-rity, including pensions replacing roughly 80percent of wages upon retirement. This hasbeen viewed as compensation for relativelymodest wages during the working years.Retirement ages were set very low, with lotsof exemptions and special privileges. As aresult, the average effective retirement age inthe ECE countries is currently about 57 formen and 53 for women, compared with 65 and67 for most OECD countries. Despite recentdeclines in health indicators, the average post-retirement life span in most Eastern andCentral European countries is still longer thanin most OECD countries. In other words, thesecountries, with much lower incomes and tax-collection capabilities, have promised pensionbenefits whose accumulated value after the

retirement period is higher than some of therichest countries in the world (many of whichare now finding their own generous welfaresystems unaffordable). Aging societies in bothOECD and ECE countries imply that the fiscalburden will only become heavier in the future.

Fixing this problem involves, first and fore-most, a strong effort to convince the popula-tion of the need for reform. This effort must becombined with plans for a new, economicallyviable system that is affordable, equitable, andpromotes growth. Key elements of this planwill have to include reforms of the public pen-sion system, such as increasing the retirementage (either through incentives or legal limits,or both), removing the inequitable and costlyspecial regimes for favored occupations andother groups, tightening up disability regula-tions, and developing privately managed,

funded pension systems, in order to take thepressure off the PAYG pension systems in themedium term.

Early mistakesThe policy measures many ECE countries

took to cope with the social costs of transitionhave significantly worsened the financial posi-tions of their public pension systems. In hopesof reducing unemployment, some countriesallowed workers to retire up to five years ear-lier than usual and still receive a full pension.This well-intentioned move swelled the ranksof pensioners while reducing the ranks of tax-payers. Since pension benefits are reduced ifthe pensioner continues to work, most quit theformal sector to work in the informal sector.Today, an estimated 50-70 percent of pension-ers continue to work during the first decade oftheir "retirement," but most of their income isoutside of the tax net. Although the averagepension in ECE countries is only about $15-25per month, recent results derived from surveyresearch show that most pensioners are notpoor and have not suffered disproportionatelyduring the transition.

It is working families with children whotend to be poor. To pay for social insurancebenefits, countries raised payroll taxes from10-25 percent of employees' gross wages to40-60 percent. This substantial differentialbetween the cost of labor to firms and employ-ees' take-home pay has lowered real wagesand probably exacerbated unemployment.Many working-age people have fled these taxrates by moving out of the formal sectorentirely (with up to a third of them employedin the informal sector in some countries), leav-ing the burden of paying for pension benefitsto those who cannot evade taxes.

Shock therapy?In its study, Averting the Old Age Crisis,

the World Bank argued that the best way formost countries to meet their populations'needs for income security is by setting up amultipillar pension system that includes thefollowing elements:

• pillar 1: a mandatory PAYG public pen-sion system designed to provide an incomefloor for all elderly persons;

• pillar 2: a mandatory privately managed,funded pension system—that is, one whosecurrent reserves are equal to or greater thanthe present value of all future pension pay-ment liabilities, based on personal accounts(the Latin American approach) or occupa-tional plans (the OECD approach); and

• pillar 3: a voluntary system (also fundedand privately managed), with strong govern-ment regulation, to provide for additional sav-ing and insurance.


Percentage of population over 60


Missed opportunities for pension reform

Although Estonia, Hungary, Lithuania, and Polandall began their transitions with similar, Soviet-stylesystems, they have taken different paths to pen-sion reform over the past five years. Nevertheless,the medium-term prospects of all of them are com-promised by large implicit pension debts.

Missing the boat in Central Europe. BothHungary and Poland started their transitions withfavorable initial conditions for pension reform.Possibly as a result of these more favorable condi-tions, the seriousness of the problem was notgrasped and hard decisions on pension reformwere not taken. On the contrary, the policy choicesmade have exacerbated their problems.

Poland began the transition with a system thatprovided for higher retirement ages than those ofall other ECE countries—60 for women and 65 formen—which should have been an advantage dur-ing the transition period. However, throughout thestabilization period (1990-92), the retirement agewas lowered as an "employment-generating" mea-sure. During this period, the number of pension-ers grew by more than 10 percent per year. Polandalready had a lax disability policy—in 1989, therewere almost as many disability pensioners as old-age pensioners. At the same time that Poland'sratio of pensioners to contributors (dependencyratio) was increasing, pensions were indexed towages, starting when real wages were at theirlowest point since the transition began. Today,Poland spends a higher percentage of GDP onpensions than almost any other transition econ-omy—approximately 16 percent in 1995, which isroughly 50 percent higher than the correspondingshare of GDP of an OECD country with compara-ble demographics.

Six years into the transition, Hungary has alarge fiscal deficit and a large pension debt.Unlike some other countries, Hungary has notraised the retirement age. Legislation to equalizethe minimum retirement age for women and men(at 60) was passed in 1992 but rescinded later the

same year. Early retirement has been on theincrease since 1989, and the growth rate of dis-ability pensions has doubled since the transition.Given that Hungary has the highest payroll taxesof all the ECE countries, payroll tax evasion isgrowing. Today, each Hungarian contributor sup-ports two thirds of a pensioner. If the retirementage in Hungary were similar to that of the OECDaverage, pension expenditures would be about20 percent lower.

Incomplete reforms in the Baltics.Estonia and Lithuania have avoided the early mis-takes made by their southern neighbors. Facedwith demographics and labor-market dilemmassimilar to those of Hungary, Poland, and theBalkan countries, these two Baltic countries didnot permit pension expenditures to get out of

hand during the initial transition period. Bothcountries introduced flat-rate pensions and discre-tionary nominal pension adjustments as stabiliza-tion measures. Early retirement was not used tofacilitate the shedding of workers in the state sec-tor. Reformed public pension systems were intro-duced in 1993 (Estonia) and 1994 (Lithuania).Nevertheless, despite their success in controllingcurrent expenditures, both countries face the same

dilemma—how to cope with looming fiscal prob-lems owing to incomplete reforms, on the onehand, and increasing voter discontent with thepublic system, on the other. Although these twocountries have taken the politically painful step ofcutting PAYG entitlements, their failure to capital-ize on these cuts by introducing a funded schemeor addressing the remaining problems in the sys-tem may have undercut efforts to boost economic-growth.

Lithuania still spends a smaller share of GDPon pensions than any of its neighbors. But therecent reform of its public system included cre-ation of an earnings-related benefit, which isindexed to the average wage in the economy,implying that the pension burden grows as realwages grow. The system also allows credits fornoncontributory periods (such as time spent athome taking care of children). Retirement ageswere also raised rather slowly—by two monthsper year for men and four months per year forwomen. The law originally provided for increas-ing the retirement age—from 55 for women and60 for men—to 65 for both sexes, but subsequentlegislation halted this in 2009 at 60 for womenand 62.5 for men.

Estonia's reform of its public pillar raises retire-ment ages faster—by six months per year formen and women—from their former levels of 55for women and 60 for men, to maximums of 60 forwomen and 65 for men. But, in addition toLithuanian-style credits for noncontributory peri-ods, the Estonian system continues most of theentitlements to early pensions that prevailedbefore the transition, which entails an additionalcostly intragenerational redistribution. The dis-ability pension system is also weak—the numberof disability pensioners has jumped by 30 percentsince 1990. With Estonia's payroll taxes already at38 percent of gross payroll, the scope for increas-ing taxes in order to finance the looming liabilitiesis very limited.

Applying this multipillar approach is morecomplicated in ECE countries than in therecently reformed and currently reformingLatin American countries or in countrieselsewhere that are in the early stages ofdeveloping formal social security systems,owing to the ECE countries' large existingpension debts. Adding a funded pillar impliescapitalizing some of the future pension debtwhile continuing to service the current pen-sion liabilities.

This is similar to making payments for twohome mortgages at the same time—one onyour own house and one on your parents'

house. If your parents' house is small and yourincome is rising (which is analogous, forexample, to the situation in Chile during thepast decade), the payments are manageable. If,however, your parents' house is large and yourincome is low and/or shrinking, the burden onthe working generations will be high.

In the ECE countries, the pension debt islarge—about 1.5 times GDP. The large debt iscaused mostly by the large number of currentpensioners, for whom pensions must still bepaid for long periods out of current revenues,but also by the number of labor force partici-pants near the current, low retirement age.

Unlike a mortgage, however, the pension debtof ECE countries increases every year, despitethe payments made to pensioners during theprevious year. This is because demographictrends cause pension benefits to grow fasterthan GDP at current retirement ages.

Putting in place an additional funded pillarin a manner affordable to generations of cur-rent workers requires renegotiating the infor-mal agreement between generations embodiedin the current pension system—in effect, forc-ing the parents to pay part of the mortgage ontheir house by accepting lower pensionsand/or longer periods of employment before



retirement. This has proved to be difficult toachieve, however, since older workers knowthey will not benefit directly from the develop-ment of additional funded pillars.

Simulations prepared for ECE countriesshow substantial gains in the future accruingfrom a "shock-therapy" approach to pensionreform. The main shock required is a one-shot,three-to-five-year increase in the effectiveretirement age—to be achieved by taking themeasures recommended above. Payroll taxescould then be cut by at least one third. Part ofthe reduction in contributions made possibleby implementing these reforms could be usedto start a funded pillar, which would build upsavings in order to finance the retirement ofthe generations currently working. In returnfor accepting the increased retirement age,older workers could also be offered an actuari-ally fair structure in the PAYG system—whichrewards delayed retirement—and a partialwage indexation, which would allow workersover 50 to share in the benefits of the economicgrowth their sacrifices have helped to create.

Modest reforms to dateUnfortunately for most ECE countries, there

is not yet a consensus in favor of this type ofshock therapy. Indeed, most pensioners feelthey have already endured enough shocks.Raising the retirement age has been fiercelyresisted by the generation that suffered themost under central planning and politicalrepression. Even among today's workers, fewunderstand the full costs of the current systemin savings and economic growth terms. Nor domany of them understand that the only waythey can avoid the trap that their parents' gen-eration fell into—in which inadequate old-agesecurity for all was created by paying too lit-tle, too early, to too many people—is to reformthe system now. Reducing entitlements—anecessary condition for restoring a sustainablefiscal balance, as well as restoring incentivesfor efficient resource allocation—is no morepopular in transition economies than any-where else. Finally, recent banking systemcrises have made some countries hesitantabout the ability of capital markets to effec-tively intermediate funds.

The strategy in most ECE countries seemsto be to muddle through, hoping that aresumption of economic growth—includingreal wage growth—combined with the grad-ual increases in the retirement age that coun-tries have enacted or are about to enact (toabout 60 for women and 65 for men by about2020) and a policy of holding the value of pen-sions constant in real terms will resolve theproblem. Economic projections do not supportthis expectation. ECE demographic trendspoint to aging populations in these countries,

and as their baby-boom generations reachretirement age, existing pension systems willsimply not be able to support the entitlements,even in countries that have already imple-mented partial reforms (see box). In addition,the distortions and heavy fiscal burdensembodied in the current systems impede sav-ing and growth, implying that pension reformis a precondition for economic growth and notthe reverse. The experience of Hungary andPoland also suggests that the longer reformsare delayed, the harder the problems of pen-sion debt are to solve.

The path to successful reformMany ECE countries view West European

countries as models on which to base theirplans for transition to multipillar pension sys-tems. The latter countries' experience mayoffer ECE countries only limited guidancetoday, however, because, in Western Europe,the funded pillars were put in place whenpublic pension systems were young, econ-omies were growing rapidly, and much lowerbenefits were promised (for example, in theNetherlands, Sweden, Switzerland, and theUnited Kingdom). Thus far, none of the OECDcountries has needed to carry out a shock pro-gram (although some countries may come tothis if they do not implement reforms soon).What ECE countries can learn from OECDcountries is how to build the consensusneeded, in a democratic society, for reformof social policy. The experience of LatinAmerican countries that have reformed theirpension systems, such as Argentina and Peru,can also offer lessons for ECE reformers, sinceit demonstrates that radical reform is possiblein a democracy.

As in other key areas of ECE countries'transitions, progress on pension reform isunlikely to be made unless the authorities arewilling to take bold and innovative steps. (Theexperience of voucher privatization—a wholenew approach developed in ECE countries—isinstructive here.)

The proposed new Latvian system is onesuch model. The principal elements of thisproposed system are as follows:

• Improved incentives and a lighter fiscalburden. The existing pension debt (and thusthe fiscal burden) will be reduced by tyingbenefits in the public PAYG system completelyto contributions through adopting a "notionaldefined-contribution" approach. This involvesreducing promised benefits to those who retirebefore 65 to much less than the target of a50-60 percent replacement rate—that is, thepercentage of workers' average wages that arereplaced by their pensions—and increasingsubstantially the benefits for those who worklonger and continue to contribute. Favorable

treatment for special groups is also to be abol-ished, although those who have already begunto receive their pensions will not have themtaken away; and

• Increased savings resulting from introduc-tion of a funded pillar. By 2000 or so, the sav-ings from the reform of the first pillar willallow roughly one quarter of expected contri-butions to be channeled to the second, fundedpillar. These contributions will be held inreserve or invested by private managers.

Croatia is also developing a reform pro-gram involving a major reduction in benefitsfor future retirees and a proposed mandatorysecond pillar. In one version currently underdiscussion, the second tier would be financedinitially by privatization proceeds, whichwould allow it to have a wide coverage at anearly stage. Using privatization of governmentassets to pay off pension obligations is anoften-discussed idea in transition economies.However, it has not been used effectively todate, since it inevitably involves concentratingilliquid assets whose value is uncertain in thehands of the age group most in need of liquid-ity and income security. In Estonia, where pri-vatization vouchers were given to workers onthe basis of their years of service, pensioners'dissatisfaction with the weak voucher markethas created pressure to allow them to swapvouchers for an annuity—a potentially costlytransfer to this age group, given that vouchersare currently trading at less than 20 percent oftheir face value.

