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STRATEGIES FOR STRUCTURAL ADJUSTMENT

The Experience of Southeast Asia


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STRATEGIES FOR STRUCTURAL ADJUSTMENT

The Experience of Southeast Asia

Moderator Ungku A. Aziz

Papers presented at a seminar held

in Kuala Lumpur, Malaysia,

June 28-July 1, 1989

INTERNATIONAL MONETARY FUND BANK NEGARA MALAYSIA

Washington • 1990


© 1990 International Monetary Fund

Cover design by IMF Graphics Section

Library of Congress Cataloging-in-Publication Data

Strategies for structural adjustment : the experience of Southeast Asia

papers presented at a seminar held in Kuala Lumpur, Malaysia, June 28-July 1, 1989 I moderator, Ungku A. Aziz.

p. em. Includes bibliographical references. ISBN 1-55775-147-1

I. Asia, Southeastern-Economic policy-Congresses. 2. Eco

nomic stabilization-Asia, Southeastern-Congresses. l. Abdul Aziz,

Ungku, 1922- . II. International Monetary Fund. lli. Bank Negara

Malaysia. IV. Title: Experience of Southeast Asia.

HC441.S76 1990

338.959--dc20 90-5296

Price: US$16.50

Address orders to: International Monetary Fund, Publication Services

700 19th Street, N.W., Washington, D.C. 20431, U.S.A.

Telephone: (202) 623-7430

Telefax: (202) 623-7491 Cable: lnterfund

CIP


Foreword

Southeast Asia's rising prominence in the world economy raises many questions regarding the economic policies followed by individual countries of the area. The Fund is pleased to have been a cosponsor with the Bank Negara Malaysia of a seminar that addressed such questions.

The seminar, held in Kuala Lumpur, Malaysia, on june 28-July 1 , 1989, provided a forum for a dynamic exchange of ideas based on papers presented by Fund officials, officials from nongovernmental organizations, and academicians. Royal Professor Ungku A. Aziz moderated the seminar and deftly balanced the proceedings so all who wished to had the opportunity to express their view.

The individual successes of such a politically and economically diverse group of countries provided many insights into structural adjustment and proved, once again, that economic policies followed by one country will not necessarily work for another.

v

MICHEL CAMDESSUS Managing Director

International Monetary Fund




Acknowledgement

The far-sighted wisdom of the International Monetary Fund in planning and organizing a series of seminars on themes related to structural adjustment sowed the seed for this report. The willingness of Bank Negara Malaysia to participate in its realization ensured a rich exchange of ideas.

This seems to be the appropriate place for me to record the gratitude of all the participants to these two institutions for providing the ingredients that made possible whatever results this seminar has achieved. In carrying out my tasks I have benefited from the excellent cooperation and courteous responses that made the work of the moderator feel much lighter than it really was. Personally, I am indebted to Azizali F. Mohammed from the Fund for his encouragement and guidance at every stage.

The seminar was ably coordinated by Graham Newman of the Fund and jaafar Ahmad and Md. Khir Abdul Rahman of Bank Negara Malaysia. juanita Roushdy of the Fund put the manuscript into published form. My secretary, Violet Fernando, bore the brunt of scripting the taped records and the preparation of several versions of the final text. Without her patient perseverance, it would have been difficult to meet deadlines.

For all that I have learned I am grateful. UNGKU A. AZIZ

Moderator

vii




Contents

Foreword

Acknowledgement

Contents

1 Introduction and Summary UNGKU A. AZIZ

2 Opening Address LIN SEE YAN

3 Economic Adjustment, Financing, and Growth in Southeast Asia During the 1980s

BERNARDO M. VILLEGAS

Comment by Tan Tat Wai

4 The Role of Fiscal and Monetary Policy in The Growth Process

v

VII

Vlll

12

16

39

RICHARD HEMMING and KALPANA KOCHHAR 45

Comment by Tanya Sirivedhin 67

5 Trade Policy as a Strategy for Structural Adjustment SUHADI MANGKUSUWONDO 72

Comment by Mohamed Ariff Abdul Kareem 95

6 Exchange Rate Policies and Managements: A Model for Successful Structural Adjustment

PETER QUIRK 99

Comment by Bongsung Oum

7 Export Volatility and Stabilization in Malaysia JAAFAR AHMAD

Comment by Azizali F. Mohammed

ix

127

130

154


X Contents

8 Structural Adjustment: Lessons from the Southeast Asian Experience

JORGE MARQUEZ-RUARTE

Comment by Mukul Asher

9 Strategies for Successful Structural Adjustment GOSAH ARYA

Lists of Participants, Panelists, and Observers

The following symbols have been used throughout this book:

to indicate that data are not available;

156

166

1 7 1

197

tO indicate that the figure is zero or less than half the final digit shown, or that the item does not exist;

between years or months (e.g., 1987-88 or January-June) to indicate the years or months covered, including the beginning and ending years or months;

between years (e.g., 1987/88) to indicate a crop or fiscal (financial) year.

"Billion" means a thousand million.

Details may not add to totals shown because of rounding.

The term "country," as used in this book, does not in all cases refer to a territorial entity that is a state as understood by international law and practice; the term also covers some territorial entities that are not states, but for which statistical data are maintained and provided internationally on a separate and independent basis.


1

Introduction and Summary

UNGKU A AZIZ

A seminar to discuss structural adjustment in a region that is at times seen as becoming a pivotal part of the global economy in the twenty-first century is likely to be quite exciting. The task of being a moderator for such a seminar is a privilege and deserves some reflection. Indeed, the structured functions of the moderator need to be adjusted through at least five phases of the seminar.

lniLially, he is one of the uackmom coo,·dinawrs who ensures thaL the protocols for each day's proceedings are carried out by the right participants at the right times. Besides the well-recorded tapes, the moderator keeps note of the progress of the discussions. Toward the end of the seminar, the moderator briefly metamorphoses into a panelist, who also proffers a summary of the discussions. The really difficult work begins with the scripting and editing of the transcripts and the preparation of summaries of the discussions. In a more subjective, if slightly academic, mode, the moderator draws his conclusions about what can be learned from the discussions. His final duty is to deliver a clean manuscript for publication.

The seminar itself was so structured as to present a kind of contrapuntal effect within an overall theme, which attained an essential harmony between the three papers prepared by the staff of the Fund and the four papers by participants from the region, who were central bank staff or academics. Similarly, the three papers by staff from the Fund were commented on by participants from the region. Overall, perspectives of place and time were balanced by selected discussions regarding the respective roles of fiscal and monetary policies, trade policies, and exchange rate policies. The lessons from the Southeast Asian experience, as interpreted by Ruarte, were balanced by specific discussions about commodity price fluctuations by Jaafar. Generally, a considerable degree of agreement


2 UNGKU A. AZIZ

characterized the seminar, with commentators offering statements of a supplementary nature or indicating that there were alternative viewpoints. The panel discussion was the most exciting part of the seminar. The respective backgrounds of the panelists ensured stimulating discussion that was set within a background paper that provided the appropriate boundaries.

All this made the task of the moderator both easy and difficult. The well-written papers and comments required virtually no editing and are so apposite that they need no further comment. Difficulty emerged when one tried to draw conclusions and lessons from the seminar and its discussions. Perhaps, Zen-like, the first lesson is, "That the basic lesson is that there is no lesson."

The greatest danger in the social sciences, of which the study of monetary, fiscal, and trade policies is a part, is that of making generalizations without adequate realization of all the major factors involved. It may be true that when there is an economic crisis of an urgent nature, some immediate action has to be taken to remedy the situation. Therefore, some advice has to be given as to which particular measures should be taken. The decision maker will have some model in his mind. I n countries where the data bases are inadequate, estimates have to be made. Most advisers will draw upon two sources for their recommendations: their knowledge of the theoretical aspects of monetary, fiscal, and trade policy formulation and administration and their direct, as well as indirect, experience of the successes and failures in certain countries, or in their own country, in the past.

Since the coinage of the term "newly industrializing economies," these advisers may be inclined to hold up the accomplishments of these economies as models for the lesser developed countries or for countries facing crises or shocks that the newly industrializing economies have overcome. In case this comment is taken to be somewhat xenophobic, I should hasten to add that the term "adviser" includes regional economists, most of whom would have undertaken their tertiary education in appropriate fields in the well-developed countries. This kind of danger is referred to by Asher, who presents a series of rather pertinent questions by referring to well-known writers, such as Toye, Dornbusch, and Ferguson.

It may be well realized, although it was not referred to in the seminar, that prior to their metamorphosis into newly industrializing economies, the little "tigers" experienced rather authoritarian political systems that were only modified, in some instances, after economic growth had reached a satisfactory level.

It may seem to be unnecessarily pedantic to argue about words or technicalities, per se. Nevertheless, it is often useful in the social


Introduction and Summary 3

sciences, especially in economics, to be as dear as possible about the conceptual basis of any term that is used. The term "structural adjustment" seems to be adequate for the purposes of the seminar. Nevertheless, there remain two aspects of structural adjustment that should always be borne in mind. First, there is the realization that the type of structural adjustment being thought of in our context is mainly limited to the formulation of trade, monetary, and fiscal policies and to their administration. Second, every package of measures recommended needs to be carefully customized to meet the specific needs of a country at a particular time.

Furthermore, while some economists may be quite certain about such concepts as the real effective exchange rates (Quirk, p. 99),

others consider that there are many problems involved in its calculation (Oum, p. 128). Finally, apart from the admonition regarding the making of generalizations from inadequate data, fallacies could emerge from confusion regarding the nature of causality itself. No apologies are offered for bringing in seeming irrelevancies. Some justification may be derived from the notion that generalizations and derived lessons from the successful experiences of certain developing countries with structural adjustment have sometimes been applied to others, unsuccessfully.

SUMMARY OF DISCUSSIONS

In the presentation of a summary, it is useful to begin with a Cartesian approach.

I n Paul Streeten's introduction to a similar seminar in 1988, he remarks that structural adjustment usually has six objectives : 1

• The reduction or elimination of a balance of payments deficit. • The resumption of higher rates of economic growth. • The achievement of structural changes that would prevent future

payments and stabilization problems. • The making of an economy that would be less vulnerable to

future shocks. • The reduction of rigidities in the economy, that is, increased

flexibility and adaptability for both products, as well as factors of production.

• The elimination of hunger and malnutrition; the alleviation of poverty; or the development of cultural autonomy, self-reliance, or greater national strength and military power. These are fundamental.

' Paul Streeten. ed .. Beyond Adjustment: The Asian Experience (Washington: International

Monetary Fund. 1988). pp. 1 and 2.


4 UNGKU A. AZIZ

The four participants from the Fund presented their views about the nature and scope of structural adjustment. Azizali Mohammed, in his opening remarks, touched upon Malaysia's structural adjustment and its transformation from a vulnerable primary commodity producer to a balanced and diversified trading nation. He also noted that the Fund's involvement in the 1980s with the problems of heavily indebted countries has moved it into areas of longer-range structural adjustment and reform, rather than short- to medium-term macroeconomic management. This shift has generated scope for misunderstanding, if not deliberate obfuscation.

Hemming justified a tighter definition of structural adjustment on the grounds of "the seriousness of the initial imbalances, the urgency with which balance of payments viability and price stability must be restored, and the mechanisms used to achieve these objectives" (p. 45).

Quirk drew lessons from the experience of Korea and some of the countries of the ASEAN (Association of South East Asian Nations) to the effect that "any model of structural adjustment will have as essential components a realistic, market-related exchange rate and positive real interest rate strucrure, and an adequate after-tax return to exporting industry. These are necessary but not sufficient conditions for successful adjustment" (p. 1 15).

Ruarte, in the longest definition, said, "Structural adjustment can be defined as the creation of conditions for sustained, noninflationary growth, and the elimination of impediments to the full and efficient use of resources. Furthermore, adjustment must permit the attainment of certain basic, and widely shared, social goals" (p. 156).

Two of the commentators (Sirivedhin and Ariff) amplified the scope of structural adjustment with the following comments. From the point of view of phasing, Sirivedhin said, "In general, monetary policy and e�change rate policy are the major players in short-term balance of payments adjustment, with fiscal policy playing a supportive role; whereas when it comes to long-term growth-oriented adjustment, fiscal measures can assume a prominent role, together with other structural adjustment measures. Monetary measures will help to improve the efficiency of resource allocation and expand productive capacity" (p. 67). Ariff said, "Structural adjustments in a country should reflect the changes taking place in the country's comparative advantage. Industrial transformation is never-ending and ongoing in a dynamic setting" (pp. 97-98).

This discussion about the scope of structural adjustment was rounded off with Sirivedhin's reference to the prerequisite for Thailand's accomplishments, " . . . the Government had the political



will to painstakingly follow through the adjustment program that had been mapped out" (p. 71).

I f there are any lessons to be learned from this seminar, they are likely to be more useful for decision makers and theorists who are concerned with the ASEAN region of Southeast Asia. In a general way, some of the lessons may be stimulating starting points for those who are concerned with other regions of the Third World. With due modesty, it should be realized that the report of this seminar cannot aim to be either a comprehensive textbook on the strategies for structural adjustment, nor can it try to be an encyclopedic survey of the current economic history of the countries included in the scope .)f the study. Neverthelss, there are many useful lessons about strategies, tactics, and techniques for initiating structural adjustment and for managing it. The blending of participants with global expertise together with practitioners in situ, including a dash of academics, has created a rich brew that should nourish the minds and hearts of those who are compelled to think of economic management every working day of their lives.

Growth Is the Aim

It would seem that states of the region have accorded the highest priority to economic growth. For the achievement of this end, each state has endeavored to manage its resources and arrange its "structure" in such a way as to sustain the highest possible rate of economic growth.

From the experience of most of the economies that now seem to have enviable rates of growth, in the longer term, broad-based rearrangements of structures were essential. These included shifts of emphasis in patterns of production, as well as employment, from agriculture, especially from small-scale agriculture, to manufacturing and ultimately to the production of services. Ex-colonies that derived wealth from the export of primary commodities have slowly turned toward the export of manufactured goods to the advanced countries and where possible, to the export of oil. Within cquntries, import substitution, which represents the initial phase of industrialization, has gradually evolved to export promotion. To support these longerterm adjustments, certain institutional reforms of fiscal and monetary policies, as well as trade, must occur.

Philosophically, there seems to be a hidden dogma that, apart from exceptional circumstances, market forces are likely to be more conducive toward the realization of conditions favorable for growth. The term "the market" actually implies a situation where there are virtually


6 UNGKU A. AZIZ

no restrictions on the behavior of buyers and sellers of products and services. This is sometimes referred to as "deregulation," or the removal of constraints. Occasionally, a critical finger points at the misallocation of resources that result from bureaucratic attempts to administer the market.

The state is discouraged from being involved in entrepreneurial endeavors. A well-recommended method for reducing deficits in public expenditure is the removal or "privatization" of state enterprises.

Empirically, several papers point out that the ASEAN-4 (Indonesia, Malaysia, the Philippines, and Thailand) have performed better than many other Third World countries, especially in Latin America. By virtually every measure, the four newly industrializing economies (Hong Kong, Korea, Singapore, and Taiwan Province of China) are therefore held up as models to be emulated by countries aiming at growth.

Some papers remind us that there could be objectives other than rapid and sustained economic growth. It may be said in a lighter vein, however, that the axiom is, "If growth is the aim, structural adjustment is the game."

At this point, it may be useful to mention that by the end of the decade some of the ASEAN-4 may have leapfrogged some of the newly industrializing economies to create a new model that may come to be known as the post-newly industrializing model.

Growth Comes with Trade

In order to obtain the benefits of scale, the countries of the region must engage in international trade. All of them have centuries of experience in commodity trading. Nevertheless, in recent times the terms of trade have consistently run against the ASEAN exporters of primary commodities. Economic growth has been hampered by a similar trend occurring in imports of consumer goods and capital goods. Therefore, the lesson for them is to bring about structural adjustments that will enable them to develop industrial exports. Frequently, the evolutionary cycle is seen as stages that proceed from import substitution to export promotion with the possibility of both stages co-existing at an advanced position.

There are discussions regarding the detailed techniques involved in adjusting monetary and fiscal regimes to enable the promotion of exports to expand without undue hindrance. Internally, the path toward high growth needs to be paved with a high level of domestic saving. Another prerequisite that involves other parties is the need



to manage exchange rates so that while there is flexibility, on the whole, there is stability.

The role of the other parties concerned becomes more significant if we remember that it takes two to trade. A free market in country P that is actually making structual adjustments in the interest of stability and flexibility needs to interface with a corresponding free market in country Q. The whole approach may fail if country Q engages in strategies of open or disguised protectionism to ensure political support from its home front. Thus it is feared by some that in 1992 Europe will be more closed than open to the manufactured exports from the ASEAN-4 and the newly industrializing economies of Southeast Asia. In the long run, it may be wise not to overestimate the accessibility of Japanese or Korean markets for manufactured products from Southeast Asia.

Money and Growth

Seminar participants continually returned to the subjects of monetary and fiscal, as well as exchange rate, matters in almost every session.

Essentially, fiscal policy has the role of ensuring that there is sufficient domestic saving, in general, and public saving, in particular, to guarantee that the investment requirements associated with the growth target are met without threatening the balance of payments and inflation objectives. For tax policy, a broad-based tax on final consumpion, such as a value-added tax levied at a single rate to ensure neutrality, is suggested as being most desirable. Various other recommendations on trade taxes, personal income tax, and company tax were discussed.

Although Hemming recommended that wage levels should be adequate to guarantee that the public sector can retain the quality of manpower it needs and to discourage employees from taking second jobs or engaging in fraudulent activities to increase their incomes, empirical evidence from the r.egion suggests that only one country has succeeded in following this recommendation. For many of the other countries in the region, privatization of public enterprises or the expansion of the financial sector has led to a severe drain of talented public administrators toward the financial or manufacturing sector.

Public enterprises are said to be inefficient producers who rely heavily on budget subsidies to cover their losses. The pervasive influence of politicians should be reduced so that public enterprise management has greater autonomy over policy and investment.


8 UNGKU A. AZIZ

In the long run, "money is neutral." This is a view that deserves to be considered by all planners who wish to make structural adjustments in the hope of achieving growth. Resource distribution is thought to be more effective in promoting growth if interest rates are allowed to rise to their market-clearing levels.

In sum, creditability is greatly enhanced by fiscal discipline.

Experience of the Region

The actual experiences of countries in the region that have made structural adjustments may help those concerned with policy formulation and implementation in countries that are considering structural adjustment. Those concerned can prepare conceptual maps of the achievements and failures of those countries that have made structural adjustments. In this way, by designing maps of several types of experiences, planners can realize the range of choices that are open to them, besides the interrelated nature of the variables that comprise structural adjustment.

In one sense such maps are a mirror of the past. In another sense, they may provide the basis for drawing insights as to alternative choices for the future. Even though the map may be a crucial tool for the policymaker, it is only an aid. Every country has its own unique historical situation. The matrix of socioeconomic variables embraces more than fiscal, monetary, or trade matters.

Even the experience of a single country can be rather different at different times in its history. It should be realized that all changes, reforms, or adjustments are not only interacting with other variables but the net effects are cumulative. In the seminar, the regional scene in its widest scope was described by Villegas. He traced the patterns of growth for the ASEAN-4 and two newly industrializing economies (Singapore and Korea) for the period 1980-88.

Structural changes, gross investment, and the "domestic resource gap" led to a discussion of foreign sources of investment.

From the point of view of trade policies, Mangkusuwondo chose a wider scope by including South Asia. Oum, for his discussion on exchange rate policies in the search for a model, compared the region, including Korea, not only with three Latin American countries (Argentina, Brazil, and Mexico) but also with Turkey. The exports of Southeast Asia are composed of primary commodities and manufactured products. An empirical view of external factors affecting growth can only be understood if the markets for which these exports are destined are also examined. This was the main thrust of Jaafar's paper. In passing, he concluded that Malaysia has been quite successful



in living with instability both in trade and in product diversification within a long period of sustained growth.

Many quite specific lessons that may be conducive toward the achievement of successful structural adjustment were drawn from the experience of Korea and from specific instances in the region.

The Panel Discussion

In the background paper for the panel discussion, Arya knitted together and highlighted the information provided in the previous papers. Significant patterns were delineated and important new perspectives offered so as to keep the ensuing panel discussion within manageable boundaries. Once again the map-making concept was relevant.

Instead 'Of delving into causality and modeling, the paper examined the history of the previous two decades in terms of challenge and response. A statistical model of the term "total shock" was defined to include the terms of trade effect, the export volume effect, and the interest rate effect. Essentially, the paper indicated that the shock tremors included the oil market collapse, global inflation, and the deteriorating terms of trade for countries in the region. Incidentally, it may be observed as a matter of interest that the actual experience of passing over the threshold and being recognized as a newly industrializing economy may itself be a kind of shock or rite of passage that has not attracted much attention thus far.

The paper concluded with admonitions in three directions. If all .or many of the countries of the region are successful in structural adjustments and manage to expand their industrial exports, then finding enough absorptive capacity in the developed countries might become a problem. Second, while it may be excellent strategy to leave more and more of the business of resource allocation to the unregulated market, export-oriented strategies, such as import substitution, involve a high degree of government intervention, including selecting industries, providing support, and guiding and directing their development. Third, trade barriers would need to be dismantled.

As has been mentioned above, it takes two to trade.

CONCLUSION

To paraphrase a fragment of a joke often heard at meetings on development some two decades ago, " . . . as a topic, structural adjustment has been much explored, although it is still quite attractive."


10 UNGKU A. AZIZ

The seminar had the essential purpose of exploring the dynamics of success in promoting economic growth. The examples were the newly industrializing economies of East Asia; the novitiates were the ASEAN-4. Equally important was the attempt to understand the contributions by the respective governments and private sectors toward the creation of vibrant economies that demonstrated sufficient adaptability in the face of vicissitudes of the world economy during the last two decades.

A Positive Assessment

The respective economies of the region and the main concepts involved in structural adjustment were thoroughly explored from a variety of perspectives. Many lessons were mentioned and many models were demonstrated, but no prescriptions for specific therapy of particular countries were offered. In any case, every participant always spoke in his or her personal capacity.

The papers were concise, objective, and amply supported by data. Most of the commentators either amplified or complemented the papers they were commenting on. Thus one can assume that they were generally in agreement with the statements and conclusion in the papers.

Indeed, the whole seminar was characterized by a high degree of passive consensus. That is to say, there was a minimum of sharp dissent. Nevertheless, a few questions were diplomatically put forward. In a limited sense an outsider could feel that he was listening to a colloquium of sages rather than a "contention" of gurus. This gave the seminar its pragmatic elegance and its harmony.

A certain proclivity for the free market in resources and in trade was perceptible. The only challenges to this view were regarding the timing of deregulation or the fine-tuning of particular structural adjustments.

There seemed to be an implied absolute that the right metamorphosis would be from a backward, primary producing country to an export-driven economy like that of a newly industrializing economy, with the possibility of becoming a more advanced �ype of economy in the full course of time.

Some Lacunae

I t has been pointed out that there were no empty moments in the agenda of the seminar. Nevertheless, as in all economic matters, the means (i.e., the time ) could have had alternative uses and it is in this respect that some missing topics may be mentioned.


UNGKU A. AZIZ 1 1

In logic, Mill's methods encourage thinkers to examine not only the positive aspects but also the negative aspects of problems. There was rather little discussion of attempts at structural adjustment that had failed. From this, should we conclude that all the reforms of all the newly industrializing economies and some of the ASEAN-4 were always successful? Some examination of what not to do could have been useful too.

There is what the Japanese call kaizen, or improvement, that may make successful structural adjustment even better. This aspect could be given more attention in considering the current situation among the ASEAN-4.

Another philosophical challenge is the consideration as to whether structural adjustment is absolutely inevitable if economic growth is intended. And, of course, the extent to which the need for structural adjustment comes from mismanagement within or from exogenous political or economic pressures are irresistible.

The Wrap-Up

In Japanese culture, the wrapping is often valued as much as the gift itself.

As Mohammed said, " . . . this seminar has been a success . . . of all the seminars I have attended, I can assure you, Mr. Chairman, that this is one of the most enjoyable. One where the interest has been sustained at all times, where people even at the end of the day have been making points that were useful, valuable insights . . . . "

What more could be desired from a seminar devoted to the exploration of a rather technical subject, structural adjustment, with participants from the financial and academic sectors of the region.

For the opportunity of being in the seminar and rubbing shoulders with such a pragmatic and learned group, this moderator is most grateful.


2

Opening Address

LIN SEE YAN

I am very pleased to be here this morning to officiate the opening of the International Monetary Fund Seminar Program for NonOfficials. As co-host, 1 would like to take this opportunity, on behalf of Bank Negara Malaysia, to extend a warm welcome to all participants and observers, particularly those of you who are visiting Malaysia for the first time. I note from the program that you have a heavy agenda before you. Nevertheless, I do hope you will take some time off to see what you can of our country and to enjoy our Malaysian hospitality.

The theme for this seminar, namely, "Strategies for Structural Adjustment: The Experience of Southeast Asia" presents enormous scope for thoughtful discussion. In the course of the next few days, we can all look forward to a lively exchange of experiences among the Southeast Asian representatives, matched by well-informed intervention from our experts from the Fund.

Southeast Asia represents one of the most dynamic growth centers in the world today. The region has already produced one newly industrializing economy-Singapore-with several more on the way. Despite apparent differences in terms of economic structure, population size, and social and political environment, the region has consistently demonstrated an ability to sustain economic growth at a creditable rate, even in the face of global recession. Indeed, Southeast Asia is renowned for its success in weathering the storms and vagaries of an ever-changing world economy. And, as the region contemplates the challenges of an increasingly difficult world trading environment in the next decade, this seminar presents an excellent forum for the exchange of ideas and for the sharing of one another's experiences.

Looking back, we all wonder about the underlying thrust of structural adjustment strategies in Southeast Asia. Why did they

12


Opening Address 1 3

succeed when many others failed? I hope this seminar will be able to dwell on valuable experiences in the recent past within this region and shed some light on this matter. As food for thought, I would like to share briefly with you Malaysia's recent experience in voluntary structural adjustment.

In the thirty odd years since the country's independence in 1957, Malaysians have traditionally enjoyed rapid economic growth, with per capita income rising from a mere $200 in 1957 to nearly $ 1 ,900 by 1988. The crunch came in 1981-82, with the onset of the global recession and the debt crisis. Despite a well-diversified economic base, Malaysia, like so many other export-oriented countries, was not spared the contractionary effects of the worst world recession since the Great Depression. During the initial downturn, the Government resorted heavily to traditional Keynesian measures to "ride out the recession," under the impression (which later proved false) that the world recession would be short-lived. While fiscal pump-priming helped to return a respectable growth averaging about 6.4 percent annually in 1981-82, the toll was heavy. Within a span of three years, the federal government's fiscal deficit deteriorated from 8 percent of GNP in 1979 to nearly 18 percent in 1982. The prospects then were for a further worsening of the fiscal position in view of the deflation of world growth and trade. Equally daunting was the corresponding deterioration in the balance of payments. The deficit in the current account of the balance of payments, which was only about 1 percent of GNP in 1980, surged to 14 percent by 1982. I n order to finance these deficits, our external debt increased sharply from only $4.5 billion in 1980 to nearly $10.5 billion by 1982, equivalent to 4 1 percent of GNP. Although still modest by international comparison, it was far too high by Malaysian standards.

By the middle of 1982, it was dear that the rapid increase in government spending was not sustainable, particularly at a time when the global economy was on the retreat. Once this was recognized, the Government was determined to tighten its belt, reorientate its priorities, and move back to the path of sustainable growth with stability. A multiyear economic adjustment program was initiated in late 1982 to significantly reduce the size of public sector expenditure. Many tough but necessary measures were implemented to cut government spending and rationalize the operations of public enterprises, including privatization. Subsidy programs were cut back significantly and a moratorium was imposed on civil-service wage increases. As government spending was reduced, the emphasis of public policy shifted toward the promotion of private sector activity as the main engine of growth. Central to the Government's strategy to promote private


14 LIN SEE VAN

investment was the provision of generous tax incentives, the liberalization of restrictive laws and practices, and the deregulation of cumbersome rules and regulations. In effect, the Government was determined to reduce the cost of doing business in Malaysia and to ensure that private entrepreneurs were adequately rewarded for their efforts. Measures were also initiated to provide the necessary infrastructure and create a business climate conducive to private investment activity and the taking of risks.

The adjustments were as tough as they were painful. But through perseverence, the Government has since managed to turn things around. The facts speak for themselves: by the end of 1985, the federal budget deficit had been reduced from 1 8 percent to 6 percent of GNP; and the balance of payments deficit from 14 percent to 2.1 percent of GNP. For an economy so accustomed to receiving strong governmem stimulus to sustain growth, the sharp fiscal retrenchment had certainly contributed to deflationary effects on the economy. This was one price we were willing to pay, for without adjustment, the escalating twin deficits would have been clearly unsustainable. Indeed, we were right there on target in terms of adjustment efforts when, as luck would have it, the economy was confronted with yet another formidable challenge in the mid-1980s. The second collapse in commodity prices across the board in 1985 sent the economy into a tailspin; economic growth was negative for the first time in recent history.

It is, I think, to the Government's credit that it remained fully committed to its structural adjustment program, however painful in the short run. These events are now behind us. The economy has been on the recovery path since late 1986 and by the end of 1988, growth had accelerated to nearly 9 percent in real terms, a record not achieved since 1979. To some extent, the strong recovery was stimulated by a pickup in world demand as well as higher commodity prices, which contributed to a record surplus in the current account of the balance of payments to the tune of more than $2.5 billion, or 8.5 percent of GNP in 1 987. The current account of the federal government also turned around to record a small surplus in 1988, a year ahead of schedule.

Admittedly, structural transformation in any country is difficult to achieve. By the same token, the adjustment process in Malaysia is by no means completed. The process of transforming the economy from one that is highly dependent on government spending to one that relies more and more on private sector initiative and enterprise will necessarily take time. What matters, however, is that the commitment toward economic efficiency and prudent economic management will


Opening Address 15

continue well into the future. As a result, stronger foundations have already been built, and the economy is now poised for sustainable growth with stability in the longer term.

Enough said about Malaysia's experience in structural adjustment. Over the next few days, you will have an opportunity to exchange views and learn from one another's experiences about some of the critical elements underlying all successful adjustment strategies. J udging from the papers tabled for discussion, I am optimistic that your deliberations will prove to be both stimulating and fruitful.

On this note, I now have great pleasure in declaring open the International Monetary Fund and Bank Negara Malaysia Seminar on ''Strategies for Structural Adjustment: The Experience of Southeast Asia."


3

Economic Adjustment, Financing, and Growth in Southeast Asia

During the 1980s

BERNARDO M. VILLEGAS

The debt crisis that emerged in the early 1980s forced many countries to reconsider their development strategies. Many had embraced international borrowing as a way to boost investment levels, despite low rates of domestic savings. Some countries and regions in Asia, such as Korea and Taiwan Province of China, were extremely successful. Korea, in particular, raised huge amounts of international capit.;:�l, which it invested in efficient operations and used to spur the growth of export-oriented industries. Latin American countries were far less successful. They succeeded in building large domestic industries but were unable to manage their debts. As a result, their indebtedness brought them exchange depreciation, inflation, and stagnation.

The Asian example highlights the advantages of foreign borrowing; the Latin example points out its dangers. Taken together they show that foreign borrowing can be an effective means of overcoming low levels of domestic savings. I t is not enough, however, to invest the new capital efficiently; the economy must also be able to generate the foreign exchange needed to carry the international borrowing. Heavy borrowing from international markets can rarely be sustained without a strong export program in a country's development strategy. This has been the lesson of the 1980s.

PATTERN OF EXPORTS AND GROWTH

The Southeast Asian countries have been among the first to react to this lesson. From 1980 to 1985, the world economy expanded by

16


Economics Adjustment, Financing, and Growth 17

only 2.4 percent a year; the industrial countries grew only 2.6 percent a year; but Malaysia, Indonesia, and Thailand all averaged rates above 4.0 percent--clearly above-average performances. For both Malaysia and Thailand, growth was accompanied by a strong expansion of exports during a period when world trade was actually contracting. Indonesian exports, however, dropped sharply as oil prices declined. The pattern of export and growth is already clear for both Malaysia and Thailand. In Table 1 the data identify more characteristics in the pattern and suggest that Indonesia and the Philippines are also pursuing the same path.

The growth of manufacturing exports was one of the earliest signs of reorientation toward exports. This growth was both a result of declining commodity prices, such as, those for oil and copper, and of efforts to promote and diversify exports. Data suggest that the Philippines was the first to recognize the importance of developing an export manufacturing sector. In 1981, manufactured exports jumped from 40 percent to 47 percent of total exports, and by 1987, manufactured products accounted for 66 percent of exports.

In 1983, as exports began to crash, Indonesia also recognized the need to diversify. In that year, manufactures grew from 5.6 percent to 9 . 1 percent of exports and expanded to 20.4 percent by 1986. Table 2 shows that Thailand and Malaysia expanded manufacturing exports somewhat later, 1985 or 1986; however, both maintained strong gross nation product (GNP) growth rates during the first half of the 1980s. This gave them less incentive to restructure their exports.

Expanding exports depends on improving the competitiveness of a country's products on the world markets. Table 3 shows that the currency of all four countries depreciated against the dollar. In several cases, major devaluations were followed by either an expansion of manufacturing exports or a large increase in total exports. Of the four countries, Malaysia is the only one that has not experienced a major devaluation since 1980.

Indonesia depreciated its currency by over 40 percent in 1983. Much of the depreciation occurred in the first quarter, and this stimulated gro·:1th in manufacturing exports. The following year, exports grew by 1 1 percent, after having dropped almost 20 percent over the previous two years (Table 4). Indonesia devalued again in the second half of 1986. In that year, the currency depreciated by almost 50 percent; manufacturing as a share of exports climbed from 1 4 percent to 20 percent, and the following year exports grew by almost 30 percent.

In the Philippines, exports declined by almost 1 5 percent between

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Table 2. Share of Manufacturing In Exports

(Percent of total exports)

Average

1980 1981 1982 1983 1984 1985 1986 1987 1980-82 1985-87

Indonesia 4.0 4.7 5 6 9.7 1 1 .4 13.9 20.4 na 4.8 17.12

Malaysia 28.4 28.4 28.9 30.8 27.7 32.1 39.9 42.1 28.6 38.01

Philippines 39.7 46.7 50.5 52.5 57.8 62.2 62.1 66.0 45.6 63.43 Thailand 39.8 35.4 34.6 37.1 38.4 42.7 46.1 na 36.6 44.38

Singapore 51 .9 52.7 53.3 58.4 584 59.6 66.4 72.4 52.6 6614 Korea 905 90.9 91.8 91 .5 91.7 91.8 92.3 92.8 91 . 1 92.32

Taiwan Province of China 88.2 89.0 89.1 89.9 91 .0 90.7 91.3 92.2 88.7 91.42

Sources: Asian Development Bank, Key Indicators of the Developing Member Countries of ADB

(July 1988): and official country sources. Note: Manufactured exports were calculated as the sum of exports SITC 5 through 9. This value

was then divided by total exports, fob. na = nonapplicable.

1980 and 1983. But after a depreciation of almost I 00 percent between October 1983 and june 1984, exports recovered to grow by 7.7 percent for 1984. At the same time, manufactured exports rose from 58 percent to 62 percent of total exports. In 1985, exports again declined as political turbulence disrupted much of the economy. Since then, however, exports have taken off without any further help from major currency depreciations.

The Thai case is less dramatic than that of either the Philippines or Indonesia. From October to December of 1984, the baht underwent a modest 1 8 percent devaluation. It had been pegged at B23 to the dollar since 1981, and during that time exports had dropped by 8 percent. The next year, manufacturing jumped from 38 percent to 43 percent of total exports, and in 1986, exports began to grow at rates well above 25 percent a year.

By 1987, all four countries were experiencing a rapid growth in exports, and compared with 1980, manufacturing had increased its share of total exports by an average of 1 5 percentage points. During this period, the average growth rates for exports were above world averages; however, they were erratic. By contrast, the establishment of strong export growth rates since 1986-87 has brought with it gross domestic product (GDP) growth rates in the 5 percent to 8 percent range, and growth rates are expected to persist at this level through 1990.

As Malaysia has shown, exchange depreciation is not a prerequisite for export growth, and the Philippine experience in 1985 has shown

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22 BERNARDO M. VILLEGAS

that depreciation does not necessarily lead to an increase in exports. Devaluation is an important tool in stimulating and restructuring exports, but it is not a guaranteed recipe for growth. By the same token, exports are not a guarantee for economic growth. They are a powerful force in stimulating growth but the internal economic structure must also be able to support and finance the growth.