One important lesson drawn from othercountries is that a successful pension reformstrategy in an open political system must offersomething to most of the key stakeholders.Systemic reform, including the creation of amultipillar system, does this by offering theworking generations more generous futurepensions in return for increased savings.Systemic reform could also benefit older gen-erations by offering them more secure pen-sions in the future. But the starting point forchange has to be a recognition that thepromises made by the centrally planned sys-tem cannot be honored and that attempting todo this will ensure a slower and more painfultransition to a robust market economy.

This article is based on the author's study, "OldAge Security in Transition Economies," WorldBank, Policy Research Department Working PaperNo. 7257, February 1994.

Suggestions for further reading: World Bank,Averting the Old Age Crisis: Policies to Protect theOld and Promote Growth, Oxford University Press,New York, 1994.



Quantifying the Outcomeof the Uruguay Round

G L E N N H A R R I S O N , T H O M A S R U T H E R F O R D , A N D D A V I D T A R R

empirical model, theauthors quantify the

I welfare benefits of theUruguay Round. Their resultssuggest that because industrialcountries liberalized the most,they stand to gain the most fromthe agreement in the short run.However, in the long run, thegains to all countries would bemuch larger, and virtually allregions are expected to gain.

How large are the global welfare benefits to bederived from the Uruguay Round agreement?What are the quantitatively most importantaspects of the Round? How are developingcountries affected by the Round? Are therecountries or regions that will lose from theRound and, if so, why? Subject to a statisticalmargin of error, our study (see box) found thatthe world as a whole will gain substantiallyfrom the reforms agreed under the UruguayRound: about $96 billion annually in the shortrun and $171 billion in the long run. However,the short-run gains are concentrated in de-veloped countries, especially in Japan, theEuropean Union (EU), and the United States.

This outcome reflects the fact that theindustrial countries, especially the UnitedStates and the EU, "gave up" the most in theUruguay Round. In other words, these coun-tries are modifying policies that are verycostly, in terms of forgone welfare, to them-selves, most notably distortionary agricul-tural policies and the import quota protectionin textiles and apparel afforded through theMultifiber Arrangement (MFA), which is to bedismantled. In contrast, under the UruguayRound agreement, the developing countriesreduce agricultural distortions relatively less(although the reduction of production subsi-dies is important in some cases) and do notrestrict imports under the MFA. The only gen-eral exception is that developing countriesreduce protection in manufactures by morethan Organization for Economic Cooperationand Development (OECD) countries, since thelatter now have relatively lower protection, onaverage, in this area.

In fact, some developing countries will benet losers from the Uruguay Round in theshort run. These short-run losses derive pri-marily from two effects. First, the reduction ofagricultural subsidies in the member countriesof the EU and the European Free TradeAssociation (EFTA), and the United Statesresults in terms of trade losses for some coun-tries. Second, MFA liberalization induceslosses for some developing countries becausethe elimination of the MFA quotas will reducethe prices received by all exporters to OECDcountries (this is known as capturing the quotarents), and less efficient developing countryclothing exporters will lose market share.

What developing countries can do toimprove their relative position is to limit self-inflicted costs by reducing their trade barriersand other distortions further. The post-Uruguay Round world presents a more openglobal trading environment. Unilateral tariffreduction or the reduction in other distortionsin developing countries will lead to a changein developing countries' production andexports based on comparative advantage, andthe export expansion that follows is less likelyto be impeded by global protectionism.Moreover, in the long run, higher income lev-els are expected to result in gains for almostall countries that lose in the short run. Thissuggests that all countries at least have thepotential to gain from the Uruguay Round.

Results of the studyThe Uruguay Round is a complex agree-

ment that includes:

The modelGiven the complexity of the Uruguay Roundagreement, the study by the authors used a 24-region, 22-commodity model of world trade toquantify the impact of the Uruguay Round.This model is considerably more disaggre-gated than other models and presents resultsfor many more regions and countries. For athorough discussion of the data and themethodology used in the study, see theauthors' discussion paper (cited below under"Suggestions for further reading").

Glenn Harrison,an Australian national, is Professor of Economicsat the University of South Carolina.

Thomas Rutherford,a US national, is Assistant Professor of Economicsat the University of Colorado.

David Tarr,a US national, is Principal Economist in theInternational Trade Division of the World Bank'sInternational Economics Department.


SING a large-scale

U


Manufacturing Complete Complete reformAgricultural sector Uruguay as a percentage

reform MFA reform reform Round of GDP

Short-term Long-term Short-term Long-term Short-term Long-term Short-term Long-term Short-term Long-termeffect effect effect effect effect effect effect effect effect effect

Australia 0.7 0.9 0.0 0.1 0.5 2.3 1.2 3.3 0.4 1.1New Zealand 0.3 0.5 0.0 0.0 0.1 0.9 0.4 1.4 1.0 3.6Canada 0.3 0.2 0.9 1.0 0.1 1.3 1.3 2.6 0.2 0.5United States 1.8 3.2 10.0 9.2 1.2 13.7 13.3 26.7 0.2 0.5Japan 15.1 16.8 -0.6 -0.5 2.2 6.2 16.9 22.7 0.5 0.6

Korea 4.6 5.2 -0.5 -0.4 0.7 2.7 4.8 0.5 1.5 2.5European Union 2 28.3 26.4 7.6 7.8 3.0 14.9 39.3 0.9 0.6 0.7Indonesia 0.2 0.3 0.6 0.9 0.6 1.4 1.3 2.6 1.1 2.1Malaysia 1.2 2.2 0.1 0.3 0.7 2.6 1.8 5.0 3.3 8.8Philippines 0.7 1.1 0.0 0.2 0.4 1.1 0.9 2.4 1.6 4.4

Singapore 0.6 0.5 -0.2 -0.2 0.5 0.4 0.9 0.7 2.1 1.7Thailand 0.8 1.4 0.1 0.8 1.8 10.3 2.5 12.6 2.1 10.9China -0.5 -0.8 1.0 1.7 0.9 1.2 1.3 2.0 0.3 0.5Hong Kong 0.6 0.6 -1.7 -1.5 -0.1 -0.2 -1.2 -1.1 -1.4 -1.1Taiwan Province of China 0.0 0.0 -0.4 -0.3 0.8 1.3 0.4 1.1 0.2 0.5

Argentina 0.4 0.7 0.0 0.1 0.3 1.6 0.7 2.3 0.3 1.0Brazil 0.3 0.1 -0.0 0.1 1.2 4.0 1.4 4.3 0.3 1.1Mexico -0.0 0.7 -0.1 0.2 0.3 1.4 0.2 2.3 0.0 0.7Latin America 1.5 2.0 -0.5 0.3 0.3 3.2 1.3 4.7 0.4 1.7Sub-Saharan Africa -0.2 -0.5 -0.0 -0.1 0.1 0.2 -0.3 -0.7 -0.2 -0.4

Middle East and North Africa -0.3 0.1 -0.4 0.2 0.8 1.9 -0.3 1.5 -0.1 0.3Eastern Europe 3 -0.1 -0.0 -0.5 -0.3 0.8 2.3 -0.2 1.2 -0.1 0.1South Asia 0.3 0.2 0.9 1.9 3.1 5.3 3.7 6.7 1.0 2.0Other European countries 2.2 1.6 -0.2 -0.8 1.7 7.0 4.2 8.8 0.3 0.7

Developing countries (total) 9.9 13.9 -1.5 3.4 12.9 40.5 19.4 55.2 0.4 1.2Industrial countries (total) 48.7 49.8 17.9 16.9 8.7 46.3 76.7 115.4 0.4 0.6

World 58.6 63.7 16.4 20.3 21.7 86.8 96.0 170.6 0.4 0.7

Source: Authors' calculations.Note: The first three headings represent the effect of each reform by itself. The fourth heading (Complete Uruguay Round) reports the welfare effects of all of the reforms combined.1 1992 dollars.2 Membership in 1994.3 Also includes the Baltic countries, Russia, and the other countries of the former Soviet Union.

• tariff reductions in manufactured prod-ucts;

• tariffication of nontariff barriers in agri-culture and binding commitments to reducethe level of agricultural protection;

• the reduction of export and productionsubsidies in agriculture;

• the elimination of Voluntary ExportRestraints (VERs) in textiles and apparel andthe elimination of the MFA;

• institutional and rule changes, such as thecreation of the World Trade Organization(WTO) and safeguards, as well as antidump-ing and countervailing duty measures;

• new areas such as Trade-Related Invest-ment Measures (TRIMs), Trade-Related As-pects of Intellectual Property Rights (TRIPs),and the General Agreement on Trade in Ser-vices (GATS); and

• areas receiving greater coverage, such asgovernment procurement.

Our study evaluated the changes in the firstfour of these areas. To the extent that there areadditional benefits (or, possibly, costs) fromUruguay Round changes in the other areas,our findings may underestimate (or overesti-mate) the gains from the Uruguay Round.

Our results suggest that the world as awhole stands to gain about $96 billion annu-ally, and that the gains in dollar terms areconcentrated in the developed countries, espe-cially in the EU, Japan, and the United States,which gain $39 billion, $17 billion, and$13 billion annually, respectively, from thechange (see Table 1). Nevertheless, somesmaller countries also gain significantly:Malaysia gains 3.3 percent of GDP, Singaporeand Thailand about 2.1 percent of GDP each,and the Republic of Korea and the Philippinesabout 1.6 percent of GDP each.

Since our model is the most geographicallydisaggregated one available, we produce

results for a number of countries and regionsnot otherwise available. On the one hand,although developing countries as a whole gainfrom the Round, a few developing regions areestimated to lose, on balance, in the short run.Countries in sub-Saharan Africa would loseabout 0.2 percent of GDP annually, while forcountries in the Middle East and North Africa,the effect would be slightly negative (a loss of0.1 percent of GDP). On the other hand, thestudy by Frangois and others finds that thecombined Africa and Middle East region willgain from the Uruguay Round, owing largelyto beneficial terms of trade effects resultingfrom the Round's reduction of manufacturingprotection. While developing countries gainless overall than industrial countries, theopposite would be true if we considered onlythe reduction of protection in manufacturing,since industrial countries have relatively lowerprotection, on average, in this area. Compared


Welfare effects of the Uruguay RoundTable 1


All Export Production Importdistortions1 subsidies subsidies distortions

Australia 0.7 0.1 0.1 0.4New Zealand 0.3 0.1 0.1 0.1Canada 0.2 0.0 0.3 -0.1United States 1.7 -0.0 1.5 -0.1Japan 15.2 -2.2 -0.5 17.7

Korea 4.6 -0.2 -0.0 4.7European Union 2 28.5 11.5 17.8 -1.2Indonesia 0.2 -0.0 0.1 0.1Malaysia 1.2 -0.0 0.1 1.2Philippines 0.6 -0.1 0.0 0.9

Singapore 0.6 -0.0 -0.0 0.6Thailand 0.7 -0.0 0.2 0.6China -0.6 -0.2 -0.1 -0.3Hong Kong 0.6 0.1 0.0 0.2Taiwan Province of China 0.0 -0.0 -0.0 0.1

Argentina 0.4 0.1 0.2 0.1Brazil 0.3 -0.0 0.2 0.1Mexico -0.0 -0.0 -0.0 0.1Latin America 1.4 -0.0 1.4 0.1Sub-Saharan Africa -0.3 -0.4 -0.1 0.3

Middle East and North Africa -0.4 -0.8 0.2 0.1Eastern Europe3 -0.2 -0.6 0.3 0.0South Asia 0.1 -0.0 0.1 0.0Other European countries 2.4 -0.6 2.1 0.5

Developing countries (total) 9.2 -2.3 2.4 8.8Industrial countries (total) 49.1 9.0 21.5 17.3

World 58.3 6.7 24.0 26.1

Source: Authors' calculations.1 Import distortions and export and production subsidies on agricultural goods.2 Membership in 1994.3 Also includes the Baltic countries, Russia, and the other countries of the former Soviet Union.

with the industrial countries, the developingcountries reduce agricultural distortions rela-tively less under the agreements (although thereductions in their production subsidies areimportant in some cases), and developing coun-tries do not restrict imports under the MFA.

MFA reform. In fact, countries such asthe members of the EU and the United Statesthat used import quotas under the MFA toprotect their home-market producers areexpected to gain from the removal of the MFA,while developing countries in the aggregateare estimated to lose. The reasons for this pat-tern are as follows. Countries that removeimport quotas can obtain more imports,which will drive down import prices for theirconsumers (thus capturing quota rents). Inaddition, they will experience efficiency gainsas they shift their productive resources intosectors where they have a comparative advan-tage. Net importing countries that do not con-strain imports under the MFA, such as Japan,will lose from MFA removal owing to a termsof trade loss. Net exporting nations shift their

sales to the previously constrained markets,such as those in the EU and the United States,and this diversion of sales drives up prices inmarkets such as Japan.

Among developing countries that are netexporters, the results vary. The most efficientsuppliers also typically gain, but their gainsvary substantially. These exporters suffer aterms of trade loss in the previously quota-constrained markets but gain on the terms oftrade in previously unconstrained marketssuch as Japan, and they also experience anefficiency gain from shifting more productiveresources into textiles and apparel where theypossess a comparative advantage. Most of themarginally inefficient suppliers among devel-oping countries lose, because they lose quotarents and, in the long run, lose market share tomore efficient suppliers in developing coun-tries. Without a change in their competitive-ness, that loss of welfare and market sharewill be larger in the long run.

Agricultural reform. A distinguishingfeature of our study is that we decomposed

the overall agricultural reform scenario intoits three major components (see Table 2):export subsidies, production subsidies, andimport protection.

Reducing agricultural export subsidieswould result in welfare gains for the EU of$11.5 billion. The principal food exportingnations—Argentina, Australia, Canada, andNew Zealand—gain slightly, whereas mostother countries lose. This component of agri-cultural reform was the one feared by the "netfood importing" countries, which expected tosuffer a terms of trade loss.