INTERNAL STRUCTURAL ADJUSTMENT

Though there has been a large expansion and diversification of exports in Southeast Asia, internal adjustments have progressed more slowly. For the four countries in Table 5, the industrial sector has generally expanded slightly, and in some the service sector has grown dramatically. As for the agricultural sector, although it has accounted for a smaller portion of the employed labor force in all four countries, surprisingly Thailand has been the only country to show a marked decline in the agricultural sector's share of gross production. The net structural change for these four coumries has been small, but individual countries have achieved sharp changes in certain areas.

Both Malaysia and Thailand have expanded their industrial sectors. For both countries, the share of the industrial sector as a percentage of GDP has increased by approximately 2 percentage points since

Table 5. Structure of Production: Industry and Manufacturing

Average

1980 1981 1982 1983 1984 1985 1986 1987 1981H12 198&-87

Industry as percent of GOP Indonesia 434 41 .1 390 37 0 37 3 36.2 31.9 na 41 .2 34.0 Malaysia 35.8 34.7 34.9 36.3 37.5 36.6 37.9 38.5 35.1 37.7 Philippines 36.6 36.6 36.0 20.2 34.4 32.7 32.0 32.4 364 32.4 Thailand 28.5 28.5 28.0 27.7 29.2 30.4 na na 28.3 30.4

Manufacturing as percent of GOP Indonesia 1 1 6 1 0 8 12.9 1 1 . 1 1 2.7 13.5 14.4 na 1 1.8 13.9 Malaysia 1 9 6 19.2 19.2 1 9 5 203 19.7 209 22.4 19.3 21.0 Philippines 24.4 24.6 24.4 13.9 25.4 24.6 24.5 24.5 24.5 24.5 Thailand 19.6 20.1 19.5 1 9. 1 19.8 20.1 na na 19.7 20. 1

Source: Asian Development Bank. Key Indicators of the Developing Member Countfles of ADB (July 1 988).

Note: All data were calculated from the series for GDP by industrial origin at market prices Agriculture was taken directly. without any additional sectors. Industry was calculated as the sum of mining. manufacturing. construction. and electricity. gas. and water. Service was calculated as the sum of all other sectors not included in either industry or agriculture na = nonapplicable



1980. In contrast, the Philippines and Indonesia stand out for the marked decline in the share of industrial production. These declines can be explained, however, by exogenous factors that have served to cover up positive trends within each country's industrial sector.

In Indonesia, declines in the share of industry are largely due to falling oil prices. This has affected both the country's petroleum industry and its construction sector: movements in the construction sector are closely associated with changes in the Government's oil revenues and level of development expenditure. Despite these problems, Indonesia's manufacturing industries. have been expanding significantly, rising from 10.8 percent of GDP in 1981 to 14.4 percent in 1986. This trend parallels the expansion in manufacturing exports noted earlier and represents a positive restructuring of the industrial sector, although the effect has largely been overshadowed by· the adverse effect of oil price declines on the world market.

For the Philippines, the reduction in the share of industry has been far smaller than for Indonesia. The 4-point drop was directly related tO the sharp recession and political turmoil from 1983 through 1986. The data for 1987, however, indicate a slight recovery in GDP share, and final figures for 1988 should show further recovery owing to a very active construction sector as well as capacity expansions and generally robust growth. Of particular note is the fact that the share of manufacturing showed little change during the period. And, at 24.5 percent of GDP, the Philippine manufacturing sector as a percentage of GDP is the largest of any of the four countries.

Table 6 sumarizes the performance of the service sector in each country from 1980 to 1987. Here, Malaysia and the Philippines have only showed slight changes, as the share of the service sector remained in the low 40 percent range. Indonesia, on the other hand, showed a steady growth in services as the share in GDP rose from 33.7 percent in 1981 to 42.3 percent in 1986. For Thailand, services were at a high of 52.4 percent in 1985, up more than 6 percentage points from 1980. At that time, the four countries split easily into three groups. Thailand had the largest share of the services sector-more than 5 points larger than either Malaysia or the Philippines-and Indonesia had by far the smallest. By the middle of the decade, Thailand had further expanded its services sector, while the other three countries appeared to settle into a temporary equilibrium where services accounted for 40 percent to 43 percent of GDP.

For Thailand, the rapid expansion of its services sector was marked by an even more rapid decline in agriculture. From 1980 to 1986, agriculture dropped almost 10 points falling from 25.4 percent of GDP to just 16.2 percent. Table 6 shows that in 1980, each country



Table 6. Structure of Production: Service and Agriculture

Average

1980 1981 1982 1983 1984 1985 1986 1987 1980--82 1985-87

Service as percent of GOP Indonesia 31 .8 33.7 34.7 38.9 39.3 40.1 42.3 na 334 41.2 Malaysia 41.3 42.9 42.5 42.6 42.4 42.5 40.7 40.0 42.2 41 .1 Philippines 40.1 40.7 41.5 67.4 39.7 40 8 42.1 42.8 40.8 41.9 Thailand 46.1 47.6 49.7 50.2 51.4 52.4 na na 47.8 52.4

Agricultural as percent of GOP Indonesia 24.8 25 3 26.3 24.0 23.4 23.7 25.8 na 25.5 24.8 Malaysia 22.9 22.4 22.6 21.1 20.1 20.8 21.4 21.5 22.6 21 .3 Philippines 23.3 22.7 22.5 12.4 25.8 265 25.9 249 22.9 25.8 Thailand 25.4 23 9 22.3 22.1 1 9 3 1 7.1 16.2 1 6 2 23.9 16.5

Source: Asian Development Bank, Key Indicators of the Developing Member Countries of ADB (July 1988).

Note: All data were calculated from the series for GDP by industrial origin at market prices. Agriculture was taken directly, without any additional sectors. Industry was calculated as the sum of mining, manufacturing. construction. and electricity. gas. and water. Service was calculated as the sum of all other sectors not included in either industry or agriculture. na = nonapplicabfe.

had an agricultural sector that was about 23 percent to 25 percent of GDP. Except in Thailand, these levels persisted throughout most of the 1980s. In the Philippines, the share of agriculture rose slightly after 1983, but since 1986, it appears to be returning to its earlier levels. Malaysia, on the other hand, showed a slight decline in agricultural share. These adjustments, however, were not large in either case.

A slightly different pattern emerges when we look at employment patterns (Table 7). In all four countries, agriculture accounted for a smaller share of employment in 1986 than it did in 1980. For the Philippines and Indonesia, the adjustments in employment were quite small-one or two share points. Between 1980 and 1986, however, Malaysia shifted 5 percent of its employed work force out of agriculture, and Thailand shifted more than 4 percent. Despite the shifts in agricultural employment, the table shows that no clear corresponding increase occurred in employment by the manufacturing sector. This suggests that much of the labor adjustment was funneling into the services sector.

In Thailand, labor shifts from agriculture to services are certainly understandable given the large expansion in the services sector and the corresponding decline in agriculture as a percentage of GDP. What is surprising is that the sector accounted for such a large share of the existing jobs, 67 percent, while the sector produced only 16



Table 7. Employment and Productivity

Average

1980 1981 1982 1983 1984 1985 1986 1987 198�2 198!HI7

Distribution of Employment (Percent of Total Employment)

Agriculture Indonesia 55.9 61 .5 54 7 55.4 55.1 54.7 55.1 na 57.3 54.9 Malaysia 37.2 352 33.0 31.5 31 .0 31.3 31.7 31 8 35.1 31.6 Philippines 51.4 51.2 51 .3 51.4 4 9 6 49.3 49.9 47.8 51.3 490 Thailand 70.8 71.9 68.4 69.1 69.7 68.4 66.7 na 70.4 67.6

Manufacturing Indonesia 9.8 8.5 1 1 . 1 9 9 9.9 9.9 8.2 na 9.8 9.1 Malaysia 16.8 16.8 1 6.6 16.4 16.6 1 6.0 1 5.7 16.2 16 7 16.0 Philippines 1 1 .6 10 8 1 0.5 10.4 10.5 10.3 9.9 10.6 1 1 0 1 0 3 Thailand 8.1 7.4 8.3 7.5 8.1 8.3 7.9 na 8.0 8.1

Productivity Ratio (Manufacturing I Agriculture)

Indonesia 3.07 4.02 2.72 2 78 5.00 5 23 6 05 na 3.3 5.6 Malaysia 2.06 1 .94 1.80 1.88 1 .98 1 .95 2.05 2.12 1.9 2.0 Philippines 4.56 4.82 4.94 5.30 4.63 4.17 4.13 4.09 4.8 4.1 Thailand 7.42 8.35 7.26 8.38 8.33 7.62 8.20 na 7.7 7.9

Source: Asian Development Bank, Key Indicators of the Developing Member Countries of ADB

(July 1988). Note: Distribution of employment was calculated from the data on sectoral employment and total

employment. The productivity ratios were calculated by first calculating productivity in the manufacturing and agricultural sectors. Productivity was calculated as the sector's contribution of GOP at constant prices divided by employment in that sector. na = nonapplicable.

percent of 1986 GDP. In fact, compared with other countries, Thailand had a far larger portion of its labor force employed in agriculture, even though agriculture as a percentage of GDP was far lower in Thailand than in the other countries. This suggests that in 1986 Thailand had a large amount of surplus labor in the agricultural sector. In contrast, Malaysia's agriculture accounts for only 32 percent of the available jobs.

Productivity measures also provide an interesting insight into the changes and structural differences between the countries. Table 7 provides the data for the agricultural and manufacturing sectors. Over time, we expect the measures for the two sectors to become more equal. Productivity in manufacturing is likely to be larger than in the agricultural sector, but large differences are likely to induce resource shifts. If we recognize this, the productivity ratios become particularly interesting. First, Malaysia has the lowest ratio, which has


26 BERNARDO M . VILLEGAS

remained a stable 2 : I throughout the 1980s. This suggests a welldeveloped agricultural sector and little pressure for structural changes either in terms of resource allocation or relative production levels of the sector.

In the Philippines, the ratio has been between 4: 1 and 5: I . This gap is more than twice as big as for Malaysia, but it has been narrowing since 1987. A pessimist might suggest that this is due to a stagnant manufacturing sector. The data, however, refute such a hypothesisthe manufacturing sector has constantly held a 24 percent to 25 percent share of GDP. The answer is an improving agricultural sector that expanded its output, while 2 percent of the employed work force shifted out of agriculture. Thailand and Indonesia tell a different story. In Thailand the ratio has fluctuated around 8: l , while in Indonesia the productivity gap has been expanding. This pattern is indicative of the strengths of the manufacturing sectors in these countries. I n essence, the growth rates of manufacturing have been so consistently high that the resource adjustments have not been able to keep pace.

Of the four countries, Thailand appears to have undergone the most internal restructuring. It has greatly expanded the services sector and sharply reduced the size of its agricultural sector relative to GDP. These adjustments seem to have been very successful, as the country has posted a compounded growth rate of 5.7 percent since 1980. Future development may be hindered, however: the agricultural sector still accounts for a massive 67 percent of all jobs, although it only produces 1 7 percent of GDP. The challenge for Thailand will be to improve the productivity of agricultural workers and to absorb more of the workers into other sectors with higher productivity.

The 1980s have also brought change to the Philippines. From 1983 to 1986, this was in the form of a severe economic recession. During that time, real output declined more than 10 percent, agriculture expanded its share in GDP, and the services sector swelled, as it absorbed many of the unemployed and destitute in marginal activities. Since 1986, however, many adjustments appear to be under way. The share of agriculture has begun to decline in both GDP and, more important, in employment. Furthermore, the stability of the country's productivity ratio suggests that growth has been well balanced between agriculture and industry-an important consideration for a country where almost 50 percent of employment is still in the agricultural sector.

For Indonesia and Malaysia, adjustments have been quite moderate. Malaysia has steadily shifted employment out of the agricultural sector and slowly increased the share of industry in GDP. Indonesia has



worked to build its manufacturing sector, and productivity in manufacturing has grown almost twice as fast as in agriculture. Unfortunately, manufacturing still accounts for only a small part of the country's economy.

FINANCING GROWTH

The growth of exports and the adjustments in employment, production, and productivity have been important factOrs enabling Southeast Asia to be one of the fastest growing regions in the world. One crucial factor has not been discussed, however. Long-term growth will not succeed without capital accumulation (i.e., investment). Investment is used to offset depreciation and increase a country's stock of productive assets. Table 8 shows that the investment levels for all four countries have been in the 20 percent to 30 percent range. Though high, these rates are still significantly below the 30 percent to 40 percent level of the newly industrializing economies during their growth in the 1970s.

One reason for this is financing. Though higher investment levels could stimulate more production, countries may be unable or unwilling to finance the higher levels. The primary source of funding for gross investment is .domestic savings. Many countries that are trying to grow rapidly find that domestic saving, however, is not large enough to fully finance the level of capital accumulation that they desire. This difference between investment and saving is referred to as the domestic resource gap. Note the use of the word "domestic."

Table 8. Gross Investment

(In percent of GOP)

Average

1980 1981 1982 1983 1984 1985 1986 1987 1981-83 1980-87

Indonesia 20.87 32.07 29.19 29.40 25.47 26.54 2464 26.33 30.22 26.81

Malaysia 30.42 34.99 37.29 38.04 33.56 27.55 25.27 24.05 36.78 31.40

Philippines 30.68 30.56 28.33 26.69 17.02 13.94 12.91 15.29 28.53 21 93

Thailand 27.20 24 .74 21.01 22.95 23.93 23.47 21 .46 20.90 22.90 23.21

Singapore 4634 46.31 47.93 47.90 48.48 42.52 38. 18 39.44 47.38 44.64

Taiwan

Province

of China 35.96 30.28 27.55 23.1 1 21.57 18.02 16.09 19.47 26.98 24.01

Source: International Monetary Fund. International Financial Statistics (IF$). Note: Gross investment was calculated as the sum of gross fixed capital formation and the net

increase in stocks.



Countries faced with a resource gap have two basic choices. They can reduce the level of investment or they can use foreign savings to fill the gap. The foreign savings may come in the form of loans, grants, or even direct investment.

From the late 1970s through the early 1980s, all four countries maintained investment levels near or above 30 percent of GDP. These high investment levels created a resource gap that averaged 7.2 percent of GDP in 1981 and 7.9 percent in 1982. This represented a substantial use of foreign savings. In 1984, in an effort to reduce their dependency on foreign savings, Indonesia, Malaysia, and the Philippines all began to reduce their investment levels. (Thailand had already reduced its levels during 1980 and 1981). This action substantially narrowed the resource gap for all four countries (Table 9). Thailand and the Philippines, however, also had to contend with falling levels of domestic saving. In the Philippines, investment levels fell more than saving, resulting in a resource surplus by 1986. In Thailand, investment levels remained stable, while saving declined from 1982 until 1985. Thus in 1985, the gap peaked at a high of 6.9 percent of GDP. In 1986 and 1987, the gap was reduced as saving climbed and investment fell.

The efforts to shrink the resource gap grew out of the emerging debt crisis. The most common source of foreign savings had been foreign loans. But countries tried to evade the debt trap by reducing the resource gap and pursuing other forms of foreign savings. Thailand was the most successful of the four countries. Just as it

Table 9. Domestic Resource Gap

(In percent of GOP)

Average

1980 1981 1982 1983 1984 1985 1986 1987 1981-83 1980-a7

Indonesia -3.87 7.35 8.23 5.63 -0.22 2.21 3.92 2.51 707 3.22

Malaysia 1 .10 9.67 13.33 13.61 4.84 1 .98 0.44 -7.13 12.20 4.73

Philippines 6.04 7.01 7.27 5.58 0.67 0.13 - 1 .27 - 1.17 6.62 3.03

Thailand 4.95 4.74 2.80 5.63 605 6.93 3.51 0.74 4.39 4.42

Singapore 11 .15 8.57 8.37 3.35 1.26 - 1 .74 -4.43 2.1 8 6.77 359

Taiwan

Province of China 3.03 - 1 .51 -2.83 -9.01 - 1 2.47 - 16.08 -23.56 -21 .92 -4.45 -10.55

Source: International Monetary Fund, International Financial Statistics (IFS).

Note: The resource gap was calculated as gross investment less gross domestic savings. In turn, gross domestic savings was calculated as GOP less private consumption less government consumption plus net factor payments from abroad.



started to narrow its resource gap in 1980/8 1 , it also began to cut back on its use of foreign savings. In 1980, long-term financing was equivalent to 20 percent of gross investment, but by 1987 it was less than 1 percent (Table 10).

Malaysia and Indonesia both reacted later. Between 1982 and 1983, both countries increased their dependency on foreign borrowings largely in expectation of a recovery in oil prices. In Indonesia, longrun financing climbed to 1 9 percent of investment, while in Malaysia it rose to 1 1 .8 percent. In both countries, these levels were substantially higher than their pre-1982 levels. By 1985, Malaysia had begun tO cut back on its borrowing, and by 1986 it measured less than I percent of gross investment. Indonesia had a harder time reducing its dependency on foreign savings. In 1985, long-term financing was equivalent to only 7 percent of investment, but the following year, borrowing rebounded to just over 1 2 percent.

It is interesting to note the timing between the efforts to reduce foreign borrowing and the efforts to lower the levels of gross investment. In Thailand, investment levels began to fall in 1981 and long-term borrowing as a percentage of gross investment began to decline in the same year. The same pattern holds true for Malaysia, thus suggesting a systematic effort to reduce each country's debt exposure. The two exceptions to this pattern are Indonesia and the Philippines. In the Philippines, a significant narrowing of the resource gap after 1988 was not followed by reduction in foreign borrowing. This was largely due to the fact that the borrowing was in response tO balance of payments issues and political pump-priming. They did

Table 10. Borrowing as Percentage of Gross Investment

Average

1980 1981 1982 1983 1984 1985 1986 1987 1980-87

Indonesia 12.74 7.19 17.31 19.57 12.81 7.09 12.80 1 2.55 12.76 Malaysia 1 .32 2.03 4.04 1 1 .37 1 1 .79 6.41 0.45 - 0. 57 4.60 Philippines 9.67 1 1 .57 13.81 27.09 1 6.88 42.52 29.28 4.75 19.45 Thailand 20.54 1 7.43 14.59 10.92 1 2 30 6.20 - 1 .94 0.40 1006

Singapore 5.75 1.31 7.72 -3.03 -3.13 0.45 - 1 .06 -5.37 0.33 Taiwan

Province of China 6.22 7 99 12.42 7 69 -981 - 1 1 .58 - 16.65 - 1 2.03 - 1 .97

Source: International Monetary Fund, International Financial Statistics (IFS).

Note: Borrowing was calculated from balance of payments data as the sum of other long.term capital and exceptional financing. This value was then converted Ia national currencies using the average exchange rate for the year (see Table 3).



not represent funding used for investment. By 1988, however, borrowing had fallen to only 4.8 percent of gross investment.

The Indonesia case is more interesting in that it highlights the ability of the other countries to find attractive sources of foreign savings. Between 1981 and 1987, Indonesia managed to cut back its level of investment, producing a resource gap that averaged only 2.9 percent of GDP for the years 1985 to 1987. Nevertheless, it was unable to significantly reduce its borrowing as measured against gross investment. Moreover, the borrowing rose when measured against the size of the resource gap. A key difference between Indonesia and the other countries, which helps to explain the anomaly, is that they were able to identify alternative sources of funds-transfer payments, bilateral aid, and direct investment. For Indonesia these alternative sources were all negligible.

In Thailand, and particularly in the Philippines, transfers have been growing as a percentage of gross investment. These funds include bilateral and multilateral aid, as well as private donations to programs in agriculture, education, health, and other areas. These projects may not all contribute to gross investment, but to the extent that they free domestic resources they contribute indirectly. In the Philippines, these funds have grown from 4 percent of investment in 1980 to 1 1 percent in 1987, and in Thailand it has fluctuated around 2 percent of investment. In both countries, the subcomponent grants to the central government have grown steadily; however, for grants, the level in Thailand was almost twice as high as in the Philippines.

The other major alternative source of foreign savings has been direct investment. It is particularly appealing as there is no net interest or guaranteed repayments for this form of foreign savings. Repayment and interest, or profits, are purely dependent on the investments' viability. Direct investment avoids the "white elephants" that have plagued government projects and government-owned corporations. Two other advantages are that investments are usually long term and the profits are often plowed back as reinvestment.

Of the four countries, Malaysia has made the most use of direct investment, particularly in the early 1980s. This helps to explain how it was able to maintain investment levels in the mid-30 percent range despite a resource gap of 1 0 percent to 1 4 percent of GDP. Though direct investment has since fallen off, it still accounted for 7.5 percent of gross investment in 1987 and averaged 10.3 percent between 1986 and 1987 (Table 1 1 ). In the early 1980s, Thailand also appeared to take advantage of direct investment. From less than l percent of gross investment before 1980, direct investment rose to account for

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4 percent by 1984. Since then it has fallen back to between 2 percent and 3 percent of investment.

From a broad perspective, all four countries have worked to reduce their foreign borrowing requirements. They cut back gross investment so that domestic saving would meet more of their financing needs, and to varying degrees, they also increased their use of alternative sources of foreign savings. Thailand was the first country to move in this direction. As early as 1980/8 1 , Thailand began to reduce public investment, increase direct investment, and entice more transfer payments. Malaysia followed the same pattern in 1984 and 1985, though transfer payments to Malaysia have been inconsequential. Indonesia has successfully shrunk its resource gap but has yet to reduce its borrowing requirements. Finally, the Philippines, recovering from the Marcos years, is now striving hard to further reduce its borrowing requirements, while raising investment over 20 percent.

A challenge for all four countries will be to maintain or increase their levels of gross investment, as this should stimulate further economic growth. Levels for 1987 were well below peak levels for the decade, but none of the countries wants to embrace debt financing. The only alternatives are increasing the levels of domestic investment, which is a long-term proposition, and utilizing alternative sources of foreign savings. So far, direct investment has not accounted for a large portion of gross investment, except in the case of Malaysia. With the maturation of the newly industrializing economies, however, this is likely to change, and there will be more competition among these four countries as they try to capture the benefits of direct investment.

EMERGING INVESTMENT PATIERNS IN SOUTHEAST ASIA

Economic growth and the focus of investors in Asia have been centered on the newly industrializing economies, or "Tiger Economies," of Asia (i.e., Hong Kong, Korea, Singapore, and Taiwan Province of China). This is beginning to change, however, as these economies lose some of their competitive advantage. They are likely to have continued economic success, but their poorer neighbors of the Association of South East Asian Nations (ASEAN) are beginning to show signs of following the same path and investors are beginning to take notice.

In 1988, Thailand posted an I I percent growth in GDP. Much of this growth was fueled by a large influx of Japanese investors driven out of Japan by the increasing labor costs and the yen's appreciation.



Similar competitive adjustments are also beginning to be felt in Taiwan Province of China and South Korea. Both countries have already felt the pressures of exchange appreciation and their currencies should further appreciate by 1 0 percent to 25 percent by the end of 1990. Furthermore, Korean manufacturers are under fierce pressure to increase wages, thus providing additional incentives for labor-intensive manufacturing to move offshore. Labor unrest in both Korea and Taiwan Province of China is becoming a serious threat, especially to foreign investors.

Another critical factor that is shifting the focus of Asian investors is the loss of tariff-free status in the Generalized System of Preferences (GSP) in the U.S. market. As of January 1989, Hong Kong, Korea, Singapore, and Taiwan Province of China no longer qualify for preferential access to the export markets in North America and Europe. This is a sharp blow for many export manufacturers, particularly for those in industries such as garments, semiconductors, and electronic equipment.

Together, three factors, exchange appreciation, loss of GSP, and rising wages, represent a loss of competitive advantage for the newly industrializing economies. For some industries this is not critical, but others will be forced to set up new offshore production facilities. The question for most investors is where?

The neighboring ASEAN countries, Indonesia, Malaysia, Philippines, and Thailand, are obvious candidates. These countries still retain their GSP status, their exchange rates are either stable or

1980

Indonesia 18.5 Malaysia 6.7 Philippines 18.2 Thailand 1 9 8

Singapore 8.5 Korea 28.7

Taiwan Province of China 1 9 0

Table 12. Inflation Rate

(In percent)

1985 1986 1987 1988

4.7 5.9 9.3 8.1 0.3 0.7 0.9 2.9

23.1 0.7 3.8 8.7 2.4 1 . 8 2.6 3.8

0.4 - 1 .4 0.5 1 . 5 2.5 2.8 3.0 7.1

-02 0.7 na na

Forecast

1989 1990

8.5 7.5 4.5 3.5 9.5 9.0 5.0 5 0

1 .8 1 .5 6.5 4.5

3.5 3.5

Source: lnternalional Monetary Fund, International Financial Statistics (IF$).

Average

198G-88

9.0 3.5

14.2 4.1

2.1

6.0

3.4

Note: Calculated from the consumer price index. Forecast data for 1989 and 1990 were taken from Asian Economic Commentary (Merrill Lynch Capital Markets), March 1989.



depreciating slowly, and their wage structures are significantly helO\, those of the new industrializing economies or Japan. This \rOtlld more than offset the loss of competitive advantage for manufacturer� in the newly industrializing economies. Many investors. howen·r. arc concerned about the economic conditions in these four countries.

ECONOMIC ENVIRONMENT OF ASEAN

The economic indicators show that these countries han: ma(ltsu·ides in terms of their development and structural adjustnH·nt for growth. They have not auained the level achie\'ed by the rw"·h industrializing economies, but they are striding forward alon� the same path.

Over the decade of the 1 980s, Thailand and Mala�·sia han· po�tcd on average the strongest growth performances. 6.:$ percent ;mel :->.-1 percent, in the region. Indonesia by comparison has ;rvera�ed onl � 4.3 percent since 1980. These growth rates an: being fudecl J ,, investment levels that are regularly in excess of 20 percent of CDP. As for the Philippines, its average was by far the worst of 1 he I om countries ( I . 7 percent). This was due to the political and economi( crises that the Marcos government faced from 19H2 to 19X6. Thl'�l· troubles are behind the country now as indicated by the stron� �n"' tIt rates of 1987 and 1 988.

The export performances of these four countries abo indicatl' strong, growing economies. Accepting the lessom of thl' nnd' industrializing economies, all four countries have ,,·orked to incrl'a�l' and diversify their exports. They are also becoming nHHT opl'n I n

outside investors. Investors in t u rn should be able to l rnd nH1n·

opportunities. Export growth was quite erratic during the ilr!>t part of the 1 980s, and Indonesia was hit hard "·hen oil prices !'ell durin.�{ 1985 and 1986. On ly in the last two years ha,·e all !'our rnu111rin

shown significant export growth. Both Mala�'sia and the J>hilippinD averaged more than 20 percent a year, and Thailand boosted export:by over 30 percent each year.

Though the export growth rates of Indonesia were not a:- hi�h a� the other countries, the statistic hides the fact thaL I ndonesia I ra� been able to restructure the composition of its exports. in partilular its reliance on oil, which in 1981 accounted for H2 percent of' export� but by 1986 accounted for only 56 percenl. This went hand in har1d with a steady increase in the share of manufactured exports fro1n I

percent to 20 percent. I n other countries, the share of manufactured exports Ira� ;d,u

risen. Both Thailand and Malaysia have managed w push up 111an-



ufactured exports to over 40 percent of the total. For Malaysia, this represents far more of an adjustment, as in 1980 manufacturing accounted for 28 percent of exports, while for Thailand, they already represented 40 percent of all exports. The performance of both these countries, however, is overshadowed by the achievements of the Philippines. In 1980, manufactured exports accounted for 40 percent of all exports. But by 1987, the share of manufactured exports had been pushed up to 66 percent.

Despite the high growth rates in exports noted above, both the Philippines and Thailand have a persistent trade deficit. For both countries, the deficit has averaged 20 percent or more of merchandise exports. Forecasts suggest that this pattern will persist as imports, particularly of machinery and capital goods, continue to grow. This imbalance puts pressure on the countries' exchange rates and sources of foreign currency, but the problem can be offset by inflows from direct investment, foreign aid, and willing lenders.

The strong export growth figures and the steady expansion of manufactured exports indicate economies undergoing important adjustments and realigning themselves on export-oriented development strategies. The success of this adjustment can already be seen in the improved growth rates, particularly those of Malaysia, the Philippines, and Thailand. In comparison, Indonesia's efforts have yet to have an impact on its growth rate. Because of these improvements, all four countries are becoming increasingly attractive to investors prospecting in the Asia Pacific region.

Four Countries in the ASEAN

Recently, the country of choice for investors has been Thailand. They have been attracted by the incentives, stable economic environment, and low-cost labor. Unfortunately, wages are beginning to rise rapidly and the labor market is tightening. The Government is no longer providing incentives for certain types of labor-intensive manufacturers. And, worst of all, the pace of growth is beginning to be hampered by poor infrastructure, particularly in the area of transport. For some investors, particularly those involved in capital goods manufacturing, these problems may be offset by additional government incentives and the high productivity of Thai labor.

With probably the best infrastructure of the four countries, Malaysia is certainly attractive to investors. The exchange rate is expected to depreciate by not more than 1 0 percent or 1 2 percent over the next two years, and inflation has generally been extremely low. On the



other hand, wages are higher in Malaysia than in any of the other countries, and investors will have to navigate the system of regulation and ownership restrictions. It is not surprising then that Malaysia's government expenditure at 35 percent of GDP is by far the highest of any of the four countries.

As a potential location for new manufacturing, Indonesia should not be neglected. Though it has the lowest growth rates for GDP and is the least developed of the four countries, it does have several advantages. Wage rates are certainly the lowest here, though the ability of labor to adapt to new technology is probably not as good as in the other countries. Also by far the largest of the four countries, Indonesia would be particularly attractive to those able to tap the large domestic market and thus establish economies of scale. However, like Thailand and the Philippines, the country also has woefully inadequate infrastructures.

Remembered for its crisis years in the early l 980s, the Philippine economy is now taking off and it must be considered as a candidate for offshore manufacturing. GDP and export growth rates are both rising sharply, and the manufacturing sector is becoming increasingly important. Despite these signs of good economic health, investors are still nervous about several factors. At the top of their list is the inadequate infrastructure, particularly electricity and transportation. To address this problem, the Government is developing several export-processing zones that would have all the necessary infrastructure linkages, with financing coming in from a multilateral aid initiative. Other issues, such as political stability and labor unrest, are beginning to disappear or be offset by other advantages the Philippines offers. Chief among these are the Filipinos who are generally well educated and who are familiar with English. This insures that Filipino labor can easily adapt to new technologies and manufacturing processes. This advantage, when added to those of a large labor pool and low wage rates, makes the Philippines an attractive location for offshore investments.

Clearly, each of the four countries has its own set of advantages. Thailand is attractive for its productive and adaptable labor force. Unfortunately, it is becoming overcrowded, the labor market is tightening, and the infrastructure systems are becoming clogged. Malaysia has the best infrastructure, but it is a small country with comparatively higher wages and a complex government and regulatory structure. Indonesia has the advantage of a large domestic market and a pool of extremely cheap though unskilled labor. Unfortunately, its infrastructure is poor. I n the case of the Philippines, the country's economic stability and its talented and low-cost pool of



labor are major attractions, but infrastructure is still a problem-this may be solved by the Government's investment in several exportprocessing zones. In the end, investors will have to weigh the tradeoffs offered by each country and consider ·what are the needs of their particular projects. One certainty is that each of the four countries will reap some benefit from the eroding competitive advantage of the newly industrializing economies.

The Example of Singapore

Singapore is one of the best examples of a country that has successfully pursued a strategy of export-led growth. With a population of only 2.5 million, it was forced to look toward external markets if it were to achieve even minimum economies of scale. Over the last twenty years, Singapore has built itself into a major manufacturing and trading center for Southeast Asia.

Since 1980, merchandise exports have averaged more than 30 percent of GDP. This reflects the strong trading and re-export nature of the Singaporean economy. The export composition also indicates Singapore's emphasis on manufacturing. Since 1980, manufactured goods have accounted for an average of 59 percent of exports, and this ratio increases to over 80 percent if petroleum products from the country's refining industry are included.

This export strategy has clearly been successful for Singapore. After Japan, Australia, and Brunei, Singapore has the highest per capita income in Asia. Since 1980, its average compound growth rate has been 6.5 percent, and inflation has averaged an extremely low 2 . 1 percent a year.

Singapore is now facing new challenges. It has lost its GSP status, it has an extremely tight labor market, and it is facing a slump in one of its major industries, disk-drive manufacturing. To meet these challenges, Singapore is emphasizing more capital-intensive manufacturing. This should help to boost productivity growth and ease the pressures in its labor market. I t is also building a strong services sector based on tourism, transportation, and technical services. Singapore already has the second largest container port in the world. Singapore Airlines is planning to expand and the Singapore airport is known as one of the most efficient in Asia.

These developments make Singapore an extremely attractive base for consulting and other service industries wanting to serve the Southeast Asian market. Its excellent infrastructure in both transportation and communications will also be attractive for manufacturers not deterred by the countries high wage scales.



The Singapore example is an excellent case study for other countries pursuing export-led growth. In particular, it demonstrates the importance of being able to recognize transition periods and adapt strategies accordingly. Labor-intensive manufacturing can only be a temporary strategy during a period of low wages and excess labor. Eventually the country should graduate to more capital-intensive or service-oriented industries.

This is what is happening in Singapore and in the other newly industrializing economies. As a result, the more labor-intensive industries must migrate to other Southeast Asian countries. This process, in turn, should set the stage for more investment and faster growth in Indonesia, Malaysia, the Philippines, and Thailand.


Comment

TAN TAT WAI

In his paper, Dr. Villegas focused on the following six observations regarding economic adjustment, financing, and growth for the four larger ASEAN countries, Indonesia, the Philippines, Malaysia, and Thailand.

• The importance of having an export orientation, especially in export of manufactures, to propel economies to faster-than-normal growth.

• The importance of depreciation in pushing exports. • In spite of rapid growth in exports, international industrial

structural change has been quite slow, except in Thailand. • The services sectors in Thailand and Indonesia have grown at

the expense of agriculture and mining. • The productivity gap between agriculture and manufacturing is

widening in Thailand and is stable in the Philippines and Malaysia. In the Philippines, it is probably due to a long history of industrialization, while in Malaysia a sophisticated agricultural sector exists.

• To cover the domestic resource gap, ASEAN countries have been able to switch from external borrowing to direct foreign investment.

The observations focus almost entirely on the supply side of the economy without any analysis of the international economic environment or the pattern of domestic demand. Before discussing the observations, it would be useful to take stock of these two aspects of economic adjustment.

In the 1980s, Southeast Asian economies generally came under pressure to adjust. The need for adjustment came from both external and internal factors. If one believes official writeups, the greatest pressure to adjust came from external factors, namely, an unfavorable world economic environment. In reality, during this period, the economies of the industrial world grew at an average rate of 2.6 percent. At first glance, this growth rate appears modest. Yet for countries with about a 2.5 percent rate of growth in population, it is equivalent to a 5 percent ·economic growth rate. Since a 5 percent growth rate is respectable, what really prompted officials to attribute a large part of their problem to the external world?

39


40 TAN TAT WAI

Throughout most of the 1980s, commodity prices have generally been to the disadvantage of the commodity-dependent Southeast Asian nations, causing grave economic and financial pressures. It is relevant, indeed imperative, to ask why did commodity prices decline if the growth rate in the industrial world was satisfactory? The answer lies in the materials revolution that has been occurring. Technological innovations have led to declining consumption or switching of raw materials. However, the buoyant commodity prices of the 1970s led to substantial investment and expansion in the capacity of commodities production. In other words, the growth in the supply of commodities has outpaced demand and lead to soft prices.

Looking ahead to the 1990s, there is no reason to believe that there will not be continued savings in the use of raw materials, and with it, continued downward pressure on commodity prices as a general trend. Of course, short-term disruption in supply may push up prices temporarily. In such an environemnt, macroeconomic and microeconomic planning must assume low commodity prices and evolve plans to deal with them. Commodity-producing countries must be more efficient at production, develop new uses, and diversify into manufacturing and services to adjust to the changing world economic environment. In cases when commodity prices shoot up, as occurred in the 1970s, they should be regarded as a windfall gain and saved rather than consumed.

Quite apart from the external factor of unfavorable commodity prices, internal factors played an even more important role in putting the ASEAN economies under stress in the early to mid-I980s. The four bigger ASEAN countries were all living well beyond their means (probably caused by treating the windfall gains of thP 1970s as recurring gain). A comparison of the consumption and investment expenditure of these countries with their GNP is revealing (see Tables 8 and 12). It is surprising that Villegas has largely ignored the issue of excessive domestic demand. Thailand had excess demand from 1980 to 1985. With a domestic resource gap of 5 percent or more in all but one of the six years, it had to, and did, undertake to adjust its economy. By the same token, Indonesia's resource gap in 1981-83 was more than 21 percent of GDP; for the Philippines it was 26 percent of GDP, and for Thailand, 3 1 percent in 1980-85. In contrast, Singapore had a far bigger domestic resource gap in 1980-82 amounting to 28 percent of GDP and Malaysia, in 198 1-84 of more than 4 1 percent of GDP. Both, however, quickly narrowed the resource gap. The cost of it for both countries was a serious recession. Thailand has been able to slow and steadily narrow its resource gap without excessive cost to its economy. In contrast, Indonesia and the


Comment 41

Philippines, especially, have suffered severely and over longer periods in order to adjust to the resource gap. A discussion of economic adjustment of the 1980s for ASEAN countries must address the greater ability of Malaysia and Singapore to withstand excessive demand in their economies compared with the Philippines and Indonesia.

The methods used to finance the resource gaps have also been equally varied (Tables 8 and 9). While Malaysia relied on both foreign investment and foreign borrowing to temporarily bridge the gap, Singapore was entirely dependent on foreign investment. The other three ASEAN countries, in particular the Philippines, relied heavily on foreign borrowings. Even though investment in the Philippines dropped to 1 4 percent of GDP in 1985 and 13 percent in 1986, its borrowings hit 42.5 percent of gross investment in 1985 (Table 9). This divergent trend of financing resource gaps points to the possible hypothesis that foreign direct investment is a better way of financing a resource gap.

From a conceptual point of view, borrowing has a fixed obligation to repay regardless of economic performance and ability to repay. In contrast, outflow of earnings occurs only when the venture is successful in the case of foreign investment. This leads to the logical question of why have Singapore, Malaysia, and, of late, Thailand been more able to attract foreign investment? How much of this is due to the realignment of the world economy in the aftermath of the appreciation of the yen, New Zealand dollar, and won and how much of it to the inherent attraction of these economies. It also raises the question of how to balance the inflow of direct foreign investment with sufficient indigenous capital formation. Can the bigger ASEAN countries afford to be overly reliant on foreign investment? Certainly for Japan, Korea, and Taiwan Province of China, the rise of local entrepreneurs has been crucial to their sustained growth and development.

The reason for excess demand should also be examined. Did it come from consumption, subsidy, or excessive investment? Even when funds are chaneled into investments, as occurred in Malaysia in the early 1980s, substantial waste is likely to exist. Macroeconomic evidence for this is not easy to come by; however, a high incremental capital output ratio is plausible indication of the prevalence of inefficient investment. On the other hand, research based on microeconomic study can establish the observation more readily. In other words, the efficiency of investment is an issue that should also be examined.

In sum, the reluctance of government and populace alike to address


42 TAN TAT WAI

the question of living beyond one's means may have led to heavy and excessive foreign borrowing to finance the resource gap in the 1980s. Singapore did not need to adjust as its resource gap was financed by direct foreign investment. By the same token, the economy could not have had excessive consumption or subsidy. Thus, the root of Singapore's problem in 1985/86 must have been elsewhere and not the same as its neighbors. Thailand and Malaysia made serious attempts to adjust their economy and the impressive results reflected their effort. While one can argue that the Philippines was in political turmoil, which led to its recession, the lack of political will to adjust the economy in prior years must have helped to trigger subsequent political difficulties.

On the first observation, export has always been an important focus for some of the ASEAN countries, especially Singapore, Malaysia, and, to a lesser extent, Indonesia (using export/GNP exceeding 20 percent as a criteria). The push for export of manufactures in Singapore and Malaysia started in the 1960s and 1 970s, respectively, and both have been reasonably successful. Therefore, this push into exports cannot possibly explain Malaysia and Singapore's problems in the mid-l980s nor their subsequent recovery after 1987.

Among the ASEAN countries, the Philippines was the first to industrialize (manufacturing as a share of GDP reached 20 percent in the 1960s, well ahead of all its neighbors). But then that process came to a standstill in the late 1970s and in the 1980s. So, once again, the drive into manufacturing did not come only in the 1980s and cannot explain either the Philippines' economic difficulties of the 1980s or its present indication at resurrection. The only thing that differs in the Philippine industrial policy is its earlier focus on import substitution and its present interest in export promotion.

Of all the ASEAN countries, Indonesia is probably the most difficult to manage. First, it is huge. Second, it has been essentially a onecommodity exporting country. The dependence on oil is so great that it will take a huge effort and be a long time before the development of other industries can begin to have an impact on balancing the decline in oil prices. Precisely because it is difficult to deal with a big country dependent on one highly volatile commodity export, it is important to develop early warning signals and preventive policies. Some of the issues on development policies in resource rich countries are dealt with in several multinational research projects.

On the issue of the impact of depreciation on exports, it is useful to make a distinction between the impact of depreciation on exports of commodities and exports of manufactures and of services. The ASEAN countries tend to dominate the world market in exports of


Comment 43

commodities that have an inelastic supply, except oil. Thus, depreciation is not likely to cause buyers to switch suppliers; that is, price changes will not alter the supply, and suppliers will have to absorb price declines in a downturn. Depreciation will probably not mean an increase in receipts. On the other hand, for exports of manufactures and services, the ASEAN countries account for a small part of the world market. Depreciation would, therefore, make ASEAN exports of manufactures and services far more attractive and buoyant. In other words, a substantial gain from both quantity and value· can be expected through depreciation. Villegas's statement that depreciation in iself is not a guaranteed recipe for growth is merely a basic understanding of economics. The Philippine depreciation in 1985 did not stimulate growth or exports because its economy could not produce for the world market sandwiched as it was between low investment and high consumption and political turmoil. .

While exports tend to respond to policy changes quite fast, the internal economic structure cannot change as fast. This is because within existing production facilities, one can choose between producing more for domestic use or more for export and squeeze out a limited additional supply. New activities, however, have a long time lag between the feasibility study in response to policy and factor price changes to implementation and full production. From a businessman's point of view, a major investment decision, such as relocating or building new investment facilities, takes at least three years, if not longer, to bring to full production. Since ASEAN economic adjustments occurred mainly in the mid-1980s, macroeconomic data up to 1987 are hardly able to capture the impact of response to changes. At any rate, changes in the internal economic structure are the result of policy and the economic response to policies. I t is not an interesting tool for analyzing and understanding the structural adjustment problems and how to propel and finance growth.

Looking at the productivity ratio of manufacturing to agriculture is also not interesting. Malaysia has a well-developed commercial farming sector. It is also a small country with a mobile work force. As such, the productivity ratio would tend to equalize. Moreover, it has a long-standing program of upgrading technology, even at the smallholder level. This is part of the reason why investment and subsidies at the farm-gate level have remained high. In contrast, Indonesia, the Philippines, and Thailand are all large countries where commercial farming is small and subsistence farming prevails. In such a situation, a large agricultural labor force producing a small percentage of GDP via the agriculture sector illustrates the problems faced by such countries. When industrial development in Indonesia,


44 TAN TAT WAI

. . the Philippines, and Thailand is focused in a few key industrial areas, the productivitiy ratio cannot move, as industrial development hardly changes the subsistence farming in the vast rural areas. Only a long period of sustained growth and widespread industrialization can change the internal industrial structure in a big country. An eightyear survey through a period of difficult adjustment will show hardly any difference.

To sum up, Villegas's paper would be far more interesting if it began by tracing the roots of the need for adjustment in the ASEAN countries. Second, the results should then be compared with those in Korea and Taiwan Province of China. The big share of domestic savings and investment in GNP in both economies would be a marked difference from those of the three bigger ASEAN countries. Singapore and Malaysia, who have both performed relatively better than their ASEAN neighbors in the 1970s, also have relatively high saving and investment. The moral of the story is clear: if a company wants to grow fast, it should have a small dividend so that earnings can be reinvested. For a country, saving and investment must also be high to sustain high growth rate. It is not possible to consume plenty and grow rapidly. I t is even worse if there are waste and leakage of funds.


4

The Role of Fiscal and Monetary Policy in the G rowth Process

RICHARD HEMMING AND KALPANA KOCHHAR'

In the context of Fund-supported adjustment programs, there is now much discussion of growth-oriented adjustment. This involves the integration of traditional short-term adjustment-essentially the correction of external and internal imbalances through aggregate demand management-with longer-term structural measures aimed at stimulating the supply side of the economy. The Fund has been criticized for not paying enough attention to growth; the most common claim is that the fiscal and monetary policy prescriptions that characterize short-term adjustment programs are inimical to growth, and that this reflects inadequate concern. A similar line of reasoning is used by those who argue that the Fund has lacked concern about the social implications of adjustment, and in particular its impact on poverty and inequality.

While the basis for these claims is not entirely unfounded-it is difficult to argue against the proposition that Fund-supported programs have, in several cases, been associated with lower growth and increased poverty and inequality in the short term-it is misleading to attribute this to the pursuit of stabilization at the expense of all other considerations. Rather, it reflects the seriousness of the initial imbalances, the urgency with which balance of payments viability and price stability must be restored, and the mechanisms used to achieve these objectives. Fund-supported programs, even in the most extreme cases, have called for measures that should improve the efficiency of

'The paper has benefited from comments by Vito Tanzi, Alan A. Tait, Peter S. Heller. G. A. Mackenzie, and R. Barry Johnston. The seminar discussant, Tanya Sirivedhin of the Bank of Thailand, also provided valuable comments David Goldsbrough, Louis D. Dicks-Mireaux, and Juha S. Kahkonen assisted in the preparation of the section on adjustment.

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46 RICHARD HEMMING AND KALPANA KOCHHAR

resource allocation. Most notably, an exchange rate depreciation is intended to increase international competitiveness, thus enhancing the prospects for growth. The same is true for many fiscal and monetary policy measures. The problem is that the supply-side effects are slower to emerge than those on the demand side. A short-term Fund-supported program is then associated with demand restraint and any immediate adverse effects this has on growth; it is not linked with the beneficial longer-term impact that supply-side measures have on growth.

It would be less than honest to claim that the current emphasis on growth (and poverty) issues in the Fund is not a response to criticism. There are, however, other relevant considerations. The most important is the impact of the debt crisis. In many of the poorer developing countries, where domestic resources are insufficient to offset the impact of sharply reduced access to external resources and heavy external debt service obligations, the adjustment process would inevitably be slow. It is also clear that fundamental structural adjustments and exceptional assistance are necessary to expand productive capacity, and that the recovery in growth takes time. It is in recognition of this that the Fund has introduced concessional longer-term borrowing facilities for the poorest countries, with programs that emphasize the growth objective and attach considerable importance to structural policies. A longer horizon for these programs provides time for responses to supply-side initiatives, and the resulting growth should allow for a steady reduction in debt burdens.

While a discussion of the link between structural policies and growth does not have to be placed in the context of Fund-supported adjustment programs, it is in this connection that some of the more interesting issues arise. This is especially true where fiscal and monetary policy are concerned, since these are central tO traditional adjustment programs. The principal aims of this paper are therefore (i) to describe the characteristics of fiscal and monetary policies directed at influencing domestic demand; (ii) to highlight the channels through which these policies have an impact on growth; and (iii) to examine the nature of fiscal and monetary reforms that would enhance efficiency and growth.

FISCAL AND MONETARY POLICIES IN ADJUSTMENT PROGRAMS

In their most basic form Fund-supported adjustment programs can be viewed as an application of the simple monetary approach to


Fiscal and Monetary Policy in the Growth Process 47

the balance of payments. The objective is to achieve a desired outcome for the balance of payments through controlling the rate of domestic credit expansion. Monetary policy clearly plays the central role in this approach; fiscal policy is only supportive, ensuring that the ceiling on domestic credit expansion is not exceeded because of the need to finance a larger-than-anticipated fiscal deficit . 1 In the simple monetary model, nominal income is exogenous. In Fund-supported programs, however, the domestic inflation rate is also a target, and the exchange rate is the additional instrument used to facilitate independent determination of the balance of payments and inflation. Real income is now exogenous; fiscal policy remains supportive.

While the fiscal and monetary policy rules arising out of the monetary model are straightforward, as indicated above, policy prescriptions in Fund-supported programs have tended to be more complex. They are the subject of detailed discussion between country authorities and the Fund, and extend well beyond the domestic credit restraint, fiscal deficit reduction, and exchange rate depreciation that dominate most summary descriptions of the programs. As regards fiscal and monetary policy, typical programs contain agreements with respect to the restructuring of taxation, changing public expenditure priorities, public enterprise reform, reform of the financial system, and interest rate and credit policies. In these areas the focus of attention is not the degree of adjustment embodied in a program but the quality of adjustment, and the most important aspect of quality relates to the growth implications of alternative policy packages.

FISCAL POLICY

In terms of the underlying analytical framework, the more recent stress on growth-oriented adjustment attaches greater significance to fiscal policy than the monetary model. Relaxing the assumption of exogenous real output that characterizes the monetary approach has been reflected in efforts to integrate a simple open-economy growth model with the monetary model. A principal implication of this integration is that as a counterpart to the inclusion of growth as an additional target, fiscal policy is assigned the role of ensuring that there is sufficient domestic saving, in general, and public saving, in particular, to guarantee that the investment requirements associated with the growth target are met without threatening the balance of payments and inflation objectives.

' This distinction is blurred when domestic credit is largely a function of the fiscal deficit: in extreme cases (i.e .. the West African Monetary Union). fiscal policy is dominant and monetary policy is passive.



While the integrated analytical framework introduces an explicit growth objective, it continues to emphasize in policy terms the role of the fiscal deficit, since this is the difference between public saving and public investment. Public saving and public investment are not, however, the only channels through which fiscal policy affects growth; the structural aspects of public sector activities also have to be considered. A more fully articulated growth-oriented model would allow fiscal (and monetary) policy a more direct role in the output determination process, taking into account the impact of structural reforms. There are, however, problems with pursuing this too far. The behavioral relationships underlying supply-side responses are complex, and the introduction of supply-side considerations would result in considerably more detailed models, which would necessarily be more country-specific and lack general applicability. The relationship between structural policies and growth tends therefore to be focused on separately.

Fiscal Policy and Growth

Before exploring the relationship between fiscal policies and growth in more detail, a few methodological issues need to be addressed. First, the concept of the public sector used in this paper refers to the government (at all levels) and public enterprises. If public enterprises were distinguishable from private enterprises only by their ownership, they could be excluded from the public sector and operations on their behalf omitted from the government accounts. In most meaningful respects, however, public enterprise operations have little in common with practice in the private sector; rather, their activities are inextricably linked to those of the government. Second, the public sector deficit is defined as the difference between public sector revenue (including the investable surplus of public enterprises) and total public expenditure and corresponds to the gap between public saving and public investment. This number, however, captures only one aspect of the public sector's impact on the economy, namely, the extent to which its activities require net borrowing and therefore repayment obligations in the future. This in turn has an impact on monetary conditions, domestic demand, and the balance of payments, both now and in the future. Tracing the implications of the deficit more precisely and, as other circumstances demand, focusing on the separate components of the overall deficit, such as bank financing or private sector borrowing, or alternative deficit concepts, such as the inAation-adjusted deficit and the cyclically corrected deficit, can be more helpful. For this paper, the overall deficit provides an appropriate summary of public sector activities.



A reduction in the public sector deficit-either through an expenditure cut or a tax increase-is consistent with both the balance of payments and inflation targets but could lead to a fall in output, reflecting the reduced fiscal stimulus to the economy. I f public sector borrowing has previously crowded out the private sector from financial markets and restricted investment, the reduced public sector claim on available credit and domestic saving will instead crowd in private sector investment. I f the reduction in the deficit was not achieved by cuts in productive public investment, the resulting increase in private investment, if it too is productive, will lead to higher growth in the longer term. If private investment is substituted for public investment and the rate of return on private investment exceeds that on public investment, only higher growth will result.

The idea that fiscal policy can be used to release resources to finance additional investment is appealing only insofar as private saving does not adjust to offset changes in public saving. There is a view that money creation and borrowing to finance a deficit are equivalent to taxation. Money creation imposes an inflation tax on holders of money balances, while servicing the debt created by borrowing requires higher taxation or additional money creation at some time in the future. According to the debt neutrality hypothesis, sophisticated taxpayers recognize the equivalence of taxes and debt, and adjust their private savings to offset anticipated future tax changes (including use of the inflation tax). While there may be an element of truth in this argument, the degree of rationality that is necessary for it to hold in its strictest form is unlikely to exist in practice. Evidence suggests at most only a modest degree of substitution.

While reducing the public sector deficit in pursuit of demandmanagement objectives can lead to an initial reduction in output growth, growth can increase without threatening macroeconomic stability, to the extent that private investment is crowded in by the lower deficit. There are, however, other important channels through which fiscal policy can influence growth. As indicated above, these relate tO the structural features of the public sector. Without affecting the public sector deficit, changes in tax policy, expenditure policy, and public enterprise policy can have a potentially significant impact on resource allocation and growth.

Tax Policy

Considerable attention has been focused on the relationship between the structure of taxation and its impact on resource allocation and growth. In particular, the combination of a heavy dependence



on a few tax instruments applied at high rates to narrow bases has severely distorted relative prices and economic behavior. For example, many developing countries collect a large share of total revenue from import taxes; but in so doing, protective barriers are raised that promote inefficient import-substituting activities and discourage exports. All taxes for which revenue varies at the margin with the extent of the activity being taxed give rise to similar distortions; moreover, the magnitude of the distortion increases more than proportionately with the tax rate. A significant part of the problem stems from inadequate administrative capabilities, which limit the range of feasible tax instruments. Administrative weaknesses also admit widespread avoidance and evasion, which usually have adverse distributional consequences. The challenge for tax policy is to design tax structures that are administratively feasible, raise sufficient revenue, are equitable, and minimize distortions.

The scope for tax reform varies from country tO country, depending on the nature of the initial tax system, administrative constraints, and the government's social and economic priorities. Some general conclusions about the appropriate direction of tax reform in developing countries can nevertheless be drawn, based on accumulated experience. To reduce tax rates and so minimize distortions, the tax base should be as broad as possible. As much economic activity as possible should be brought into the tax net, and tax exemptions should be given in only the most compelling cases. A special effort should be made to ensure that relatively fast-growing sectors are effectively taxed, since this, in combination with administrative reforms that reduce collection lags, will provide for an elastic tax system. A high tax elasticity minimizes the need fo1· frequent discretionary tax measures to prevent tax revenue growth falling behind that of public expenditure.

Commodity taxation should be a major revenue source. A broadbased tax on final consumption, such as a sales or value-added tax, levied at a single rate to ensure neutrality (i.e., to minimize distortions to consumer prices owing to taxation) is most desirable.2 This tax should apply equally to domestically produced and imported goods, and all inputs should be free of tax. Where raw materials, intermediate goods, and capital are not relieved of tax-as in the case of a turnover tax-final taxation is unrelated to the value of output, but depends more on the structure of production; this can lead to inefficient

2 Uniform commodity taxation contrasts with the structure that minimizes all distortionsincluding the choice between consumption and leisure-which implies taxes that reduce demand for all commodities in the same proportion. The administrative arguments against such taxes are formidable, however.



production decisions. While the consumption tax should ideally apply at the retail stage, a full-fledged consumption tax requires a degree of administrative sophistication that we only begin to find in middleincome developing countries. Administrative considerations might therefore dictate that the consumption tax be restricted to the manufacturing stage. Similar considerations may also preclude the taxation of more atomistic sectors, such as agriculture, small-scale business, and services; consideration could, however, be given to imposing a minimum tax on these activities. A case can be made for levying heavier taxes on certain sumptuary and luxury items, where practical, at ad valorem rates to prevent the erosion of revenue through inflation. The resulting non-neutrality can be justified by reference both to the benefits of discouraging excess consumption of alcohol, tobacco, petroleum, etc. and the equity of taxing purchases of consumer durables, jewelry, and other conspicuous consumption items.

Trade taxes typically call for extensive reform in developing countries. Import taxes should be set only with a view to establishing a desirable level and pattern of effective protection, which will in general imply a significant reduction in the general level of tariff protection and a much reduced dispersion of rates. Since this will lead to large revenue losses in many cases, the appropriate offset is an increase in general consumption taxes. Many countries levy export taxes, especially on major agricultural products. Since these are a disincentive to exports-and given the strong link between exports and growth-they should in general be eliminated. An exception could arise where it is administratively difficult to tax agricultural incomes, and land taxation is impractical. In such circumstances, an export tax may be a reasonable proxy for a tax on farmers' incomes. It should, however, be accompanied by a presumptive tax on the rest of the agricultural sector to preserve equity.

Personal income taxes present something of a problem in a developing country tax structure. Their primary objective is redistributional. But because they tend to be more difficult to administer than consumption taxes, their base is often dominated by less wellpaid public sector employees and the wage bills of larger private sector companies. At the same time, high rates are usually associated with disincentives to work and, in many cases, to save, as well as evasion and avoidance. Equity objectives are therefore not well served. A better structure would feature a large exemption, so that many low-income workers do not pay tax, with low and at most mildly progressive rates. Tax bands should be indexed to ensure that taxpayers are not exposed to higher tax rates simply as a result of



inflation. While incentives and compliance should improve, the combination of the large exemption and a fairly flat rate structure would still result in significant redistribution. However. the overall effectiveness of such reforms would critically depend on establishing the administrative capability to ensure that most income is reported to the revenue authorities and that tax is actually collected. In the latter regard, tax withholding has considerable administrative disadvantages.

Since companies are indistinguishable from their owners, an effective personal income tax-where all corporate profit is allocated to shareholders-would appear to eliminate the need for a separate company tax. Such taxes are nevertheless commonplace. One explanation for this concerns the administrative problems involved in taxing the profit of international companies effectively under a personal income tax. Another justification for company taxationmore applicable in developing countries than elsewhere-is that since personal income is difficult to tax, it is better to levy tax at the corporate level. One problem with a company tax, however, is that it tends to fall not only on the returns to investment but also on investment itself. This is because existing systems of depreciation and other investment allowances tend to result in only partial relief of investment from tax. Taxing investment, even in part, probably reduces the amount undertaken, and the method of taxation certainly distorts investment decisions. In principle, the full expensing (or free depreciation) eliminates the tax disincentive to investment and is nondistortionary. But given that it also reduces revenue significantly compared with existing arrangements, a compromise is to raise initial depreciation allowances, apply them uniformly across investments and sectors, and eliminate all other allowances.

Tax systems of developing countries often also comprise taxes levied on land, wealth, and capital transfers. These taxes are often complex to administer and easy to avoid or evade; this is reflected in low revenue yields. As such, these taxes are little more than a nuisance, and their elimination would be appropriate; however, where they can be administered effectively and compliance is not a problem, not only might such taxes perform a useful function in their own right (for example, where wealth is unevenly distributed) but they may also be a reasonable proxy for more difficult to administer income taxes.

Expenditure Policy

Public expenditure can contribute to the growth process through a number of channels. The public sector can undertake large-scale



investment, such as infrastructure projects, that are beyond the scope of private investors; it provides social goods like education and health that raise the stock of human capital and its productivity; and it more generally provides or subsidizes the production of a wide range of goods and services that can contribute to economic, political, and social stability and thereby enhance the prospects for investment and growth. The body of knowledge on the desirable direction for expenditure reform has not, however, produced a cohesive package of reforms similar to that described above in the case of tax policy. But, again, experience suggests the desirability of certain structural changes.

Of paramount importance in encouraging growth is a good public investment program. Current expenditure is not necessarily the principal source of inefficiency in expenditure as often claimed, and the frequent call for protection of capital investment in many cases preserves wasteful projects. Since capital expenditure is usually more import-intensive than current expenditure, an inefficient investment program can be especially costly. Effort should therefore be made to ensure that the public investment program comprises high quality projects that are justifiable on economic grounds, taking due account of social objectives. Public investment expenditure should also be supported by sufficient funds for the appropriate operation and maintenance of new investment. Effective operation and maintenance activities also increase the productivity and longevity of the existing capital stock.

As regards other categories of current expenditure, wage levels should be adequate to guarantee that the public sector can retain the quality of manpower it needs and to discourage employees from taking second jobs and engaging in fraudulent activities to increase their incomes. Particular attention should be paid to maintaining performance incentives through appropriate pay differentials. Materials and supplies must also be sufficient to ensure that public employees can function efficiently. Insofar as possible, however, less productive expenditure should continue to be eliminated. Moreover, to the extent that the objectives of a particular expenditure program can be met more efficiently, for example, by targeting expenditure more directly at beneficiaries or substituting one form of expenditure for another, this should be pursued. In this connection, spending on subsidies warrants special attention. Although in many cases subsidies can be easily justified, there are numerous examples of expensive subsidies with no economic and social justification.



Public Enterprise Policy

The operations of nonfinancial public enterprises have been a major source of weakness in the public finances of many countries. A number of factors have contributed to their poor performance. These include complex bureaucratic relations between the government and public enterprises; the need to pursue a wide range of social and other noneconomic objectives; the protected monopoly status of many enterprises; administrative control of public enterprise prices; powerful trade unions; and the ready willingness of the government to cover public enterprise losses. In this environment, public enterprises have emerged as typically inefficient producers relying heavily on budget subsidies. They tend to be overmanned with wage levels significantly out of line with productivity, the quality of management is often poor, investment decisions are not made using economic criteria, capacity utilization is low, and prices are out of line with international prices.

While the problems associated with public enterprises are widely recognized, effective solutions have been slow to emerge. Moreover, the time lag between implementation and response is particularly long. However, the identification of the sources of poor public enterprise performance points to the principal elements of a reform strategy. In particular, emphasis should be placed on freeing public enterprise management from political and ministerial interference, giving them greater autonomy over pricing and investment decisions, and letting them pursue clearly specified objectives. In many cases, major efficiency gains can be expected from exposing enterprises to competition and, where it serves the promotion of competition, privatizing enterprises. Even in those cases where public monopoly is inevitable-for example, in markets where average costs are continuously decreasing-particular activities can still be contracted out to the private sector. It is critical that the government provide financial support for public enterprises on a selective basis only, primarily where compelling noneconomic objectives prevent efficient enterprises from making a profit. Enterprises that are expected to operate commercially but cannot survive in a competitive environment should certainly be liquidated.

The above summary of a public sector reform strategy consistent with more efficient resource allocation and higher growth is highly selective, focusing on the key structural changes. From this brief description, it should be clear that the reforms discussed represent a major dislocation and could create much political difficulty. They also have the potential to frustrate stabilization objectives, especially



in the short term. Many of the tax measures may initially reduce revenue-for example, tariff reform, the elimination of expon taxes, and higher investment allowances-but offer the prospect of higher growth and additional revenue in the future. Similarly, many expenditure measures may increase spending-for example, wage restructuring, improving operations and maintenance, and severance payments associated with reducing overmanning in public enterprises-but will improve efficiency in the longer term. This should not, however, be taken to imply that the fiscal deficit ought not to be reduced in the short term. Rather, the growth objective should play a larger role than before in determining how fiscal adjustment is achieved. Sound demand management policy is essential both to the creation of investor confidence and the maintenance of credibility on international capital markets that ensures the external resource availability essential to growth.

MONETARY POLICY

Monetary policy is primarily concerned with controlling inflation and achieving a sustainable balance of payments; and in this connection, it needs to be closely coordinated with fiscal policy. Without fiscal discipline, the stabilization role of monetary policy is limited. As with fiscal policy, in a stabilization role monetary policy supports growth. Monetary impulses also have a direct effect on output. Thus the credit restraint that characterizes Fund-supported programs is often associated with some reduction in output growth in the short term, although the effect of credit restraint is difficult to disentangle from that of the fiscal contraction, which it usually accompanies. In addition, the structural characteristics of the financial system-like the structure of taxation, expenditure, and the public enterprise sector-have a longer-term influence on resource allocation and growth.

In many developing countries, the financial system is characterized by a highly oligopolistic banking sector and pervasive interest rate and credit controls that are used to promote investment, develop priority sectors, and provide low-cost finance to the public sector. These controls have often resulted in an inefficient allocation of financial resources and low savings, which have impeded investment and growth. Moreover, such controls tend to be undermined over time as unregulated financial markets proliferate, which severely limits the ability of monetary policy to achieve stabilization objectives. Financial reform can play a role in structural adjustment and growth over the medium term by promoting the development of financial



markets and by increasing the reliance on market-determined interest rates and credit allocation mechanisms. The effectiveness of monetary policy may also be enhanced as a result.

Financial Reform

A principal objective of financial reform is to foster a more efficient allocation of financial resources and to mobilize savings through increasing financial intermediation and promoting competition in the financial sector. Financial reform is often part of a broader economic liberalization that emphasizes a greater role for market forces. More extensive financial intermediation typically involves increasing both access to money and capital market institutions and the range of financial instruments. While new markets and new instruments can be created in a heavily controlled system, savings mobilization has tended to be more responsive to market-based developments. Nevertheless, the government can be a catalyst in developing financial markets, for example, through primary issues of government and central bank paper and by making greater use of the central bank's rediscount window for monetary management.

A first step in any financial reform should be the removal of regulations that inhibit competition and a lifting of barriers to entry and exit. Total deregulation is not the objective. Government intervention will remain necessary to ensure the smooth functioning of the financial system-for example, government responsibilities for bank supervision cannot be relinquished. Indeed, liberalization will probably require more effective regulation directed toward preventing incumbent institutions from exploiting existing monopoly positions and ensuring that appropriate prudential standards are observed. The objective is to rationalize the extent and form of government intervention. In a competitive financial system, new markets and new instruments will emerge in response to signals given by savers and investors. This assumes, however, that the price mechanism provides appropriate signals.

Interest Rate and Credit Policy

Competitive interest rates would be differentiated to reflect the maturity of loans (or the associated investments), and the associated risk of credit would flow into what are judged to be the most profitable investments. Pervasive interest rate and credit controls prevent this from happening. Financial systems in developing countries are characterized by direct control of interest rates, in the form of entirely



administered rates or binding ceilings; bank credit ceilings; selective credit controls and preferential central bank refinance facilities to direct credit to priority sectors; or high reserve and liquid asset requirements designed to absorb liquidity and to finance the fiscal deficit.

Removing interest rate and credit controls is essential to financial reform. It cannot be undertaken independently of more general financial liberalization. For example, raising interest rates in an uncompetitive financial system may result only in wider margins for existing institutions. Similarly, with binding credit ceilings-which cause excess liquidity in the banking system and discourage deposit taking-higher interest rates may have little impact on savings. Market-oriented interest rates, the elimination of credit controls, and the promotion of competition in the financial sector together provide the appropriate incentives for saving, investment, and growth. This does not, however, preclude a phased approach to reform. Rather, it suggests that the elements of a phased reform package need to be mutually supporting.

Monetary Control

As a result of financial reform, monetary control will also become more market oriented. Direct instruments of monetary control will be replaced by indirect instruments. In essence, the monetary authority will control the stock of reserve money, and hence money market interest rates. Deposit and lending rates, together with the allocation of credit, will be determined by the market. At the same time, the relationship between money and credit, interest rates, and output are a reflection of institutional arrangements. Financial reform will change these arrangements, with implications for money demand elasticities, the money multiplier, and other parameters that influence monetary policy and its impact. The shift in the underlying determinants of money demand and money supply will render monetary control less precise in the short run; however, in the longer termonce new relationships have been established-market-based monetary control exercised at the level of the central bank's balance sheet will allow more effective targeting of inflation and balance of payments o�jectives.

ADJUSTMENT AND GROWTH IN SELECTED SOUTHEAST ASIAN COUNTRIES

Three countries in Southeast Asia-Korea, Thailand, and the Philippines-have implemented . Fund-supported adjustment pro-



grams during the 1980s. Korea has achieved enormous success (Table 1). Following a period of high inflation and very low output growth in the late 1970s, the authorities implemented a comprehensive adjustment program, while maintaining the emphasis on export-led growth. Growth in the 1981-88 period averaged nearly 1 0 percent annually, and inflation subsided from nearly 30 percent in 1980 to around 7 percent in 1988. The external payments position exhibited significant improvement: the current account moved from a deficit of nearly $5 billion in 1980-81 to a surplus of almost $ 1 4 billion in 1988. The fiscal deficit widened relative to gross domestic product (GOP) in the early years of adjustment, reflecting increases in capital expenditure on education, housing, and energy. Between 1983 and 1988, however, the deficit averaged less than 1/2 of 1 percent of GOP, primarily because of tight control over current expenditure. The evolution of domestic credit reflects the objectives of supporting the growth momentum and containing inflation. Financial sector reforms and the shift to high and positive real interest rates have led to a steady increase in the ratio of financial savings to GOP.

A marked deterioration in public finances, owing in part to an ambitious public investment program, and adverse developments in Thailand's external environment, including the 1979 oil price increase, led to an unsustainable buildup of external imbalances and debt (Table 2). Despite several years of adjustment effort in the early 1980s, which met with some success, Thailand's external situation remained weak. Following the implementation of the adjustment program beginning in 1985, and reflecting favorable external developments, Thailand's situation improved considerably. Although it is difficult to discern clear trends in growth, as in the case of Korea, real growth has been strong in the second half of the 1980s and inflation considerably lower and more stable than in the early 1980s. Fiscal imbalances, however, remained large despite a significant improvement in tax effort, owing largely to the increasing current expenditure. The more recent reduction in the deficit reflects not only measures to increase revenue and contain current expenditure but also the cutting back of capital spending. Interest rate policy and financial sector reforms have been successful in generating a steady and marked increase in the ratio of financial savings to GOP during the 1980s.

The Philippines has had a series of stand-by arrangements covering almost the entire 1980s. The evidence of balanced and sustained growth has not emerged as clearly, however, as in the case of Korea or even Thailand (Table 3). The performance of growth and inflation has fluctuated considerably during this period. The adjustment efforts



in 1984-85 were largely concerned with macroeconomic stabilization-the reduction in explosive inflation rates and the restoration of normal external financial relations. The major recession that followed is, in large part, attributable to the disruptions following the crisis in late 1983, reduced access to external credit, and the collapse of investor confidence. The 1986-88 program focused on stable macroeconomic policies, together with widespread structural reforms, and has been successful in increasing efficient private sector investment, improving the external payments position, lowering inflation, and restoring growth. Fiscal imbalances, measured by both the national government deficit and the consolidated public sector deficit, were reduced in the mid-1980s, mainly through reductions in capital expenditure. Interest rates are market determined in the Philippines, responding to developments in both international and domestic financial markets and changes in the monetary policy stance. Real interest rates have exhibited considerable variation over the period, reflecting movements in the inflation rate and the fact that nominal rates lagged behind inflation. The ratio of financial savings to GDP has changed little, reflecting, in part, the onset of the internal and external financial crises of late 1983 and the subsequent decline in confidence in the financial system, and the impliciL Lax on financial intermediation resulting from the large increase in reserve requirements in 1984.

The lessons that can be learned from the experiences of Korea, Thailand, and the Philippines are limited. While the adjustment programs in each of these countries contained significant elements of structural reform in the fiscal and monetary spheres, the contribution of this to growth performance is difficult to discern (Table 4). This is especially so in the case of fiscal policy, where sometimes temporary changes necessitated by stabilization objectives-ad hoc tax increases and cuts in current and capital spending-did not help growth. Certainly for Korea and Thailand, it can reasonably be claimed that structural changes in the external sector-and in particular trade liberalization in Korea and devaluation in Thailand-have contributed greatly to growth through the promotion of the export sector. In both cases, it is clear that sound monetary and fiscal policies have contributed to an environment that has facilitated structural change, and that this has encouraged growth. In the Philippines, the most recent adjustment efforts, which have been based on more stable macroeconomic policies and far-reaching structural reforms, have already begun to yield similar benefits.

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

Ta

ble

1.

Korea

: A

dju

stm

ent

an

d G

rowth,

1980-88

0)

0

1980

198

1 1982

1983

1984

1985

1986

198

7

198

8

(Percenta

ge

chan

ge

)

Real

GD

P -

3.0

]_

4

5_7

10

.9

9.3

7

.0

12.9

12

.8

12.2

llll

taOOn'

28

.7

21�

3

7.3

3

-4

2.3

2

5

2.8

3.

0 7

.1

{Pef

cent

of G

OP. unles

s otherwis

e indicale

d) ::0

lrweslme

nl

31.

1 29

.1

27

_4

28

.9

30:9

30

.0

28

.8

29.1

30

.2

0

Saving

23

_4

23_7

2

4.2

2

7.8

30

.0

29.5

33

.5

36.9

38

.1

:I:

)>

Qm

en

l aco

ooot ::0

0

(ln

billions of

U.S

. dolla

rs)

-5

.3

-4

.6

-2

.7

-1

.6

-1_

4 -

0.9

4

.6

9.8

14

.2

:I:

Rese

rves

m

�

(In

bilfioos o

f U

.S. dol

lars)

3.0

2.

7

2.8

2

.4

2.8

2

.9

3.3

3

.6

12.3

�

Gove

rnment de

lici1

-2

.2

-3

.4

-3

.1

-1

.1

-1

.2

-1

2 -

0.1

0

.6

1.6

z

Tax

lev

enue

15

.6

15.7

16.

1 16

.7

18.0

17

8

17.5

17

.9

18.5

G)

Cu

ne

n1 e

xpeoclitu

re

14.9

14

.7

15.7

15

.0

16

.8

16.7

15

.3

14.7

14

_7

)>

z

Capilal

expe

nd

ilu

re

2.4

2

.4

3.4

2

.5

2.4

2

.3

2.3

2

.5

22

a

�

(Percenta

ge c

hang

.e)

r

-o

Bro

ad mone

y"

26.9

2

5.0

2

7.0

15

.2

7.7

1

5.6

18

.4

19.0

20

.1

)>

Oomesti

ic credi1

4

0.6

3

1.1

2

5.1

16

.0

13.1

17

.7

14.6

1

63

f1

_6

:z

)>

Rna

ncia

l savings

as pe

rcent

;;o:;:

of G

OP'

28.1

2

9.0

3

2.9

3

2.8

3

1.5

33.