Regarding production subsidies, almost allof the economies included in the study have atleast some agricultural production subsidies.In some cases, such as grains in the MiddleEast and paddy rice in Korea, the subsidy isextremely high, although it is often paid on alow volume of output. Thus, the reduction ofthis production distortion produces benefitsfor most countries, although several net foodimporters of wheat and nonrice grains sufferlosses (Japan, Korea, Mexico, Singapore, sub-Saharan Africa, and Taiwan Province ofChina). The EU again enjoys substantial wel-fare benefits, with other European countriesand the United States enjoying the nextlargest, although considerably smaller, gains.

As for reducing import protection in agri-cultural products, the two dominant gainersare Japan and Korea, which is not surprisinggiven their extremely high level of agricul-tural protection. The other regions with rela-tively high agricultural protection also gain.The EU loses in this scenario because weassume that its export and production subsi-dies in agriculture are maintained. Hence, theadditional exports the EU countries wouldobtain from the reduction of import protectionin the rest of the world aggravate their alreadycostly export position.

Combining all effects, the EU gains over $28billion owing to the reduction of subsidies.Japan gains from the reduction of its highimport protection. Although China and someother developing regions lose small amounts,there are few overall losers, which is surpris-ing given the concern about losses of the netfood importing countries. This is explained bythe fact that most regions have something togain by reducing their own production subsi-dies and most also export some food, even ifthey are net food importers overall. Clearly,countries need to reduce agricultural produc-tion subsidies if they wish to avoid losses fromthis component of the Uruguay Round.

Dynamic effects. While the dynamicbenefits of trade liberalization and theUruguay Round are often described, they arerarely estimated. Our study estimated theseeffects, assuming a sufficiently long adjust-


Decomposing the welfare effects of agriculture reformTable 2


ment period so that the capital stock in eachcountry could readjust to its optimal "steady-state" level after the initial changes inducedby the Uruguay Round. The resulting calcula-tion may overestimate the potential welfaregains in a long-run neoclassical growthmodel, because forgone consumption toachieve the higher capital stock is not takeninto account; the model may underestimatethe long-run gains, however, since it fails tocapture endogenous growth effects such asthose arising from induced improvements inproductivity or innovation.

The results from our long-run, steady-statemodel appear in Table 1. The obvious differ-ence with respect to the short-run model isthat the global welfare gains from theUruguay Round rise from $96 billion to $171billion, nearly half a percentage point of worldGDP. Using this approach, the gains for devel-oping countries are striking—they rise from0.4 percent to 1.2 percent of total developingcountries' GDP. In addition, the Middle Eastand North Africa, as well as Eastern Europeand the Baltic countries, Russia, and the othercountries of the former Soviet Union are nowestimated to gain.

Comparisons with other modelsIn addition to our model, there are two

other general models that employ the actualchanges agreed in the Uruguay Round bythe Contracting Parties to the General Agree-ment on Tariffs and Trade (GATT): theGATT/WTO team of Frangois, McDonald,and Nordstrom; and Hertel, Martin,Yanagishima, and Dimaranan (see references),who used the GTAP (Global Trade AnalysisProject) model. Estimates of the gains fromthe Uruguay Round from all three of our mod-els were presented at a conference organizedby the World Bank and entitled "The UruguayRound and the Developing Economies" (heldJanuary 18-20, 1995, in Washington). Wheresignificant differences in the estimates exist,they may be intuitively explained. Indeed,subject to a statistical margin of error, what isremarkable is our ability to interpret the rea-sons for the differences and their broad consis-tency in terms of the overall benefits and therelative importance of various components.

In one of their earlier models, the GATTSecretariat estimated that the gains from theUruguay Round would equal about $510 bil-lion annually. This relatively high estimatewas obtained by projecting the world econ-omy forward to the year 2005 (when all theUruguay Round changes would be imple-mented). Given a much larger world economyin 2005, the same percentage cuts in tariffsand export subsidies, and the same percent-age gains expressed as percentages of GDP

yield larger absolute dollar gains. That is,even though the gains from the UruguayRound estimated in the GATT study are quitecomparable to the long-run estimates from ourstudy in percentage terms, the dollar value ofthe former is much higher owing to the size ofthe economy on which the tariffand export subsidy cuts are applied. In theirlater World Bank conference paper, theGATT/WTO authors estimate the impact ofthe Uruguay Round changes based on theeconomy of 1992, as we do; they then obtainestimated gains of $193 billion in their steady-state, increasing-returns-to-scale model, ratherthan $510 billion. There is nothing inherentlycorrect about using either 2005 or 1992 as thebase year of the model, but when the estimatesare in terms of dollars rather than percentagesof GDP, it is important to keep the year of theestimate in mind.

There have been earlier studies of theimpact of the Uruguay Round, including thatof Goldin, Knudsen, and van derMensbrugghe using the RUNS model. In gen-eral, earlier estimates were based on assumedformula cuts in tariffs and subsidies. Thesecuts were overly optimistic, especially withrespect to developing countries. Consequently,those authors who have updated their welfareestimates have revised them downward as itbecame apparent that the Round wouldachieve somewhat less than expected.

The estimate by the GATT/WTO team of$193 billion is comparable to our estimate of$171 billion, since both estimates wereobtained using models that evaluated theUruguay Round in a long-run steady statewith increasing returns to scale. In the staticor short-run version of their increasing-returns-to-scale model, these authors obtain$99 billion per year of estimated gains, com-pared with our estimate of $96 billion. That is,taking into account dynamic or steady-stateeffects roughly doubles the estimated gainsfrom the Uruguay Round in both of our mod-els. Model variants with lower elasticities pro-duce lower estimated gains in both models;but, given that the Uruguay Round will beimplemented over ten years, we do not reportestimates from low-elasticity versions.

Hertel and others have estimated the globalgains from the Uruguay Round at about$258 billion. Since they do not incorporatedynamic, steady-state, or increasing-returns-to-scale effects, the appropriate comparisonwith their model is our static constant-returns-to-scale model. But their estimatesare based on the world in the year 2005,and the projection of the world forward from1992 roughly doubles the dollar estimates.Even after adjusting for the forward projec-tion the estimates of Hertel and others

remain somewhat larger than ours. This isdue to two factors: they project that theMFA quotas will grow at a somewhatslower rate than the world economy, sothe gains from removing the MFA areslightly larger than those calculated usingour model; and they employ slightly larger(but plausible) elasticities.

The remaining differences between our esti-mates and those of the GATT/WTO andGTAP teams are not significant. The broadthemes emphasized elsewhere in this articleare quite similar across the models. In particu-lar, all the models indicate that those countriesthat liberalized the most gained the most. Thegains may be expected to be larger in the longrun when the capital stock can adjust, and theresponsiveness of firms and consumers toprice changes (as indicated by elasticities) willbe greater.

ImplicationsOur evaluation of the quantitative effects of

the Uruguay Round suggests that althoughthere may be some losers in the short run, inthe long run almost all countries will gain, andunilateral liberalization (both of tariffs and ofproduction distortions) can be implemented toensure that all regions can gain. In fact, ouradditional estimates for sub-Saharan Africaconfirm that it will gain substantially if itallows its exporters to capitalize on theimproved export opportunities presented bythe post-Uruguay Round environment. ••

Suggestions for further reading:Will Martin and L. Alan Winters (editors), TheUruguay Round and the Developing Economies,World Bank Discussion Paper No. 307,Washington, World Bank, 1995; Joseph F. Francois,Bradley McDonald, andHdkan Nordstrom (WTOteam), "Assessing The Uruguay Round," in Martinand Winters; General Agreement on Tariffs andTrade (GATT), "The Results of the UruguayRound of Multilateral Negotiations," Geneva,GATT Secretariat, November 1994; Ian Goldin,Odin Knudsen, and Dominique van derMensbrugghe, Trade Liberalization: GlobalEconomic Implications, Paris, OECD, andWashington, World Bank; Glenn Harrison,Thomas Rutherford, and David Tarr (World Bankteam), "Quantifying the Uruguay Round," inMartin and Winters; Thomas W. Hertel, WillMartin, Koji Yanagishima, and Betina Dimaranan(GTAP team), "Liberalizing Manufactures Trade ina Changing World Economy," in Martin andWinters; Merlinda Ingco, "AgriculturalLiberalization in the Uruguay Round: One StepForward, One Step Back?" Washington, WorldBank, 1994.



N I C H O L A S B U R N E T T , K A R I M A R B L E ,

A N D H A R R Y A N T H O N Y P A T R I N O S

MI LTHOUGHmany coun-\ tries have become con-vinced that they need toinvest more in human

capital, efforts to improve theireducational systems have fre-quently been disappointing. Inthis article, the authors suggestspecific steps that governmentscould take, in cooperation withthe private sector, to achieve amore efficient, equitable, andsustainable allocation of invest-ment in education.

In recent years, a global consensus hasemerged on the importance of investing inhuman capital, which is viewed as an essentialpart of efforts to raise incomes and achievesustained economic growth. The pace ofchanging technology, economic reforms, andthe rapid increase in knowledge have broughtabout more frequent job changes in individu-als' lives. This has created two key prioritiesfor education: it must meet economies' grow-ing demands for adaptable workers who canreadily acquire new skills, and it must supportthe continued expansion of knowledge.

Education is a sound economic investment.For individuals and families, education in-creases income, improves health, and reducesfertility rates. For society, investing in educa-tion raises per capita GNP, reduces poverty,and supports the expansion of knowledge.

For example, in 1960, only 7 percent ofGuatemala's children attended secondary

school. Had thatshare been 50 per-

cent, Guatemala'sper capita income today

would have been almost 40 per-cent higher than the actual outcome.

Numerous studies have shown that the mone-

tary returns on investment in education arewell above the 10 percent yardstick that is com-monly used to indicate the opportunity cost ofcapital. The returns on investments in primaryeducation are the highest (see chart).

Investing in education complements invest-ment in physical capital, and the benefitsderived from both are highest where macroeco-nomic policy is sound. Investing in educationsets off an intergenerational process of povertyreduction, because better-educated persons aremore likely to ensure the education of theirchildren. Massive investment in both primaryand lower secondary education—comple-mented by a pattern of growth that channelslabor into productive uses—was one key ele-ment in the East Asian development "miracle."Other countries, including India and Mexico,have come to this realization more recently andhave started to expand and reform their basiceducation systems extensively.

Progress and challengesThe economies of low- and middle-income

countries have been growing at historicallyrapid rates. Progress in education—expandedenrollments and longer schooling—has con-tributed to this growth and so has helped to

Nicholas Burnett,a UK national, is Principal Economist in theEducation Group of the World Bank's HumanDevelopment Department.

Kari Marble,a US national, is a Consultant in the EducationGroup of the World Bank's Human DevelopmentDepartment.

Harry Anthony Patrinos,a national of both Greece and Canada, is anEconomist in tlte Education Group of the WorldBank's Human Development Department.


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reduce poverty in developing countries. Forthe first time in history, most children at leaststart school. By 1990, 76 percent of the 538million children between the ages of 6 and 11in developing countries were in school, upfrom 48 percent in 1960 and 69 percent in1980. As a result of these gains, in 1990, anaverage 6-year-old child in a developing coun-try could expect to complete 8.5 years ofschool, up from 7.6 years in 1980. In EasternEurope and Central Asia, the norm is 9 or 10years of schooling. In East Asia, LatinAmerica, and the Caribbean, primary educa-tion is almost universal. Countries in SouthAsia, the Middle East, and North Africa arealso making steady progress in increasingprimary school enrollments, though SouthAsian countries lag considerably behind. Thenumber of expected years of schooling rose inthe 1980s in every region except Africa, wherethe gross enrollment ratio for primary schoolactually fell and 50 percent of 6-to-ll-year-oldchildren were not in school as of 1990.

The transition economies of Eastern andCentral Europe have high primary and sec-ondary enrollment ratios but need to adjusttheir entire education systems to better meetthe needs of a market economy. It is particu-larly important for these countries to main-tain funding levels for basic andupper-secondary education; to shift awayfrom overspecialization at vocational, techni-cal, and higher education institutions; and toreform the governance and financing ofhigher education.

Despite substantial achievements in theworld as a whole, major educational chal-lenges remain: to increase access in somecountries; improve equity; improve quality;and, where needed, speed reform.

Finance and managementPublic intervention in education can reduce

inequality, open opportunities for the poor anddisadvantaged, compensate for market fail-ures in lending for education, and make infor-mation about the benefits of education moregenerally available. But public spending oneducation is often inefficient and inequitable. Itis inefficient when it is misallocated amongcompeting uses; it is inequitable when quali-fied potential students are unable to enroll ininstitutions because educational opportunitiesare lacking or because of their inability to pay.Present systems for financing and managingeducation often fail to meet these challenges.Public financing, moreover, is becoming moredifficult to provide as enrollments expand.

Basic education ought to be the priorityfor public spending on education in countriesthat have yet to achieve nearly universalenrollment at the primary and lower-sec-

Social rates of return to investments in education 1

Source: George Psacharopoulos, "Returns to Investment in Education: A Global Update," World Development,Vol. 22 (1994), pp. 1325^(3.

1 Private rates of return are even higher than social rates of return because of the public subsidization of education. Percapita income levels of country groups, in US dollars per year, are defined as follows: low-income ($610 or less),lower-middle-income ($611-$2,449), upper-middle-income ($2,450-37,619), and high-income ($7,620 or more).

2 Not applicable.

ondary levels. Most countries are alreadyallocating the highest share of public spend-ing on education to primary schools. Publicspending on primary education generallyfavors the poor, but public spending oneducation as a whole often favors the af-fluent because of heavy subsidization of theupper-secondary and higher education levels,which usually have relatively few studentsfrom poor families.

There is no theoretically appropriate pro-portion of national income or public spendingthat should be devoted to education. Somecountries that spend very little on educationcould, of course, dramatically improve resultssimply by increasing public spending.In many countries, however, education couldbe improved with the same—or evensmaller—amounts of public spending byfocusing on the lower levels of education andincreasing internal efficiency, as has beendone in East Asia.