5 3

4.9

36

.1

38.8

0

C'>

::J:

(PelC:en

l a y

ear

) ::J:

)>

In

teres

t ra

les

:0

Oeposit

rale'

19

.5

16

.2

8.0

8

0 9

.2

10.0

10

.0

10.0

10

.0

lend

ing r

a1e

1

8.0

17

.4

11

.8

10.0

10

.0

10.0

10

.0

10.0

10

.1

Rea

l de

posil

rate"

-

71

-4

.2

0.7

4

.4

6.7

7

.3

7.0

6

.8

27

Rea

l lending

rate

" -

8.3

-

3.2

4

.2

6.4

7

.5

73

7

.0

6.8

2

8

Sourc

es lntema:

oonal �

Food.

ln!emaoonal Frnanoa!

Sla"JSIJCS and

Govertl

ll1erl! F.na

nce Sra

rm.cs. v

anous IS

Stlt!!S. and F

ood s

tall es:ma=es

1 Percent

age c

hange r,

lhe periOd

ave

rage consu

mer pnc:e

ondex (CPI

) 2

Excludes

cer

Moca::es or

deposi

l J

Fonancoa

l S<Mng

S demed

as broad

money les

s currency

in eo<oula

bon

• Maxmum

<ale

on l

ime Oepos>

ts of

d.Jra

ll(ln ooe

yea: or

rTIOfe.

• Based

on aa

ual inf

laloon

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

Ta

ble

2.

Th

ail

an

d:

Ad

jus

tme

nt

an

d G

rowth

, 19

80-88

1980

1

98

1

198

2

1983

19

84

1985

1

986

198

7

198

8

(Pe

rce

nla

ge c

ha

ng

e)

Rea

l G

OP

4

.8

6.4

4

.0

7.3

7

.1

3.5

4

.5

8.0

1

0.3

Infla

tion'

19.7

1

2.7

5

.3

3.7

0

.9

2.4

1

.8

2.5

3

.9

-n

(Percent oJ

GOP

. unless oth

erw

ise

indi

ca

ted)

;;;-

n

Inves

tment

26

.4

26

.3

23.1

25

.9

24

.9

24

.0

22

5

23

.9

26

.9

�

Savi

ng

21

0

21

.5

20.6

2

1.2

2

0.6

19

.5

20.9

2

3.2

25

4

I»

:::l

Cun

eot aco

ounl

c.

(In bit/ions

of U

.S. dol

lars)

-2

.1

-2

.6

-1

.0

-2

.9

-2

.1

-1

5

0.3

-

0.3

-

1.7

s:

0

R

ese

rves

::

:l

(In bil

lions of U

.S. dol

lars)

1.6

1

.7

1 5

1

.6

1 9

1

.9

28

4

.0

61

�

I»

Go"e

mm

ent d

elici

t -

4.9

-3

.4

-6

.5

-4

.0

-3

.5

-5

.4

-4

.5

-2.

4 1

.0

-<

Tax r

evenue

1

33

13

.5

12

.8

14 4

1

4 3

1

4.1

14

2

15.0

16

.3

-o

£

C!I

rent e

xpendit

ure

14.

6 1

4.8

1

5.8

1

5.9

16

.2

17

0

16

.7

16.0

1

4 1

<5

" C

apilal

expe

ndiiU

Je

4.4

4

.3

4.6

4.0

3

5

4.0

3

.7

3.1

2

.7

'<

3"

(Pe

rce

nta

ge

clla.ng

e)

::T

Broad

money

22

4

16.2

2

4 1

2

3.3

2

1. 5

1

0�

1

2 7

20

2

18

.2

CD

DomeS1Jr: c

redJl

18

1 1

77

2

1.5

26

.3

18

.1

8.4

5.8

17

.6

16.0

en

a

F1

11ancial

savin

gs a-s

percent

�

oi

GOPZ

31

2

32.1

3

7.6

4

2.5

4

9.3

52

.7

54

.9

605

6

1 0

�

-o

(Pe1cen

t a

ye

ar)

a

Interes

t ra

les

C>

CD

"'

Depos;1 rat

e"

12

0

12

5 1

3.0

13

.0

13

.0

13.0

9

.8

95

9

.5

"'

Lend

ing ra

1e

18.

0

19

0

19

.0

17

6

18

.8

19

.0

17 0

1

50

15

.0

Rea

l depos

it rate

•

-6

.4

-0

.2

7.3

9

.0

12

.0

10

.4

79

6

.8

54

Rea

l lerldin

g ra

te•

-1

4

5.6

1

3.0

13

4 1

7.7

1

62

1

49

1

2 2

10

7

Sources

11

1!ernaoonal Mone

!ary F

und.

fnrema&onal f

Nlancfal Sl.aliSl

lCS and Gove/lrJ

letll FNrance

Slalls!JCS

. vatlOU

S IS

SUeS. and F

und sta't

esoma:es

1

Percent

age c

hange .,

1he pe

nod a

verage consume<

pnce lflCie>.

(CPf

) �

2

Fillanc•al

SilWlQS

are d

efone

d as

broad

money les

s currency "'

aroulallOO

l M

axlfJUTl t

ale

of'.ered by

oon-.me

roal bati

ks on

deposits of

'"'"' :t.e

e � su:

monlhs

'

Based oo

actual

in.tlallon

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

Ta

ble

3.

Ph

ilipp

ine

s:

Ad

jus

tme

nt

an

d G

rowt

h,

1980-88

C>

N

1980

198

1 1982

1

983

1984

198

5

1986

198

7

1988

(Pe

rcentage cl

lan

ge

}

Real G

OP

5

.1

4.0

2

.9

1.0

-

6.0

-

4.2

2.

0

5.9

6.

7 ln

fla

tioo

' 18

.2

13.1

10

2

10.0

50

.3

23

.1

0.8

3.8

8.

7

(Percen

t of

GO

P, unle

ss ot

herNise

ind

ica

tecf)

::J

J In

ves

tme

nt

30.7

3

0.6

28

.3

26.7

17

.0

13

.9

12

.9

15.6

17

.1

C')

Savi

ng

24.7

2

4.1

2

2.6

2

2.5

18

.6

1 6.2

16

..5

14

.1

17.2

:X:

)>

C

urre

nt ac

count ::J

J 0

{f

n bil

lions ol U

.S. dotlars

) -

1.9

-

2.1

-

32

-

2.8

-

13

10

-0

.4

-0

4

:X:

Re

serv

es

m

(In bil

lions ol U

.S. rial

lars)

3.1

2

.6

1.7

0

.9

0.9

u

2

.5

2.0

2

.1

:!::

:!::

Govem

me1

1t defici

t -

1 .3

-

4.0

-

42

-

1.9

-

18

-

1.8

-5.

1 -

2.9

-

3.1

z

T

ax

re

venu

e

11

..5

10.3

9

.9

10.3

9

2

10.0

l0

.7

12.

2

11

.1

G>

Cur

rent e

xpenditu

re

9.1

8

.6

9.0

9.0

7

.9

9.0

1

6.0

1

5.1

14

6

)>

z

Capit

al e

x:pend

�ure

3

2

4.2

2

9

2.7

1

"6

1.4

2

.1

2.2

2

.2

0

Con

solidate

d p

ubl

ic

�

sector

defici!Z

-9

.0

-6

.2

-5

.9

-4.

8

-2

.7

-3

.4

r- "

)>

(Percen

lag

e c

lla

ng

e)

z

)>

Broad

money

22

1

18.4

19

.9

21

.8

14

_8

12.9

9

.9

14

.4

23..5

;:.:;

Domes

tic

credit

259

2

4.0

2

3.2

29

.8

5.6

-

6.9

-

164

-

7.8

3

..5

0

C')

Rnan

cial s

aving

s as

percern

:X:

:X:

o

f G

DP3

17

1

17

.7

19

.4

19.9

1

6.3

16

.3

17.1

17

.0

16.4

)>

::J

J (Perceq

r a

ye

ar)

1r11er

est

rate

s D

eposit ra

te'

12

3

13.7

13

. 7

13.6

21

.2

18.9

1

1 3

8

.2

11 3

l

end

ing r

ate

1

4.0

1

5.3

1

8.1

1

9.2

2

8.2

28

.6

\7

5

133

1

59

Real deposit

rale5

-

5.0

0

.5

32

3

3 -

19.7

-

3.4

10.4

4

.2

24

Re

al lendi

ng r

ateS

-

3.6

1

9

7.2

8

.4

-1

4 7

4

.5

16.

6

9.2

6

.6

Sources:

ln1emai!

IO<lal Uone!a<y

Fend.

lntem<roJOnal Fmancial

S!a!IS

OCS and

Government Frnance

S!�.llStics

. va

nous

issues. and

FtJnd s

lafl

eslimates.

' Pesoenla

ge change on

U1e period

ave

rage ccnsumer

proce .ndlex

(CPI

) 2

The

C<JnSOIH:Ia:

ed public

seclor

Qe!oc

it is

no1 ava

i-prior

!o 1

983.

lliJKl

ludes non

financial

and bnanc

•al nSblt!Do

ns. ux:

luding

lhe Cen

iJal Bank.

3

F"onanclal saYings

del61ed as

broad money

ress

CU'ren:y

in circ

ulaJj(Jn

� Ral

e on

61-

10-90-<iay

tme d

eposJ:s

5 :Ba

sed on

acll

lal intlalior1.

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

Ta

ble

4.

Fu

nd

-su

ppo

rted

Pro

gra

ms

in

K

orea.

Th

aU

an

d,

an

d the

Ph

iUp

pin

es

Korea

Pe

riod

covered

b

y F

und

prog

ram

s

Ma

rdh 1

98

0-F

ebru

ary

19

82

: S

tan

d-tly

a

rra

ng

eme

nt.

Ju

ly 1

98

3-M

arc

h 1

98

5:

Sta

nd

,by

a

rra

nge

me

nt.

Ma

in s

tru

ctu

ral

mea

su

res

198

0-82

Fis

ca

l pol

icy

T

ax

re

form

-

Re

form

cor

pora

te l

aJ<es

. -

Re

form

tax

es

on in

tere

st a

nd

div

i-d

en

d inco

me.

-In

trod

uce

va

lu�

ad

ded

laJ<.

Pu

blic

exp

end

itu

re

-Con

serv

e e

ne

rgy

an

d e

nc

ou

rag

e

dom

esti

c su

bstit

utes

fOf

oil.

-

Em

ph

asiz

e ho

usi

ng

and soci

al in

fra

st

ruct

ure

. M

oneta

ry a

nd

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CONCLUDING COMMENTS

This paper has described the contribution structural reforms in the areas of fiscal and monetary policy can make to growth-oriented adjustment. In principle, there appears to be a much-expanded role for fiscal policy compared with less ambitious adjustment strategies. While the focus of monetary policy should continue to be stabilization, there is scope nonetheless for structural change to enhance efficiency, although this is likely to be less influential than fiscal reform.

The set of reforms described in the paper is not intended to be exhaustive. Moreover, while the reforms are derived from principles that are probably of general applicability, it should be emphasized that the precise package of reforms that can most successfully foster improved resource allocation and growth is very much dependent on the circumstances of the country in question.

Lastly, it should be borne in mind that the empirical support for the suggested reforms is not overwhelming. While in many cases such reforms have been successfully implemented, there is a risk that they may not have their intended effect, or at least that any impact will be much less than expected. The economic principles that point to their beneficial consequences are not natural laws; they are simply the best basis -for reform that we currently have.

BIBLIOGRAPHY

Blejer, Mario, 1., and Ke-Young Chu, eds. Measurement of Fiscal Impact: Methodological Issues, Occasional Paper No. 59 (Washington: International Monetary Fund, 1988).

Corbo, Vittorio, Morris Goldstein, and Mohsin Khan, Growth-Oriented Adjustment Programs, proceedings of a symposium held in Washington, D.C., February 25-27, 1987 (Washington: International Monetary Fund and The World Bank, I 987).

Gandhi, Ved P., Supply-Side Tax Policy: Its Relevance to Developing Countries (Washington: International Monetary Fund, I 987).

Hemming, Richard, and Ali M. Mansoor, Privatization and Public Ente1prises, Occasional Paper No. 56 (Washington: Imernational Monetary Fund, 1988).

Hernandez-Cata, Ernesto, "Issues in the Design of Growth Exercises," IMF Working Paper, No. 88/65 (Washington: International Monetary Fund, July 1988).



International Monetary Fund, Fund-Supported Programs, Fiscal Policy, and Income Distribution: A Study by the Fiscal Affai1·s Depm-tmenl of the lntenUltiorwl Monetary Fund, Occasional Paper No. 46 (Washington: Imernational Monetary Fund, 1986).

--, Theoretical Aspects of the Design of Fund-Supported Adjustment Programs: A Study by the Research Department of the International Monetary Fund, Occasional Paper No. 55 (Washington: International Monetary Fund. 1987).

Johnston, R. Barry, and Odd Per Brekk, "Monetary Control Procedures and Financial Reform: Approaches, Issues, and Recent Experiences in Developing Countries," IMF Working Paper, No. 89/48 (Washington: International Monetary Fund, June 1989).

Khan, Mohsin S., "The Macroeconomic Effects of IMF-Supported Adjustment Programs: An Empirical Analysis," IMF Working Paper, No. 88/ 1 1 3 (Washington: International Monetary Fund, December 1988).

--, and Malcolm D. Knight, Fund-Supported Adjustment Programs and Economic Growth, Occasional Paper No. 4 1 (Washington: International Monetary Fund, I985).

Khan, Mohsin S., and Peter J. Montiel, "Growth-Oriented Adjustmem Programs: A Conceptual Framework," Staff Papers, International Monetary Fund (Washington), Vol. 26 U une 1989), pp. 279-306.

Tait, Alan A., Vahte-Added Tax: lntemational Practice and P1·oblems (WashingtOn: International Monetary Fund, 1988).


Comment

TANYA SIRIVEDHIN

The International Monetary Fund has received widespread criticism over the years concerning policy prescriptions it has made for member countries. Partly as a reaction to these criticisms, and partly through its own experience, the emphasis of its policy recommendations appears to be shifting toward greater attention to growth.

The paper prepared by Messrs. Hemming and Kochhar, it would not be an exaggeration to say, offers a comprehensive and unbiased treatment of the role of fiscal and monetary policy in growth-oriented adjustment.

In general, monetary policy and exchange rate policy are the major players in short-term balance of payments adjustment, with fiscal policy playing a supportive role; whereas when it comes to long-term growth-oriented adjustment, fiscal measures can assume a prominent role, together with other structural adjustment measures. Monetary measures will help to improve the efficiency of resource allocation and expand productive capacity.

I also agree completely with the paper's conclusion that the precise package of reforms that can most successfully foster improved resource allocation and growth is very much dependent on the circumstances of the country in question.

My comments will address three areas: first, some of the specific policy issues raised in the paper; second, the experience of Thailand; and third, other ingredients of successful growth-oriented adjustment.

SPECIFIC POLICY ISSUE

I n the discussion of tax policy, one of the recommendations made is that commodity taxation should be the major source of revenue. In principle this is desirable. Whether and to what extent it is feasible, however, is another matter, particularly for poorer countries. As these countries usually produce only a few commodities, and the majority of the population relies on these few commodities for income, it may not be possible to prevent the tax incidence from falling on the poor farmer, notwithstanding the fact that the tax may be collected

67


68 TANYA SIRIVEDHIN

at the final consumption stage or at the wholesale stage. When this happens, the principle of equity may not be achieved.

In countries where it is not practicable to impose a value-added tax, direct taxation may be the next best choice insofar as revenue raising is concerned. This is because in poor countries, it may not be so undesirable for the tax burden to fall on persons with fixed incomes, since these people will generally be in a higher revenue bracket than the large majority, who are farmers. Taxes on property should also not be completely overlooked, though this is usually not politically feasible in poor countries.

On the question of government expenditure, the paper correctly encourages strict control of capital expenditure in order to limit investments to efficient activities that truly contribute to economic growth. Here, there seems to be some scope for increased cooperation between the Fund and the World Bank. Besides financial assistance, the latter could provide technical assistance in order to help ensure that government capital expenditure is used efficiently and leads to balanced growth.

Current expenditure may merit somewhat more attention. One of the reasons for overspending by the government may be the attempt by bureaucrats to extend their "domain," for example, by increasing their agency's staff. This leads to overstaffing and inefficiency and makes it difficult to control current expenditures.

Spending on subsidies, the paper correctly asserts, warrants special attention. I t would be interesting to see a discussion on the pros and cons of transparency-subsidies provided in budget allocations are more easily amenable to evaluation of costs and benefits-as opposed to hidden subsidies, for example, those indirectly implemented through the financial system, such as in the form of regulatory provisions. In the latter case, it is difficult to ascertain whether or not the benefit falls on the target group, and who is bearing the brunt of the burden. Where the central bank is the provider of a subsidy, economic stability may suffer; that is, in effect, an inflation tax is imposed. In discussions of adjustment programs, the relevant authorities should be alerted to these issues.

It is a standard prescription that interest rate policy should be implemented in a flexible manner. How effective positive real interest rates can be in promoting adjustment, however, depends greatly on the structure of financial markets. Thailand's experience is that when interest rate flexibility was increased, the downward rigidity of interest rates inherent in the financial system gave rise to a sustained period of high real interest rates. Despite an ensuing economic downturn, businesses continued to have to put up with high interest rates, to


TANYA SIRIVEDHIN 69

the detriment of both the debtor businesses and their financial institution creditors. In some cases, some intervention may therefore be necessary, for example, in the form of timely adjustments of ceiling interest rates. The lesson here is that liberalization of interest rate policy may need to be implemented step by step.

On the subject of deposit insurance, attractiveness is at present much diluted by the problems currently being faced by the oftenquoted model, the deposit insurance scheme in the United States.

THE CASE OF THAILAND

Thailand's long-term policy objective has always been sustained economic growth, that is, growth with stability and an appropriate income distribution. The authorities have used both stabilization and structural adjustment policies to help the country cope with continually changing world economic conditions. This does not mean that the policy measures used by Thailand are universally applicable. The policy mix and timing of implementation must be adjusted to the circumstances of each country.

Problems

A combination of adverse economic factors and serious weakness in domestic policies began threatening the stable growth of the Thai economy in the late 1970s. The former comprised the second oil shock in 1979, weakening demand for traditional Thai exports, and high international interest rates. The rising U.S. dollar, to which the baht was pegged, made Thai exports less and less competitive during 1983-84. Agricultural production stagnated owing to land shortage, low production efficiency, and inadequate incentives. The industrial sector was distorted owing to a strategy which, since the mid-1 970s, encouraged import substitution under a heavy shield of protection and discouraged nontraditional exports. Government revenues were low, with 80 percent consisting of indirect taxes; state enterprises had large deficits; and price distortions led to excessive use of imported oil when international prices were soaring. Domestic inflation reached almost 20 percent in 1979, and the current account was almost 7 percent of GDP in 1 979-81 . International reserves fell and external debt climbed.

Various measures were subsequently introduced underpinned by financial assistance from abroad, particularly the 1MF's Trust Fund,


70 Comment

various stand-by programs, and two structural adjustment loans from the World Bank.

Policy Implementation

A wide range of measures were simultaneously adopted. To stabilize the economy, improvement in the Government's fiscal position was accomplished by improving public sector expenditure management, increasing tax revenue, improving the tax structu

.re, 1 and strength

ening the planning and implementation stages of tax administration. New initiatives were launched in state enterprise finances: public utility rates were raised, investment programs were scaled down, and monitoring systems were set up.

Restrictive monetary policy was adopted in 1980-82 and again in 1984-85. The Thai baht was devalued by 8. 7 percent in 1981 and again by 14.8 percent in 1984 when it was also floated with a basket of currencies. A committee was set up to oversee official external debt policy, and restrictive annual ceilings were placed on new borrowing commitments.

Structural measures were also taken. To reduce demand for energy, domestic oil prices were adjusted upward to reflect costs. Conservation measures and domestic and alternative energy sources were introduced. Through fiscal measures, the trade system was liberalized to strengthen export development. Price controls on various commodities were lifted, in order to eliminate distortions that impeded the efficient working of market forces. Financial assistance was given by the central bank to promote exports. Various privileges were given by the Board of Investment to promote manufacturing activities. In agriculture, modern technology was gradually adopted and crop diversification promoted. Concessional agricultural credit and cheap fertilizer were made available. Commercial banks were encouraged to pay more attention to rural lending. The financial sector was completely overhauled through new legislation and guidance by authorities. Interest rates were made more flexible to reflect global trends.

Achievements

Thailand experienced a slowdown of economic acuvtues during 1985-86 owing partly to domestic stabilization measures and partly

• For example. restructuring and reducing personal income taxes (from 65 to 55 percent maximum), reducing corporate income tax (from 40 to 35 percent), and revising taxes on revenues from various financial instruments to promote saving. Introduction of a value-added tax is still in the pipeline as is a restructuring of the import tariff structure.


TANYA SIRIVEDHIN 71

to global recession. The degree of setback, however, was not very severe. Even at its slowest, real gross domestic product managed to grow at not less than the 3.5 percent attained in 1985. A decline in oil prices and global interest rates in 1986 helped to start the turnaround of the Thai economy. Recovery began in 1987, led primarily by manufacturing exports, which were in turn supported by exchange rate policy, a more liberal export regime, and increased promotion efforts. Inflation averaged under 2 percent during 1984-87, the current account enjoyed a small surplus in 1986, and the external debt/service ratio fell sharply from the almost 23 percent peak in 1985 to under 1 3 percent currently.

FACTORS SUPPORTING GROWTH-ORIENTED ADJUSTMENT

From the lesson of Thailand, the only thing that can be concluded is that comprehensive policy packages are necessary for growthoriented adjustment. It cannot, however, be concluded that a comprehensive package is sufficient for growth-oriented adjustment. In Thailand's case, external factors have played a crucial role in its economic woes and achievements. For example, the problems of the early 1980s were partly due to high oil prices, high global interest rates, sluggish demand for commodities by industrial countries, and the unrelenting appreciation of the U.S. dollar. Subsequent improvement, besides being due to stabilization and structural adjustment measures adopted by the authorities, was helped by lower oil prices, lower international interest rates, global economic recovery, and the downturn of the U.S. dollar. Furthermore, Thailand has vast natural resources, an adaptable and inexpensive labor force, and a multitude of entrepreneurs who are responsive to external developments. Last but not least, the Government had the political will to painstakingly follow through the adjustment program that had been mapped out. This firm commitment on the part of the Government is a prerequisite to any such accomplishment.


5 Trade Policy as a Strategy for

Structural Adjustment

SUHAOI MANGKUSUWONDO

The decade of the 1970s will be remembered as one of economic turbulence. It caused profound changes in the structure of world trade, the consequences of which were felt by all countries until the end of the 1980s. Starting with the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s, followed by sharp rises in the prices of oil and most other commodities, inflationary pressures were building toward the end of the 1970s. Economic growth generally slowed down from the high rates of the 1960s.

SLOWDOWN OF ECONOMIC GROWTH IN THE EARLY 1 980s

In the early 1980s, as a consequence of the tight fiscal and monetary policies adopted by the major industrial countries in their attempt to stop inflation, the cycle reached its turning point. Recession set in, followed by sharply declining commodity prices, including steep drops in oil prices in 1983, and again in 1986. The situation was particularly burdensome for the developing countries, which depend mostly on exports of commodities. ln addition, there was a general decline in the Aow of capital from the industrial countries to the developing nations. At the same time, interest rates tended to rise, adding to the burden of those developing countries still in need of laa·ge amounts of foreign borrowings.

Before the oil boom, between 1965 and 1973, the developing coumries in general succeeded in achieving a postwar, high average economic growth rate of 6.5 percent a year (see Table I). During the inflationary period of 1973-80, the average annual rate of growth

72


Trade Policy as Strategy

Table 1 . Growth of Real GOP, 1965-87

(Annual percentage change)

Average

Country Group 1965-73 1973-80 1980-85 1986

Industrial countries 4.5 2 8 2.4 2.7 Developing countries 6 5 5.4 3.2 4.7

Low-income 5.5 4.6 . 7.4 6.4 Excluding China and India 3.4 3.4 3.0 4.8 China and India 6.1 4 9 8.6 6.8 Low-income Africa 3.6 2 0 0 7 3.7

Middle-income 7.0 5.7 1 . 6 3.9 Oil exporters 7.0 5.9 0.9 0.3 Exporters of manufactures 7.4 6.0 5.8 7.2 Highly indebted countries 6.9 5.4 0.1 3.5

High-income oil exporters 8. 7 8.0 -2.5 - 8. 1

Source: World Bank, World Development Report 1988 (Washington. 1988), Table 1 .3

Note: Data for developing countries are based on a sample of 90 countries.

73

1987

2 9 3.9 5.3 4.5 5.4 3.0 3.2 0.8 5.3 1 .7

-2.9

slowed down to 5.4 percent, and declined further to 3.2 percent during the recession of 1 980-85.

In spite of the slowing growth of developing countries, during the twenty years from 1965 to 1985, the average growth of these countries as a group exceeded that of the industrial countries. More important is the fact that during the same period the difference in growth rates among the developing countries themselves widened. As shown in Table 1 , during 1965-73 the lowest rates of growth took place in the low-income developing countries (3.4 percent), excluding China and India, and the highest in the group of exporters of manufactures (7.4 percent). During 1980-85, the slowest growth was recorded in the highly indebted developing countries (0.1 percent) and the fastest again in the group of exporters of manufactures (5.8 percent), giving a ratio of 58: 1 . It is this considerable difference in economic performance among the developing countries that needs scrutiny. Many studies have been conducted lately to understand better the factors underlying the apparent failures and successes of different countries to adjust to the rapidly changing international economic environment.

In this paper, we shall look at a selected number of Asian developing countries: the ASEAN-4 (Indonesia, Malaysia, Philippines, and Thailand), three newly industrializing economies (Hong Kong, Korea, and Singapore), and four South Asian countries (Bangladesh, India, Pakistan, and Sri Lanka). These countries differ in size (population and area), level of income, and resource endowments. Nevertheless,


74 SUHADI MANGKUSUWONDO

we shall look at some common features of their economic development, particularly during the adjustment period of 1980-87, and see if some inferences about the effect of different trade policies can be drawn.

RECENT PERFORMANCE

A convenient way of comparing the relative economic performance of the Asian developing countries during the last two decades is by looking at the average annual growth of per capita income. Table 2 shows that during the period of 1965-87 Hong Kong, Korea, and Singapore achieved the highest average rate of growth of per capita gross national product (GNP) (6-7 percent a year), followed by the ASEAN-4, except the Philippines (4-4.5 percent a year), while the South Asian countries trailed behind the ASEAN-4 ( 1-3 percent a year). The highest rate of growth was achieved by Singapore (7 .2 percent), the lowest by Bangladesh (0.3 percent). The average growth rate for all developing countries was 2.7 percent a year.

Table 2. GNP Per Capita

1987

(In millions of U.S. dollars)

ASEAN-4 Indonesia 450 Malaysia 1 ,810

Philippines 590

Thailand 850

Newly Industrializing economies Hong Kong 8,070 Korea 2,690 Singapore 7,940

South Asia Bangladesh 160 India 300

Pakistan 350

Sri Lanka 400

Developing countries (low- and middle-income economies) 650

Average Annual Growth Rate

1965-87

(In percent)

4 5 4.1 1 . 7 3.9

6.2 6.4 7.2

0.3 1 .8 2.5 3.0

2.7

Source: World 6ank, "World Development Indicators," World Development Report 1989 (New

York: Oxford University Press, 1989). Table 1 .


Trade Policy as Strategy 75

A difference of 2 to 4 percentage points in growth rates, if maintained over a period of 10 to 25 years means considerable differences in the final level of income. Such differences in growth rates accounted, lO a large extent, for the large differences in the levels of per capita GNP in 1987. The figures in Table 2 show significant differences in the level of per capita income, high incomes prevailing in the newly industrializing economies, medium-level incomes in the ASEAN-4 except in the Philippines, and low levels in South Asia. All the South Asian countries have incomes well below the average for all developing countries ($650 per capita), while those of the newly industrializing economies are well above the average level. The initial levels of income at the beginning of the period were different, but the differing rates of growth made the disparity in income levels at the end of the period even more pronounced.

Having looked at the average growth during the last twenty-two years, it would also be interesting to see the picture before and after 1980, the post-1980 years being the time of recession and economic adjustment.

Table 3 shows the growth rate of GDP and the share of trade in the GDP. During the period of 1965-80, the newly industrializing economies grew the fastest (8-10 percent a year), then the ASEAN-4 (5-8 percent), followed by the South Asian countries (2-5 percent). Compared with the average growth for all developing countries (5.9 percent), the growth rates of the newly industrializing economies and the ASEAN-4 were above average, while those of the South Asian group were below average. After 1980 ( 1980-87), all the newly industrializing economies and the ASEAN-4 recorded slower growth rates, while those of the South Asian countries accelerated, overtaking the average for all developing countries. Thus, while the growth of GDP of the developing countries slowed down generally during 1980-87, in South Asia growth picked up.

Apparently, this had something to do with the degree of exposure of the economy to external influences. The newly industrializing economies and the ASEAN-4 are generally more open to international trade. Table 3 clearly shows that in 1987, except for Sri Lanka, the share of exports plus imports in GDP of the South Asian countries is much smaller than that of the newly industrializing economies and the ASEAN-4. This implies that the South Asian countries have been less affected by the ill effects of the world recession than the other countries under discussion.

On the other hand, there are indications that since 1986, as the world economy recovered from the recession, the newly industrializing economies and the ASEAN-4 have regained their higher growth

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rates. In 1988, for example, according to some estimates, Korea, Singapore, and Thailand scored double digit rates of growth. Indonesia, Malaysia, and the Philippines also achieved higher growth rates (between 5 percent and 8 percent). In other words, the more open is a country to international trade, the more it will feel the adverse effects of a recession and the more it will benefit from an upturn in world economic activity.

The difference in structure of trade also affected the trade performance of the Asian countries. Since prices of primary commodities declined much more than manufactures, primary-producing countries suffered more during the recession. As shown in Table 4, commodity prices have declined in nominal dollars, as well as in real terms, during 1980-85. In nominal terms, non-oil commodity prices recovered somewhat in 1986 and 1987; in real terms, however, prices continued to decline through 1987. Thus, for seven consecutive years, starting in 1981, prices of primary commodities have been sliding downward. This, obviously, has affected particularly those developing countries that are highly dependent on exports of raw materials.

Table 5 shows the structure of merchandise exports of the Asian developing countries. For the developing countries as a group,

Table 4. Commodity Prices, 198o-87

(In average annual rates of change)

198<Hl5 1985 1986

Commodity prices In nominal dollars

Food and beverages -4.8 - 12.1 6.4 Nonfood agriculture -6.9 - 14.9 -87 Metals and minerals - 6.2 -5.6 -8.0

Total non-oil - 5.6 - 1 1 . 1 0.6 Petroleum - 2.3 -2.9 -49. 1

Commodity prices In real terms'

Total non-oil -4.7 - 1 2.2 - 1 5.0 Petroleum -1.6 -4.0 -57 0

In SDR (special draw-ing rights) terms

Total non-oil - 1 . 1 - 1 0 6 -13.2 Petroleum 2.8 -2.1 -56.1

Source: World Bank, Annual Report 1988 (Washington. 1988). Table 2-6. ' Deflated by export prices ol manufactures of major industrial countries.

1987

- 16.2 24.6 15.7

0.3 26.6

-9.4

14.5

- 8.7 1 5.3

Note: Commodity price indices are weighted by commodity exports of all developing countries.



Table 5. Structure of Merchandise Exports

(In percent)

Primary Textiles and Commodities Manufactures Clothing'

1965 1987 1965 1987 1965 1987

ASEAN-4 Indonesia 96 72 4 27 0 5 Malaysia 94 61 6 40 0 3 Philippines 95 38 6 62 1 6 Thailand 95 47 4 53 0 1 8

Newly Industrializing economies Hong Kong 1 3 8 87 92 44 34 Korea 40 7 59 92 27 25 Singapore 65 28 35 72 6 6

South Asia Bangladesh 49 50 India 51 31 49 69 36 16 Pakistan 64 33 36 67 29 41 Sri Lanka 99 60 40 0 25

Developing countries 85 45 1 5 55 5 1 1 OECO 30 1 9 70 80 7 5

Source: World Bank, "World Development Indicators," World Development Report 1989 (New York. Oxford University Press. 1989). Table 16.

' Textiles and clothing is a subgroup of manufactures

primary commodities still play a major role in total exports, although their share has declined from 85 percent in 1965 to 45 percent in 1987. The table also shows that primary commodities still dominate the exports of the ASEAN-4 (except for the Philippines in 1987). The newly industrializing economies are the least dependent on primary commodities, even though Singapore's share for 1987 is still 28 percent. But this consists mainly of re-exports from Singapore of primary products originating from its neighboring countries (Indonesia, Malaysia, Thailand). South Asia's position lies between the newly industrializing economies and Lhe ASEAN-4. Primary commodities' share in exports exceeds the average (45 percent), for Sri Lanka (60 percent) and Bangladesh (49 percent) . From the structure of merchandise exports, one can draw the inference that the ASEAN-4 plus Sri Lanka and Bangladesh must have been hardest hit by the precipitous fall of commodity prices between 1981 and 1987, while the newly industrializing economies have been least affected.

Of all the Asian nations, Indonesia is most heavily dependent on



primary commodities: 72 percent of export earnings in 1987 came from commodity exports. Malaysia (61 percent) and Sri Lanka (60 percent) are also still predominantly primary commodity exporters, although the pattern is rapidly changing since exports of manufactures from these countries are increasing rapidly.

For Indonesia, the sharp fall in oil prices in 1983, and again in 1986, was particularly painful, since oil is a dominant export (54 percent of total exports in 1987 consisted of fuels, minerals, and metals). Oil export is also important for Malaysia and Singapore, but to a much lower degree than for Indonesia. Thus, while the fall in oil prices may have been a blessing for the oil importing countries of Asia, for Indonesia it was a serious setback.

Although exports of primary commodities still play a major role, exports of manufactures have increased rapidly in all the Asian developing countries. However, if we look at the composition of manufactures exports, again it is the newly industrializing economies and the ASEAN-4 that are more "advanced," in the sense that exports from South Asia still consist mostly of textiles and clothing. These are typically "traditional" manufactures exported by developing countries at the early stage of development.

Table 6 shows the imports of manufactures from the Asian developing countries by the Organization for Economic Cooperation and Development (OECD). Bangladesh has the smallest exports ($696 million in 1987) and the highest proportion of textiles and clothing (84 percent). Pakistan and Sri Lanka also have very high proportions of textiles and clothing (76 percent). Even India (46 percent) has a higher proportion than Hong Kong (42 percent), the leading and traditional exporter of textiles and clothing. All the ASEAN countries have a much lower proportion than Bangladesh, Pakistan, and Sri Lanka.

The "nontraditional" items in manufactures exports are chemicals, electrical machinery, electronics, and transport equipment. Malaysia, Singapore, Philippines, and Korea are the leading exporters of these items. The South Asian countries appear slower in developing internationally competitive manufacturing industries.

Another important aspect of the performance of the developing countries of Asia is the varying sizes of their external debts. All the Asian developing countries have increased their external debts, many of them quite substantially, between 1970 and 1987. Table 7 shows that the developing countries as a whole have increased their external public debt from 12.7 percent of GNP in 1970 to 39.2 percent in 1987. The ASEAN-4, except Thailand, have debt ratios well in excess of the average (around 65 percent). Similarly, the South Asian



Table 6. OECD's Imports of Manufactures from the Asian Developing Countries, 1987

Value of Imports Share of Textiles Share of of Manufactures and Clothing Manufactures

(In millions of US. dollars) {In percent) (In percent)

ASEAN·4 Indonesia 2.599 33 7 Malaysia 4,553 16 63 Philippines 3,119 34 33 Thailand 3.919 33 16

Newly Industrializing economies Hong Kong 21 .753 42 1 6 Korea 33.247 27 28 Singapore 10.265 8 40

South Asia Bangladesh 696 84 0 India 5,537 46 4 Pakistan 1 ,884 79 0 Sri Lanka 775 76 5

Developing countries 180.158 28 25 OECD 1,030,645 6 45

Source: World Bank. "World Development Indicators." World Development Report 1989 (New York: Oxlord University Press. 1989). Table 17.

countries, except India and Pakistan, have raised their external debts to a level far above the average figure (50-60 percent). Only the newly industrializing economies managed to keep their external debts low. Even Korea, with quite large external debts, has succeeded in keeping them at managable levels (20.7 percent of GNP in 1987, well below the average for all developing countries).

It is worth noting that while most of the Asian developing countries have debt ratios higher than average in 1987, most of them have below average debt-service burdens, measured in percentage of exports of goods and services. This is due mainly to the high proportion of exports to the GDP of the region. In 1987 the average debt/service ratio for all developing countries was 22.0 percent; only four of the Asian countries, Indonesia (27.8 percent), the Philippines (23.2 percent), Bangladesh (24.2 percent), and Pakistan (25.9 percent), have higher ratios. The debt problem which is a most serious issue in Latin America and Africa, is therefore not a major issue in the developing countries in Asia, except perhaps for Indonesia and the Philippines.



Table 7. External Public Debt and Debt/Service Ratios

ASEAN-4 Indonesia Malaysia Philippines Thailand

External Public Debt Outstanding and

Disbursed

1970 1987

(As percentage of GNP)

25.2 62.6 9.5 65.4

8.8 65.0

4.9 29.6

Newly industrializing economies Hong Kong Korea 203 20.7 Singapore 7.9 12.4

South Asia Bangladesh 0.0 50.6 India 14.7 15.1 Pakistan 30.6 38.0 Sri Lanka 16.1 62.9

Developing countries 1 2.7 39.2

Debt/Service Ratios

1970 1987

(As percentage of

exports of goods and

services)

7.0 27.8 3.8 14.3

7.5 23.2

3.3 13.6

19.5 21.9 0.6 1 .4

0.0 24.2 22.2 18.9 23.5 25.9 10.9 19.2

11 .2 22.0

Source: World Bank, "World Development Indicators." World Development Report 1989 (New York: Oxford University Press. 1989). Table 24.

EFFECTS OF DIFFERENT TRADE POLICIES

The World Bank's World Development Report 1987 shows that trade strategy has a great influence on economic development. Trade strategy is divided broadly into two kinds, outward-oriented and inward-oriented. The Bank uses a rather unique definition of outward-oriented strategy, namely, one in which trade and industrial policies do not discriminate between production for the domestic market and exports, nor between purchases of domestic goods and foreign goods. Even when this strategy is neutral and is not biased in favor of exports, it is referred to as export promotion strategy. By contrast, an inward-oriented strategy is one in which trade and industrial incentives are biased in favor of production for the domestic over the export market. This approach is usually known as the importsubstitution strategy.

The argument in favor of a neutral trade regime is that it avoids distortion in the allocation of resources. An import-substitution



regime, characterized by high levels of protection for manufacturing, direct controls on imports and investments, and overvalued exchange rates, is likely to distort the market. Resources will be induced to move from unprotected activities to protected ones. Producers in the unprotected export sector would find that the price of their output has fallen relative to both protected imports and nontradables. The effect of protection is thus similar to a tax on exports. At the same time, domestic demand will tend to switch to the cheaper products, namely, exportables. Hence, exports will be further discouraged.

Many developing countries have taken measures to encourage import substitution in the mistaken belief that they have no adverse impact upon the export sector. In fact, as shown by empirical studies in a number of Latin American and African countries, the "shift parameters" are usually quite high, indicating that more than half of the burden of protection is shifted to the export sector.

It is now generally recognized that export expansion often acts as an engine of economic growth. Countries that fail to expand their exports may soon find it difficult to achieve or maintain a satisfactory growth rate. There are a number of interacting reasons why this should be so. First, exports provide a source of demand for domestic products, resulting in higher incomes for domestic producers, which in turn create demand for domestic consumer goods. Second, exports produce foreign exchange, which will ensure financing of additional imports of intermediate and capital goods. Third, increasing exports gives assurance that the country will not be facing a foreign exchange crisis, thereby encouraging investment. Fourth, exploiting the country's comparative advantage, economies of large-scale production, and higher capacity utilization will enhance efficiency. Last, but not least, competition in foreign markets will provide incentive for technological change.

While there is mounting evidence of the superiority of an outwardlooking strategy, the World Bank, as a rule, does not recommend the promotion of exports by creating positive export incentives. Such incentives may take the form of rebates in excess of actual import charges on imported inputs, or excessive "wastage" allowances on imported inputs, export credits at concessional interest rates, or other explicit subsidies. Apart from the market distortive effects, such policies are difficult to administer and require substantial budgetary resources. They tend to be discriminatory and are open to abuse. Furthermore, they are increasingly threatened by countervailing measures by major importing countries.

From the study, the World Bank found that among the 4 1 developing countries included in the study, those that have adopted



an outward-oriented strategy performed better than those with an inward-oriented strategy. For the study, countries were divided into four groups: strongly outward-oriented, moderately outward-oriented, moderately inward-oriented, and strongly inward-oriented economies. The classification of countries was based on policy indicators, both qualitative and quantitative, such as the effective rate of protection and the use of direct controls (for example, quotas and import-licensing schemes, use of export incentives, and the degree of exchange rate overvaluation).

Economic performance was measured in terms of average annual growth rates of real GDP and per capita income, the gross domestic savings ratio, the average incremental capital/output ratio, the average annual growth rate of real manufactures export, and the average annual rates of inflation. As stated earlier, the available data suggest that the economic performance of the out\vard-oriented economies has been broadly superior to that of the inward-oriented economies in almost all respects.

Of the Asian developing countries, the newly industrializing economies, Hong Kong, Korea, and Singapore, consistently fall under the category of strongly outward oriented, for the periods 1963-73 and 1973-85 covered by the study. Malaysia and Thailand fall under the category of moderately outward oriented for both time periods; Indonesia falls under the same category for 1963-73 but moves to the category of moderately inward oriented for 1973-85 owing to the introduction of import substitution policies in the early 1980s. It should be noted, however, that since 1983 Indonesia has embarked on a deregulation program covering a wide range of areas, such as banking, investment, industry, trade, and transportation. Apparently these liberalization measures have not been taken into account because of the time frame of the study. The Philippines remains in the category of moderately inward oriented for both periods. As in Indonesia, the Philippines has adopted significant liberalization policies since the Aquino administration took office in 1986. Pakistan and Sri Lanka, belong to the category of strongly inward oriented for 1963-73, but move to the category of moderately inward oriented for 1973-85 when they introduced some liberalization measures; Bangladesh and India fall under the category of strongly inward oriented for both periods.

As we have seen earlier, the conclusion of the Bank's study is generally consistent with the data in Table 2 above, which shows that during the period of 1965-87 the Asian newly industrializing economies achieved &-7 percent average growth of per capital GNP, followed by the ASEAN-4, except the Philippines, with 4-4.5 percent



growth, and then the South Asian countries with 1-3 percent annual growth.

As also stated earlier, an inward-oriented strategy, by adhering to policies biased in favor of production for the domestic market, tends to discourage exports. Therefore, inward-oriented countries are low exporters as well as low importers. The data in Table 3 seem consistent with this hypothesis. The newly industrializing economies, with strong outward-looking policies, have high ratios of trade to GDP, ranging from 72.6 percent for Korea to 306.9 percent for Singapore. The small size of the domestic market of Hong Kong and Singapore accounts for the high ratios, but Korea with a population of 42 million is not particularly small; yet the trade ratio is high.

The ASEAN-4, with the exception of the Philippines, also have high trade ratios, ranging from 46.1 percent for Indonesia to 97.2 percent for Malaysia. But even for the Philippines, the ratio (37 percent) is still higher than the average (34 .5 percem) for all developing countries. The more inward-oriented South Asian countries, with the exception of Sri Lanka, have lower trade ratios, ranging from 14.3 percent for India to 3 1 .6 percent for Pakistan. As we have seen earlier, Pakistan and Sri Lanka have lately taken steps to liberalize their trade regime, which moved them from the category of strongly inward oriented to that of moderately inward oriented. This explains their relatively high trade ratios; the lowest ratios are found in India and Bangladesh ( 14.3 percent and 2 1 . 0 percent, respectively), both strongly inward-oriented countries.

LESSONS FROM EXPERIENCE IN TRADE REFORM

One of the most important lessons we can get from the experience of many developing countries that have embarked on the road to structural adjustment is that trade reform seldom stands on its own; it usually goes hand in hand with a program of controlling inflation. Trade reform is normally part of a larger package, including fiscal and monetary policies, to restore or maintain the stability of an economy that has been subjected to destabilizing internal or external shocks.

Export promotion is likely to fail, or is difficult to sustain, if inflation is not under control. This has been demonstrated in many Latin American and African countries that for some reasons were unable to keep inflation at sustainable levels. If inflation goes on for an extended time at a rate substantially above the world rate, exports will suffer, unless prompt and continuous adjustments are made in



the exchange rate. High inflation thus creates, among other things, difficult exchange rate management problems.

In this respect, the record of the Asian developing countries is much better than many other countries. The Asian countries have been rather successful in containing inflation, although notable differences exist among individual countries.

During the last two decades, when the average rate of inflation of the developing countries showed an upward trend, inflation in the Asian developing countries, except in the Philippines and Sri Lanka, slowed down (see Table 8). ln India, the inflation rate was more or less constant at 7.7 percent a year. During 1980-87, the average inflation rate for all the developing countries was 43.9 percent a year, while in Asia, the average for individual countries was much lower (ranging from 1 . 1 percent to 16.7 percent). Even in the Philippines, where the highest rate prevails among the Asian countries during that period, the inflation rate ( 16.7 percent) was less than half the overall average. Compared with some Latin American countries, such as Brazil, where the rate was 166.3 percent, and Argentina, 298.7 percent, the Asian economies are stable.

Table 8. Average Annual Rate of Inflation as Measured by the GOP Deflator

(In percenl)

1965-80 1980-87

ASEAN-4 Indonesia 34.2 8.5 Malaysia 4 9 1 1

Philippines 1 1 . 7 16.7 Thailand 6.3 2.8

Newly Industrializing economies Hong Kong 8.1 6.7

Korea 18.8 5.0 Singapore 4.9 1 .3

South Asia Bangladesh 14.9 1 1 1

India 7.6 77 Pakistan 1 0.3 7 3

Sri Lanka 9.4 1 1 8

Developing countries 1 6.5 43.9

OECD 7.6 5 0

Source· World Bank. "World Developmenl lndicalors:· World Development Report 1989 (New York: Oxford University Press. 1989). Table 1.


86


SUHADI MANGKUSUWONDO

Table 9. Overall Fiscal Deficits

(In percenl of GOP)

1972

- 2.5 -9.4 -2.0 -4.2

Newly industrializing economies Hong Kong Korea Singapore

South Asia Bangladesh India Pakistan Sri Lanka

-3.9 1.3

- 1 .9 -34 -6.9 -5.3

1987

-0.9 -8.2 -5.0 - 2.3

- 0.5 1.4

- 1 .4 - 8. 1 -8.2 - 8.9

Source: World Bank. "World Developmenl Indicators:· World Development Report 1989 (New York: Oxford University Press. 1989). Table 1 1

Nevertheless, one can notice that inflation in South Asia has been generally higher than in the newly industrializing economies and the ASEAN-4, with one or two exceptions. One can thus surmise that in South Asia export promotion has been more difficult, because rising domestic prices have given exporters less incentive to expand exports.

Experience in Latin America and Africa indicates that a major cause for inflationary pressures has been the inability of governments to keep government budget deficits under firm control. In Asia, the fiscal deficits have not been excessive overall, but they are generally higher in the South Asian countries (more than 8 percent of GNP in 1987, except for Bangladesh) than in the newly industrializing economies and the ASEAN-4 (5 percent of GNP or less, except for Malaysia, see Table 9). The ability of the Asian governments to keep budget deficits within reasonable limits is perhaps a reflection of the relative political stability in these countries. Under such conditions price stability is easier to control, and this in turn is an important condition for any trade liberalization effort.

Inflation calls for flexible exchange rates, otherwise the balance of payments will be under constant pressure. High inflation rates need to be compensated for by a corresponding depreciation of the currency to maintain the real effective rate of exchange. If we look now at the movement of the real effective exchange rate in the Asian developing



Table 10. Real Effective Exchange Rate

(National currency per U.S. dollar, deflated by the consumer price 1ndex. 1981 = 100)

1983 1985 1987

ASEAN-4 Indonesia 1 1 7.5 1 24. 1 158.8 Malaysia 918 94.2 94 1 Phillip pines 116 . 1 104.9 1 1 0.9 Thailand 96.6 1 1 0.4 100.2

Newly industrializing economies Hong Kong Korea 102.7 109.9 98. 1 Singapore 95.1 96. 1 92.8

South Asian Bangladesh 1 1 1 .1 103.3 94.0 India 96.7 1035 91 .7

Pakistan 1 1 7.1 127 5 128.6

Sri Lanka 96.8 94.4 87.9

Source: International Monetary Fund. lnternattonal Finanetal Stattsltcs (Washington. January 1989).

countries, it seems that on the whole the countries have managed to keep the real rate of exchange stable (see Table 1 0). Nevertheless, it seems that the higher rate of inflation in South Asia has led to some real appreciation of their currencies against the U.S. dollar during the period 1981-1987 (with the exception of Pakistan). On the other hand, the ASEAN-4 have depreciated their currencies, except for Malaysia. This implies that inflation and foreign exchange policy in South Asia have been less conducive to export promotion than in the other Asian countries.

Trade policy reform is not something that comes easily. Once a country has adopted an inward-looking policy and once protective walls have been erected for domestic producers, it is not easy to start tearing down those walls. There must be compelling reasons for a country to reverse its policy, particularly in such an important area as trade and finance. Usually it happens when a crisis emerges that needs drastic measures to overcome. Most often the crisis takes the form of a balance of payments crisis or an acute inflation, or both.

Take, for example, the case of Indonesia. Loose monetary and fiscal policies in the early 1960s led to mounting inflationary pressures, culminating in the runaway inflation of 1965 and 1966 (more than a 600 percent rate of inflation in 1966). After a short political upheaval, a new government came into power that quickly reversed all economic policies of the previous government, including trade policies. The



new policies were mostly outward oriemed, and the economy moved in the direction of a more open system.

This course was not maintained for very long. The oil boom, which started in 1973, brought very substantial foreign exchange and revenues to the Indonesian Government. Gradually trade policies turned inward, aimed at developing domestic industries rapidly, as part of a catch-up program with other countries that were one or two steps ahead on the road toward industrialization. Manufacturing industries grew rapidly during this period of import substitution, supported by ever-widening protective trade policies.

It took another crisis to stop and reverse these policies. This time it was the collapse of oil prices, in 1983 and again in 1986, which led to a serious balance of payments problem. A very large current account deficit in 1983 (7 .6 percent ofGDP) convinced the government that Indonesia needed to diversify its exports quickly, meaning that non-oil exports needed to be stimulated. Thus, trade and investment policies were again reversed, this time becoming more outward oriented, as the only way to boost exports of agricultural and nonoil manufactured products.

In retrospect, the sharp drop of oil prices in 1983 and 1986 may have been a blessing in disguise for the Asian oil exporting countries, like Indonesia and Malaysia, because the balance of payments crisis created by the collapse of oil prices forced these countries to undertake the necessary trade reforms. Similarly, the oil booms of 1973 and 1979 may have been a blessing in disguise for the Asian oil importing countries, like Thailand and the Philippines, because the steep rise in the trade deficits, owing to sharp increases in oil prices, forced these countries to adopt an aggressive export promotion strategy, which in the longer run turned out to pay very handsomely.

On the other hand, one could argue that the less open character of the economies of South Asia has saved them from serious internal and external imbalances, but by the same token, since no crisis emerged, there were also no compelling reasons to change their trade policies. This may explain, at least partly, why countries like India and Bangladesh have not made any significant change in their essentially inward-oriented policies.

Devaluation is often a vital step toward trade policy reform. Many of the Asian developing countries have had, at one time or another, to go ahead with the painful process of devaluation as part of a package of trade reform. Devaluation will not solve the balance of payments problem, however, if inflation is not kept under control, as has been so often demonstrated by the Latin American experience. A program of trade reform, in order to succeed, must show concrete



results as soon as possible, in the form of increased exports and improved balance of payments. I f tangible results are slow in coming, resistance to the reform may gain strength, mostly from industries that are losing their protected status. The situation, of course, becomes worse if inflation continues unchecked and undermines the trade liberalization efforts.

Another important issue is whether, and to what extent, trade liberalization should be accompanied by liberalization of the financial sector. I n principle, the two should go hand in hand, the one reinforcing the other. Many capital transactions are linked to trade. Restrictions in financial and capital transactions may inhibit the free flow of goods and services. Experience in some Latin American countries seems to indicate that the sequence of policies taken is important. Liberalization of the capital account of the balance of payments should come after liberalization of the current account and not the other way around. The reason is that under the present international monetary system of flexible exchange rates, very large amounts of capital are moving across national borders, therefore, a premature introduction of a free foreign exchange regime may destabilize the fragile economy and undermine the trade promotion effort.

I t is quite possible that the experience of some countries has confirmed the above hypothesis. But the experience of Indonesia proved otherwise. The foreign exchange regime in Indonesia has been liberalized since the early 1970s, well before trade liberalization was introduced. It is true that occasionally large capital movements in and out of the country have caused considerable instability in the financial sector. But so far it has not posed an obstacle to the liberalization of the trade regime. On the contrary, the very liberal foreign exchange regime has contributed positively to the achievement of rapid export growth when trade was liberalized.

Still another lesson that we can draw from the experience of the Asian newly industrializing economies that have succeeded in achieving high economic growth during the past two decades is that high export growth is associated with high rates of domestic saving. This is important because in order to maintain a high rate of growth of exports, large and sustained levels of investment in export industries and in economic infrastructure are necessary. At the initial stage of export expansion, foreign investment, particularly multinational companies, usually play a major role. But as the country prepares to take off, domestic saving must be available in larger volumes to ensure that no supply bottlenecks develop owing to lack of investment. The success of the export promotion efforts, in the longer run, will thus


90


SUHADI MANGKUSUWONDO

Table 1 1 . Gross Domestic Savings

(In percent of GOP)

1965

8

24

21

19 Newly Industrializing economies

Hong Kong 29

Korea 8

Singapore 1 0

South Asia Bangladesh 8

India 1 6

Pakistan 1 3

Sri Lanka 1 3

Developing countries 20

OECD 20

1987

29

37

1 6

26

31

38

40

2

22

1 1

1 3

25

21

Source: World Bank. "World Development Indicators," World Development Report 1989 (New York: Oxford University Press, 1989). Table 9.

be determined by the country's ability to generate the necessary domestic saving.

If we look at the situation in the region, the available figures show that gross domestic savings have generally increased during the last two decades, in line with the average for all developing countries, which have increased from 20 percent of GNP in 1965 to 25 percent in 1987 (see Table 1 1 ) . Only in three countries, the Philippines, Bangladesh, and Pakistan, were the saving rates lower in 1987 than in 1965. But what is noteworthy is that in all the South Asian countries the rate of gross domestic savings is relatively low. Even India (22 percent in 1 987) shows a saving rate below the average of all developing countries (25 percent). Bangladesh has an extremely low saving rate, namely 2 percent of GDP in 1987. The high levels of saving in the newly industrializing economies in 1987 (ranging from 3 1 percent for Hong Kong to 40 percent for Singapore) are particularly striking. The ASEAN-4, except for the Philippines, also show high saving rates in 1987 (ranging from 26 percent for Thailand to 37 percent for Malaysia). The data on domestic saving rates, thus, confirm the earlier observation that among the Asian developing



countries the South Asian countries are the least export oriented, and therefore least able to generate sufficient domestic saving.

EFFECT OF TRADE POLICIES OF INDUSTRIAL COUNTRIES

In this final section we shall look at the impact of restrictive trade policies of industrial countries on the developing economies of Asia, and how these countries react to those policies. The countries of the Organization for Economic Cooperation and Development (OECD) have now become more protectionist than in the past. They have roughly similar trade policies, with all emphasizing restrictions on imports of labor-intensive consumer goods, such as textiles, clothing, footwear, and leatherware. These are manufactures in which the developing countries have a natural comparative advantage. The European Community's (EC) wider protectionist policies have increased sharply its trade diversion impact on the rest of the world. Japan puts a universal emphasis on restricting imports of agricultural goods. Japan also uses nontariff measures to restrict imports of hightech goods. The United States has strong restrictions on imports of consumer goods in general, with particular emphasis on limiting imports of textiles and garments.

I t is true that tariff rates in the industrial countries have been reduced substantially as a result of the Tokyo Round of trade negotiations among the members of the General Agreement on Tariffs and Trade (GATT). Since then, however, more and more trade restrictions have been introduced in the form of nontariff barriers. I n effect, import restrictions have not diminished since the Tokyo Round. Moreover, the industrial countries were the beneficiaries of the tariff cuts and not the developing countries. For example, the EC reduced tariffs on total imports of finished and semifinished manufactures with a weighted average of 28 percent. Tariffs on the imports from developing countries, however, have been on average reduced only 25 percent. The figures for Japan are 46 percent and 32 percent respectively. While for the United States the figures are 30 percent and 24 percent.1 The total impact of the tariff reductions, therefore, have not improved the competitiveness of the developing countries with the industrial countries.

Another policy of the industrial countries that makes industrialization more difficult for the developing countries is tariff escalation. Most industrial countries levy higher tariffs on manufactures than

I GATI (1980). p. 37.



on the raw materials used to make them. The tariff reductions of the Tokyo Round did not change the escalation of tariffs, because tariffs on manufactures have been reduced more or less at the same rate as tariffs on raw materials. According to some estimates, owing to higher tariff rates on finished goods than on parts, components, or raw materials, the average effective rates in the OECD countries are considerably higher than their average nominal tariffs. In the United States, after the Tokyo Round, the average nominal protective tariffs for manufactures are 7.26 percent, but the average effective protective tariff, owing to the escalation of tariffs, is 1 1 .5 percent. In Japan the nominal rate is 9.60 percent, but the effective rate is 15.91 percent. The figures for the EC are 7.85 percent and 15.20 percent respectively, and for Canada 1 1 .35 percent and 20.63 percent. 2 These high effective rates of protective tariffs continue to obstruct the industrialization of many developing countries.

It is often said that the effect of protection in industrial countries has been mostly exaggerated, since in fact exports of manufactures from developing countries have increased quite rapidly. Look at the share of developing countries in world exports of manufactures: in 1963 the share was 4.3 percent (the share of industrial countries was 82.3 percent), but in 1985 the developing countries increased their share to 12.4 percent (that of the industrial countries dropped to 78.8 percent). I t is quite likely that protection in the industrial countries has not been entirely effective. There are numerous ways in which developing countries (in particular the newly industrializing economies) can avoid the protective obstacles, first by producing products not subject to restriction and second by moving to higher quality products that enjoy higher prices, thereby increasing the value of exports.

Nevertheless, the trade diversion effect of protection can be substantial. For example, textiles and clothing exports into the United States between 1980 and 1985, originating from OECD countries (excluding Japan) have increased by 269 percent, while imports from restricted suppliers increased only by 104 percent. Imports from Japan (restricted) increased only by 55 percent, and from the Asian newly industrializing economies by 7 1 percent.3 Little doubt remains that without discriminatory trade restrictions, exports of textiles and clothing, as well as other restricted products from the developing countries, would have increased much faster.

Another effect of protection in the industrial countries is that,

2 Ray and Marvel (1984). 3 World Bank (1987). Table 8.9.



together with the slowdown of world demand owing to the recession, it may have discouraged many developing countries from adopting an export promotion strategy. Restrictive trade policies, especially those directed toward imports from developing countries, may have induced the emergence of a new export pessimism among some developing countries, and encouraged them to turn more inward in their development policies.

This seems to have taken place in India and Bangladesh, two of the Asian developing countries that consistently leaned toward inwardoriented policies. That policy choice may have been reinforced by the existence of a sizable domestic market. The evidence during the years 1980-87, when GDP growth in South Asia was quite impressive (see Table 3), seems to vindicate the adopted strategy. However, as we have seen from the available evidence, these countries have also forgone the many advantages of an outward-looking strategy.

The reaction of the Asian newly industrializing economies and the ASEAN-4 to the restrictive policies of the industrial countries was to adopt a more aggressive trade policy, particularly export policy. One reason is, perhaps, that these countries, except Indonesia, have small domestic markets. There is no way for them to get rapid industrial development by relying mainly on the internal markel. And, unlike the major industrial countries, these countries have no credible retaliatory powers to protect themselves. The EC, for example, may react by limiting its imports from the United States, or from Japan, if it feels that these countries with their protective policies have damaged the EC's interest. The small developing countries of Asia do not have that option.

Regional cooperation among the ASEAN countries, at one time, was expected to offer the possibility of adopting a strategy of retaliation against the industrial countries. Since ASEAN together forms a sizable market, by acting together they might have the bargaining strength to face the threat of protectionism. Based on the experience so far, however, the ASEAN member countries seem to realize that, in their own long-run interest, they will be better off by adopting the alternative strategy, namely, an outward-looking strategy to gain maximum benefit from international trade. In the ongoing GATT Uruguay Round, ASEAN is fighting for the preservation and strengthening of an open, nondiscriminatory, multilateral trading system.

For the moment, this seems to be a more realistic attitude. Although the ASEAN countries have more than 300 million people, their purchasing power, although growing, is still limited. ASEAN also still needs lots of capital and technology from outside. Therefore, it seems rational for ASEAN to look outward, and try to get the utmost benefit


94 SUHAOI MANGKUSUWONOO

from the international division of labor, by concentrating on improving their own efficiency and competitive strength.

BIBLIOGRAPHY

Ariff, Mohamed, and Hal Hill, Export-Oriented Industrialisation: the ASEAN Experience (Sydney; Boston: Allen and Unwin, 1985).

Ariff, Mohamed, and Tan Loong-Hoe, eds., The Untguay Round, ASEAN Tmde Policy Options (Singapore: Institute of Southeast Asian Studies, 1988).

Balassa, Bela, "Adjustment Policies in Developing Countries: A Reassessment," W01-ld Development (Oxford), Vol. 1 2 (September 1984), pp. 955-72.

Jagdish N. Bhagwati, "Export Promotion as a Development Strategy," in Economic Policy and Development: New Perspectives, ed. by Toshio Shishido and Ryuzo Sato (Dover, Massachusetts; London: Auburn House Publishing Co., 1985), pp. 59-68.

ESCAP, Restructuring the Developing Economies of Asia and the Pacific in the I 990s ( 1989).

General Agreement on Tariffs and Trade (GATT), International Trade I9871 88.

Gerald M. Meier, "The New Export Pessimism," in Econ01nic Policy and Development: New Perspectives, ed. by Toshio Shishido and Ryuzo Sato (Dover, Massachusetts; London: Auburn House Publishing Co., 1985), pp. 19-32.

Nelson, joan M., "The Political Economy of Stabilization: Commitment, Capacity, and Public Response," World Development (Oxford), Vol. 1 2 (October 1984), pp. 983-1006.

Ng, C.Y., R. Hirono, and Norongchai Akrasanee, eds., lndustrial Rest1·ucturing and Adjustment for ASEAN:fapan Investment and Trade Expansion: An Overview (Singapore: Institute of Southeast Asian Studies. 1987).

Rana, Produmra Bickram, and Florian A. Alburo, eds., Economic Stabiliwtion Policies in A SEAN Countries (Singapore: Institute of Southeast Asian Studies, 1987).

Ray, Edward J., and Howard P. Marvel, "Pauern of Protection in the Industrialized World," The Review of Economics and Statistics (Cambridge, Massachusetts), Vol. 66 (August 1984), pp. 452-58.

World Bank, "Barrie1·s to Adjustment and Growth in the World Economy," Part I in World Development Repo1·t 1987 (Washington, 1987), pp. 14-35.

---, "Opportunities and Risks in Managing the World Economy," Part I in World Development Report 1988 (Washington, 1988), pp. 13-39.


Comment

MOHAMED ARIFF ABDUL KAREEM

The paper by Suhadi Mangkusuwondo is extremely interesting and refreshing. Its empirical content and analytical treatment of the subject matter render the paper a useful addition to the trade and development literature. I have little criticism, as J am in sympathy with the author's line of reasoning and am generally in agreement with his main conclusions. As such, my comments will serve mainly to reinforce some of the points made in the paper and underscore some of my own reservations.

The author's choice of countries and the typology used have been particularly helpful in bringing the issues relating to trade strategies into sharper focus. The growth performance of countries of differing size, per capita income, resource endowments and factor proportions, and at various stages of development is explained mainly in terms of trade policies and strategies.

Mangkusuwondo's analysis of 1965-87 data shows that countries which have pursued an outward-looking industrialization strategy have performed better than those which had chosen the inwardlooking strategy. His analysis also suggests that during 1980-87, the inward-looking South Asian countries tended to fare better than the export-oriented East and Southeast Asian countries. Needless to say, there is much more to this than meets the eye. There is no denying that industrialization strategies and trade policies do matter, but, one needs to go behind these strategies and policies and discover why some countries opt for certain strategies and why some policies work better in some countries than in others. It would be erroneous to chart an outward-looking industrialization path for all countries. Export-oriented industrialization cannot be a policy prescription for all countries, just because it has worked well in some countries.

This, of course, begs the question: what is export-orientation? Mangkusuwondo addresses this conceptual issue and draws on the World Bank definition according to which "export promotion" does not necessarily entail a bias in favor of exports. He poims out that, according to the World Bank, an outward-oriented strategy can imply a neutral trade regime.

95


96 MOHAMED ARIFF ABDUL KAREEM

A pertinent question tO ask in this context would be, Do the Asian newly industrializing economies and the ASEAN-4 really fit this definition of outward orientation? The kind of export orientation pursued by Korea and Taiwan Province of China was distinctly different from that of Hong Kong and Singapore. Korea and Taiwan Province of China have followed highly protectionist policies. They have fanatically protected their domestic industries and at the same time vigorously promoted their exports. As a result, import-substituting and export-oriented industries have coexisted in these economies. Until quite recently, their trade regimes were truly mercantalist in character. It is only Hong Kong and Singapore that can fit fairly comfortably into the World Bank description of a neutral trade regime that is truly outward looking.

The ASEAN-4 lie in between, although there are considerable variations among them. Like Korea and Taiwan Province cf China, the ASEAN-4 have also pursued, in a paradoxical fashion, import substitution and export promotion simultaneously. But, the degree of protection, in both nominal and effective terms, for manufactures in the ASEAN-4, especially Malaysia and Thailand, has been significantly less than that in Korea or Taiwan Province of China.

In those countries where import-substituting and export-oriented industries have coexisted, the anti-export bias present in the structure of protection has been offset by all sorts of export promotion incentives. These countries have seemingly adopted a "neutral'' trade regime by "neutralizing" the distortions caused by their structure of protection.

To be sure, export incentives cause distortions just like tariffs. Therefore, each is as objectionable as the other. And, one may say a lot against the principle and practice of offsetting one set of distortions with another set in the opposite direction. Of course, the first-best solution would be to eliminate the distortions at the source and not to offset them with others. There is also the danger of export incentives more than offsetting the bias against exports. In fact, there is evidence of exports being subsidized in some cases. It is no secret that Korea and Taiwan Province of China have been subjected to U.S. countervailing duties many a time.

Although the trade regimes in most of the high-growth countries in the paper are not truly "neutral," they have all tended to adopt somewhat liberal policies. Export orientation in these countries has necessitated decontrol and deregulation to a considerable extent. All this can lead to both static and dynamic gains. Seen in this perspective, it is not hard to understand why export expansion has tended to act as an "engine of growth."


Comment 97

Another feature common to all these high-growth economies is the extent and role of foreign investment, which reflect the fairly liberal policies toward foreign investors. All these countries have also had reasonably sound macroeconomic policies. In short, one cannot single out trade policies to explain the success or failure of groups of countries.

The point is that it is not export orientation per se but the other things that go with it (e.g., deregulation) that really matter. It is quite possible for a country to do these "other things" without having to resort to export orientation. The latter is critical and crucial only for small economies like Singapore and Hong Kong, given their domestic market constraints. For big countries like India and Pakistan, where such constraints are not severe, an inward-oriented strategy with fairly liberal economic policies and minimum government intervention can facilitate rapid growth.

Data presented by Mangkusuwondo support this view. He observes that during 1980-87, the newly industrializing economies and the ASEAN-4 recorded slower growth rates, while the South Asian countries accelerated theirs. The disparity, he attributes to the degree of exposure of these economies to external influences. One cannot deny that outward orientation renders the economy vulnerable to external fluctuations, while inward orientation tends lO insulate the economy from external vagaries. I t is not difficult, therefore, to understand why the world recession of the early 1980s was particularly painful for the newly industrializing economies and the ASEAN-4 but not for the South Asian group. Be that as it may, we must not Jose sight of the fact that the South Asian countries had undertaken bold policy liberalizations in the 1980s. I would argue that the better economic performance of these countries during the decade was primarily due to their domestic policy reforms.

I do not intend to downplay the significance of trade policies. Far from it. I do recognize how important trade policies are and am in favor of trade liberalization, as it can help allocate resources efficiently. But, having a liberal trade regime is one thing; aggressively pursuing export orientation is quite another. There is always the danger of going overboard. For excessive export promotion is just as bad as excessive import substitution. It is a well-known theoretical proposition that ultra-pro-trade bias can lead to immiserizing growth. My stance, which admittedly is very neoclassical, calls for liberal policies that would allow market forces to determine the pattern of industrialization in a country consistent with its resource and factor endowments.

Structural adjustments in a country should reflect the changes taking place in the country's comparative advantage. Industrial


98 MOHAMED ARIFF ABDUL KAREEM

transformation is never-ending and ongoing in a dynamic setting. Policies should facilitate, not frustrate, the process. This means that aging industries should be allowed to die without being put on a lifesupport system. As Mangkusuwondo has observed, traditional manufactures already play a more important role in the South Asian countries than in the ASEAN-4. The latter may soon lose their comparative advantage in some nontraditional activities, such as electronics assembly operations, to their South Asian neighbours. It would be wrong for the ASEAN-4 to obstruct such migration of industries. Instead, they should move away from sunset activities and upgrade themselves as Japan has been doing quite successfully.

With respect to the protectionist trade policies of the developed countries, I do agree with the author that it is nontariff measures, and not tariffs, that really affect the market penetration of developing country products. Although tariffs have become less important as barriers over the years, the degree of tariff escalation seems to have increased, discriminating even more strongly against the products of developing countries.

As Mangkusuwondo has observed, the share of developing countries in the developed country markets has increased, despite such protectionist measures. He conjectures that protection in the industrial countries has not been entirely effective. This may have been the case, as many newly industrializing economies have been able to circumvent the barriers quite successfully. ll is also important to highlight the fact that many of them have managed to respond to the protectionist threats positively through structural adjustments and market diversification.

I hasten to reiterate that trade policies cannot be considered in isolation and to underline that trade policy reforms cannot always be equ:necl with export orientation.


6

Exchange Rate Policies and M anagement: A Model for Successful

Structu ral Adjustment

PETER QUIRK'

Over the past two decades rising economic performance in the developing countries of East Asia has propelled the region into growing prominence and has raised important questions regarding the role of economic policies in that performance. Annual growth rates since 1965 have averaged over 7 percent. Exports have surged, more than doubling their share of output. The extent of such generalized vitality is unequaled by other regions. Given the resource, cultural, and other diversities of the various countries, evidence regarding a model for structural adjustment may be derived from differences in economic performance and policies.

It is widely agreed that the role of exports has been crucial to the successes of the East Asia region. Only in one country, Indonesia, did the windfall of increased oil prices play an important role. In most others, the increase in oil prices was a significant negative factor, and nontraditional exports, largely of manufactures, have been the key source of dynamism. This points to the importance of policies affecting directly the external sector of these economies-including the role of the exchange system in regulating and pricing international trade and financial flows.

This paper describes and analyzes the principal features of exchange rate policies to date in the region, including points of divergence

• The author wishes to thank the discussant Bongsung Oum of the Korean Development Institute and colleagues in the Fund. including Jeffrey Davis and Jose Fajgenbaum. for helpful comments. also Virgilio Sandoval for capable research assistance. Remaining errors are. of course, the author's responsibility.

99


100 PETER QUIRK

from performance in some other major developing countries. I t traces briefly the impact of these policies through to such key variables as export openness, domestic investment, and growth rates. Because the focus is on the adjustment of economic structures rather than macroeconomic adjustment, a longer time frame of analysis is provided (the last two or three decades, depending on data availability). The role of exchange rate management is also examined briefly in the specific context of financial sector development, which could be viewed as a continuing vital stage of structural adjustment in the East Asian region.

The first part of the paper summarizes salient features of developments since 1970, comparing performance in East Asia and a small sample of major developing countries in Latin America and Europe (Argentina, Brazil, Mexico, and Turkey). The emphasis is on the role of exchange rate policies in investment and growth. The second focuses on more recent developments in financial sectors, particularly in foreign exchange systems, and draws conclusions for future policies and management aimed at securing structural adjustment.