Finding additional moneyThe inefficiencies and inequities described

above, along with expanding enrollments inpublic schools at all levels, have helped toincrease the share of GNP devoted to publicspending on education. The result has beenincreasing pressure on public funds at a timewhen many countries, especially in EasternEurope and Africa, are experiencing generalfiscal difficulties. As enrollments increase,resources per student will decline, as will thequality of schooling unless public spendingbecomes more efficient.

Although measures to increase the effi-ciency of public spending on education canmake existing funds more productive, suchmeasures alone may not be enough. Somecountries have chosen to reallocate publicspending to education from other publiclyfunded activities, such as inefficient publicenterprises that can be run better by the pri-vate sector. Other countries have found ways,



within macroeconomic policy constraints, toincrease government revenues and thereby tospend more on education. For example, sev-eral Indian states increased their spendingon education from about 2.5 percent of statedomestic product in the mid-1970s to morethan 4 percent in 1990. Still other countrieshave sought to supplement public funds foreducation with private funds. In Asia, the morethat higher education costs have been financedthrough student fees, the broader the overallcoverage of the education system has been.

Private financing can be encouraged eitherto fund private institutions or to supplementthe income of publicly funded institutions.Although private schools and universitiestend to draw their students from moreadvantaged socioeconomic backgrounds, theynevertheless promote diversity and provideuseful competition for public institutions,especially at the higher levels of education.

Reorganizing educationMost education systems are directly man-

aged by central or state governments, whichput a great deal of effort into dealing withsuch issues as teacher salary negotiations,school construction programs, and curriculumreform. This central management, which oftenextends even to instructional inputs and theclassroom environment, allows little room forthe flexibility that leads to effective learning.

The main ways governments can helpimprove the quality of education are by set-ting clear and high performance standards incore subjects, supporting inputs known toimprove achievement, adopting flexible strate-gies for the acquisition and use of inputs, andmonitoring performance. Generally, however,these steps are not taken because they goagainst the grain of existing education spend-ing and management practices and areopposed by groups with vested interests.

Priorities for reformSix key reforms in education finance and

management, with priorities among themdepending on individual country circum-stances, will go a long way toward enablingcountries to meet the challenges of improvingaccess, equity, and quality, and will also accel-erate the pace of reform.

Giving education a higher priority.Because of its important role in enabling coun-tries to achieve both economic developmentand poverty reduction, education deserveshigher priority on governments' agendas—notjust those of their ministries of education. Thishas long been recognized in East Asia andis coming to be increasingly understoodelsewhere, particularly in Latin America.Education alone, however, will not reducepoverty; complementary macroeconomic poli-cies and physical investments are also needed.

Paying greater attention to out-comes. Educational priorities should be setwith reference to outcomes, using economicanalysis, standard setting, and the measure-ment of achievement through learning assess-ments. Governments need to look at the wholeeducational sector before setting priorities.Countries that have yet to achieve universalbasic education will need to pay attention toall levels of education, using economic analy-sis to guide their decisions about which invest-ments will have the greatest effect. Focusingon outcomes also entails the establishment ofperformance standards, particularly for pri-mary and general secondary schools, anddevelopment of a system of assessmentsto monitor what students are learning.Standards, curricula, and monitoring are mosteffective when they are directly linked throughappropriate incentives.

Emphasizing investment in basiceducation. A more efficient, equitable, andsustainable allocation of new public invest-ment in education would do much to meet thechallenges that education systems face today.Efficiency is achieved by making public-

investments where they will yield the high-est returns—usually in basic education.

Working to improve equity.Equity in education has two prin-

cipal aspects: (1) everyone'sright to a basic educa-

tion—that is, to acquirethe basic knowledge

and skills necessary to function effectively insociety, and (2) the government's obligation toensure that qualified potential students arenot denied education because they are poor orfemale, are from disadvantaged ethnic (includ-ing linguistic) minorities or geographicallyremote regions, or have special educationalneeds. At the lowest and compulsory levels ofeducation, equity simply means ensuring thatschools are available. Beyond that, it meanshaving fair and valid ways of determiningpotential students' qualifications for entry.

Achieving equity requires both financialand administrative measures. Financial mea-sures, such as scholarships, are important atall levels to enable the poor to acquire an edu-cation. Scholarships can cover fees and otherdirect costs, such as transportation, books,and uniforms and, when appropriate, cancompensate families for the indirect costs ofsending children to school—for example, lossof labor services for the household. Ad-ministrative measures can increase enrollmentof the poor, females, linguistic minorities, andstudents with special educational needs.Programs designed to demonstrate the impor-tance of educating children can increase thedemand for schooling among the poor. For lin-guistic minorities, bilingual programs andschools offering a choice of language ofinstruction are important, especially in pri-mary education.

Increasing household involvementby providing real choices. Around theworld, parents and communities are becomingmore involved in the governance of their chil-dren's schools. Effective involvement in schoolgovernance does not come about easily, how-ever, and training is generally advisable.Several countries have a long tradition ofparental choice, and increased experimenta-tion with school choice is now a worldwidephenomenon.

For choice to be effective, students must beable to choose from two or more possibleschools. Each of these should have some dis-tinguishing characteristics—for example, inregard to what aspects of the curriculum areemphasized; what teaching styles are used;and, at higher levels, what courses are offered.Finally, teachers need to enjoy considerable

autonomy concerning what andhow they teach, within limits

set by a broad national cur-riculum. The availability

of real choices giveseducational institu-

tions an incentiveto adapt to

demand.


Expanding schools' auton-omy. The quality of education canbenefit when schools have the auton-omy to use instructional inputsaccording to local school and com-munity conditions and are account-able to parents and communities.Fully autonomous institutions havethe authority to allocate theirresources (not necessarily to raisethem), and they are able to create aneducational environment adapted tolocal conditions inside and outsidethe school (see box).

Reliance on local funding must betempered with adjustments by higherlevels of government to compensatefor differing resource levels amonglocalities. Local control of resources need notimply local raising of revenues. The goal oflocal financing of schools should be to improvelearning, not to reduce overall resources.

Implementing changeIn all countries, entrenched ways of operat-

ing and vested interests will make change diffi-cult. Education is intensely political: it affectsthe majority of citizens, involves all levels ofgovernment, almost always makes up the sin-gle largest component of public spending indeveloping countries, and involves public sub-

Encouraging schools to be autonomousand accountable

Financial measures to encourage school and institutional autonomyand accountability can include the following:

• using local and central government taxation;• sharing costs with local communities;• allocating block grants to communities and schools without

putting restrictions on allocation of funds;• charging fees at higher levels of education;• encouraging revenue diversification;• using financing mechanisms in which money follows students,

such as capitation grants, vouchers, and student loans; and• providing funding to schools and universities based on output

and quality.

sidies that are biased in favor of the elite.Prevailing systems of education spending andmanagement often protect the interests ofteachers' unions, university students, elites,and the central government rather than thoseof parents, communities, and the poor. Thereare, however, strategies that can ease change.

Financing and management reforms arebest introduced in parallel with the expansionof educational opportunities. Sometimes thereforms themselves make for expansion—forexample, when prohibitions on the private sec-tor are lifted. Increased cost sharing in public

higher education is politically mostfeasible when it is linked to expan-sion of opportunities for higher edu-cation. Building a national consensusrequires stakeholders in the educa-tion system to participate in anational consultation mechanism,such as those developed in Boliviaand the Dominican Republic, wherereforms recommended by nationalcommissions (composed of stake-holders and all political parties) per-sisted through changes ofgovernment. Increasing the involve-ment of parents and communities bymaking schools autonomous andaccountable can offset the power ofvested interests; it is also critical for

increasing flexibility and improving instruc-tional quality. Careful design of reform mea-sures is necessary to avoid disrupting the vitallinks among education subsectors. An essen-tial, although often neglected, step is theprovision of appropriate resources and mecha-nisms to accompany policy changes.

This article is based on Priorities and Strategies forEducation: A World Bank Review, DevelopmentPractice Series, 1995, World Bank.

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Why Mcicroeconomists and EnvironmentalistsNeed Each Other

RONALD MCMORRAN AND LAURA WALLACE

macroeconomic and environ-mental policies. This willrequire macroeconomistsand environmentalists towork together.

Imagine a developing country—let us call it"Ecotopia"—where macroeconomic policy-makers care deeply about the environmentand environmental policymakers care deeplyabout the macroeconomy. Of course, the pri-mary job of each group is different:environmentalists must address the country's environmental problems, and macro-economists are responsible for achieving pricestability and balance of payments sustainabil-ity, to lay the foundation upon whichEcotopia's economy can grow. But they recog-nize that they have a great deal to gain, interms of sustaining and improving domesticliving standards, by working together.

At the moment, Ecotopia is threatened withimminent macroeconomic instability andsevere environmental degradation if it doesnot immediately undertake dramatic environ-mental and economic policy reforms. How willEcotopia fare when its policymakers simulta-neously tackle environmental and macroeco-nomic problems? Much will depend upon thewillingness of both groups not only to talk butalso to implement sound macroeconomic andenvironmental policies. Inaction by onegroup—or lack of coordination—is bound tohave effects on the ability of each group toachieve its primary objectives. Exactly whatthese effects will be, however, still remainsuncertain, largely because the links betweenmacroeconomics and the environment arecomplex and, as yet, not fully understood. Inan effort to explore those links, the IMF held aseminar on May 10-11, 1995, that wasattended by about 80 individuals from theIMF, the World Bank, academic institutions,and nongovernmental organizations (NGOs).This article draws heavily on the studies pre-sented and the discussions that ensued, in thehopes of sharing the insights gained withEcotopia's policymakers.

Economic effects of degradationEcotopia's environmental policymakers

know that if their country were a developed

one, it would have more resources to spend onenvironmental problems. Moreover, developedcountries generally have relatively well-func-tioning markets, adequate environmentalinfrastructure and institutions, well-definedand secure property rights regarding commu-nal resources, and well-structured andenforced environmental standards and regula-tions. Some even have environmental taxes(though these are not always adequate) forinternalizing environmental costs, and publicutility prices normally reflect long-term pri-vate (if not social) costs.

By contrast, many developing countries,like Ecotopia, must grapple with nonexistent,thin, or uncompetitive markets, inadequateenvironmental infrastructure and institutions,poorly defined and insecure property rights,poorly designed or enforced environmentalstandards, few (if any) environmental taxes,and public utility prices that do not reflecteven the long-term private costs. Thus, pricesfor environment-intensive goods and servicestend to be too low to reflect environmentalcosts in Ecotopia. Moreover, high rates of pop-ulation growth, acute rural and urban poverty,and the dependence of total output andexports on depletable natural resources typi-cally exacerbate the root causes of environ-mental problems—market, policy, andinstitutional failures. The most serious conse-

Ronald McMorran,a Canadian national, is an Economist in the IMF's Fiscal Affairs Department.

Laura Wallace,a US national, is a Senior Public Affairs Officer in the IMF's External RelationsDepartment.


O SUSTAIN and im-prove living standards,countries must simul-taneously pursue sound

D


Economists and environmentalists in one room: the Norwegian experimentGetting macroeconoraists and environmentaliststo talk to each other about policy options—prefer-ably in the same language—is no easy task. ButNorway seems to have found a way to do so, asStein Hansen, Director, Project for a SustainableEconomy, Norway, and Knut Alfsen, Directorof Research, Statistics Norway, reported atthe seminar.

Two years ago, the Ministry of Finance, theMinistry of Environment, and the NationalResearch Council launched an innovative studybased on initiatives taken by Friends of the Earthand Project Alternative Futures of Norway at thetime of the 1992 Earth Summit in Rio de Janeiro.The idea was to simulate the long-term environ-mental and economic impacts of imposing envi-ronmental demands on a small, open economy,thereby providing a basis for a dialogue amongtoday's decision makers on policy options thatwould affect future generations. The results wouldbe used to see how different Norway would lookby 2030 if the environmentalists were calling theshots, rather than the macroeconomists.

The simulation was accomplished by feed-ing the environmentalists' top 26 demands—suchas restraints on carbon dioxide and sulfur dioxideemissions, as well as on oil and gas into the long-run computable general equilibrium model usedby Norway's Ministry of Finance for its own long-run macroeconomic policy analysis.

This rather unusual approach to a dialogue wasmade possible by several features perhaps uniqueto the political economy of Norway. First,

Norway's wealth is, to a larger extent than anyother OECD country (except Iceland), based onhow it manages its natural resources (fish.tim-

ber, petroleum, and sources of hydropower).Second, Norway has a long tradition of makinguse of operational models in policymaking—acollaborative effort that brings together aca-

demics, the Ministry of Finance, and StatisticsNorway. Third, Norway's political traditioninvolves including different constituencies,especially NGOs, in environmentaldiscussions—part of a political process aimed atgenerating a consensus.

What did the Norwegians learn from this experi-ment about enhancing communication betweenmacroeconomists and environmentalists?

• A model that integrates the environment andthe macroeconomy offers an excellent way offocusing the debate between macro-economists and environmentalists because itoffers a common framework for analysis—forcingboth sides to see the linkages and, when neces-sary, face the trade-offs. This occurs because thetechnical analysis gives rough estimates of themagnitude of the changes in the level and struc-ture of output associated with alternative environ-mental control policies.

• It is preferable to integrate resource and envi-ronmental issues directly into existing macroeco-nomic policymaking tools—rather than dealingwith these issues in a separate exercise—as thisapproach gives environmental issues more promi-nence and forces policymakers to recognize thelinks between macroeconomic and environmentalobjectives.

quences of these failures are likely to be out-put and human capital losses.

Macroeconomy. Environmental prob-lems may directly affect the macroeconomicbalances—particularly external and fiscalones—sometimes to the point of threateningtheir viability and sustainability. On the exter-nal side, exports that lead to exhaustion ofnonrenewable natural resources (e.g., frommines) and of renewable natural resources(e.g., from forests and fisheries) without ade-quate replacement and renewal may seriouslyerode a country's future export base, forcing itto import primary products. On the fiscal side,revenues may be greatly reduced if output ofprimary exports declines because of soil ero-sion or other environmental degradation.

Over time, environmental degradation andnatural resource depletion can also affect themacroeconomy by leading to reduced output,which, in turn, can seriously reduce the rateof economic growth. Studies give abundantevidence of lost labor productivity resultingfrom ill health, forgone crop output fromagricultural soil degradation and erosion,lost fisheries output and tourism receiptsfrom coastal erosion, or lost soil productivityfrom deforestation.

Human capital. A growing body of epi-demiological studies suggests that air andwater pollution are taking a heavy toll, partic-ularly on people in the developing world,through ill health and premature mortality.Studies cited at the seminar by David Pearce,

Director of the Center for Social and EconomicResearch on the Global Environment,University College, London, indicate that "pol-lution control is not a 'luxury good' to beafforded after the development process has'taken off', but a prior requirement for sustain-able development."

Tackling degradationFaced with these potential costs, how will

Ecotopia's environmental policymakers tacklethe nation's environmental problems? It isimperative that they introduce policies thataddress the root causes of the problems.Environmental policy tools—designed withthe assistance of microeconomists with envi-ronmental expertise—could include establish-ing property rights for open-access resources,eliminating subsidies for environmentallydamaging goods or activities, introducingenvironmental user charges or pollution taxes,and establishing environmental regulations. Inpractice, a combination of policy instrumentsmay be most effective, and, of course, it wouldfall to the finance ministry to implement thetax and subsidy policies.

Clearly, Ecotopia's policymakers will wantto take the macroeconomic implications ofthese policies into account, although this willnot be easy, given the uncertainty still sur-rounding many of the links, particularly overthe longer run. A recent major Norwegianstudy, which brought macroeconomists andenvironmentalists together in an unusual

dialogue, looked at this issue by askingwhether Norway's economy would survivevery strict environmental policies, such as acarbon-emissions tax (see box above). Theanswer: yes, given sufficient time toadjust—say 40 years—albeit with lower, butstill significant, economic growth relative to aworld without a carbon tax.

The Norwegian study, which was presentedat the seminar, also highlighted the need foradequate environmental data compatible withexisting national accounts. Another seminarpaper, by IMF national accounts expertsAdriaan Bloem and Ethan Weisman, hasnoted that the idea of placing statistical cover-age of environmental concerns in a nationalaccounts framework now commandswidespread support. The United Nationsrecently completed a major revision of theSystem of National Accounts. Although coun-tries will not be required to fully integrateenvironmental concerns into their coreaccounts, it is suggested that they prepare"satellite" accounts denominated in bothphysical and monetary units. Already, severalattempts have been made at experimentingwith satellite accounts—notably in CostaRica, Mexico, the Netherlands, Norway, andPapua New Guinea, among others. Indicativeestimates suggest that conventionally mea-sured GDP may exceed GDP adjusted fornatural resource depletion and environmentaldegradation by between 1.5 percent and10 percent.



Comments by Stanley Fischer on the IMF and the environmentThe following is drawn largely from informalremarks made by IMF First Deputy ManagingDirector Stanley Fischer at a luncheon talk duringthe May 10-11, 1995, IMF seminar on"Macroeconomics and the Environment."

To a remarkable extent, the work of the IMF isstill guided by its original mandate, as spelled outin the Articles of Agreement. In 1944, the found-ing fathers charged the IMF with, among otherthings, facilitating "the expansion and balancedgrowth of international trade, and to contributethereby... to the development of . . . productiveresources" and helping member countries withtemporary balance of payments problems so thatthey do not have to adjust by "resorting to mea-sures destructive of national or international pros-perity." These goals are pursued primarilythrough balance of payments assistance and whathas come to be called surveillance.

Although the environment is not referred to inthe Articles of Agreement, it is clear that environ-mental issues must be taken into account in tryingto attain what the Managing Director often refersto as "high-quality growth"—that is, growth thatis sustainable, that brings improvements in livingstandards, and that does not mortgage the futurefor short-lived gain. For instance, natural resourcedegradation that threatens growth cannot beignored by the IMF. Taking account of such envi-ronmental concerns is just good economics.

How might environmental issues show up in

our dealings with member countries? Here are afew examples:

Developing countries. The economicgrowth strategy of a developing country thatrelies on depletable resources for current economicactivity has to be different from that of other coun-tries. Resources need to be used at an optimal rate,and provision needs to be made— through savingand investment—for the time when economicactivity cannot rely to such an extent on rawmaterials. Most obviously, these considerationsare paramount in the oil exporting countries, butthey are also important in other natural resourceexporting countries—for example, Kiribati builtup a reserve fund as it used up its stock of guano.

Economies in transition. For countriesswitching to a market-oriented economy, theopportunities for efficiency gains—throughrealigning prices, removing subsidies, and endingsoft budget constraints for state-owned-enter-prises—are enormous. The IMF can encouragethese countries to adopt policies that would serveboth the economy and the environment. Thesemight include, as a first step, adjusting energyprices to their market value, which the WorldBank has estimated could reduce atmosphericemissions of sulfur by up to 60 percent in Centraland Eastern Europe.

Industrial countries. In countries where ourefforts focus largely on surveillance, we can drawon the work by national governments, interna-tional organizations, and academics on country-

specific studies of the impact of environmentalpolicies and conditions on the macroeconomy (e.g.,proposed carbon taxes and common environmen-tal policies in the European Union), and bringthese to bear on our policy discussions.

There is no question, however, that environmen-tal issues tend to be of a longer-term and sectoralnature. Thus, it is generally up to the WorldBank—our sister organization—to take the leadon these issues. The Bank and the IMF cooperatein two key ways. First, in connection with some ofthe IMF's longer-term lending programs, we workclosely with the Bank to help countries preparepolicy framework papers, which often includemedium-term plans for addressing environmentalproblems. Second, together we assist countries indesigning public policy reforms that are support-ive of the environment.

Finally, green accounting is expected to helppolicymakers fashion better environmental andeconomic policies. For that reason, the IMF hasbeen supporting the work of the World Bank, theUnited Nations, and others to develop methodolo-gies for environmental satellite accounts that aug-ment conventional national accounts. This work isextremely useful and important in practice—in-deed, improved measurement has already shownin some cases just how significant environmentalfactors are in long-term growth.

Peter Bartelmus, of the UN's StatisticalDivision, which is charged with developingthe system of environmentally adjustednational accounts, argued at the seminar thatwhat is important is ensuring that the useof environmental resources is measured ina way consistent with conventional economicaggregates. At this stage, many outstandingconceptual and methodological problems,especially on valuation issues, remain. Evenso, seminar participants agreed that thisshould not prevent further efforts to devel-op satellite accounts, at least on an experi-mental basis.

Tackling economic problemsWhile Ecotopia's environmentalists address

environmental problems, its macroeconomistsmust pursue policies aimed at avoidingmacroeconomic instability. Instability canharm the environment, largely by distort-ing incentives to preserve environmentalresources or undertake investments in envi-ronmental protection. For example, high andvariable rates of inflation—which frequently

distort intertemporal choices concerning theuse of forests, mines, and other naturalresources—reduce the incentive to preserveresources, as producers and consumers act asthough they were facing high discount rates,thus ignoring the future. Macroeconomicinstability may also hinder the effectiveness ofenvironmental policies, as it may necessitatefrequent adjustments to environmental taxesand subsidies.

Thus, to the extent macroeconomic reformshelp control inflation, lower discount rates,and create stable macroeconomic conditions,they encourage decision makers to take alonger-term view and ensure that the rightprice incentives work to preserve environmen-tal resources.

If Ecotopia's policymakers were working ina "first-best" world, where environmentalresources were priced to reflect social costsand private decisions were based on socialcosts, they would need to worry little aboutthe environmental impact of macroeconomicpolicies. But our policymakers are working ina "second-best" world characterized by perva-

sive market, policy, and institutional failures.In such a world—as pointed out byIMF economists Ved Gandhi and RonaldMcMorran—macroeconomic policy reformscan have an adverse impact on the environ-ment, albeit only indirectly. However, it is thelack of sound environmental policies—not ofsound macroeconomic policies—that leads toenvironmental degradation.

Two World Bank economists, MohanMunasinghe and Wilfrido Cruz, reported thatstudies carried out by the World Bank andothers supported this conclusion. A study ofMorocco showed that trade liberalization ledto increased GDP, as exports became morecompetitive, resources were allocated moreefficiently, and household incomes and con-sumption grew. But the expansionary effectsof liberalization would also lead to increaseduse of scarce supplies of water in sugarcaneproduction, as the relative price of water washeld artificially low because of a prevailingpolicy distortion.

The good news, however, is that there are"win-win" policies that can benefit both the



economy and the environment. A World Bankstudy of Sri Lanka shows, for example, thatincreasing the price of electricity to its long-run supply cost would encourage more effi-cient use of electricity—an economic benefitthat would also have favorable environmentalimpacts (e.g., improved air quality, reducedbiodiversity loss, and lower greenhouse gasemissions).

Thoughts for policymakersWhat should the Ecotopian government do

to ensure that the standard of living ofEcotopians is sustained or improved as it willhave to weigh the macroeconomic and finan-cial implications of various policies? A fewhelpful hints can be culled from the seminar:

Ensure coordination. There is no sub-stitute for coordination between environ-mentalists and macroeconomists to ensurethat policies are consistent with sustainingand improving living standards. Moreover,there may well be a need for such cooperationon a regional or international level, espe-cially to address transboundary environ-mental problems.

Pursue macroeconomic stability.This is a minimum and necessary conditionfor preserving the environment, because it

ensures that the right price incentives work toimprove both economic growth prospects andthe environment. Indeed, macroeconomicinstability is bound to hinder any strategy forpreserving the environment.

Exploit "win-win" opportunities.Policies that promote allocative and produc-tive efficiency should be adopted to enhanceboth economic growth and the environment.The IMF and the World Bank can help coun-tries in designing and implementing such poli-cies (see box on p. 48).

Adopt sound environmental poli-cies. If environmental policymakers everhope to tackle the root causes of environmen-tal degradation, they must—working with thefinance ministry—introduce and enforcesound environmental policies so that house-holds and businesses recognize the environ-mental costs of their actions. Moreover,this internalization of environmental costs, ifcomplete, would ensure that the necessaryconditions were met for the sustainable man-agement of the macroeconomy, as noted byseminar discussant Andrew Steer, Director ofthe World Bank's Environment Department.

Consider computable general equi-librium (CGE) models. These modelsoffer both a framework for a dialogue between

macroeconomists and environmentalists, anda tool for unraveling the complex linksbetween the environment and the macroecon-omy. But, while CGE simulation results mayprovide an indication of directions and, possi-bly, magnitudes of change, they are based onimprecise assumptions and thus cannot pro-vide precise forecasts.

Search for better environmentalindicators. Developing national accountsthat incorporate the effects of environmentaldegradation and depletion can go a longway toward providing basic data for asssess-ing the links between the macroeconomyand the environment. However, environmen-tally adjusted accounts can provide only apiece of the puzzle. To evaluate whethercountries are on sustainable developmentpaths, policymakers must develop a morecomplete set of indicators (e.g., on equity,health, and culture)—indeed, efforts to do soare under way at the World Bank and theUnited Nations.

The proceedings of the May 10-11, 1995, IMFseminar on "Macroeconomics and theEnvironment" will be available in a forthcomingIMF volume.

New Economics Journals from CambridgeAsia-Pacific Economic ReviewPublished on behalf ofEMBA, Inc.

The dramatic economic expansion of theAsia-Pacific region has led to a surge ofinterest in the region from elsewhere in theworld, as economists try to explain Asianeconomic successes and as companies seeAsian markets as important for their ownpotential growth. Asia-Pacific Economic

Review (APER) aims to meet the needs ofboth groups by providing empirical econ-omic analyses, from more general descriptive

analyses through to advanced applied econo-metric research. The gaps in understanding

between policy makers, applied economists,econometricians and advanced mathematical

modellers have grown steadily wider andAPER aims to narrow these gaps. Throughexecutive summaries and an editorial digest

relating the material to topical issues andeconomic policies, the journal provides aninvaluable resource for readers withoutextensive technical knowledge. APER

encourages contributions from private andpublic sector economists as well as academics.

Asia-Pacific Economic Review is publishedthree times a year; Volume 2 in 1996: £75institutions; £38 individuals.ISSN 1358-6653.

Environment andDevelopment EconomicsPublished in association with the BeijerInstitute of Ecological Economics, RoyalSwedish Academy of Sciences

This new journal, firmly positioned at theintersection of economics, environment anddevelopment, publishes papers addressedequally to the research and to the policycommunities and is designed to be accessibleto a broad readership. The Editor andAssociate Editors are supported by distin-guished panels of advisors from around theworld, who will together ensure that thejournal becomes a major forum for keyresearch conducted in low-income countriesthemselves as well as elsewhere. The journalis divided into two main sections, Theoryand Applications and Policy Options, andalso includes book reviews and review essays.Articles include research on theoretical andapplied aspects of sustainable development,on the valuation of environmental resourcesin low income countries, on the environ-mental implications of institutional change,and on specific issues such as biodiversity loss.

Environment and Development Economicsis published quarterly. Volume 1 in 1996:£81 institutions; £42 individuals; £21 individualsin low-income countries. ISSN 1355-770X.

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CAMBRIDGEUNIVERSITY PRESS


BOOKS

D not let the improbable title put you offfrom reading this fascinating volume. Aslunddoes not take his own title too seriously: largestretches of the book are about how Russiadid not become a market economy.

Even if things begin to look up toward theend, this is mostly a story of missed opportu-nities. Only privatization and price liberaliza-tion emerge as unambiguous leaps toward amarket economy. In other areas—the failureto control inflation, the disastrous evolutionand final collapse of the ruble zone, the col-lapse of trade between former Sovietrepublics, the uneven and chaotic liberaliza-tion of agriculture and energy, the takeoff of

Anders Aslund

How Russia Became a Market EconomyBrookings Institution, Washington, 1995, xviii + 378 pp.,$39.95 (cloth), $16.95 (paper).

crime (one of the few growth industries)—reforms took the proverbial two steps for-ward, one step back (or sometimes even onestep forward, two steps back).