EXCHANGE SYSTEM POLICIES AND GROWTH

Exchange Rates

The movement of one industrial country exchange rate against another has had significant effects on the pricing of exports of East Asian countries, as over two thirds of their export markets are in industrial countries. Somewhat different inflation rates in the home and export markets have also affected export pricing. Patterns in the evolution of real effective exchange rates show a depreciation in the East Asian countries from the 1960s, but more stable rates from 1975 to J 985 (Table I). This trend in competitiveness does not differ greatly from the other major developing countries surveyed here. Some differences are apparent for Argentina and Turkey, where there was initially a real appreciation on balance (through 1980 in Argentina, and 1979 in Turkey), followed by sizable depreciation in the 1980s. Significant differences are also indicated in the stability of competitiveness between the individual countries, but not between the two groups.'

' Absolute annual percentage changes in real effective exchange rates averaged over the period 1971-88 were higher in the following countries: Argentina. 31 percent; Mexico. 12 percent; and the Philippines. 1 0 percent. In the six other countries (Korea. Malaysia, Singapore. Thailand, Brazil, and Turkey), the corresponding averages were in the relatively narrow range of 6 to 8 percent.

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102 PETER QUIRK

Using effective exchange rate calculations to judge whether or not the level of the exchange rate is realistic has a number of problems. The indices show only changes over time and therefore must assume some base period in which the exchange rate was right. Second, the prices on which they are based do not reflect fully the trade competitiveness of the economy. For example, consumer prices, which are the only data available for many countries over a long enough period for structural analysis, do not relate to the export sector specifically. Third, real shocks to the economy must be expected to be reflected in shifts in real effective exchange rates.

I t is more instructive to look at how markets assessed the exchange rate over time. Because exchange rates of developing countries have been subject in the past to official determination or management, such assessments may be derived only from black or free secondary markets in foreign exchange for their currencies. These market rates indicate private sector judgment as to the true value of the currency.2 It is therefore important that there has been no sustained and large premium or discount for East Asian currencies in their black markets since 1965, although from time to time some discounts have arisen, indicating temporary overvaluation of the exchange rate-for example, Korea in the early 1970s, and the P_hilippines in the late 1960s and early 1980s (Table 2). Otherwise, official exchange rates have served to clear broadly foreign exchange markets in the East Asian countries, with allowance made for sustained support from official foreign exchange reserves and the effects of trade and exchange restrictions.

This exchange rate policy, leading to broadly clearing unified exchange markets contrasts sharply with policies in the other major developing countries. Apart from a two-to-three-year period around 1980, Argentina's exchange rate has been substantially overvalued against the black market. Brazil has had an active black market for foreign exchange d uring most of its postwar history, with the exchange rate in that market indicating overvaluation of the currency at various times, by as much as one half in some years. Similarly, a severe overvaluation of the Turkish lira emerged in the second half of the 1 970s. Although the existence of an open market for foreign exchange kept the Mexican peso broadly competitive through 1981, the exchange rate became overvalued for the following five years (1981-

2 The relevance of black or free secondary market rates has become clearer from the experience with the introduction of independently floating exchange rates by a number of developing countries in recent years. In the absence of official intervention in most instances. after the official rate was floated, the new certified rate moved initially to a level close to that of the black market rate prevailing before the float.

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104 PETER QUIRK

86), as rates in the black market persisted at levels as much as half as high again as for official market transactions. More recently, free markets have also dominated the setting of official rates in Argentina, Mexico, and Turkey.

Thus, an important difference in exchange rate policies between the East Asian group and the sample of other major developing countries is revealed by observation of black or free market determined exchange rates. Although exchange rates have been set or administered officially in virtually all of the former group, this has been done in such a way as to clear foreign exchange markets in their broadest sense (i.e., including illegal transactions)-an outcome analogous to floating. In the other group of countries, sustained and marked differences between official exchange rate policies and the views of exchange market participants have been evident.

Restrictive Systems

Analysis of the adequacy of exchange rate policies requires that the policies for exchange and trade restrictions also be examined, because an exchange rate that otherwise would be overvalued may be held in temporary equilibrium by exchange and trade restrictions. It should be noted that over time the restrictions will increasingly tend to become either ineffective or costly to administer. The exchange rate itself will therefore have to be depreciated ultimately, probably by even more than without the restrictions, because the distortions created by the restrictions will undermine investment efficiency and performance in the production of tradable goods.

Major features of exchange systems since 1970 in this group of countries are shown in Table 3; it is apparent that there has been considerable diversity both within the group of East Asian countries and with respect to the other major developing countries. However, the group of East Asian economies has over time been moving to more flexible exchange rate regimes and taking less recourse to exchange restrictions, while the evolution of exchange systems in the other group (at least until 1988-89) has been less clear. Exchange rate regimes have grown broadly more flexible in the latter group but, as discussed above, without giving rise to competitive exchange rates over most of the period. This has led to attempts to support the exchange rate with bouts of increasing restrictiveness from time to time.

Korea's exchange system has been marked by the absence of multiple exchange rates in the period examined, but until recently restrictions on payments and transfers imposed on both current and


Exchange Rate Policies and Management 105

capital account have been combined with surrender requirements for foreign exchange earnings and certain import measures, such as import surcharges and advance import deposits. The Philippines is the only country in the region to have maintained a multiple exchange rate system, which was abandoned in the early 1970s, although both current and capital restrictions have been used throughout the period. In Malaysia, Singapore, and Thailand, the systems on balance have been freer from restrictions since 1970, and multiple rates have not been used.

In the group of other developing countries, Brazil and Turkey have had the most consistently restrictive systems of exchange controls. Mexico's system before 1980 was characterized by a free exchange market with no restrictions on either current or capital transactions and freedom from multiple rates. In the 1980s, under pressure from debt, Mexico first introduced multiple exchange rates combined with a severely restrictive exchange and trade system, but has in recent years returned to its original freedom. Argentina has been marked by occasional recourse to complex multiple exchange rates, including a free exchange rate in the market for capital transactions. Turkey's system has been based on multiple rates and restrictions throughout most of the period since 1965, although recently the exchange rate has been floated and the exchange system increasingly liberalized.

Quantitative restrictions imposed directly on imports and exports perform functions similar to those administered through the exchange system, although differing in the stage of the external transaction on which they have a direct impact. In analyzing the trade systems, it is difficult to find sharp differences between the two groups of countries.3 Some of the systems have been extremely complex and have been subject to many changes in the direction of policy, for example, Argentina. In contrast, the Mexican system has been kept quite simple and has experienced fewer changes. In the 1960s, all Korean imports required licenses and the import regime was divided on the basis of local funds (KFX) and U.S. aid. Within the KFX it was subdivided into automatic, semi-restricted, restricted, unspecified, and prohibited items; automatic approval was reserved for "essential" consumer and intermediate goods. This basic system of import licensing has been retained although much liberalized since the mid-1970s. Some countries began with liberal treatment of imports in the 1960s (the

3 Quantification of the overall intensity of systems of quantitative restrictions is inherently difficult and has to involve qualitative judgments. To date. econometric testing of such data along with other determinants of the balance of payments has been confined largely to ··onoff" dummy variables for specific measures rather than overall restrictiveness-although such tests are the only means of establishing the validity of indicators of overall restrictive intensity.

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X

X

Ad

va

nc

e im

port

de

posit

s X

X

X

Surr

en

de

r re

qu

ireme

nls

X

X

X

X

X

X

X

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

1987

E

xcha

nge

ra

te r

eg

ime

M

F

CB

IF

M

F

CB

M

F

MF

M

F

MF

M

ulti

ple

exc

ha

ng

e r

ate

s X

X

X

Cu

He

nl

rest

ric

tion

s'

X

X

X

X

Ca

pit

al

con

1ro

ls

X

X

X

X

X

X

X

Impo

rt s

urc

ha

rge

s

X

X

X

X

Ad

va

nc

e im

port

de

pos

rts

X

X

Su

rre

nd

er

requ

ire

men

ts

X

X

X

X

X

X

X

Source

: lnte

malio

oal M

oneta

ry Ftmd

. Annual R

eport on

Exch

ange

Arrangements

and E

xchange R

esrriclion

s, va

rious

issues.

Note

: x ind

icales thal

ltle

specifie

d pr

actice

is a

fea1

ure

of the

exchange

sys

tem; -

ind'icat

es 1hal

it i

s not

CB

= peg

ged lo

cur

rency basket; I

F =

inde

pE!fl

dently

floalin

g;

MF

=

man

ii9!ld

lloaling;

S =

peg

ged to

U.S

. dol

lar; a

nd £

S =

peg

ged lo

poond

st.erli

ng.

' E

xchange

re

strictio

os imposed

on in

ternatio

na

l tran

sactions in

the c

urr

ent a

c�

t ol t

he bal

anc

e ol

payments.


108 PETER QUIRK

Philippines and Thailand) and then more stringent licensing. Despite Mexico's liberal exchange system from the mid-1960s, most of its imports were licensed and, with the emergence of payments difficulties in the mid-J970s, licensing was tightened. In the 1980s, the Mexican trade system was relaxed again as part of liberalization measures to cope with the debt situation. Argentina and Brazil also renewed liberalization efforts.

Nevertheless, in policies affecting the pricing of trade flows through the imposition of import and export duties, as well as the exchange rate policies described above, there are clear differences between the two groups of countries. Most Latin American economies had an ambitious program of import substitution dating back into prewar years (Ground ( 1 988)). Generally speaking, traditional exports have also been heavily taxed under Latin American systems and remain so today. Argentina had in place in the 1960s industrial promotion import surcharges ranging from 5 percent to 235 percent, on top of which there was a 50 percent advance import deposit for some imports. At the same time, Argentina also exercised restrained use of export incentive devices (although there was an export rebate scheme for nontraditional imports). In Brazil, exports of beef, cocoa, and cocoa products were subject to "contribution quotas" (in effect, export taxes ranging from 5 percent to 30 percent). Coffee was taxed through a margin for the "Coffee Defense" fund, corresponding to different effective exchange rates (roughly, Cr. 2,000 = $ 1 in the official market as against Cr. 800 = $ 1 for coffee receipts). In addition, Brazil has had a tax on industrialized products (IPI), although this has been subject to credit for exporters of manufactured products, and has maintained other incentives, such as lines of credit at preferential rates of interest and export credit insurance guarantees. Export taxes have generally been less extensive and maintained at lower rates in the East Asian region. Thailand has subjected rice and sugar to export taxes on an occasional basis (so-called export premiums), and Malaysia has taxed rubber exports. The Philippines introduced a stabilization tax on exports in 1970, but at the same time introduced an export incentives law based on income tax exemptions. In 1980 it introduced further incentives for exportoriented firms.

Differences in exchange rate policies between the two groups thus appear to have been reinforced by differences in the tax treatment of exports and imports, with overvalued exchange rates thereby becoming even more overvalued in effect.



Interest Rates

Although interest rate policies would be assigned loosely to the category of "domestic" rather than "external" instruments, it is not possible to give a balanced account of exchange rate policy developments without reference to them. As a determinant of savings behavior, interest rates have important implications for flows of capital over borders and for decisions tO consume or invest, which lie at the heart of trade imbalances.

As with exchange rates, it is necessary to take account of differences in inflation rates when comparing interest rate policies between countries (see Table 4 for "real" interest rates). Here again, clear differences exist between the groups of countries. Although domestic interest rates in the Asian group were somewhat negative in real terms in the 1970s, they were considerably closer to interest parity (with the United States) than in the other sample group:• Moreover, real rates have been positive in the latter group with only one exception in the 1980s. Singapore and Thailand have maintained positive yields on domestic saving after inflation throughout most of the period for which data are generally available ( 197 1-87), while in Malaysia they have been positive on average in the 1980s. In contrast, the Philippines and the other sample of developing countries have had largely negative real rates over the period analyzed.

Effects of Policies

The effects of realistic exchange rate policies as against overvalued exchange rates and large export taxes are clearly demonstrated by the evolution of ratios of exports of goods and factOr services tO gross domestic product (GDP). Here the startling growth of exports in the East Asian group is evident. The "openness" ratio for Korea rises from 3 percent in 1960 to almost one half of total output in 1987 (Table 5). In both the Philippines and Thailand it has roughly doubled over the same period. The importance of exports in the Malaysian economy has been evident from as early as 1955 when one half of annual output was exported; this has changed little to date. I n contrast, in Latin America under the long-standing import substitution policies outward orientation of the economies actually diminished in the 1950s and 1960s. In Mexico, the ratio of exports to GDP was only half as high in 1970 as it had been in the 1950s, and in Argentina

• The absence of clearing forward exchange markets in several countries precludes calculation of covered interest differentials. In lieu of these. the use of real interest rate differentials assumes that purchasing power parity determination of the exchange rate is approximated in the short run.

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

Ta

ble

4.

Re

al

lnte

res1 R.

ates

(Pe

riod a

ve

rages

. per

ce

nt a

ye

ar)

United

Stat

es•

KOI'W

Ma

laysia'

PNiip

pines'

Singapore'

19

71

-7

5

-0

.3

-2

.1

-2

.0

-6

.9"

-1

.8

19

76

--80

1.0

-

3.2

-

5.8

-

2.0

2

.5

198

1--85

4

.6

3.5

5

.1

-1

.5

5.1

1986-

87

4

.3

6.8

6

.0

0.3

5

.5

Source

s: In

ternat

ional

Mon

eta

ry F

urld. l

n!emation

al F

inanc

ial Stalisti

cs; and

na1iona

l da

ta.

Mole:

Annu

al a

verage

s d

ellate

d by

cha

nge

of

GOP

de

f.la!or i

n sam

e y

ear.

•

Money m

arke

t inte

resl ra

te.

2 Oe

posil r

ate

.

3Bank

rate.

4

Oiscounl rate

priof t

o 1

976

.

• Discoun

l rate

priof to

19

79.

s T

reasu

ry bi

ll ra

te.

1 Th

e figu

re i

s for

1986

. 8 De

flated

by c

hange

in consum

er p

rice

ind

ex

alter 1

985.

Thai

land'

0.4

10.7

4.1

0

Argentina�

Brazil'

Me

xico

Turkey•

-8.

4 -

11

.3S

-2

.9

-8

.5

-1

0.1

2 -

42

.7"

""0

m

-4

0.8

-

22

.5

-1

0.1

6 8

.1

-t

m

::XJ

-1

6.9

' 2

.5

-1

1.06

2

.4"

0

c:

::XJ

;:o:;:

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

Ta

ble

5.

Ex

port

Ope

nn

es

s:

Ex

ports

of

Go

ods

an

d F

acto

r Serv

ices

(Pa

cen

t ol G

OP

)'

m

X

(")

Ko

rea

Mal

aysi

a P

hilip

pines

Si

ngapore

Thai

land

Argent

ina

BrazJ

I Me

xico

Tu

rkey

=

"'

�

00

19

55

2

50

1

3

19

1

7

5

...

:0

1960

3

56

1

1

17

1

0

8

11

4

..

. <D

196

5

9

4a

17

1

8

7

7

10

5

"'0

2.

c;

· 1

97

0

14

4tl

1

9

17

9

7

8

6

(i

' (I)

19

75

28

45

19

1

40

19

9

8

7

6

..

. �

0.

1980

35

5

8

21

207

2

4

6

9

13

6

s:

:: ..

.

1985

3

7

55

2

1 15

8

24

1

5

12

1

6

:::J

20

"'

<0

CD

1

98

7

45

63

23

17

5

29

1

F

9

20

1

2

3

CD

�

Source

: rn

tem

alion

al Mon

etary

Furld

, lntemati

onal Financia

l Sta

tistics

. ' EJ:

ports fro

m na

lional

ioo

ome ac

counts.

Data

for

Singapore

ino

lud

e r

e-expo

rts.

2

The

fig

ure

is IOJ

1986

.


1 1 2 PETER QUIRK

it was falling until 1980. In Brazil, export orientation \vas low at 7 percent through the 1960s, and in Turkey it was also small to begin with (around 5 percent). As a consequence, the sample group of nonAsian economies entered the 1970s with small export markets.'·

The export opening in the sample of non-Asian developing countries remained modest despite significant growth of domestic investment activity as the ratio of investment to GOP rose to well over 20 percent in 1976-80 in all four economies (Table 6). However, investment rates were even higher in the East Asian group, where they peaked at around 30 percent in the same period in Korea, Malaysia, the Philippines, and Thailand. The rate of investment in Singapore was yet higher, reaching almost one half of GDP by the early 1980s.

In part, because of their limited external sectors, the non-Asian economies borrowed more heavily in the 1970s to finance increased domestic investment and public sector expenditures, and their associated imports. Capital inAows had cumulated to large amounts by the end of that decade (Table 7). In contrast, the growth of capital inflows in the East Asian group was steadier, and with the expansion of export sectors from their already strong base in the early 1970s, export earnings were generally sufficient for the servicing of the external debt that had been incurred. In the Latin American economies, although export sectors grew in prominence in the 1970s, they remained insufficiently large tO service the enormous debt that had been accumulated, and investment then dropped off sharply in the 1980s and with it the export orientation of the economies and overall growth rates.

The import substitution policies adopted in earlier years therefore had a crucial effect years later on structural adjustment in the Latin American economies: they rendered them susceptible to the instabilities of successive oil shocks. On the other hand, the position of the Asian economies was more secure, despite the shocks to their impon bills and export markets administered by the two major oil price increases. They had a larger initial export base and exchange rates that were not overvalued. Consequently, their export sectors were able to grow sufficiently to service the capital needs of the economies, and rapid growth ensued.

This is not to say that periods of difficulty were not evidenl. In Korea, for example, questions of overindebtedness did arise in 1975

5 This is not to say that development is a simple maHer of the ratio of exports to GOP. Clearly. the size of the internal market is a factor. As an example. Japan achieved takeoff with a structure that was less e)(port oriented (reaching a ma)(imum ratio of 15 percent of GOP only by 1984).

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

Ta

ble

6.

GN

P/G

OP

Gro

wth

Ra

tes

(1)

an

d I

nc

rem

en

tal

Ca

pita

J!O

utp

ut

Ra

tio

s (

2)

(Period a

verag

es

)'

m

X

C')

=

...

Ko

rea

M

ala

ysia

P

hili

pp

ines

Sin

ga

pore

Th

aila

nd

Arg

en

tin

a.

Braz

il M

eld

co

Turk

ey

::J

CCI

(1)

(2)

(1)

(2)

(1)

(2)

(1)

(2)

(1)

(2)

(1)

{2)

(1)

{2)

(1)

(2)

(1)

{2)

<1>

.::JJ

1961--65

6

.5

15

16

5.2

20

5

.9

17

7.3

19

5

.8

22

19

7

.2

18

5.0

15

�

<D

,

196

6-70

12

.7

25

1

7

5.1

2

1 1

2.8

2

7 8

.6

25

2

.9

19

6

.4

23

6

.9

21

6.8

1

8

0

c;·

197

1-7

5

8.8

2

6

7.5

2

4

6.1

2

3

10

.0

41

6.3

26

4

.9

22

10

.1

28

6

.6

22

7

.7

19

c;;·

<I>

...

19

76

-80

7

.9

30

8.6

2

7

6.2

3

0

8.8

4

1 7

.6

27

1.

5

25

7

.1

23

6.7

25

2

.7

25

::>

CL

1981-

85

7

.6

29

5.2

34

1.

4

24

6

.3

47

5

.0

23

-

2.1

15

1

. 8

19

1.7

2

2

4.6

20

s:

: "'

::>

19

86

--8

7

11

.4

29

3.2

2

5

-1

.3

14

5.3

39

4

.9

21

3.8

12

5

.6

21

-3

.7"

19

7

.8

"'

<C

"'

3

<D

Soorce

: Inte

rnationa

l t.4onetary

Fund

. lnlemalior

ral Fina

ncial S

tatis

tics.

a

1 GroMh

rales

are

ave

rag

es o

l percen

t cha

ng

es i

n G

DP

lrom

preced

ing y

ear.

Gros

s domestic

inveslme

nl is

exp

ressed as

perc

en

t ol

GD

P.

2 "h

e figu

re is

for

1986

.

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

Ta

ble

7.

Ne

t C

ap

ita

l Infl

ow

s (In

billi

ons

o1 U

.S. d

ollaJS

; neg

ativ

e s

ign

deno

tes

outfl

ows

)

Ko

rea

Ma

lay

sia

P

hil

ipp

ines

S

ing

apo

re

Tha

ilan

d

Arg

entina

B

razil

Me

xico

T

urk

ey

-o

m

1

97

2-

75

5

.3

1.7

2

.1

4.1

1.

7

0.1

2

1.1

9

.9

0.5

-i

m

:0

19

76

-80

1

5.5

0

.9

8.2

6

.1

6.6

6

.3

43

.3

23

.5

3.6

c

198

1-

85

5

.1

9.8

10

.2

-3

.6

1.9

-

10.0

3

.7

�

11

.4

12

.9

:0

;><;

198

6--8

7

-1

2.3

0

.2

0.4

0

.6

1.7

0

.3

-2

0.4

5

.4

3.6

Source

: ln

temal1onal

Monetruy

Fun

d,

lntern

atiooal F;nancia

J Statis

!Jcs.

Note:

Inclu

ding

ne

t e

rro

rs a

nd

om

iss

ions

. bul

exc

lucfmg

reseNes

. exc

ep

tiona

l11

1lancin

g. and

liabil

ities

oonsli1

u1ing

lore

ign

au1horities'

re

seN

es.


Exchange Rate Policies and Management 1 1 5

and 1983, underlining the finely gauged extent of the investment effort. While the development of the export sectors was reasonably rapid in the 1970s in the sample of non-Asian economies, it was nevertheless impeded by a system of heavy export taxation for traditional goods, coupled with overvalued exchange rates. By limiting the external orientation of these economies, the exchange rate and restrictive system policies therefore sowed the seeds for the problems of the region-vulnerability to the effects of the recycling of oil receipts. The effects of these policies were compounded by negative real interest rates, which limited domestic saving and contributed to overdependence on foreign gross savings, accommodated by easy availability of credits at the time. Poor yields on domestic assets, reflecting both the negative real interest rates and expectations of exchange rate depreciation, also caused resident capital w flee abroad. Net saving available for domestic investment was thus sharply reduced. Such dissavings through the external capital account occurred despite extensive capital controls, emphasizing the ineffectiveness of these controls.

This brief discussion of the experience in East Asian and some other developing countries suggests strongly that any model of structural adjustment will have as essential components a realistic, market-related exchange rate and positive real interest rate structure, and an adequate after-tax return to exporting industry.6 These are necessary but not sufficient conditions for successful adjustment. Flexible exchange and interest rates may for a time, perhaps even for several years, buffer the economy from the worst effects of inappropriate fiscal and monetary expansion, but ultimately a point will be reached where the financial markets will no longer be able to handle such uncertainties, and growth will suffer.

EXCHANGE RATE MANAGEMENT AND THE STRENGTHENING OF FINANCIAL MARKETS

Exchange Rate Regimes

Exchange rate "policies" and "management" are distinguished in that management refers to the technique by which a policy is implemented. There are two main areas of decisionmaking in the management of exchange rates. The first is the extent of official intervention (usually by purchases or sales of foreign exchange), and

6 See the Appendix for econometric testing of the role of the first two variables in growth.


1 1 6 PETER QUIRK

the second is the frequency of adjustment of the exchange rate. In principle, any technique may be used to replicate the effects of another, but in practice, the form of exchange rate management, ranging from a single currency peg to a market-determined float, has led to major differences in the evolution of competitiveness of exchange rates in Fund member countries.

The exchange rate policies described above have been the product of a number of management techniques that have varied between countries and over time. Malaysia and Thailand have used a currency composite peg to set their exchange rates on a month-to-month and day-to-day basis against the U.S. dollar. Korea, on the other hand, has moved from a freely floating exchange rate in the 1960s to a peg to the U.S. dollar, and subsequently in the 1980s to a managed float by which the rate is varied frequently against the dollar. In the late 1980s, after following a number of different arrangements, the Philippines, Mexico, Singapore, and Turkey either floated or came close to accepting market determination of their exchange rates. Argentina in 1989 adopted a virtually unified float of the currency after experimenting with different forms of pegging and managed flexibility.

I n practice, the choice of technique for exchange rate management has mattered substantively, in the sense of giving rise to exchange rate variations lasting beyond one year.; Authorities in many countries, including the sample of other major developing countries discussed here, have been unable in the face of inflation to undertake adjustments of their pegged or heavily managed exchange rates that were sufficient and timely enough to avoid serious overvaluation. The exchange rate has often been imbued with a political significance that has made it difficult for governments to act-the "weak" currency problem in the case of deficit countries, and to be seen as "caving in" to pressures from abroad in the case of surplus countries. Further, problems are arising from short-term tradeoff's between exchange rate adjustment and transitional cost-push inflation effects and Jcurve effects on the balance of payments.

The usual asymmetry between debtors and creditors means there is no early limit to surplus countries' attempts to maintain a depreciated currency through reserves accumulation. Ultimately, however, trading partners' debt-servicing capacities corresponding to the surplus will be broached, or there will be serious problems for domestic monetary

7 In the 1980s. developing countries' exchange rate regimes have yielded markedly different magnitudes of real effective exchange rate adjustment. In descending order of adjustment the regimes have been ordered as follows: independently floating, managed floating, single currency pegs, and composite pegs (see Quirk and others (1989, p. 1 1)).


Exchange Rate Policies and Management 1 1 7

management in the surplus country resulting from attempts to sterilize reserves accumulation. As an example of the latter, Taiwan Province of China has had to turn somersaults in order to sterilize an enormous reserves accumulation. (It recently gave up these operations and liberalized the exchange market.) The problem arose because the central bank had been paying above-market rates of interest, thus withdrawing credits available for domestic investment. In addition, there were losses on the foreign exchange transactions by the central bank, and the sterilization of capital inflows may also have redistributed credit within the private sector, creating financing difficulties in some sectors. For the debtor countries, the lack of timely exchange rate adjustment has had even more disturbing real effects, as documented above, including acting as an incentive for massive capital flight leading to external payments arrears.

The net effect on international reserves of policies aimed at sustaining exchange rates is shown in Table 8. Reserves accumulation has been modest for most of the East Asian countries because debt servicing and repayments have accelerated in recent years. (Malaysia and Singapore had the equivalent of 6 and 7 months' of imports, respectively, in reserves at the end of 1987.) The converse has been a sizable decline in the reserves of two of the countries in the comparator sample (Argentina and Brazil) to support an overvalued exchange rate. The declines would have been even more marked if the reserves changes were adjusted for incurrence of external arrears.!!

Similar arguments apply to the effects of inflation on official interest rate determination (but are not discussed further in this paper) as the negative real rates reinforce the adverse balance of payments effects of a disequilibrium exchange rate. In the particular case of surplus countries, in accordance with the covered interest parity condition, expectations of exchange rate appreciation would have a counterpart in lower domestic interest rates, thus exerting a reflationary effect and increasing demand for foreign goodsY However, from a comparison of differences in real interest rates vis-a-vis the U.S. money market (see Table 4), it can be seen that, generally speaking, real interest rates in the East Asian region in the 1980s have been higher than in the United States and have contributed to strong incentives for capital inflows-given that both exchange rate expectations and real interest differentials have been in favor of the domestic currencies.

8 Countries with severe payments difficulties have also tended to carry a large portion ol reserves that is earmarked against liabilities; these are not truly "in reserve."

9 In the absence of capital controls or taxes. and interest rate controls.

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

00

Ta

ble

8.

Inte

rna

tio

na

l Rese

rves A

ccu

mu

lati

on

(In b

illion

s o

f SD

Rs)

Korea

Ma

laysia

Phlll

ppi:MS

S

ingapore

Tha

iland

Argent

ina

Brazil

Mexi

co

Turny

197

1 -75

0

.1

0.6

0

.9

1.6

0

.6

-0

.3

2..3

0

.6

0.5

197

6-ao

1.

6

2.2

1

.1

2.6

-

0.2

5

.0

1.1

u

-u

"'

�

1981�

0

.3

1.0

-

1.7

6

.5

0.8

-

2.3

5

.2

22

0.1

"'

::

:0

0

1986-

-a7

-0

.1

0.8

0

.2

-1.

0

0.8

-

1.8

-

5.2

4

.3

0.2

5:

: ::

:0 Me

mora

ndum

:;><;

End-o

l-198

7 re

serves

as

months

of

im

port

s 1

.1

7.1

1

.9

5.6

3

.8

3.6

4

.6

11.

9

1.6

Source

: Int

ernationa

l Mon

etary

Fu

nd. ln

temational

Fina

ncial S

tatjs!

ics.

Note: T

otal change

in g

ross

offiCial

inter

national r

eserves

011er

the pe

riod

shown.



Liberalization of Capital Controls

The issue of the optimal sequencing of trade and capital liberalization has mostly been taken up in the context of deficit developing countries. However, Belassa and Williamson ( 1987) argue that there was not a case for liberalizing capital inflows into Taiwan Province of China, a surplus economy, because "it [the liberalization] would [have] preclude[ d) any chance of securing the adjustment because of expected appreciation attracting a flood of hot money." This argument may not recognize sufficiently the interdependence of the capital inflows and the overvaluation. It is primarily the prospect of a realized appreciation of the exchange rate that attracts speculative capital inflows and the pressure for hot money inflows will continue, delaying the abolition of capital controls, for as long as an exchange rate is kept at an undervalued level. The key point is that it is easy to obtain an exaggerated impression of the likely extent of appreciation following floating, if the mutual interdependence of the exchange rate and the controls is not recognized.

In the presence of market-clearing interest and exchange rates, La! ( 1987) argues that the question of sequencing does not arise when a moderate fiscal policy is adhered to. Some (e.g., Edwards ( 1985)) have argued that the experience in the southern cone countries of Latin America strongly suggests liberalization of trade before the capital account, but as LaJ notes, this precedent is limited in applicability because none of the countries in question had in place marketclearing exchange rates at the time that they liberalized capital.

The argument most often given for continued capital controls in deficit developing countries is that their liberalization would lead to capital flight. This assumes that capital controls are an effective constraint on capital Aight, which manifeslly they have not been. In fact, adoption of liberalized interest rates and a floating exchange rate coupled with a freeing of capital controls has been seen to stem and then to reverse capital flight in deficit countries. The opposite would be expected from adoption of such policies by a surplus country-namely, a sharp reduction in pressures for capital inflows.

The experience with international capital controls in industrial countries shows clearly that the disruptions that were expected to follow liberalization of the controls did not occur. 10 The German and Swiss experiences with controls on capital inflows in the 1960s and 1970s are instructive. In the end, both nations abandoned their attempt to control capital inflows because they were ineffective.

'0 The United States in 1974. Switzerland in 1979, and the Federal Republic of Germany and the United Kingdom in 1978.


120 PETER QUIRK

Australia and New Zealand floated their currencies and eliminated exchange controls in the mid-1980s, and in both, substantial capital inflows followed. Nonetheless, it should be noted that in the years prior to these actions the Australian and New Zealand dollars had been overvalued, thus the unwinding would be the opposite of that to be expected in a surplus country.

Another reason for capital liberalization includes the pursuit of structural efficiencies. Achievement of efficiency in the use of capital requires a sound and sophisticated institutional basis for risk assessment in the bank and nonbank sectors. This is vital because of the increasingly fine distinctions to be made in the choice of investments in a more developed economy, as rising standards of living rapidly shift competitiveness between industries and sectors. It is generally accepted that the "picking-of-winners-by-government" strategy for industrial development is even less appropriate for more advanced developing and industrial countries.

In this environment, the existence of inflexible interest and exchange rates seriously impedes investment efficiency. For foreign financing, the assessment of risk becomes largely a matter of politicoeconomic judgment as to the timing of government actions to change interest and exchange rates, and subsidy policies. In the case of nonmarket domestic interest rates, the allocation between investments is likely to be distorted if there are limitations on lending that bias the selection of investments. The elimination of ceilings on the rates and more active involvement of the private sector in appraising yields and risks and directing credits will become increasingly crucial for investment efficiency over time.

On the question of the timing of capital liberalization, a major problem with a gradualist approach is that it hinders progress by making credibility more difficult to achieve. In contrast, a quick transition to free mobility of capital means that the design and assessment of future investment projects can be based on realistic pricing and availability of domestic and foreign exchange financing, thus avoiding needless industrial restructuring and bankruptcies when controls are dropped and prices are adjusted ultimately. Transitional problems aside, it is instructive that Indonesia has kept an open exchange system, free of capital controls, since the early 1970s and has not had destabilizing Aows of foreign capital.

There is the broad question of the impact of exchange liberalization on macrostructures, through its effects on the elements of the aggregate production function. In many developing countries one effect of a restrictive trade system backing up an overvalued exchange rate has been to encourage the overimporting of capital goods, thus



raising capital intensity beyond its optimal level. However, in the case of surplus countries with an undervalued currency the tendency may be in the opposite direction: making imported capital goods relatively expensive shifts the production function toward labor intensity. Policies to raise real wages directly were adopted by Singapore in the early 1 980s with the aim of reducing labor intensity. Instead the policies depressed activity and had to be eliminated.

Restraints on the ability of the domestic banking and nonbanking sectors to participate in the international market for their services can also have a direct bearing on overall growth rates and efficiency. For example, Singapore has been able to sustain outward growth in the early 1980s to a large degree on the strength of expansion of markets and financial and business services. This would not be possible in an economy without a liberalized environment.

The sophistication of the financial markets varies widely from country to country. The full menu of forward exchange market transactions is available in both Singapore and Thailand, while the market in the Philippines is more limited in depth, and Indonesia, Korea, and Malaysia have maintained an official presence in the market through the provision of swap facilities (Table 9). Indonesia, Malaysia, and Singapore maintain no controls on financial capital, including no restrictions of residents' holdings of foreign currency deposits with domestic banks. Korea does not maintain the latter restrictions, while the Philippines and Thailand maintain both forms of capital controls. Furthermore, most continue to maintain controls on foreign participation in equity investments. In regulating domestic money and credit markets, there is similarly a diversity of recourse tO credit and interest rate controls. Clearly, scope remains for further strengthening of financial structures in a number of the East Asian economies.

SUMMARY

Successful structural adjustment in East Asian economies has been widely associated with the competitiveness of their export industries. Exchange rate policies in this region have had one major element in common over the past two or three decades: regardless of whether the official exchange rates have been pegged or flexibly managed, they have deviated little from rates in domestic free or black markets for foreign exchange. This has differentiated exchange policies in these countries sharply from a small sample of major developing countries with lower growth rates, in which politico-social considerations arising from short-run tradeoffs in adjusting exchange rates

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(inflation passthrough and J-curve effects) have led to delayed changes in pegged and managed rates. Such important differences in the market realism of exchange rates between East Asia and the sample of other major developing countries appear to have been reinforced by other policies: the absence of punitive taxes on exports, including those arising from systems of multiple exchange rates, and the absence also of significantly negative real interest rates. I n the other countries, such policies have created inefficiency in the use of imported capital recycled from oil surpluses, including capital flight that reduced net saving available for domestic investment, and "white elephant" industries that were not competitive when exchange rates, interest rates, and other controlled prices were finally adjusted to realistic levels.

That capital flight has occurred in the face of extensive systems of capital controls in developing countries with debt difficulties has underlined the irrelevance of the current and capital account liberalization "sequencing" debate. For countries not experiencing such difficulty (the bulk of the East Asian group), rapid liberalization of capital controls coupled with increasingly more market-determined exchange rates is unlikely to trigger sharp exchange rate adjustments or large shifts in capital flows. The experience freeing imernational capital controls in both surplus and deficit countries with floating exchange rates has been that the disruptions it was feared would follow liberalization of such controls did not occur.

I n more advanced developing countries, inflexibility of exchange and interest rate policies becomes an increasingly serious impediment to investment efficiency, because of the increasingly fine distinctions to be made in the choice of investments as rising standards of living shift competitiveness rapidly between industries and sectors. Restrictions on financial services and their pricing can also limit competitiveness in international markets for such services.

APPENDIX

Empirical Tests

l n order to establish the statistical significance of the relationship observed in the text between growth, free market exchange rate premiums and discounts, and real interest rates, various lags were tested. The data for the tests are those in Tables 2, 4, and 6 in the text, that is, for five-year averages spanning the period 1970-88, and nine countries (Korea, Malaysia, the Philippines, Singapore. Thailand, Argentina, Brazil, Mexico, and Turkey).


124 PETER QUIRK

The most satisfactory equation was the following (l-probabilities are shown in parentheses below the coefftcients):

C(T) = I 0.325 -( 1 .000)

0.039591 FREE(T- I ) + 0.087922 Rl R(T) (0.96) (0.93)

D.W. = 1 .76; F(PROB) ::: 0.994; R2 = 0.22.