Aslund tells how difficult it was to "Do theRight Thing" in the bewildering new world oftransition. Few of the actors—Russian re-formers, economists, apparatchiks, politi-cians, interest groups, Western governmentleaders, multilateral lenders—come outunscathed from Aslund's withering look back.(Western economic advisers do seem to get offpretty lightly, however.. . .)

Aslund is well known for his insights intothe interplay between various actors in areform process. Such insights are brilliantlyon display here as he describes how thecountermoves of reformers, interest groups,and the West often led to muddle rather thanmovement.

The highlight of the considerable drama inthe book is the "Mystery of the MissingMomentum" at the beginning of reform.Aslund castigates the reformers themselves,Western governments, the IMF, and the

World Bank for failing to seize the momentduring the initial euphoria after the failedcoup of August 1991. The West hesitated toboldly lend where no loan had gone before.The reformers made fatal compromises,notably giving up control over the centralbank. The moment was lost, and Russia wentinto a detour of extreme inflation and zigzag-ging reforms. Even if Aslund overdoes the"Blame Game," it is still an irresistibly sadtale that he tells.

Yet Aslund interjects upbeat notes through-out the story, in the spirit of the title. Thanksto reform, Russians could freely get importedconsumer goods for the first time in theirlives, if they could find the money. Mostprices were free, and lines disappeared.Macroeconomic stabilization fitfully madeprogress. Privatization occurred on an unex-pectedly massive scale. Entrepreneurial ener-gies were released.

The Russian economy is once again look-ing up as this review is being written, even ifboth politics and economics remain volatile.You could not find a better guide to the longand winding road Russia has followed to gethere than the always engaging AndersAslund.

William Easterly

Daniel Gros and Alfred Steinherr

Winds of Change: EconomicTransition in Central and EasternEuropeLongman, London and New York, 1995, 544 pp.,$60.95 (cloth), $31.95 (paper).

subjects have attracted as much eco-nomic talent in so short a time as the transi-tion of the former Soviet bloc to market-oriented economics. This reflects not only thehistorical significance of the issue but also itsprofessionally challenging character.Analysis of the transition has forced

economists to face up to the myriad assump-tions implicit in the Western economicparadigm. As a result, the outpouring of pub-lished material has tended to be fairly focusedand analytical. Winds of Change is the firstattempt I am aware of to provide an approach-able yet professional overview of the subject.

This well-thought-out book discusses thestarting point of the transition in a useful andinformative section on the nature and failuresof Soviet central planning. The book providesan overview of the main transition topics,such as the scope and timing of reform, liber-alization, stabilization, privatization, andfinancial sector reform, and discusses theseissues from the perspective of various coun-tries (eastern Germany, the Visegrad coun-

tries, the former Yugoslavia, and the states ofthe former Soviet Union—especially Russia,where the authors' convictions surface moreunequivocally than elsewhere). The authorsalso review the current and future relations ofthe transition economies with the EuropeanUnion.

Gros and Steinherr succeed in making thesubject interesting to a wide audience. Themain text is accessible to the general reader,partly because of the "political economy" cur-rent that flows through it, partly because ofthe mix of easy analysis and empiricism, andpartly because of occasional light touches (forexample, a cartoon of Karl Marx admonish-ing, like any economist whose ideas have notpanned out, that "it was just an idea!"). But


Few


the hard core of analysis will be apparent tospecialists.

The authors clearly strive to be nonpolemi-cal and to provide a balanced presentation.However, a perspective that might be charac-terized as "continental European" rather thanAnglo-Saxon is apparent. For instance, whilethe market orientation is manifest, it maystrike some readers as somewhat circumspect.

In this vein, in the discussion of the choiceof exchange rate regimes, the authors makeclear their preference for fixed rates (exceptfor capital account transactions for which afloating dual market rate is advocated in pref-erence to capital controls). While this is notsurprising—it would probably be endorsedby most economists for the early stabilizationphase of the transition, given suitable policiesand levels of international reserves—what issurprising is the limited discussion of thefloating rate option, which has been stronglyadvocated by some and applied successfullyin several countries (for instance, Albania).

The authors' discussion of privatization isanother manifestation of a Europeanapproach. On one level, the perspective ismarket-oriented, as the authors support large-scale, "give-away" privatization. Moreover,they argue that such privatizations could

compensate workers for losses in real wages,while avoiding the indexation arrangementsthat have come to bedevil policy formulationin some countries, notably Poland. On anotherlevel, however, the authors are more ambiva-lent, notably, regarding the privatization oflarger enterprises. Voucher privatization andstakeholder buyouts are viewed with skepti-cism—unless adequate institutional controlsare in place—because of their implications forcorporate governance. The arm's-length rela-tionship to simple market solutions comesmore to the fore, however, in some of theappendices. They explore more egalitarian(and ostensibly potentially more efficient)ways of distributing profits, and examinewhether the failure of labor-managed firms inYugoslavia reflected a failure of design or acase of good design being applied in inappro-priate circumstances. In the same vein, thechapter on financial sector reform argues thatuniversal banking offers the only practicableway to finance the investment needs of largerenterprises. While these views all have theirplace in the second-best world of mid-transi-tion, one can ask whether the authors'ambivalence on some of these issues—whichis in line with the attitude of reactionaryforces that have emerged in Eastern

Europe—might not help foster third- orfourth-order solutions.

This second-best perspective is not, how-ever, the dominant one. The book, instead, isabout the first five years of transition, whichwas a difficult time of rapid change. This iscaptured by the cover, which shows aStalinist-style structure being blown asunderby the fiery winds of change, the whole domi-nating a peasant woman sowing the seeds ofchange in the foreground. Prospects today,however, seem to be more for the reverse: bet-ter times of too little structural change.Inflation is being tamed; growth is rebound-ing; external positions have strengthened; andcountries worry more about capital inflowsthan outflows. At the same time, the glaringlyuneven distribution of the benefits of transi-tion has undermined the sense of commonpurpose of the early years and prompted aleftward shift in the politics and a markedslowing in the pace of structural reform. Inthat setting, this book will remain pertinentas a primer not only on the first five years oftransition but also on the structural agendafor the next five.

Michael Deppler

Matthew Bishop, John Kay, Colin Mayer (editors)

Privatization & EconomicPerformanceOxford University Press, Oxford, 1994, xiii +389 pp., $65 (cloth), $24 (paper).

aof the most significant events of theThatcher years was the sell-off of large partsof the United Kingdom's public sector to pri-vate operators. This book is a compendium of18 articles by internal and external observersof the United Kingdom's privatization pro-cess. Many articles were written in the heat ofprivatization and provide a wealth of detailand historical insights. A few, with the perfectvision that comes with hindsight, assess thedevelopments from the perspective of themid-1990s.

The collection describes the failures as wellas the successes, public and political opposi-tion to privatization, and the problems thatpersist in some privatized sectors. It will thusprovide material for both sides of the privati-zation debate, which continues to rage insideand outside the United Kingdom, and in coun-

tries as diverse as China, India, Turkey, andthe transition economies of Eastern Europeand the former Soviet Union.

The first two chapters—"Privatization:Principles, Problems, and Priorities" (MichaelBeesley and Stephen Littlechild) and"Privatization Policies and Public Enterprise:A Survey" (Simon Domberger and JohnPiggot) were written in the mid-1980s anddeal with the fundamental question ofwhether public enterprises should be priva-tized at all. These two papers review the liter-ature comparing the performance of publicand private industries and seek criteria fordeciding what should be a candidate for priva-tization and why. They discuss the need forrestructuring certain sectors as well as theimportance of regulation and competition pol-icy. They also examine the "non-commercial"obligations of public enterprises. Althoughnone of this is new, the arguments and evi-dence presented are still highly relevant tocountries now tackling privatization and arealso useful in understanding results in theUnited Kingdom.

The next half-dozen chapters deal withresults (as of the time the chapters were writ-ten) of completed privatizations: electricity,

British Airways, the water industry, the gasindustry, British Steel, and refuse collection.The following three cover sectors still "openfor discussion." In "Delivering Letters: ShouldIt Be Decriminalized?" the authors, SaulEstrin and David de Meza, develop an eco-nomic model that suggests this is an areawhere open competition may harm, ratherthan help, the consumer. Two other chaptersdiscuss the railways and the UK Govern-ment's search (after disposing of some assetsand operations) for ways to privatize the coreactivities of this loss-making sector and intro-duce competition.

The last part of the book includes piecesthat try to identify the "winners" and "losers"in the United Kingdom's privatization experi-ence to date. "Privatization and DomesticConsumers" (John Winward) concludes thatcompetition has not yet had a significantimpact in most sectors, and that many of theefficiency gains seen in regulated sectorswould probably have occurred even withoutprivatization. However, a more "open" regula-tory approach has ensured that efficiencygains are passed on to consumers, who havealso benefited (on the whole) from regulationof quality.



"Popular Capitalism" (Paul Grout) demon-strates that the number of British adults own-ing equity in companies increased dramat-ically from 1979 to 1992, but that the share ofthe total equity market held directly by indi-viduals actually fell during that period. Theauthor concludes that, in terms of actualenterprise control, real benefits come not from"popular" capitalism but from employee own-ership. Evidence supporting this view ispresented in "Management Buy-outs andPrivatization," by Mike Wright, SteveThompson, and Ken Robbie. In "Privatizationand the Labour Market: Facts, Theory and

Evidence," Jonathan Haskel and StefanSzymanski conclude that, although furtherresearch is required, privatization is likely tolead to falling employment and wages.

Another fascinating piece, "What is theAlternative? Ownership Regulation and theLabour Party," by Francis McGowan, tracesthe policy changes of the UK Labor Partythrough the Thatcher years. Not surprisingly,it finds that there has been a major policyshift; "nationalization," once a critical plank ofthe party's platform, is now a dead issue.

The lessons culled by the editors and sum-marized in the Introduction are that the UK

privatization program "missed" many of itsobjectives because of misunderstandings ofthe way financial markets work, imperfec-tions in the regulatory system, and structuralmistakes. They note that "privatized compa-nies have come to view one of their mainobjectives as minimizing interventions by theregulator." However, they conclude that, "evenif the UK privatization programme can befaulted in many respects, it has identified theway in which privatizations can be success-fully achieved."

Andrew Ewing

Steven Solomon

The Confidence Game: How Unelected Central BankersAre Governing the Changed Global EconomySimon and Schuster, New York, 1995, 606 pp., $30.

^ta/entral banks are often regarded as dull,hidebound institutions or as powerful,behind-the-scenes protectors of establishmentinterests. Solomon makes the case that theyare, in fact, exciting, innovative, and dedi-cated to promoting the welfare of all sectionsof society.

The Confidence Game provides a readableaccount of the major international financialdevelopments of the past twenty years andhow central banks reacted to them. The unify-ing theme is that volatile flows of "statelesscapital" led to a series of crises that only cen-tral banks were able and willing to deal with.The narrative starts with the stock marketcrash of 1987, then moves back in time to dis-cuss the anti-inflationary policies introducedin the late 1970s, the debt crisis of the early1980s, attempts to manage the fall of the USdollar from 1985, and negotiations over com-mon capital-adequacy standards for banksstarting in 1986. The lengthy account of theseepisodes, enlivened by novelistic descriptionand detail, is interwoven with an expositionof some principles of international financialeconomics.

The book is largely based on the author'sinterviews of hundreds of officials who helpedshape policy from the 1970s to the early1980s. Perhaps as a result, no significant reve-

lations are made, nor is the analysis much atvariance with that commonly accepted byinformed opinion. Rather, the reader enjoysan insider's view of the policy process andwhat factors—economic, political, and, insome instances, personal—were perceived atthe time to be determining.

This perspective is both the strength andthe weakness of the book. It does make clearthe interlinkages between the seemingly dis-parate crises and chronic problems of the1980s. For instance, central bankers wereoften made aware of the tension between thedesire to achieve sustained low inflation andthe need to maintain the soundness of thebanking system. One can plausibly argue thatthe outbreak of banking crises in the UnitedStates and Japan was triggered but not neces-sarily caused by monetary tightening, and, ina number of countries, monetary policy waslimited by concern over the financial positionof banks. The author's perspective also bringsout how officials of even the most indepen-dent central banks felt constrained by politi-cal considerations, and how their responses tocrises had to be put together ad hoc and werebased largely on intuition.

Yet critical distance is lacking. The author'srhetoric suggests that central bankers are sin-isterly secretive and unaccountable but, in

truth, Solomon finds them both sage andheroic. Central bankers generally, and formerand current US Federal Reserve ChairmenVolcker and Greenspan in particular, seem tobe almost without fault—at worst, they mayfail to convince politicians of the dangers thatthey have correctly foreseen. In contrast,politicians and officials in charge of fiscal pol-icy can do no right: in the short run, theylobby for excessively low interest rates, makedestabilizing remarks about exchange rates,and ignore the fragility of the banking sector;in the long run, they connive in generating fis-cal "profligacy" in the United States and a"fixation" with fiscal consolidation in Japan.

The book ends with a collection of sug-gested reforms designed to "civilize" interna-tional capital movements and improvepolicymaking, notably through enhancedcooperation between policymakers in differ-ent countries. However, given what is saidabout the effectiveness of government deci-sion making, the fact that "stateless capital"and the "Court of World Savings" are "with-out any political regulation" may not beentirely negative, and the prospects for theestablishment of a comprehensive and coordi-nated regulatory system seem dim.

The Confidence Game offers professionaleconomists a useful reminder of the intensity,diversity, and unpredictability displayed byinternational financial crises. The book alsoallows a wider audience to appreciate thatthose nondescript central bankers are largelywell-meaning but fallible human beingsengaged in a task where errors are magnifiedand success is measured by its invisibility.

Daniel Hardy



Barry Eichengreen

InternationalMonetaryArrangements forthe 21st CenturyBrookings Institution,Washington, 1994,171 pp., $28.95 (cloth),

$10.95 (paper).