Coefficients therefore have the expected signs and the exchange rate and interest rate variables "explain" about one fourth of the variation in growth rates within the overall sample. Of particular interest is the pattern of actual and predicted growth rates:

East Asian Group Comparator Group

Actual Predicted Actual Predicted

K1 8 8 6.0 A1 4.9 6.0

K2 7.9 5 6 A2 1 .5 0.4

K3 7.6 6.3 A3 -2.1 -0.3 K4 1 1 .4 6.8 A4 3.8 3.3 M1 7.5 6.2 81 10.1 5.4 M2 8.6 5.8 82 7.1 5.3 M3 52 6.9 83 1.8 3.3 M4 32 6.9 84 5.6 5.4

P1 6.1 3.9 M'l 6.6 6.4

P2 6.2 6.0 M'2 6.7 5.5

P3 1 .4 5.9 M'3 1 . 7 5.4 P4 - 1 .3 5.9 M'4 -3.7 4. 1

S1 10.0 6.2 T'l 7.7 3.7 S2 8 8 6.6 T'2 2.7 2.4

S3 6.3 6.8 T'3 4 .6 5.8

S4 5.3 6.8 T'4 7 8 6.1

T1 6.3 6.4 Mean 4.2 4.2 T2 7 6 6.4

T3 5.0 7.4

T4 4 9 6.8

Mean 6.3 6.3

Although the equation does not predict all instances of significamly below-average growth performance (P3 and P4 in the East Asian group of countries and M'3 and M'4 in the comparator group), in all but one instance in the second group (T' I ) where a below-average performance is predicted, it occurred (A2, A3, A4, B3, M'4, T'2).



This supports the hypothesis that realistic interest and exchange rates are necessary but not sufficient conditions for satisfactory growth.

The equation also explains fully differences in means between the two groups, suggesting the importance of such policies sustained over the longer run as exogenous shocks to growth even out between countries.

BIBLIOGRAPHY

Aghevli, Bijan B., "Experiences of Asian Countries with Various Exchange Rate Policies," in Exchange Rate Rules: The Themy, Ptnfonnance, and Pro.spPcts of the Cmwling Peg. ed. by john Williamson (New York: St. Martin's Press. 1981 ), pp. 298-318.

Asian Development Bank, Capital Markfl Development in SeiPciPd Dfveloping Mnnber Count11es of the Asian Develofnnent Bank (Manila, 1985).

Balassa, Bela, and John Williamson, Adjustiug to Success: BaLanCI' of Paymmts Policy in the East Asian NICs (Washington: Institute for International Economics, June 1987).

Cheng, Hang-Sheng, Financial Policy and Reform in Pacific Basin Countries (LexingtOn, Massachusetts, 1986.)

Edwards, S., "The Order of Liberalization of Current and Capital Accounts," in Economic Libemlization in DevelojJing Countt'ies, ed. by A. M. Choksi and D. Papageorgiu (Blackwell, 1987).

Ground, Richard Lynn, "The Genesis of Import SubstiLUtion in Latin America," CEPAL Review No. 36, Economic Commission for Latin America and the Caribbean (Santiago: United Nations, Decembe1·, 1988), pp. 1 79-203.

Hughes, Helen, ed. Achieving Industrialization in Easl Asia (Sydney; Cambridge: Cambridge University Press, 1988).

Johnston, R. Barry, and Odd Per Brekk, "Monetary Control Procedures and Financial Reform: Approaches, Issues, and Recent Experiences in Developing Counu·ies," IMF Working Paper, No. 89/48 (Washington: !mernationa( Monetary Fund, June 1989).

K1·ueger, Anne 0., Liberalization Attempts and Consequences (Cambridge, Massachusetts: Ballinger, 1978).

Lal, Deepak, "The Political Economy of Economic Liberalization," World Bank Economic Review (International), Vol. I Uanuary 1987), pp. 273-99.

Mathieson, Donald J ., "Exchange Rate Arrangements and Monetary Policy," prepared for the San Francisco Federal Reserve Conference on Pacific Basin Monetary Policy, September 2 1-22, 1987, IMF Working Paper, No. 88/14 (Washington: International Monetary Fund, February 1988).


126 PETER QUIRK

McKinnon, Ronald l., "The Order of Economic Liberalization: Lessons from Chile and Argentina,'' in Carnegie-Rochester Conference Series on Public Policy 1 7 (North-Holland, 1982), pp. 159-86.

Quirk, Peter]., Graham Hacche, Viktor Schoofs, and Lothar Weniger, Policies for Developing Fmward Foreign £xchange Markets, Occasional Paper No. 60 (Washingwn: I mernational Monetary Fund, 1988).

Quirk, Peter J., Martin Gilman, Kyung Mo Huh, Pisit Leeahtam, and Joslin Landell-Mills, Developments in lntemational Exchange and Trade Systent�, World Economic and Financial Surveys (Washington: International Monetary Fund, September 1989).

Reisen, Helmut, and Axel van Trotsenburg, "Should the Asian NIC's Peg to the Yen," lntereconomics (Federal Republic of Germany). Vol. 23 Uuly/ August 1988), pp. 172-77.

Rafferty, Kevin, "Taiwan's Embarrassment of Riches,'' Institutional Investor (September 1987), pp. 275-78

Wickham, Peter, "The Choice of Exchange Rate Regime in Developing Countries,'' Staff Papers, International Monetary Fund (Washington), Vol. 32 Uune 1985), pp. 248-88.


Comment

BONGSUNG OUM

Mr. Quirk's paper provides an insightful analysis of the experiences of the East Asian countries in their exchange rate policies and management for the past two or three decades. Among many roles of exchange rate policy, the paper focuses on its role in the promotion of structural adjustment and financial sector development. Major findings of the paper are as follows.

First, compared with other developing countries, the East Asian countries have had greater stability in their international competitiveness. This has been made possible by the proper exchange rate policies, which resulted in steady depreciation and relative stability of real effective exchange rates around the market-clearing levels. Second, the successful structural adjustment of the East Asian countries has been facilitated not only by their exchange rate policies, but by the liberalization of various restrictions on trade, capital Aows, and interest rates, which in effect reduced distortions in exchange rates. Third, in order to enhance structural efficiencies, including efficiency in capital allocation, further liberalization of capital controls should be pursued. Furthermore, more rapid and simultaneous liberalization of capital flows and exchange rates is preferable to a gradual approach. This way it would be possible to maintain policy credibility, to reduce adjustment costs, and to prevent disruptive capital flows after liberalization. Finally, it is recommended to further strengthen and internationalize the structures of exchange and financial markets of the East Asian countries, which currently show great diversity in terms of the degree of controls and institutional arrangements.

I find myself mostly agreeing with these conclusions. J raise the following four questions, however, which are related to the main theme of the paper but are either overlooked or only lightly touched upon.

First, the diversity of exchange rate policies among the East Asian countries seems to be largely ignored; the paper is more concerned with the differences in the exchange policies of these nations as a whole compared with other developing countries. Bijan B. Aghevli,

127


128 BONGSUNG OUM

for example, focuses on such diversity and even hypothesizes an interesting relationship among the levels of inflation, real exchange rate movements, and exchange rate regimes of several Asian countries in the 1960s and I 970s.1 Quirk's paper points out the diversity of exchange rate regimes among these nations and also mentions, "[i]n practice, the choice of technique for exchange rate management has mattered substantively, in the sense of giving rise to exchange rate variations lasting beyond one year" (p. l l6). To what extent it has actually mattered is not discussed however.

Second, although the paper focuses on the longer-term effects of exchange rate policies on structural adjustment. these effects often conflict with the short-term macroeconomic effects on inflation, balance of payments, debt service burden, etc. In fact, J believe that this tradeoff between the short- and long-term effects of exchange rate changes is one of the major causes of concern about adopting the structural adjustment package of the International Monetary Fund, especially in the developing countries that are cited in the paper as having failed in structural adjustment. It would have been more persuasive had the paper elaborated on such concern by examining the experiences of more successful East Asian countries.

Third, even after so much discussion about exchange rate policies in the literature, including its economic effects, proper management, and optimal regime, several fundamental questions still seem to remain unsettled. One of them, which is related to the topic of the paper and may be most controversial, is the question of the appropriate (or equilibrium) level of exchange rates. I n this regard, my question is whether the absolute stability of real effective exchange rates can be a proper indicator for the appropriateness of exchange rate policies. Not LO memion the many problems involved in the calculation of these rates, there are also cases in which they should be allowed to change, especially in view of certain real shocks to the economy, such as crop failure and shifts in export demand.

Finally, regarding the liberalization of capital controls, the potential risk of destabilizing capital flows seems to be much greater in reality than in theory. It may be right, in principle, that if all of the controls on exchange and capital flows are liberalized in one quick step, the workings of the economy could get started from a new equilibrium position. Then no incentives for disruptive capital flows exist, only stabilizing capital flows. In practice, it would be much safer to make errors on the conservative side by taking a gradualist approach. This

' Bijan B. Aghevli. "Exchange Rate Policies of Selected Asian Countries." m Exchange Rate Rules: The Theory, Performance. and Prospect of the Crawling Peg, ed. by John Williamson (New York: St. Martin's Press. 1981). pp. 298--318.


Comment 129

is especially true when we consider for the policymakers the existence of much distortion in the real sectors, as well as the financial sectors, of most of the developing economies the paper is concerned with. In addition, as long as liberalization continues to proceed, the credibility of policy would not diminish and the adjustment costs would not be much higher than the once-and-for-all liberalization.


7 Export Volatility and Stabil ization

1 n M alaysia

JAAFAR AHMAD'

This paper presents Malaysia's experience in responding to volatile and unstable export earnings, more generally, to the adverse external shocks arising from volatile trade and capital flows.

The problems of export instability of primary commodities have been the focus of attention at both the national and international levels since the 1970s. Studies have been extensive, spanning several decades, but satisfactory solutions have not been found. Since the early 1980s, the problems of export instability have been funher aggravated in Malaysia and the countries of the Association of Southeast Asian Nations (ASEAN) by higher degrees of capital flows and exchange rate volatility.

On the international level, weak markets and rapid price declines for many commodities in the early 1980s have again called into question the effectiveness of negotiated international commodity agreements in promoting stability in primary commodity prices and export earnings of developing countries. Of the five international commodity agreements, today only one, the International Natural Rubber Agreement is still operational, the rest, covering tin, sugar, cocoa, and coffee, are either inactive or in complete disarray. Prices of primary commodities over the last decades, for various reasons stemming both from the supply side and the demand side, were subjected to extreme swings and in many cases were volatile. For the relevant commodities under the international commodity agreements,

• I wish to acknowlege the assistance of Sukdave Singh and others in the Economics Department of the Cenlral Bank of Malaysia in the preparation of this paper. All remaining errors are mine. The opinions expressed do not necessarily reflect those of the Central Bank of Malaysia.

130


Export Volatility and Stabilization in Malaysia 131

the sharp swings in export earnings reflected directly on the effectiveness of negotiated export quotas and buffer stock schemes, which are the primary mechanisms of such agreements. In the past, negotiated export quotas have proven to be more rigid in practice than envisaged in response to changing market forces. With such a dissappointing track record, it is doubtful if the international commodity agreements in their present form can continue to play a useful role in promoting price stability.

The other international response to this problem was the compensatory financing facility of the International Monetary Fund. Initially, when the facility was established in 1963, it was intended to assist member countries by offering financial assistance to those suffering from shortfalls in export earnings. In its earlier version, where access to the facility was more liberal, it proved to be extremely popular among the primary producing countries as a source of quick disbursing, short-term financing to cover a temporary decline in export earnings. In its later version, however, with harsher conditions attached to each drawing, the use of the facility fell dramatically. This had accounted partly for the fall in drawings to only $2.3 billion during 1986-87, compared with $5.4 billion during 1982-83. Further changes that were introduced in 1988 have again transformed almost completely the original character of the facility, limiting its usefulness in stabilizing export earnings.

Another response, which is also global in character, is the producers' cartel. An outstanding example is the petroleum cartel of the Organization of Petroleum Exporting Countries (OPEC). Its extension to other commodities is, however, extremely limited. To be effective, it requires control over the major portion of the market and the ability to impose discipline among the membership. Not many, if any, of the 1 8 commodities• identified by the United Nations Conference on Trade and Development (UNCT AD) as being of particular concern to developing countries qualify for such an arrangement.

But there is little doubt that achieving a stable stream of income from trade can be beneficial, at least for the following reasons. First, stability in export earnings can promote better planning by the government in its annual budgetary process, as well as economic development plans. For Malaysia, two of its development plans were significantly affected by substantial changes in the prices of primary commodities. The Third Malaysia Plan (TMP) 1976-80, was set in a framework of substantial economic growth targeted at 8.4 percent a

' Among !hem are bananas. couon. jure, tea. tropical limber. bauxite. copper. iron ore. and phosphates.


132 JAAFAR AHMAD

year in real gross domestic product (GDP), but its sectoral expenditure targets were grossly affected by an unanticipated commodity price boom, raising the average real GDP growth to 8.6 percent annually. Two factors were mainly responsible for the underestimation. First, the strong rise in the price of the country's traditional commodities (rubber and tin) during 1976-78 and second, the oil shock which nearly tripled crude oil prices during 1 979-80. These developments raised export proceeds above the Plan's projection by about $23 billion and revenues by about $ 1 0 billion, or by over I percent of gross national product (GNP) a year. Compared with the TMP projection of a current account deficit in the balance of payments of 5 percent of GNP by 1980, the higher exports had instead resulted in four years of surpluses during 1976-79, and a def-icit of only 1 .2 percent of GNP in 1980. Thus, it is possible that the Plan could have been framed differently had the sizable changes in resources been anticipated. In the Fifth Malaysia Plan (FMP) 1986-90, the position was reversed. An unexpected collapse in the prices of primary commodities altered significantly the underlying price assumptions of the Plan. This development in wrn imposed a severe resource constraint on the development budget, which forced a substantial $ 1 6.5 billion (a cut of22 percent) revision to development expenditure (a cut equivalent to nearly I percent a year of GNP) over the fiveyear period of the Plan.

Second, there is strong reason to believe that reduced variability of expon proceeds would remove much of the uncertainty surrounding investment decisions in the agricultural sector. Perennial tree crops, where gestation lags between tree planting and maturity can range from four to seven years, are particularly vulnerable to price fluctuations.

As a major exporter of primary commodities, Malaysia experienced one of the worst cases of export instability in the world. But this fact is hardly surprising given the wide open nature of the economy, with total external trade that is greate•· than GNP (an export to GNP ratio of 60 percent and imports of 42 percent in 1987) and a traditionally high concentration of exports in a few primary commodities. What is remarkable is that the high incidence of export instability appears not to have had adverse consequences on growth performances, at least over the longer term. High rate of growth was in fact achieved with relative ease and consistency during the periods of the sixties, seventies, and the latter part of the eighties.

The problem of export earnings instability in a wider context, raises a number of difficult issues. In developing countries, a price collapse would restrict their ability to fund development and meet external



financial obligations. The experience with international commodity agreemems calls for a reconsideration of strategies for dealing with this problem on an international scale. In the context of existing arrangements, a stronger mechanism than the compensatory financing facility is needed to provide primary commodity exporting countries with temporary financing for export shortfalls. And needless to say, enhanced cooperation is required between the producer and consumer countries to realize the objectives of the Integrated Programme for Commodities adopted at the fourth session of U�CTAD in 1976. Among the objectives was the welcomed establishment of a new international financial institution, the Common fund for Commodities tO assist producer coumries. On the national level, the developing countries are faced with an equally difficult choice.

This paper presents a response to export earnings instability in Mala)'Sia. The paper first reviews briefly major economic developments in the country over the last two decades and then examines the policies to moderate the impact of export instability. finally, the concluding section poses a number of policy issues for consideration in the context of stability.

SELECTED TRENDS IN THE MALAYSIAN ECONOMY

Malaysian economic performance for most of the 1970s was exceptional: the average annual growth rate was sustained at about 8 percent and gave rise to a per capita income of $1 ,563 by 1980. The economy was broadly open with imports and exports each exceeding 50 percent of GNP. The effects of the terms of trade were quickly transmitted to the domestic economy. This phenomenon is mostly true for the rest of the ASEAN countries. for Malaysia, a collapse of the primary commodity market in 1986 led to a large terms of trade loss of 15.5 percent, which induced an unprecedented fall in the aggregate consumption in the country by nearly $3 billion, or by I 0 percent in nominal terms. GNP growth collapsed by nearly 8 percent for the year. The current account of the balance of payments was in deficit for most of the first half and in surplus for most of the second half of the 1970s, with the peak in 1979 equivalent to about 5 percent of GNP, and record deficit in 1974 at 6 percent of GNP. Although federal deficits as a percentage of GNP have been traditionally large, about 8 percem in the 1970s, they have been largely financed from domestic noninflationary sources, namely, from the savings of the pension funds. The residual, only about 2 percent a year of G�P, was raised from domestic banking sources. External sources of financing during the period remained modest.


134 JAAFAR AHMAD

The sources of growth were several. The most impressive was the contribution of oil palm, which rivaled rubber as the premier crop when much of the acreage used to grow rubber trees was switched to oil palms. The rate of substitution was gradual, spanning about twenty years. When the oil palm crop began to be cultivated extensively in 1965, the share of agricultural land devoted to rubber cultivation exceeded 68 percent. Padi cultivation and other products, such as tea and coffee, were minor. By 1988, the acreage under rubber cultivation shrank to 35.5 percent of cultivatable land with oil palm making up much of the balance with 34 percent. A second source was the rise in oil exports. Production rose from about 69,000 barrels a day in 1971 to about 276,000 barrels a day in 1980. The third major contributor was the rapid growth of the manufacturing sector, which easily surpassed agriculture in the 1980s.

The rapid but different rates of sectoral growth have transformed the structure of the economy in several areas. Agriculture in 1970 accounted for 3 1 percent of GDP and 61 percent of gross exports. By 1980, the share had fallen to 27 percent of GDP and 44 percent of gross exports. Manufacturing, which has been the most dynamic, with growth averaging around 1 1 .6 percent a year during 1971-75 and 1 1 .3 percent during 197�80, increased its share from under 15.5 percent to 18.2 percent of GDP and accounted for 22.4 percent of exports in 1980 as compared with 12 percent in 197 I .

The major structural shift in the pauern o f production became much more pronounced in the 1 980s, as the commodity boom spilled over in the first half of the decade into nontradable activities, particularly in the construction sector until its collapse in I 985 along with an unprecedented fall in commodity prices. A similar pattern to that of the 197 5 recovery can be observed in the strong recovery during the second half of the eighties owing primarily to a strong resurgence in commodity trade and exports of manufactures.

What is apparent from these developments over the last two decades is that the cycle of growth in the economy is closely linked to the external sector. The recession in I 974-75 was associated with a decline in prices of commodities of about 16 percent and the subsequent fall in the terms of trade of about 14 percent, followed later by a commodity-induced boom throughout the second half of the 1970s. The same is also true for the recession of 1985-86 when export prices fell by nearly 1 6 percent and the terms of trade loss over the two years was more than 1 5 percent (Chart 1 ).

In trade, the issue is whether or not Malaysia as the leading exporter of natural rubber, palm oil, tin, cocoa, and timber can insulate itself from the sharp swings in activity in the domestic economy due to fluctuations of primary commodity prices.


Export Volatility and Stabilization in Malaysia

Chart 1 . Terms of Trade, 1981-88 (Percent change)

... .. ·

·

Four Asian NICs • -----.,...._ .: , --:,.::::-:-.. <41l ...... !. ,. . r ., -:...-- ' .

.,. .,. .,. ,:' '\.Developing Countries :' (non-fuel exporters)2 .

.. ····· ..

. . . . . •,Malaysia

. . . . . . . . . . . . 10 ••• 1981 1982 1983 1984 1985 • 1986 •

·19.1

135

1 987 1988

Source: International Monetary Fund, World Economic Outlook: A Survey oy the Staff of the lnternat,onal Monetary Fund, World Economic and Financial Surveys (Washington. April 1988)

' Gross national product. 2 Terms of trade.

EXPORT FLUCTUATIONS AND PRICE VOLATILITY

In spite of their inherent instability, primary commodities had been the mainstay of the economy until the second half of the 1980s when manufactured exports began to dominate. In 1980, close to 80 percent of exports was accounted for by primary commodities; nearly 46 percent was agricultural products and 34 percent minerals. A significant shift in the trade pattern was observed in 1985 when the total export share of primary commodities declined to 67 percent and that of agricultrual products to just below 33 percent. The slack was taken up by manufactured products, which rose to 33 percent of exports. Natural rubber exports lost the lead of almost 16 percent in 1980 to

just less than 8 percent in 1985; palm oil maintained its share at about 1 0 percent. In the mineral category, tin ex pons, once a major foreign exchange earner in the 1950s and 1960s, accoumed for only 4 percent of exports in 1985, down from 9 percent in 1980. Crude petroleum gained in importance, accounting for 23 percent of export proceeds in 1985, up from 1 7 percent in 1979. Agriculture's contribution to growth over the last twenty years has been impressive (Table 1) . Gains were made despite extremely unstable export earnings.

In terms of the index of instability, Malaysia belongs tO the group with the highest index in the world. A study in 1969 estimated the

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index for the period 194�58 was close to 392 for West Malaysia, compared with 17.6 for 18 developed coumries and 23 for 45 developing countries (Erb and Shiavo-Campo ( 1969)).

In another study of export patterns (Leith ( 1970)) using a sample of 25 developed and 70 developing countries covering the period 1948-58 and measuring the index of instability as deviations from the trend values of exports, the result was 19.6 for West Malaysia, and 7.9 for developed and 12.0 for developing coumries. Using similar techniques, Naya ( 1973) tested 18 developed and 48 developing countries for export earnings instability, using the sample period 1950-69. He found that among developing countries, Asia on average faced sharper swings in exports with an index of 12. I against 9.4 for all developing countries. The index for Malaysia was surprisingly lower at 8.9.

This pattern of instability can be observed in Table 2, on the basis of monthly samples taken.3 The index of variations for exports as a rule exhibited greater instability for commodities whose unit price was highly volatile. The surprising exceptions were palm oil and rubber, which possessed an instability price index respectively of 3.82 and 2.24 but ranked only third (palm oil) and fifth (rubber) in terms of export value. Probably, part of this volatility was partially canceled by the stability in supply, as given in Column (2).

In terms of total agriculture, the result, as expected, indicated a sharply lower variation with an index of 1 .8, although the index of the smallest individual item (rubber) was close to twice the total, and the largest (tin) by 4.5 times. But the broader index was four times more than the variation achieved by manufactured exports. Pan of the explanation apparently was due to the absolute size of the export proceeds, which was itself a significant stabilizing factor.4

2 The index used was the root of the antilog of

where

1/(n -1) L [log (X,IX,_,) -m)2.

m ; 1/(n - 1) L log (X,IX,_,), x, ; export unil value; and n = the number of years.

J The index used is adapted from Cuddy and Dellavalle ( 1978) using the formula

cv (1 - R2)'12• where CV is the coefficient of variation. that is, the ratio of the root mean square error over the mean of the dependent variable. CV was derived from a log linear trend regression and the coefficient R2 is the adjusted coefficient of determination.

• An earlier study by Massell (1970) made similar observations when the size of total exports. introduced as an approximation of export share, explained instability better than the export share itself.


138 JAAFAR AHMAD

Table 2. Export Instability Index, January 1982-September 1988

Export Value Quantity Price Price

(1) (2) (3) (4)

(In ringgit) (In ringgit) (In U.S. dollars)

Tin 8.10 2.37 2.96 4. 1 1

Logs 4 48 1 .69 2.36 3 1 7

Palm Oil 4.36 1 . 1 3 3.82 4.34

Timber 3.76 1.58 0.41 0.91

Rubber 3 . 1 1 0.66 2.24 3.24

Oil 2.91 0.54 1 .61 1 .92 Manufactures 0.47

Total Agriculture 1.81

Total Exports 0.82

Note: Export values based on quarterly data: 1960s = 0.90: 1970s = 0.50: and 1980-September 1988 = 0 49.

SOME POSSIBLE SOLUTIONS TO EXPORT INSTABILITY IN THE MALAYSIAN CONTEXT

It is now becoming increasingly obvious that Malaysia like other open economies cannot insulate itself completely from external disturbances, in either the commodity or the financial market. This is becoming more so since most obstacles to capital flows were removed in efforts to promote foreign investment.

For Malaysia, the solution to the problems posed by export instability lies in a number of areas. The first is to influence prices through direct intervention in the market. This approach embraces the international buffer stock agreementS for rubber and tin, which are subscribed by a number of countries in ASEAN, as well as production control as practiced by OPEC. I n the buffer stock scheme, the mechanism involves direct access to a commodity stockpile that can be disposed of if needed to defend the ceiling price and to cash resources in order to preserve the floor price. The agreements for rubber and tin are supported by Malaysia as a means to moderate price volatility in the international market. Bu t the results have been disappointing: success has been limited in stabilizing earnings. and technology has caused a secular decline in demand.



The other strategies that are less obvious but more difficult to achieve over the short term relate to the promotion of product diversification, a broadening of the export base and market destinations, and improving production efficiency. Second, solutions lie in the areas of fiscal and monetary management. In the latter case, a notable feature of the Malaysian financial system-but not confined only to the Malaysian experience-is the apparent presence of builtin automatic stabilizers.

Commodity Diversification and Broadening the Export Base

In terms of product diversification, a significant broadening of the product base away from a narrow specialization in only tin and natural rubber can be observed in the last two decades. A most remarkable performance has been the successful introduction of oil palm (Table 3). Oil palm, which was introduced into the country as a cash crop in the early 1960s, quickly expanded in terms of both area planted and output so that by 1980, total area under oil palm cultivation occupied nearly 1 ,023 million hectares, with a production of 2,576 million tonnes, as against rubber acreage of 2,004 million hectares, and an output of I ,530 million tonnes. In terms of export share in 1980, 9.2 percent was taken up by palm oil and 16.4 percent by rubber. Since 1980, total planted area under oil palm rose by 7.4 percent annually to account for 30.2 percent in 1988 (or equivalent to I ,786 million hectares) of total agricultural land. Total acreage under rubber was about 1,875 million hectares in 1988, representing an annual decline of 0.5 percent since 1980.

The effects of these efforts to diversify over the last two decades can again be observed in Table 2. On their own, individual commodities tended to exhibit extreme volatility, both in volume and price but when taken together were sharply more subdued. This was first due to the size of the export proceeds, which, as a proportion of GNP, reached as much as 60 percent in 1987. And second, some of the variations were either offset or made up for by the earnings, as well as volume, of the other commodities. The results were even more striking when total manufactured exports \vere included. The total instability index showed a significant decline by nearly 55 percent to 0.82 while the index for manufacturing was only 0.47. The extent over time of the 1·esults of diversification and the rise in tOtal export value are re-emphasized by the fall in the gross exports index-from 0.90 in the 1960s, to 0.50 in the 1970s and 0.49 in the 1980s.


140 JAAFAR AHMAD

Table 3. Selected Agricultural Commodities, 1975-aS

1970 1975 1980 1985 1988

Rubber Planted hectarage 2,019.5 1,991.8 2,003.9 1 ,948.7 1 ,874.7

(In thousands of hectares) Production 1 ,269.4 1 ,459.3 1 ,530.0 1,469.5 1 ,660.3

(In thousands of tonnes) Yield/hectare 1 971 .0 1 '1 1 7.0 937.3 931.4 1 ,061.6

(Kilogram per hectare) Export Value 1 ,723.7 2,025.5 4,618.0 2.872.2 5,255.9


Palm oil Planted hectarage 291.0 641 8 1,023.3 1 ,482.4 1 , 785. 7

(In thousands of hectares) Production 431.1 1 ,257.6 2,575.9 4,133.4 5,030.2

{In thousands of tonnes) Yield/hectare na na na 3.44 3.37

(Ton per hectare) Export value 263. 1 1 ,319.6 2,603.1 3.963.3 4,540.2

{In millions of U.S. dollars)

Cocoa Planted hectarage 5.9 30.3 1239 3039 353 9

(In thousands of hectares) Production 4.0 13.0 36.5 108.0 231.0

(In thousands of tonnes) Yield/hectare - na -Export value n.a. 35.5 161.9 409.5 7083


Source: Department of Statistics, Malaysia. Note: na = nonapplicable. 1 Data tor 1970 and 1975 are tor Peninsular Malaysia only.

As an approximate measure of concentration5 (see Naya ( 1973)), the degree of export diversification achieved is derived in Table 4 below taken for the years 1970, 1975, 1980, and 1987.

In terms of primary products classified under SITC 0-4, food under SITC 0,1 and 4, and raw materials under SITC 2 and 3, the

s Defined as the root of the sum of squares of export ratios as follows:

[�(x/x)2]112,

where the ratio x/x is the export ratio of the ith product in terms of total export x. The interpretation taken is that the greater or more evenly exports are diversified, the lower is the ratio.


Primary Product Food Raw Material Manufactures


Table 4. Measure of Export Concentration

SITC 1970 1975 1980

0-4 0.549 0.405 0.422

0, 1 .4 0.082 0. 1 76 0 . 117

2,3 0.543 0.365 0.405

5-8 0.230 0.195 0.176

Note: SITC = Standard International Trade Classification.

141

1987

0 325 0. 106

0.307

0.279

trend has been quite distinct over the last two decades, indicating a lower degree of concentration or greater product diversification. The rise in prominence of manufacturing products (SITC 5-8) since I 970 is significant, but the transformation over the two decades was quite gradual. I t was not until I 987 that a larger degree of concentration could be observed in this sector, but it has yet to surpass those of the five big primary products and raw materials.

Using the same index, the comparative results for the five big ASEAN countries combined are tabulated below in Table 5. Among the ASEAN, the trend since I 970 in favor of diversification is obvious in all categories of primary commodities. The trend favoring concentration in manufacturing can also be observed. A surprising result arising from Table 5 is that Malaysia in the 1980s was higher than average in its concentration in primary products and raw materials and significantly less than average in terms of its dependence on manufacturing output, although the trend pointed positively in favor of diversification.

Among the factors that have contributed positively to the policy of diversification, the following five deserve special mention.

First, the emphasis placed on export-led expansion is noteworthy. This strategy among all others may have been the most decisive factor

Table 5. Measure of Export Concentration in the ASEAN as a Group

SITC 1970 1975 1980 1987

Primary Product 0-4 0.747 0 7 1 7 0.647 0.459

Food 0,1 ,4 0.347 0.422 0.333 0.293

Raw Material 2.3 0.400 0.295 0.31 4 0 166

Manufactures 5-8 0.196 0.242 0.315 0 520

Source: International Monetary Fund, International Financial Statistics (IFS). Note: Data for 1970 do not include Indonesia: data for 1980 do not include the Philippines: and

the Philippines data for 1984 is included under 1987. The data set used covers only the five big ASEAN countries: Indonesia, Malaysia. the Philippines. Singapore. and Thailand.


142 JAAFAR AHMAD

in having a direct and systematic impact on growth notwithstanding the presence of export instability. At least in the Malaysian experience, there is some evidence to suggest that the exposure of the foreign sector to international competition has promoted the development of industries that are resilient and enjoy a comparative advantage in world markets. It follows also that products that are sheltered or heavily subsidized do not stand the test of time. A good example is rice cultivation, where a 100 percent sufficiency target has been abandoned because it is more cost effective to import. It does not seem also to matter which commodities are selected for promotion. Apparently, choosing those that tend to offset each other's variation in prices or output is not a criterion that is vigorously pursued. For example, cocoa was promoted initially more on account of its suitability as a crop that can be sandwiched under the shade of rubber trees and oil palms rather than for its price and output characteristics. In other instances, pineapple and sugarcane crops were also tried in Malaysia but failed to flourish owing to stiff competition from abroad and the presence of more lucrative crops (rubber and oil palm) in the country. The same applies to the livestock industry, which was tried as a substitute for the Australian and Indian imports of beef and cattle. The same fate applies to the fall in acreage and output of coffee, which was an important cash crop until natural rubber was introduced on a commercial basis. This trend could apply as well over the long term to the observed substitution taking place between oil palm and rubber.

Second, a corollary to the export-led strategy is the maintenance of sound fiscal and financial policies. Policies that preserve financial stability relate to minimal inflation and relatively low rates of interests. The record for Malaysia has been good on both counts. During the 1970s, domestic price inflation as measured by the changes in the consumer price index (CPI) was on average 5.5 percent a year. The interest rate during the period was only 9.7 percent a year for loans. The record for the 1980s is equally good. The CPI rose by 5.9 percent a year in the first half and fell to only 1 . 1 percent on average in the current period with expectations for it to remain at about the 3.6 percent level in 1989. The average lending rate was 9 percent a year as at October 1988.

Third, in support of an export-led orientation, the maintenance of a flexible exchange rate regime is crucial in order to maintain external competitiveness. An external policy that encourages capital investment (both domestic and foreign) and is supported by a realistic exchange rate regime helps broadly to support the diversification objective.



The strong revival of the industrial sector in Malaysia since 1985 was reflected by the external competitive edge gained since the Plaza Accord of September 1985 (Chart 2). These gains were observed through the gradual depreciation in the exchange value of the ringgit to reflect economic fundamentals. In comparison with the major ASEAN countries, the real effective exchange rate index for Malaysia was 73.6 in April 1989, compared with Thailand at 79.9, Indonesia 45.5, Singapore 104.6, and Korea at 103.9. In Indonesia, the index reflected the two mega-devaluations of the rupiah taken in March 1983 by 28 percent and in September 1986 by another 3 1 percent. The largest devaluation of the baht in Thailand took place in November 1984; it was devalued by almost 1 5 percent. As for the future, the edge that Malaysia could perhaps enjoy is its track record of low inflation and higher productivity. The stability gained from

Chart 2. Real Effective Exchange Rates for Competitor, Based on Trade Weights, January 1988-April 1989

(1980 = 100)

120�--------------------------------------------�

1 1 0

'

90 ..1 / Korea

'

r'

80

70

60

1983 1984 1985 1986 1987 1988 1989 1990


144 JAAFAR AHMAD

the ringgit and U.S. dollar alignment can also be observed in Table 2. The instability associated with the price of commodities expressed in U.S. dollars in this table is shown to be greater than in ringgit terms. This observation could mean that variations in the exchange rate have managed to stabilize movements in export unit value denominated in ringgit and therefore are consistent with the insulation property of a flexible exchange rate regime.

Fourth, the promotion of both agriculture and manufacturing in the various five-year Malaysia Plans have ensured that the push for rapid growth and development was not at the expense of agriculture. The importance placed on the agricultural sector is reflected in the Government's National Agricultural Policy, which stresses the importance of both new land and in situ developments, as well as agricultural support services. For the latter category, agricultural research programs have been among the most successful. These are exemplified by the results produced by the Rubber Research Institute (RRI), the Palm Oil Research Institute of Malaysia (PO RIM), and the Malaysian Agricultural Research and Development Institute (MARDI). It is difficult to measure precisely the effects of agricultural support service, but the fruits of research, farming, training, and credit promotion are important in raising yields and productivity. In the rubber sector, yield estimate per hectare for the high-yielding material reached as high as I ,500 kilograms (an estimated 750 kilograms per hectare in Thailand) in 1988, and 5 tonnes per hectare in the oil palm sector (3.3 tonnes in Indonesia). These yields were among the highest compared with the other producing countries in the region.

Fifth, the success in drastically lowering export instability lies much more with the policy to increase the manufacturing sector's share of exports (instability index of 0.4 7 compared with 1 .8 1 for agriculture). This was first achieved in terms of GDP when the share of the manufacturing sector rose from just below 14 percent in 1970 to 20 percent by 1980, and thereafter rose to 24 percent to surpass the agricultural sector by I 988, which has a share of 21 percent. The rise in the export share of manufacturing over the last two decades is equally remarkable, beginning with 12 percent in 1970 to 49 percent in 1988. But the success story of the meteoric rise of manufacturing has its weaknesses. Basically, this refers to the overconcentration of industries in electronic related products (54 percent export share in manufacturing in 1 987) and textiles ( 1 1 percent share) as a source of growth in the sector.



Diversification of Markets

Although a desirable objective policy to promote export stability, market diversification has not had an impressive record. I t has proved more difficult to diversify into new geographical areas than to maintain or even expand on Malaysia's existing market share (Table 6). Singapore, Japan, the United States, and the European Community (EC) have been the traditional markets for Malaysian exports, in that order.

Although the share of these markets has been generally stable, accounting for about 70 percent of total exports, the trend has been declining, particularly since 1985. This is reflected to a certain extent by the expansion of new markets in Asia and the Middle East, which have expanded from just below 9 percent in 1980 to above 12.5 percent in 1985 and 15 percent by 1987. In the case of Singapore, the declining trend was a reflection of the move by Malaysia toward direct marketing of its exports to the importing countries.