-En this excellent book, Barry Eichengreen—economic historian and analyst of currentmonetary issues—peers into the future look-ing for the likely evolution of internationalmonetary arrangements. The book containsseven relatively short chapters covering top-ics as diverse as the historical evolution ofinternational monetary arrangements, thechallenges of deep integration, and the theoryof optimum currency areas, plus a conclusion.It ends with short comments from AlbertoGiovaninni and Toyoo Gyohten, which pro-vide the reader with alternative perspectiveson the issues.

The book provides short, lucid, and highlyinformative discussions of the current state ofacademic debate on almost all aspects ofinternational monetary arrangements. I canthink of no better general introduction to suchissues, ranging from the operation of the

pre-1914 gold standard to prospects for aEuropean Monetary Union to the optionsopen to countries in choosing an exchangerate policy. Some of the discussions may besomewhat technical for noneconomists,reflecting the complexity of the underlyingdebate. Most of the book, however, is accessi-ble to all readers and is clearly and informa-tively written.

The author's underlying message is thatfixed exchange rate systems are becomingless and less sustainable and, hence, thatcountries are faced with the choice of eitherhaving an exchange rate that floats againstother currencies or joining a monetary union.The reason for the narrowing of availableoptions is the increasing openness of interna-tional capital markets. This has left govern-ments unable to withstand market pressureson exchange rates whether or not the lattercorrespond to economic fundamentals, asillustrated by the exchange rate crises inEurope in 1992 and 1993. If, on the one hand,a government wishes to have some indepen-dent control over monetary policy, it will haveto accept a floating exchange rate arrange-ment. If, on the other hand, it wishes to stabi-lize its exchange rate with regard to anothercountry, it will need to sacrifice monetaryautonomy by joining in a monetary union.

Another way of putting it is in terms ofthree mutually inconsistent goals of exchangerate regimes: stable rates; open international

capital markets; and monetary autonomy.During the pre-1914 era of the gold standard,countries enjoyed open capital markets andstable exchange rates but had limited mone-tary autonomy. The Bretton Woodsperiod—from the late 1940s to the early1970s—witnessed stable exchange rates andmonetary autonomy but limited capital mobil-ity. The future, in Eichengreen's view, is oneof open capital markets and either monetaryautonomy with floating exchange rates ormonetary union.

I basically agree with the author, althoughthe argument about needing monetary unionto maintain a fixed exchange rate may beslightly overstated (as Alberto Giovaninniimplies in his comment). After all, bothAustria and the Netherlands, which haveclearly subordinated their monetary policy tomaintaining a stable exchange rate againstthe deutsche mark, came through theexchange rate crises of 1992 and 1993 with nosignificant difficulty. The real choice for the21st century may be between monetaryautonomy with floating exchange rates and afixed exchange rate with very little monetaryautonomy—with most countries choosingflexible exchange rates. In short, this bookprovides an excellent projection of futureexchange rate arrangements, although realitymay turn out a touch less dramatic than isenvisioned.

Tamirn Bavoumi

Jiis short study, well worth perusing, ispart of an extensive research program begunin 1992 by the Brookings Institution to inves-tigate policy issues arising from increasingglobal integration. The present volumefocuses on technology development policiesand their relationship to the internationaliza-tion of business.

Techno-globalism refers to the increasingtendency for international competition to bedefined in terms of the development of newtechnologies. To be successful in this evolv-ing, competitive environment, companiesrequire competence not only in carrying outtheir own research and development but alsoin monitoring and absorbing technologiesdeveloped in other parts of the world. Partlyfor this reason, technology today is diffusedrapidly, and the lead time for a firm to intro-duce a new product and to gain subsequentlearning-curve advantages is becomingshorter and shorter. This is particularly truebecause protection of intellectual property isoften insufficient to prevent capable competi-

Sylvia Ostry andRichard R. Nelson

Techno-Nationalism andTechno-GlobalismConflict and

CooperationBrookings Institution, Washington, 1995, xxvi +132 pp., $28.95 (cloth), $10.95 (paper).

tors from quickly duplicating proprietarytechnologies. Furthermore, to fully exploitnew technologies and pay for their develop-ment, firms need ready access to foreign mar-kets, not only through trade but also (andperhaps more important) through directinvestment.

Techno-nationalism is a result of nationalgovernments' attempts, through their technol-

ogy policies, to encourage technology devel-opment in a manner that helps indigenousfirms to develop new products more quicklyand to do so in a way that allows local, ratherthan foreign, firms to reap the returns. In aworld of multinational corporations, suchpolicies are bound to result in endless con-flicts, not only between but also withinnations—for example, in determining whichcompanies are eligible to participate in gov-ernment-funded research consortia. (Should aUS subsidiary of a Japanese multinationalcorporation, for instance, be allowed to partic-ipate in a consortium financed by the USGovernment?) In addition, national policieshave fostered claims that some countriesengage in what might be called techno-mercantilism—that is, essentially closinghome markets to technology-intensiveimports and discouraging inward directinvestment, while home-based companieslaunch competitive assaults on foreignmarkets through both exports and foreigninvestment.



Ostry and Nelson are sensible enough toknow that there are no easy solutions to con-flicts between techno-nationalism and techno-globalism. The authors suggest that abeginning at conflict resolution might bemade by harmonizing technology policies inan effort to at least minimize systemic fric-tion. Because they involve policies that havetraditionally been considered purely domestic,negotiations to achieve harmonization admit-tedly would be extremely difficult to carryout, even in a bilateral context; multilateralnegotiations would be mind-boggling. Thequestion, in any case, is whether or not such

negotiations, given their difficulties, wouldresult in the desired changes in nationalbehavior. This reviewer is doubtful.

The case of Japan is illustrative. Japanbecame a major industrial power throughpolicies directed at market exclusion, technol-ogy development, and export expansion. Andyet the same policies that brought that suc-cess do not appear to be serving the country'sfuture economic interests. In fact, a case couldbe made that Japan is already falling behindin the technologies that will be most impor-tant in decades to come. One might conjecturethat harmonization of policies is not what will

change Japan's behavior. Instead, cause andeffect might run the other way. Behavioralchange in Japan, as well as a willingness tolook more favorably on harmonization efforts,will come not through acrimonious negotia-tions but, rather, from competitive pressuresemanating from an increasingly integratedglobal economy. These pressures today arguefor a more open and responsive Japanesebusiness system.

Robert R. Miller

MOVING TO THE MARKET:

THE WORLD BANKIN TRANSITION

The development paradigm isshifting, and the private sector now

holds center stage as the lead player ineconomic development. In recent years

the World Bank has been pressed byits member governments to rethink

its role in private sector development.This essay reviews the initiatives taken

by the World Bank and theInternational Finance Corporation andmakes recommendations for the future.

Richard W. Richardson is currently SeniorAdvisor to the ODC. Formerly, he served asDirector of the Development Department andEconomic Advisor of the International FinanceCorporation.

Jonas H. Haralz served as Executive Directorof the World Bank for the Nordic Countriesand, earlier, as Managing Director of theNational Bank of Iceland.

Policy Essay No. 17, 1995 ISBN: 1-56517-023-7 $9.95

Please include $3.00 /or shipping/handling and st'iuf check to:

Overseas Development Council1875 Connecticut Avenue, N.W., Suite 1012

Washineton, D.C. 20009 • Telephone (202) 234-8701Facsimile (202) 745-0067

Organization for Economic Cooperation and Development

The OECD Jobs Study: Facts, Analysis, StrategiesOECD, Paris, 1994, 50 pp., $11.

Center for Economic Policy Research

Unemployment: Choices for Europe,Monitoring European IntegrationCEPR, London, 1995, 147 pp., £10.

Olivier Blanchard etal

Spanish Unemployment: Is Therea Solution?CEPR, London, 1995, 146 pp., £14.95.

:an be no doubt that the foremost economic problem facing WesternEurope today is unemployment. From a "golden age" of very low rates, job-lessness began a major increase in the mid-1970s and has never again fallento its previous levels. The recession of the early 1990s caused unemploymentin the European Union to jump once again above 10 percent, reinforcing con-cerns that measures must be taken to overcome the perceived "eurosclerosis"of the labor market.

In a provocative and readable book, the London-based Center for EconomicPolicy Research (CEPR) has made a lively contribution to the voluminousdebate on European unemployment. The book challenges orthodox economicconventional wisdom regarding the causes and policy cures for joblessness. Amore economically orthodox diagnosis of labor market problems and theircures is found in The OECD Jobs Study, summarized in the OECD's Facts,Analysis, Strategies paper reviewed here.

The study succinctly covers basic facts of OECD unemployment: countriesof the European Union (EU) have seen wages rise steadily, while employmenthas stagnated. The United States, in contrast, has had steady job growth with


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stagnating real wages. The study rejects thepopular ideas that rising unemployment wascaused by technological change or trade liber-alization. Rather, labor market rigidities andmisguided social policies are the primary cul-prits. Hiring and firing costs lower employ-ment, as do inflexibilities in the deployment ofworkers within enterprises. Government poli-cies have unintentionally provided incentivesthat subsidize unemployment and heavily taxmarginal workers. Many countries also lackthe entrepreneurial culture that facilitates jobcreation by small and medium-sized enter-prises. The policy recommendations are forfar-reaching structural reforms aimed atincreasing labor market flexibility, whilemacroeconomic policy merely provides a sta-ble, low-inflation environment for growth.

In Unemployment: Choices for Europe, sev-eral European economists challenge commonperceptions on several fronts. They argue thatEuropean labor markets are not as stagnantas is commonly thought, with fairly signifi-cant job turnover. The difference is that inEurope, people tend to move from one job toanother, rather than from a job to unemploy-ment and back, as in the United States.Furthermore, high EU unemployment is notnecessarily socially worse than the US sys-tem, which condemns many to become "work-ing poor" in dead-end jobs.

While accepting some of the traditionalarguments regarding the role of labor marketrigidities in perpetuating high unemployment,the CEPR book suggests that "the direct evi-dence in favour of the benefits of less regula-

tion in practice are decidedly mixed." Anentire chapter is devoted to making the theo-retical argument in favor of labor market reg-ulation as a means of addressing other marketfailures: minimum wages to counteractemployer monopsony power; unemploymentbenefits to replace inadequate insurance mar-kets; and hiring and firing costs to remedysuboptimal investment in firm-specific humancapital. In the realm of macroeconomic policy,the book argues that tight monetary policy indefense of the European Monetary System(EMS) in the early 1990s was a "major policymisjudgment," which exacerbated jobless-ness. Finally, the authors argue that highunemployment in Europe may reflect a politi-cal "equilibrium" in which the median voter iswilling to pay the economic costs of labormarket rigidities in exchange for a more equi-table distribution of income.

With a jobless rate well above 20 percent, itis entirely appropriate that the CEPR shoulddedicate a study exclusively to Spain's unem-ployment problem in Spanish Unemployment:Is There a Solution? Led by influential MITeconomist Olivier Blanchard and with the par-ticipation of several prominent Spanish andEuropean economists, the Spain study broadlyfollows the policy line of the CEPR's pan-European analysis. It provides an excellentreview of the pervasive microeconomic distor-tions afflicting the Spanish labor market, andechoes many other studies in calling for easinglabor market rigidities. The macroeconomicdiagnosis, in contrast, differs significantlyfrom that of the OECD. First, it advocates

looser monetary policy to stimulate aggregatedemand and boost employment. The authorsacknowledge that this will cause the exchangerate to depreciate, implicitly advocating thatSpain leave the EMS. Second, the study arguesfor national social pacts allowing wages togrow with labor productivity, which wouldpermit continued real wage growth.

The problem with the CEPR's challenge toconventional economic wisdom is that, whilebeing contrarian makes for an interesting andprovocative read, the conventional wisdom isoften right. While raising a number of validobjections to the naive laissez-faire story thatlabor market rigidities are always bad, thealternative put forth by the CEPR authors isless than convincing. Furthermore, in the finalanalysis, many of the recommendationsadvanced by the CEPR are not radically dif-ferent from those of The OECD Jobs Study.Where recommendations do differ—onmacroeconomic policy—the CEPR uses theold Phillips curve argument to advocateaccepting higher inflation in return for lowerunemployment, a view that assumes workerswill accept inflation consistently "about onepercentage point higher than that which isbuilt into wage settlements." Twenty years ofmacroeconomic research have argued thatattempts to exploit the Phillips curve trade-off are ultimately doomed to failure becauseever higher inflation will be needed tosurprise workers into accepting lowerreal wages.

Jeffrey R. Franks

LETTERS to the editor]

Pension plan costsEstelle James and Robert Palacios have givenan excellent discussion of the probleminvolved in measuring the administrativeexpenses of pension plans ("Costs ofAdministering Public and Private PensionPlans," Finance & Development, June 1995). Iagree that meaningful comparisons betweenplans are difficult to achieve because of suchdiffering elements as relative maturity of theplan and the method of funding.

Nonetheless, I believe that an adequate andproper measure of relative administrativeexpenses is to express the latter as a percent-age of contribution income. This is especiallyso for a relatively mature system like the Old-Age, Survivors, and Disability Insurance pro-gram of the United States (OASDI) and, to a

considerable extent, for a fully funded systemlike that of Chile. In Chile's case, however, theratio of administrative expenses to contribu-tions (which are at a level rate for the future)tends to be on the low side, because so fewmembers of the plan are receiving periodicretirement benefits.

The authors point out that the administra-tive expenses of a privatized plan like that ofChile are artificially higher because of theinvestment expenses needed to produce thehigher rates of return from investment in pri-vate securities. However, proper accountingprocedure under these circumstances is not tocount the expenses involved with investmentsas administrative expenses but, rather, to off-set them against investment income to yieldnet investment income. This procedure is fol-

lowed, for example, by the United NationsJoint Staff Pension Fund.

The authors state that the administrativeexpenses of the OASDI system are under-stated because the costs of the InternalRevenue Service in collecting contributionsand enforcing coverage compliance are notincluded. This is not correct because suchexpenses are reimbursed from the trustfunds—as are the costs of the Department ofthe Treasury and the Postal Service in payingthe benefits, as well as other costs, such asrental for government-owned buildings usedfor field operations. In the year endedSeptember 30,1994, the trust funds paidadministrative expenses of $2,897 million, or0.85 percent of net contributions— $204 mil-lion of this was paid to the Department of the

Finance & Development /December 19i>o


Treasury, of which the Internal RevenueService is a constituent (1995 OASDI TrusteesReport, House Document 104-57, April 3,1995, page 51). That administrative-expenseratio is properly comparable with the roughly12 percent for the Chilean system.

Robert}. MyersFormer Chief Actuary

US Social Security Administration (1947-70)and

Former Deputy CommissionerUS Social Security Administration (1981-82)

The old-age crisisI refer to the article "Averting the Old-AgeCrisis" by Estelle James in Finance &Development, June 1995. The problem beingaddressed in the article is the increase in theaverage age of the population and how to han-dle the financing of pensions for this part ofthe population equitably.

What I want to point out is that the causeof the increase in the percentage of older peo-ple in a population is a decrease in the birthrate. If this lower birth rate stays constant, aplateau is eventually reached, which, depend-ing on what the birth rate is, may be a shrink-ing, constant, or growing population. In anycase, the problem addressed in the article is,relatively speaking, short term (50 to 100years). This is not to say that the problem offinancing pensions for a large aging popula-tion is not a pressing problem. However,assuming the world is suffering from over-population, then a decrease in the birth rate,although it has caused a short-term problemof financing pensions for old people, will, inthe long term, bring about an improvement inthe overpopulation situation.

Robert SilberstorfMedettin, Colombia

Transition: the right course?Reading all five articles on transitioneconomies that appeared in the September1995 issue of Finance & Development doesnothing to alter the unscientific impressionI have gained from reading the daily presssince the start of the shift from command tomarket economies: the so-called Western pow-ers have been egregiously callous, optimistic,and cruel in the strategy they have followedin helping (more or less) the transitioneconomies to cope with the enormous struc-tural adjustments they have faced, and theequally daunting psychological adjustmentsthis has involved for their residents.

Even in a sophisticated and experiencedmarket economy, a major structural adjust-ment takes a long time, and requires cushion-ing measures by the government, or by thecountry's trading partners, or both. Leaving itall to the leisurely functioning of the market-place would involve painful and "unnecessarysuffering by many members of the public. Forexample, recall the problems faced by Britainand other war-ravaged economies in adjustingfrom wartime to peacetime conditions in 1945,and the combined efforts of their domesticauthorities and the international communityto effect a smooth transition. A major part,but only a part, of those efforts was the estab-lishment of the International Bank forReconstruction and Development and theInternational Monetary Fund. (Be it notedthat wartime conditions had brought a sub-stantial element of "command" economics tothese countries, including rationing, directcontrols, exchange controls, and Article XIVof the Fund agreement—which, if I am notmistaken, some countries still claim the bene-fit of 50 years after the end of the war.)

The command economies faced seriouspostwar adjustment problems in 1945, too, ofcourse, but not that of a substantial change inthe instruments of economic management.However, the problems they have recentlyfaced in converting to market economies were

second only to those of the war-ravaged mar-ket economies in 1945, without counting thepsychological adjustments required of thepublic in moving to the full rigors of a systemin which the price mechanism was to becomethe determining force in resource allocationinstead of just a rather unsatisfactory guideto consumer behavior.

The help given by the international com-munity, often grudgingly, seemed to beguided for the most part by a philosophythat can only be compared to teaching some-one to swim by throwing him (or her) intodeep water and leaving him to fend for him-self, laced with admonitions to be more demo-cratic or have the grudging aid withheld.(True democracy can only grow with experi-ence over time—it is not instantly realized byhaving the president elected by popular vote.)

I see no evidence of a rational assessmentby the international community of whatchanges need to be made, how to effect themgradually while maintaining real output (andreal income), and what cushioning deviceswould be necessary to deal with the inevitablemishaps and miscalculations. All I see is afew ad hoc measures of help, focused on cor-porate governance, banking reform, fiscalprocedures, and the like—all very useful inthemselves, but not incorporated in a coordi-nated plan.

Or am I way out in left field? Does the neo-classicism that seems to have pre-empted eco-nomic thought these days hold that Britainand other war-ravaged economies ought tohave been thrown into deep water in 1945 andleft to sink or swim on their own?

Professor Alex N. McLeodThornhill, Ontario

Canada

New readers who wish to receive Finance & Development regularly shouldapply in writing to Subscription Services, Finance & Development, InternationalMonetary Fund, Washington, DC 20431, USA, specifying the language editionand briefly stating the reasons for their request. The contents of Finance &Development are indexed in Business Periodicals Index, Public Affairs Infor-mation Service (PAIS), and Bibliographie Internationale des Sciences Sociales.An annual index of articles and reviews is carried in the December issue.

Credits: Cover art and art on pages 3, 6, and 9: Robert Rathe and Luisa Watson; art on pages 20 and24: Albert B. Haab; art on pages 28 and 46: Luisa Watson; photograph on page 30: Alain Labeau; arton pages 34 and 36: Andrew Toos; photographs on pages 42 and 44: Robert Rathe; photographs onpages 19, 50, 52, 53, and 54: Padraic Hughes.

We welcomecommentsfrom our readersPlease write to:Editor, Finance & DevelopmentInternational Monetary FundWashington, DC 20431 USAFax: (202) 623-4738Internet: [email protected]



INDEX 1995 VOLUME 32

Articles

Arvil Adams and Sandra Wilson, Do Self-Employment Programs Work? September

Junaid Ahmad, Funding the Metropolitan Areas ofSouth Africa, September

Masahiko Aoki and Hyung-KI Kim, CorporateGovernance in Transition Economies, September

Leonardo Bartolini, Purchasing Power ParityMeasures of Competitiveness, September

Tamim Bayoumi, The Postwar EconomicAchievement, June

Adam G.G. Bennett, Currency Boards: Issues andExperiences, September

Joel Bergsman and Xiaofang Shen, ForeignDirect Investment in Developing Countries:Progress and Problems, December

Richard Bird, Caroline Freund, and ChristineWallich, Decentralizing Fiscal Systems inTransition Economies, September

Veronique Bishop and Ashoka Mody, ExploitingCompetitive Opportunities in Telecommunications,June

Michael Borish, Millard Long, and Michel Noel,Banking Reform in Transition Economies,September

Michael Bruno, Does Inflation Really LowerGrowth? September

Elaine Buckberg and Alun Thomas, WageDispersion and Job Growth in the United States,June

Shahid Javed Burki and Sebastian Edwards,Consolidating Economic Reforms in Latin Americaand the Caribbean, March

Nicholas Burnett, Kari Marble, and HarryAnthony Patrinos, Setting Investment Priorities inEducation, December

Jean Clement, Aftermath of the CFA FrancDevaluation, June

Uri Dadush and Milan Brahmbhatt, AnticipatingCapital Flow Reversals, December

Uri Dadush and Dong He, China: A New Power inWorld Trade, June

Margaret Garritsen de Vries, The IMF Fifty YearsLater, June

Ishac Diwan and Ana Revenga, The Outlook forWorkers in the 21st Century, September

Ishac Diwan and Ana Revenga, Wages, Inequality,and International Integration, September

Stanley Fischer, Comments on the IMF and theEnvironment, DecemberLouise Fox, Can Eastern Europe's Old-Age Crisis

Be Fixed? DecemberJeffrey Franks, Unemployment in Spain: Causes

and Remedies, SeptemberHafez Ghanem and Michael Walton, Workers

Need Open Markets and Active Governments,September

Jack Glen and Brian Pinto, Capital Markets andDeveloping Country Firms, March

Richard Harmsen, The Uruguay Round: A Boon forthe World Economy, March

Glen Harrison, Thomas Rutherford, and DavidTarr, Quantifying the Outcome of the UruguayRound, December

Merlinda Ingco, Agricultural Liberalization in theUruguay Round, September

Estelle James, Averting the Old-Age Crisis, JuneEstelle James and Robert Palacios, Costs ofAdministering Public and Private Pension Plans,June

Kathie Krumm, Branko Milanovic, and MichaelWalton, Transfers and the Transition from CentralPlanning, September

Timothy Lane, Mark Griffiths, and AlessandroPrati, Can Inflation Targets Help Make MonetaryPolicy Credible? December

Peter Lanjouw, Infrastructure: A Ladder for thePoor, March

Michael Leidy, Antidumping: Unfair Trade or UnfairRemedy? March

Armando Linde, Latin America and the Caribbean

in the 1990s, MarchGraeme Littler, The Growth of Latin America's

Equity Markets, MarchG.A. Mackenzie, Reforming Latin America's Old-Age Pension Systems, March

Ronald McMorran and Laura Wallace, WhyMacroeconomists and Environmentalists NeedEach Other, December

Shuja Nawaz, James Boughton, and WilliamWalker, IMF Chronology, June

Jonathan Ostry and Carmen Reinhart, Savingand the Real Interest Rate in DevelopingCountries, December

Arvind Panagariya, What Can We Learn fromChina's Export Strategy? June

Rupert Pennant-Rea and Ian Heggie,Commercializing Africa's Roads, December

Mahmood Pradhan, Privatization and the Develop-ment of Financial Markets in Italy, December

Sarath Rajapatirana, Macroeconomic Crisis andAdjustment, March

Ratna Sahay and Carlos Vegh, Dollarization inTransition Economies, March

Maurice Schiff and Alberto Valdes, ThePlundering of Agriculture in Developing Countries,March

Garry Schinasi, Asset Prices, Monetary Policy, andthe Business Cycle, June

Anita Schwarz, Pension Schemes: Trade-OffsBetween Redistribution and Saving, June

Clinton Shiells, Regional Trade Blocs: TradeCreating or Diverting? March

Parthasarathi Shome, Tax Reform in LatinAmerica, March

Saud Siddique, Financing Private Power in LatinAmerica and the Caribbean, March

Michael Spencer, Securities Markets in China, JuneVito Tanzi, Corruption, Governmental Activities, and

Markets, DecemberIMF staff, Progress Report on Commercial Bank

Debt Restructuring, December

Book ReviewsAnders Aslund, How Russia Became a Market

Economy, reviewed by William Easterly, DecemberBinhadi, Financial Sector Deregulation, Banking

Development and Monetary Policy: TheIndonesian Experience (1983-1993), reviewed byLloyd R. Kenward, September

Matthew Bishop, John Kay, and Colin Mayer,editors, Privatization & Economic Performance,reviewed by Andrew Ewing, December

Olivier Blanchard era/, Spanish Unemployment: IsThere a Solution?, reviewed by Jeffrey R. Franks,December

Center for Economic Policy Research,Unemployment: Choices for Europe, reviewed byJeffrey R. Franks, December

Ashok V. Desai, My Economic Affair, reviewed byDeena Khatkhate, March

Jeremy Edwards and Klaus Fischer, Banks,Finance and Investment in Germany, reviewed byDaniel Hardy, March

Barry Eichengreen, International MonetaryArrangements for the 21st Century, reviewed byTamim Bayoumi, December

James Fallows, Looking at the Sun: The Rise ofthe New East Asian Economic and PoliticalSystem, reviewed by Bahram Nowzad, June

Ricardo Ffrench-Davis and Stephany Griffith-Jones, editors, Coping with Capital Surges: TheReturn of Finance to Latin America, reviewed byGuy Pfeffermann, September

Carol Graham, Safety Nets, Politics, and the Poor:Transitions to Market Economies, reviewed bySanjeev Gupta, June

Daniel Gros and Alfred Steinherr, Winds ofChange: Economic Transition in Central andEastern Europe, reviewed by Michael Deppler,December

Donald A. Hay, Derek J. Morris, Guy Liu, andShujie Yao, Economic Reform and State-OwnedEnterprises in China, 1979-1987, reviewed byDubravko Mihaljek, June

Richard J. Herrnstein and Charles Murray, TheBell Curve: Intelligence and Class Structure inAmerican Life, reviewed by William Easterly, March

Albert O. Hirschman, Development ProjectsObserved, reviewed by Robert Picciotto,September

Peter B. Kenen, editor, Managing the WorldEconomy: Fifty Years After Bretton Woods,reviewed by Sara Kane, June

Stephen McCarthy, Africa: The Challenge ofTransformation, reviewed by Luis de Azcarate,September

John Miller, editor, Curing World Poverty: The New

Role of Property, reviewed by John Huddleston,March

Organization for Economic Cooperation andDevelopment, The OECD Jobs Study: Facts,Analysis, Strategies, reviewed by Jeffrey R.Franks, December

Sylvia Ostry and Richard R. Nelson, Techno-Nationalism and Techno-Globalism: Conflict andCooperation, reviewed by Robert R. Miller,December

Jacques J. Polak, Economic Theory and FinancialPolicy: The Selected Essays of Jacques J. Polak,reviewed by Manuel Guitian, June

Adam Seymour and Robert Mabro, EnergyTaxation and Economic Growth, reviewed byDennis Anderson, March

Judy Shelton, Money Meltdown, reviewed byMichael Spencer, March

Steven Solomon, The Confidence Game: HowUnelected Central Bankers Are Governing theChanged Global Economy, reviewed by DanielHardy, December

William Wallace, Regional Integration: The WestEuropean Experience, reviewed by Harilaos Vittas,September

John Williamson, editor, Estimating EquilibriumExchange Rates, reviewed by Paul Masson,September



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1993. 472 pages. ISBN 0-19-520891-9.$42.95.

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Macroeconomic Crises, Policies, and Growth in Brazil, 1964-90Examines events in the economic history of Brazil over a 25-year period spanning itsstrong growth phase in the late 1960s and early 1970s, the high inflation whichfollowed, and the external debt crisis of the 1980s. 1995. 256 pages.ISBN 0-8213-2293-0). $14.95.

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Macroeconomic Policies, Crises, and Long-Term Growth in Indonesia, 1965-90Examines the classic stabilization experience of Indonesia in the mid sixties and thecountry's success in handling oil booms in the seventies. 1994. 230 pages.ISBN 0-8213-2212-5. $13.95.

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