Built-In Automatic Stabilizers

The external components of the country's monetary base have been subjected to wide fluctuations measured either quarterly or annually. These had been primarily the results of volatile export proceeds and capital movements. Capital flows were observed to be exceptionally volatile in the 1980s, arising from the more liberal exchange control regime and closer integration between domestic and international

Table 6. Direction of Trade

(Market Share)

United European United Year Singapore Japan States Community Kingdom Total

1965 24.2 17.5 13.5 10.2 7.5 72.9 1970 21.6 18.3 13.0 12.7 6.6 72.2 1975 20.3 14.5 16.1 1 7.3 6.0 74.2 1980 1 9.1 22 8 1 6 4 1 4 2 2.7 752 1981 22.8 21 .1 13.1 12.2 3.0 72.2 1982 24.9 20.3 1 1 .6 12.1 2.8 71 .7 1983 22.5 19.6 13.2 1 1 .9 2.7 69.9 1984 20.4 22.3 13.6 10.0 2.6 68.9 1985 19.4 24.4 1 3.9 1 1 .9 2 6 71 .2 1986 17.1 225 16.6 1 1 . 1 3.5 708 1987 1 8.2 19.5 16.6 1 1 .1 3.2 68.6

Source: International Monetary Fund. International Financial Statistics (IFS).


146 JAAFAR AHMAD

financial markets. Much of the impact of these fluctuations has, however, been effectively neutralized by compensating movements of the domestic components of the reserve base (Chart 3), thereby keeping reserve money growth quite stable. This is an important and desirable objective of policy, as it shields the economy from sharp external payments shocks and financial instability. The Central Bank's intervention is also influenced to a large extent by its policy to keep the level of liquidity consistent with its GNP growth forecast. The degree of prudence by which this policy is exercised is borne out by the extraordinary degree of price stability enjoyed over the last three decades.6

The domestic automatic stabilizers arose as export receipts were highly correlated with government revenue (estimated elasticity was about 0.85 during 1970-87). For example, the rise in export receipts was offset partly by the consequent rise in corporate profits and government revenue. These resulted in reduced credit requirement by the Government and corporations of the banking system. Most interesting by way of comparison was that the same phenomenon in terms of built-in automatic stabilizers is observed in the other ASEAN member countries (see Charts 4, 5, and 6).

6 Annual percentage change in the CPI during 1961-70 was 0.9 percent; 5.9 percent during 1971-80: 5.8 percent during 1981-84; and 0.5 percent during 1985-87.

Chart 3. Malaysia: Factors Affecting Reserve Money, 1978-88 (Change in billions of ringgit)

3 �------------------------------------------,

1979 1980 1981 1982 1983 1984 1985 1986

Source: International Monetary Fund. Jnternarional Financial Statistics (IFS).

1987 1988


5 4 3

2

0 -1 -2 -3


Chart 4. Indonesia: Factors Affecting Reserve Money, 197�8 (Change in billions of rupiah)

Net Foreign Assets '

'• ' • I l

-4 �--�----�----�---L----�--��---L��._--�� 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988

Source: lnlernational Monetary Fund, International Financial Statistics (IF$).

Chart 5. Philippines: Factors Affecting Reserve Money, 197�8 (Change in billions of pesos)

30 Net Foreign Assets

20

10

0

-10

-20

-30 1979 1980 1981

Source: lnternalional Monerary Fund. International Financial Statistics (IFS).

147


148

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JAAFAR AHMAD

Chart 6. Thailand: Factors Affecting Reserve Money, 1981-88 (Change in billions of baht)

\ .. .. .. I I

I I

' '

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988

Source: International Monetary Fund. International Financial Statistics (IFS).

Higher Reserves Cushion

The final point is on the level of reserves. The level of external reserves is usually a reflection of a country's earnings instability in international trade. In part, it is a reflection of the need to keep enough reserves to cushion against a collapse in exports and thereby insulate the economy temporarily against disruptions in imports and payments flows. The optimum level of reserves is of course debatable. I n the last five years, Malaysia's gross international reserves varied from as low as $4 billion, or equivalent to about 4 months of imports in 1983, to as high as $7.8 billion, or 7.4 months of imports in 1987. The argument in favor of a large reserve level is that Malaysia is an open economy with relatively free capital flows. Reserve levels therefore ought to be high enough to deal with the fluctuations without any need to resort to such inefficient devices as multiple currency practices, quantitative restriction on imports, or other forms of foreign exchange rationing that can ultimately hurt the chances for exports to thrive in the international market.

POLICY ISSUES

In the final analysis, Malaysia's success with export-led expansion lies less with a strategy to insulate the economy against external shocks than with its readiness to let the shocks pass through to the rest of



the economy. This is reflected by the changes in the terms of trade and the growth rate of the country's GNP. Such a phenomenon can be observed during both the boom and recession years. The willingness to accept this fact is important, as the economy is allowed to react accordingly. Any degree of protection or stimulation can be costly, especially in a wide open economy.

A pertinent lesson can be learned from Malaysia's policy actions during a global recession. In 1981-82, the authorities decided to embark on a costly countercyclical stance, against a terms of trade loss during 1980-82 of almost 8 percent. The resulting deficits incurred in the federal government budget peaked at 18 percent of GNP by 1982, and in the current account of the balance of payments of 1 4 percent. These were well above Malaysia's sustainable financial capacity without resorting to massive external and domestic borrowings. The period of economic adjustment to the policy spanned six years resulting in a rise in unemployment and comparatively lower economic growth.

A second issue is the role of the government. l n the early stages of development in Malaysia, certainly in terms of the plan to develop both agriculture and manufacturing, the presence of the government was indeed dominant. In agriculture, the promotion and servicing of the small-holding sector in both oil palm and rubber croppings were achieved with government assistance through the opening of new land, as well as the distribution of new improved seeds, through such organizations as the Rubber Industry Small Holders Development Authority (RISDA) and Federal Land Development Authority (FELDA). The mood today is the reverse, especially in the Government's efforts to industrialize. In this respect, the right environment has been achieved in creating a viable and competitive atmosphere. Admittedly, more revision needs to be done in terms of privatizing state enterprises and the so-called nonfinancial public enterprises, but more important, the competitive edge has now been gained through maintaining a relatively flexible exchange rate regime. The latter especially has been instrumental in reviving an export-oriented manufacturing industry.

The issue above is not so much over the narrow concentration of industries, which (like the experience in agriculture) can be broadened to take up the expanding opporwnities of the rich domestic agricultural sector, but over investment, namely, direct foreign investment. The country's experience with direct foreign investment in electronics and textiles in the last two decades has been somewhat disappointing. Despite its strong presence, there has hardly been any linkages to the rest of the economy, especially to electronics and. electrical goods.


150 JAAFAR AHMAD

The spin-off in terms of research and development and of promotion of higher value-added goods has been minimal. Whether or not multinational companies on foreign soil, more so in the developing countries, will devote more investment to research and development and encourage linkages is difficult to establish. Evidence points increasingly to their single-minded pursuit of the low-wage objective. This fact makes it worthwhile to examine if, with high domestic savings, Malaysia ought not to concentrate more on local counterparts.

CONCLUSION

Much has been achieved over the last two decades. The evidence shows that Malaysia is quite successful in living with instability in both trade and product diversification. The record is impressive in terms of the level of growth that has been sustained over three decades. The key lies in the promotion of an open economy with flexible prices and prudent management of the economy.

Appendix

Note on the Econometric Analysis Used

The econometrics employed in the paper revolve around the computation of instability indices for various export commodities of Malaysia. For each commodity, instability indices are computed for export value, unit value, and quantity. Two instability indices are calculated for each unit value: one in terms of ringgit, and the other in terms of U.S. dollars. The computations are based on monthly data from Bank Negara Malaysia for the period December 1982-September 1988.

Instability indices for various exports of Malaysia were computed using the same measure as Cuddy and Dellavalle ( 1978) and Charette ( 1 985):

where CV is the coefficient of variation for the series, and R2 is adjusted R2 obtained from a log-linear time trend regression of the series:

logX, = a0 + a , · T, + e, ,

where X is the relevant export variable and T is the time trend variable.



The results of the regression are summarized below. In the first column, . V represents export value, . UM represents unit value in Malaysian ringgit, .US is unit value in U.S. dollars, and .Q for export quantity.

Regression Results

Dependent Coefficients Variable Constant (t) Trend (t) cv R2 RMSE

Rubber

.v 5.425 (1 16.5) 0.006 5.7) 3.67 0.28 0.208

.UM 5.247 (161.2) 0.004 6.0) 2.68 0.30 0.145

.us 4.425 (127.6) 0 002 3.2) 3.42 0.10 0.1 55

.0 1 8 599 (650.1) 0 002 2.5) 068 0.06 0.128

Palm Oil .v 5.485 ( 93.8) 0.004 3.2) 4.61 0.1 1 0.261 .UM 7.058 ( 1 1 5.0) -0.003 -2.6) 396 0.07 0.274 .us 6 236 ( 98.2) -0.005 -3.8) 4.69 0.15 0.283 .0 12.243 (286.2) 0.007 8.2) 1 .52 0.45 0.191

Logs .v 5.367 ( 89.6) 0.005 3.6) 4.81 0. 13 0.267 .UM 5.039 (179.9) 0.002 2.6) 2.45 0.07 0.1 25 .us 4.217 (141 .9) -0.001 -0.4) 3.1 5 0.01 0.1 32 .0 14.143 (252 9) 0.003 2.6) 1 .75 0.07 0.249

Timber .V 4.464 ( 95.5) 0.006 5.7) 4.44 0.28 0.208 .UM 5.912 (596.8) 0.003 13.1) 0.73 0.68 0.044 .us 5.090 (446.5) 0.001 4 . 1 } 0.99 0.17 0.051 .0 1 2.368 (207.4) 0.003 3.0) 1.65 0.09 0.206

Tin .v 4.929 ( 52.2) -0.011 ( -5.3) 9.37 0.25 0.421 .UM 3.573 ( 96.7) -0.011 ( - 1 3.0) 5.22 0.68 0.1 65 .us 2.751 ( 69.9} -0.012 ( - 14.3) 7.76 0 72 0.175 .o 15.171 (189.2) -0.001 ( - 0.3) 2 36 001 0.358

Oil .v 6.586 (140.0) -0.005 ( -4.8) 3 28 0.22 0.210 .UM 4.525 ( 1 14.5} -0.011 ( - 13.3) 4 33 0 69 0.176 .US 3.702 ( 87.4) -0.013 ( - 14.4) 5.96 0.72 0.189 .o 1 5.876 (534.5) 0.006 ( 1 0.2) 0.82 0.56 0.132

Manufactures .v 6.313 (243 2) 0.017 30.3) 1.65 0.92 0.115

Agriculture .V 6.669 (194.5) 0.005 6.5) 2.23 033 0.153

Total .V 7.656 (300.4) 0 007 12.9) 1.43 0.67 0.114


152 JAAFAR AHMAD

In addition, a simple regression analysis to establish the relationship between variabilities in export, on one hand, and variabilities in gross capital formation and GNP, on the other, has also been done as described below.

The issue involved in empirical testing of the effect of export variability would ideally seek a measure of the uncertainty introduced by the variability in export in any period. The approach taken here is to adopt the observed variability from the trend rate as a measure of uncertainty. In the regression that follows, the trend values were derived by assuming exponential growth rates for capital formation, exports, and GNP. The regression results, with variables measured in terms of their deviations from trends, are

a logCAP = 1.035 a log EXPORT (5.745)

a logGNP = 0.637 a log EXPORT ( 12.686)

R2 = 0.55, RMSE = 0. 192;

R2 = 0.86, RMSE = 0.054.

For this regression, annual data on gross capital formation, gross exports, and nominal GNP for the period 1 965-87 were used.

BIBLIOGRAPHY

A riff, K.A. Mohamed, Export Trade and the West Malaysian Economy: An Enquiry into the Economic Implications of Export Instability, Monograph Series, Malaysian Economic Affairs (Kuala Lumpur: University of Malaya, 1972).

Charette, M. F., "Determinants of Export Instability in the Primary Commodity Trade of LDCs," journal of Development. Economics (Amsterdam), Vol. 18 (May/june 1985), pp. 13-21.

Coppoach, J.D. International Economic Instability (New York: McGraw Hill, 1962).

Cuddy, John D., and P.A. Dellavalle, "Measuring Instability of Time Series Data," Oxford Bulletin of Economics and Statistics (Oxford. England), Vol. 40 ( 1978). pp. 79-85.

Erb, G. F., and S. Schiavo-Campo, "Export Instability, Level of Development and Economic Size of Less Developed Countries," Bulletin of the Oxford University Institute of Economics and Statistics (Oxford, England), Vol. 3 1 ( 1969), pp. 263-84



Leith, J.C., 'The Decline in World Export Instability: A Comment," Oxford Bulletin of Economics and Statistics (Oxford, England), Vol. 32 ( 1970), pp. 267-72.

Malaysia, Government of, Fifth Mala)•sia Plan 1986-90.

--- · Third Malaysia Plan 1976-80.

Massell, B. F., "Export Instability and Economic Structure," American Economic Review (Nashville), Vol. 60 (September 1970), pp. 618-30.

Naya, S., "Fluctuations in Export Earnings and Economic Patterns of Asian Countries," Economic Development and Cultural Change (Chicago), Vol. 2 1 (july 1973), pp. 629-41.

World Bank, World Tables, 1987 (Baltimore: johns Hopkins University Press. 1987).


Comment

AZIZALI F. MOHAMMED

Mr. Ahmad's paper contains many useful insights. First, and most important, it tells us that difficult as the problem of commodity price instability may be, it can be managed. The record of Malaysia speaks for itself here. This record also throws into relief the author's introductory remarks bemoaning the disarray in international commodity agreements, the diminished use of the compensatory financing facility, and the lack of institutional palliatives.

Second, while the precise approach to dealing with price volatility will of course differ from country to country, the paper identifies a number of elements and ingredients that are likely to be both crucial and generally applicable. His last sentence, in many ways, says it all: 'The key lies in the promotion of an open economy with Aexible prices and prudent management of the economy" (p. 150).

The commitment to an open economy does not serve simply to "let the shocks pass through to the rest of the economy" (pp. 148-49). Greater exposure to the rigors and discipline of the international market breeds efficiency, facilitates effective diversification, and improves the flexibility of an economy in the face of adverse external developments. We have seen this documented elsewhere. Compared with the alternative, it helps cushion part of the shock and perhaps even offset it.

To the remaining shock, the country must adapt; hence, prudent management. It is unfortunate, in this connection, that in some countries, "adjustment" has become an emotionally charged word. When circumstances change, adjustment is inevitable. And the longer the corrective action is postponed, the more drastic it is likely to be. Ahmad tellingly cites Malaysia's miscalculation here in 198 1-82.

The adjustment process can be "smoothed" by "institutional" arrangements. Indeed, Malaysia has participated in various international commodity agreements and availed itself of credits under the Fund's buffer stock financing and compensatory financing facilities, which brings me to Ahmad's implied criticism of the evolution of Fund practices here. He laments two developments: the reduced use of the compensatory financing facility after the early 1980s and, what

154


Comment 155

he sees as the complete transformation of the original character of the facility in 1988.

The reduced use of the facility he attributes to "harsher conditions attached to each drawing" (p. 1 3 1) . True, conditionality was effectively tightened in 1983. This was a prudential move designed to protect the revolving character of the Fund's resources. But there are other reasons for the lower level of use of the facility since then. During the immediately ensuing period, the value of exports of most primary producers strengthened along with world economic activity. Many countries had used up most of their access to the facility effectively for five years, as they had made substantial use of it during 1982-83. Alsu, fur the low-inCOIIlt: counu·ies, the structural aujusuuent facility and the enhanced structural adjustment facility are a cheaper form of financing.

As to the transformation of the facility's original character, there has been no fundamental change in its compensatory component. The requirement of "cooperation with the Fund" was clarified and tightened in 1983, as noted. In 1988, the maximum compensation available for temporary shortfalls in exports was reduced in most cases (from 83 percent of quota to 65 percent of quota). But the character of such assistance was not altered; indeed, compensating members for temporary export shortfalls remains an essential activity of the Fund.

Access limits were lowered because the Fund, in an effort to sustain adjustment efforts in the face of external shocks broadened the contingencies against which it would offer assistance-such that in addition to, say, drawing 65 percent of quota to compensate for export shortfalls, a country might also be able to draw 40 percent of quota to help defray the costs of, for example, an increase in interest rates on debt or a surge in import prices beyond original expectations. And where a member encounters payments difficulties arising solely from a classical shortfall in exports, it will continue to be eligible to draw 83 percent of quota.

The Fund's business is to support adjustment. As Ahmad notes, countries cannot insulate themselves from the outside world. They must adapt-and adapt on a continuous basis. The author has provided a lucid exposition of how one country has grasped this nettle.


8

Structural Adjustment: Lessons from the Southeast Asian

Experience

JORGE MAROUEZ-RUARTE

This paper discusses some general, important principles of economic policymaking, illustrates their application in some of the Southeast Asian economies, 1 and discusses several economic issues that are coming to the forefront of the policy debate in some countries in the region. The paper is organized around the theme of "successful policies for structural adjustment." Structural adjustment can be defined as the creation of conditions for sustained, noninflationary growth, and the elimination of impediments to the full and efficient use of resources. Furthermore, adjustment must permit the attainment of certain basic, and widely shared, social goals.

I would like to comment on each part of this definition. To begin with, structural adjustment must permit the attainment of growth of output that is both noninflationary and sustained. In practice, it has been difficult to sustain inflationary growth for long, even if its makers seek to achieve both steady growth and price stability in the medium term. Structural adjustment must also promote the elimination of impediments to the full and efficient use of resources. In this sense, adjustment consists of reducing distortions that discourage saving, investment, production, or employment, or that encourage the use of resources in sectors that are not the most advantageous for the community. Finally, structural adjustment must not prevent the pursuit of widely shared social and human goals: individual freedom,

' In this paper. references to ··southeast Asia" include Korea. Taiwan Province of China. and Hong Kong. in addition to the countries that are geographically located in Southeast Asia.

156


Lessons from the Southeast Asian Experience 157

satisfaction of basic needs, and equity in the distribution of income and wealth. Whether these goals are actually sought or not is a political question, but adjustment must, at least, not make it impossible to pursue them.

On the basis of the preceding definition of structural adjustment, let me characterize successful strategies for such adjustment. The first point to make is that there is not one set of policy measures that is successful. Actual policies must be formulated in very specific country contexts. Although the policy approach of one country can be enriched by the experience of another country, it is dangerous to focus on instruments or specific measures rather than on the broad thrust of the policy approach. For example, Japan's annual round of simultaneous wage negotiations is sometimes given credit for helping to maintain price stability. One should not conclude that such a system might have the same impact in other countries. It is quite conceivable that, in a different social context and underlying financial conditions, annual rounds of wage negotiations could exacerbate inflationary pressures rather than subdue them. The main point here is that certain practices and arrangements are endogenous; price performance is the result of an overall policy approach, not of any one feature of the adjustment strategy.

Then, what characteristics do successful strategies share? First, successful strategies assign top priority to financial stability. Second, successful strategies recognize the usefulness of markets, and the constraints they place on government policies.

FINANCIAL STABILITY

Financial stability has several dimensions, the most important being price stability and external viability. Of course, these two characteristics are linked, but each of them is important on its own. Price stability means that prices are stable and are expected to remain stable. At times, a jump in the price level is appropriate (for example, when increases in world oil prices or in domestic sales taxes are passed through to consumers), but sustained increases in the price level cannot but impair economic performance. Theoretically, stable and perfectly anticipated inflation might not cause much harm. But the kind of inflation that is generally observed is rarely stable or perfectly anticipated. Therefore, inflation hurts in many ways. It distorts economic planning, making it difficult to identify changes in relative prices and incentives. It discourages investment and saving and brings about unwarranted changes in the distribution of income and wealth. It is not a coincidence that the fastest growing, best performing


158 JORGE MARQUEZ-RUARTE

economies in Southeast Asia are low-inflation economies. But the same is true around the world. Among industrial countries, japan enjoys both the highest rate of growth and the lowest rate of inflation. Among developing countries, those in Asia show both the highest rates of gross national product (GNP) growth and the lowest rates of inflation (Table 1) .

The second element of financial stability is external viability. The events since 1982, when the world debt crisis set in, have shown that a vulnerable external position can severely affect economic performance. From 1981 to 1988, real gross domestic product (GDP) in the 1 5 most heavily indebted developing countries rose by only 1 .5 percent a year, while GDP in all developing countries, on average, grew by 3.4 percent a year. This does not mean that developing countries should eschew borrowing: as long as the marginal productivity of capital is sufficiently high, it pays to borrow. Indeed, net debtor countries grew consistently faster than net creditor countries during the period 1981-88. But there is a case for government monitoring of foreign borrowing. In this respect, the experience of Korea is interesting.

Quite early in Korea's development process, the Government recognized that foreign savings could make a positive contribution to the country's development, provided that it did not lead to unwise investment or an excessive debt burden. Through the years, the Government acquired a major role in coordinating foreign borrowing

Table 1 . Inflation and Growth I n Developing Countries

(Compound annual rates of change. in percent)

Average 1981-88

Inflation Growth

Developing countries 38.7 3.4 Asia 8.7 7.3

Net creditor countries 9.0 0.7 Net debtor countries 44.3 3.9

Four newly industrializing Asian economies' 3.2 8.5

Fifteen heavily indebted countries2 1 1 1 .2 1 .5

Note: Estimates based on the data and country classification contained in World Economic

Outlook: A Survey by the Staff of the International Monetary Fund. World Economic and Financial Surveys (Washington: International Monetary Fund, October 1989).

' Hong Kong. Korea, Singapore. and Taiwan Province of China. 2 As defined in World Economic Outlook.



and, until the emergence of large current account surpluses in 1986, comprehensive foreign borrowing programs were essential components of the Government's annual economic management plans. Within the borrowing programs, major syndications and bond issues were spaced throughout the year to avoid saturating the market at any one time. Regulations were issued to affect the maturity structure of external debt in line with government objectives. From 1983 to 1986, the Government reduced sharply the level of short-term external debt, in order to lessen Korea's vulnerability to disruptions in international capital markets. Careful government management of foreign borrowing, based on timely and comprehensive information on external debt, appears to have contributed greatly to maintaining Korea's creditworthiness at times when other large borrowers were facing severe difficulties.

Of course, the ultimate determinant of financial stability is not an adequate debt-monitoring system but appropriate financial policies. Other sessions in this seminar have dealt in depth with fiscal, monetary, and exchange rate policies. In the successful countries in the region, financial stability was supported by restrained fiscal and monetary policies and a realistic and flexible (although not freely floating) management of the exchange rate. Though, at times, financial policies were relaxed to deaJ with weakening economic activity, or the fiscal position was affected by special factors, such episodes were followed by decisive moves toward restraint.

For example, in Korea, the government deficit rose to high levels (3Y2 percent of GDP) during the economic crisis of the early 1980s, but was reduced steadily during 1983-86, owing to expenditure control and strong revenue performance. The fiscal position then shifted into a significant surplus during 1987-88. In Thailand, budgetary policy was countercyclical in years when growth weakened, particularly in 1982 and 1985. Therefore, the central government deficit fluctuated countercyclically between 3 percent and 6 percent of GDP during the first half of the 1980s. However, as the fiscal position of the public enterprise sector improved, the overall deficit of the public sector declined from 7 percent of GDP to 5 percent of GDP during the first half of the decade. Since 1986, public sector finances in Thailand have undergone a transformation. Rapid economic growth boosted revenue while expenditure was kept under tight control. As a result, the fiscal position shifted to surplus in 1988.

These examples can serve to illustrate several principles of sound fiscal management. First, if the government is to engage in countercyclical fiscal policy-and not everyone would agree that it shouldit must do so symmetrically, that is, in both the downswing and the


160 JORGE MAROUEZ-RUARTE

upswing of the cycle. In practice, this means strict fiscal discipline in periods of economic vigor. In the cyclical upswing, when revenue growth is strong, there is a temptation to maintain a high level of spending or even to increase it. Such a temptation must be resistedas it was done in the cases of Korea and Thailand-for two reasons: (i) during a cyclical recovery the government should adopt a contractionary stance to moderate cyclical influences; and (ii) the fiscal position will suffer in the longer term if it is not consolidated in periods of strong growth.

Second, control of spending is essential if fiscal adjustment is to take place. Revenue measures have an important role to play in fiscal adjustment, but there is a risk that revenue gains will reinforce pressures for spending rather than for fiscal adjustment. What is the optimal level of public spending? It is difficult to say in general, but there are two rules that may prove useful. One is that the recurrent budget should not be in deficit; this means that recurrent expenditures should be fully paid out of taxes and other ordinary revenue. And investment projects must be undertaken only if they are economically and financially sound. In assessing the benefits of projects, of course, nonpecuniary or external benefits should be included, but only if taxes can be generated to pay for those benefits. In this respect, medium-term projections of the government's fiscal position would help to evaluate the viability of the investment program. A third general principle of sound public finance, and closely related to the previous point, is that public enterprises should be self-supporting. There is no obvious reason why the government should subsidize public enterprises except to the extent that they supply clearly identified public goods.

Besides a sound fiscal position, financial stability requires prudent monetary and exchange rate policies. In these policy areas, which have been studied at length, I would like to comment on certain issues that have become increasingly important, particularly in the Southeast Asian region: the issue of targets and indicators of monetary policy, and the problem of current account surpluses. The first issue is to what extent monetary policy can be focused on the growth of the money stock. In a simpler world, with few alternative financial assets and flexible exchange rates, the growth of the money stock could be an adequate target for monetary policy. But this is not the case at present. I n several countries in the region, the authorities manage the exchange rate and allow exchange market pressures to be reflected, to a considerable extent, in the foreign reserve position of the central bank. Furthermore, residents usually have the opportunity to invest in assets other than domestic bank deposits, including



foreign deposits, although sometimes not legally. Therefore, the demand for money may shift drastically with expectations of devaluation or revaluation. Even when such expectations are stable, changes in domestic credit may be associated, to a significant extent, with changes in foreign reserves rather than changes in the money stock. To complicate matters further, financial liberalization has increased the attractiveness of bank deposits and led to shifts in the demand for money.

What are the implications for monetary policy? One implication is that a focus on the growth of the money stock alone may elicit an unsuitable policy response. For example, if the authorities were maintaining a fixed exchange rate and the public began to feel that a devaluation was imminent, liquidity preference might shift away from domestic bank deposits and toward foreign bank deposits. This would lead to a loss of foreign reserves and a decline in the money stock, which cannot be interpreted as monetary tightening because the demand for money has also contracted. I would suggest that, in a fixed exchange rate regime, the appropriate monetary target would be the external position of the monetary authorities. The appropriate (short-term) policy response to the undesired loss of reserves would be an exchange rate devaluation or higher domestic interest rates, or both.

The opposite situation-an upward shift in the demand for money balances-is also common. Given that yields on bank deposits may increase with financial liberalization, the expansion of the stocks of money and bank credit may accelerate as liberalization takes hold. Such expansion is not inflationary, reflecting increased financial intermediation through the banking system. This scenario has been observed in several countries in the area and may severely complicate the interpretation of monetary developments. These countries are not alone. Financial innovation and liberalization has caused moderate-to-sizable shifts in the demand for money of many industrial countries. Some central banks have responded by moving to narrower monetary aggregates, others by moving to broader aggregates, but a common response has been to reduce the focus on money stock itself, and broaden the range of indicators that guide monetary policy.

The issue of the appropriate monetary target is related to the problems created by the large external surpluses of certain Southeast Asian countries. The surpluses are associated with an acceleration in monetary expansion, and the following question arises: should the authorities try to sterilize the increase in foreign reserves and contain monetary expansion? I cannot hope to answer this question in a definitive way, but I will offer a few considerations that I believe



important. The appropriate monetary policy response to a shock that affects the balance of payments probabl)' involves adjustments in three variables: the exchange rate, domestic interest rates, and foreign reserves. The weight to be assigned to each of these variables depends on the source of the shock and on whether the shock is perceived to be temporary or permanent. For example, a shift in preference from foreign to domestic monetary assets would be translated into a surplus in the balance of payments and an increase in monetary growth. The response would involve some appreciation of the domestic currency, some decline in domestic interest rates, and some increase in foreign reserves. If the shift is believed to be temporary or nonrecurrent, the authorities may prefer to minimize the appreciation and absorb the increase in foreign reserves.

This issue is related to one of the "dilemma cases" of classical balance of payments theory: a country is faced with a balance of payments surplus and inflationary pressures at the same time. How do the authorities use their policy instruments, namely, exchange rate and financial policies? There is no question that an appreciation is appropriate because it reduces external demand and therefore helps achieve both external and internal balance. It is not dear, however, whether financial policies should be expansionary or contractionary. Expansionary policies help to reduce the external imbalance but exacerbate inflationary pressures, while contractionary policies help contain inflation but do not help on the external side. The policy response could be fine-tuned if the true model of the economy were known, which is not the case. Therefore the dilemma persists. In highlighting this issue I am not trying to elicit a definitive answer, only to emphasize that such "theoretical" questions are alive in Asia today.

THE ROLE OF MARKETS

The second important element of successful strategies for structural adjustment is the recognition that markets play an important role in adjustment and place constraints on government policies. The stimulus for reform has originated in several factors. As economies grow and become more complex, it becomes progressively more difficult to manage the economy through direct controls. For example, credit controls on a handful of banks are much simpler to enforce than credit controls on a system of numerous banks and other types of financial institutions. Also, institutions become more sophisticated, and the benefits of evasion from control generally increase, with economic development and the strictness of control. The increasing



complexity of the economy also makes it more difficult to assess the effects of controls on resource allocation, as well as the macroeconomic effects of controls, that are essentially microeconomic. Finally, governments have come to recognize that, in general, controls have adverse consequences on resource allocation and on the economy's ability to adapt to shocks. The two most important areas of economic activity that are undergoing a process of deregulation in Southeast Asia are the financial system, on one hand, and the industrial and trade system, on the other. Other sessions have dealt with financial reform,2 and I will briefly provide a few examples of reform of the industrial and trade system.

During the past four years, the Government of Indonesia has introduced a series of trade deregulation packages designed to bring about a progressive liberalization. These measures-which were formulated in consultation with the World Bank staff-have focused on phasing out nontariff barriers, reducing and simplifying import tariffs, providing inputs to exporters at international prices, and simplifying customs procedures. On the internal front, recognizing that excessive regulations had blunted competition and impaired economic efficiency, the Government initiated, in 1985, a reform program to liberalize and streamline investment licensing and to promote foreign investment. Accordingly, the number of required licenses was reduced, and capacity expansion regulations were eased, and most activities were opened for investment if at least 85 percent of production was destined for export. Additionally, to encourage foreign direct investment, the validity of investment licenses issued to foreign investors was extended, the level of minimum initial local ownership was reduced, and the transition period to majority ownership by domestic investors was lengthened.

In Malaysia, the need to strengthen private investment emerged as a key policy issue in the formulation of the Fifth Malaysia Plan ( 1986-90). The Plan emphasized both an improvement in the economic environment and a restructuring of public sectOr investment as a means of stimulating private investment. Toward this end, a number of measures have been taken over the last three years. The measures undertaken in 1985-86 included liberalization of licensing requirements under the Industrial Coordination Act; the relaxation of guidelines governing foreign equity participation; and increasing the availability of funds, including the establishment of the New

2 Useful review of financial reform issues in developing countries can be found in R. Barry Johnston and Odd Per Brekk, "Monetary Control Procedures and Financial Reform: Ap· preaches, Issues, and Recent Experiences in Developing Countries" (unpublished; Washing· ton: International Monetary Fund. June 1989).



Investment Fund to provide funding for priority projects. A new Promotion of Investment Act was introduced to replace the administratively cumbersome Investment Incentives Act of 1968; the new Act provides attractive tax incentives for the manufacturing and agricultural sectors. Several additional measures were instituted in 1987 to further expedite and simplify the procedures for investment licensing and tax exemptions.

Korea offers a very interesting example of shifts in industrial and trade strategies. In the 1970s, the Government of Korea shifted its trade strategy from the promotion of labor-intensive light industries toward the promotion of capital-intensive heavy and chemical industries. It was cuvi:sagcu that these industrics would substitute impon:s in the short term, but that they would eventually export a large share of their production. Government support, which was generous, included fiscal preferences, low-cost credit, and protection from competing imports. Thus, the program represented a reversal of the progress made in preceding years in financial reform and import liberalization.

The consequences of the program have been clear for some time. Many of the program's goals have been achieved: indeed, exports of the heavy and chemical industries have become very important, but the cost of the program was substantial. There is a large level of unused capacity in these industries. The sizable investment necessary to set up those industries was financed through a rapid expansion of bank credit, which led to an acceleration of inflation and to an eventual worsening of the financial position of the banks. The overvaluation of the won that accompanied the increase in inflation, together with the imposition of restrictions on imports that competed with the heavy and chemical industries, resulted in a substantial erosion of the external competitiveness of other exports. The consequences of the attempt to promote the heavy and chemical industries are widely blamed for exacerbating the severity of the 1980 economic crisis,3 and for retarding progress in financial reform.

During the 1980s, partly in reaction to the experience of the heavy and chemical industries, the Government adopted bold programs to liberalize imports and rationalize the tariff structure and caused a gradual shift in industrial policy away from industrial targeting. In December 1985, the Government formally acknowledged the shift by enacting the Industrial Development Law, which replaced existing promotional laws and provided new guidelines for industrial policy.

3 In 1980, real GNP in Korea declined by 5 percent. and inflation and the external current account deficit increased sharply. The proximate factors of the crisis were increases in world oil prices. a disastrous harvest. and domestic political disturbances.



The new law confined the role of industrial policy to coping with market failures, thus greatly reducing government intervention in industry. The Government would emphasize nonsectoral, functional intervention, such as the promotion of research and development and training of labor, instead of selective, industry-specific intervention, such as financial assistance to priority industries.

The common thread in these examples is that the countries in Southeast Asia are moving away from strict control of trade, production, and investment and toward a market-oriented approach. Even in the case of Korea, which is widely held to be one of great government intervention in industrial planning, the Government has recognized the risks and costs of such strategy. The state has probably played the smallest direct role in Hong Kong. To be sure, the Government has been involved in the economy in the usual spheresbuilding and maintaining infrastructure, maintaining law and order, providing primary education, and contributing to secondary and higher education. It is also a major builder of public housing, providing rented lodgings for nearly 40 percent of the population. However, the Government does not own or run the utilities, or large parts of the transportation system; makes no attempt to influence the labor market; and does not provide any concessions for capital investment, nor does it provide grants or loans to industry.

To summarize, the Southeast Asian countries are succeeding with a policy approach that involves financial restraint and a recognition of the importance of market forces in development and structural adjustment.


Comment

MUKUL A ASHER

The paper by Mr. Marquez-Ruarte is wide ranging and there is much in this paper with which there can be little disagreement. For example, it is difficult to imagine any disagreement with the author when he defines structural adjustment as consisting of " . . . the creation of conditions for sustained, noninflationary growth, and the elimination of impediments to the full and efficient use of resources. Furthermore, adjustment must permit the attainment of certain basic, and widely shared, social goals" (p. 156, emphasis added).

A case can also be made for including environmental objectives in the above definition. This is because of two reasons. First, policies, particularly those relating to adjustment should not unduly depreciate the primary resource of the earth-its environment. Second, structural adjustment programs, though of a short-term nature, can significantly influence economic strategies in the developing countries, and inappropriate policies have the potential to create great damage to the environment. This is a complex area, both technically and politically. No simple or quick solutions are in sight. But the point remains that if adjustment policies push countries to depreciate too rapidly such assets as rainforests, all countries-rich and poor alike-will be the losers.

The following comments, therefore, may be regarded as complementary to the discussion in the paper. They are designed to raise some of the issues that are only implicit in the paper and to elaborate on some of the general principles and policies emphasized in the paper.

Marquez-Ruarte associates successful policies for structural adjustment with two characteristics. The first is assigning top priority to financial stability. The second is recognition of the usefulness of the markets in designing economic policies. Before commenting on his discussion of these two characteristics, it may be useful to note that he appears to regard structural adjustment as a technical issue or at best appears to take what Toye has called a technocratic view of politics ( 1987, pp. 40-42). This view is based on " . . . an implied belief that the internal politics of developing countries can, and

166


Comment 167

should, be so arranged that development policies get a clear run" (Toye ( 1 987, p. 4 1 )). But as Toye notes " . . . yet, no one knows how to do it. That is the fundamental difficulty" ( 1987, p. 41 ).

If a technocratic view of politics is insufficient, so is the view that structural adjustment is just a technical problem. As Dornbusch has noted in the Latin American context:

Financial discipline and reasonably efficient markets are quite desirable, even indispensable, in the medium term. But that does not mean, of necessity, that the transition should take a form hostile to society and progress. We therefore have to look to ways of shaping a broad social consensus supportive of stabilization. But this means, of course, that incomes policy is the cornerstone of effective, socially acceptable conditionality. Effective stabilization is, above all, not a technical issue but a political one (Dornbusch ( 1983, p. 229), Dornbusch's italics).

The political nature of the problem noted by Dornbusch could be extended to the international level. I t may be argued that if developing countries had more influence and voice in designing structural adjustment policies, and if appropriate incentives were built in, then they would be more likely to follow the types of adjustment policies favored by the economists. That political consensus at the international level is lacking at present is indicated by the following quote:

What is particularly unacceptable to developing countries . . . is the inequity of a system where a few major contributing countries, which basically do not use the [International Monetary] Fund's resources and are thus unaffected by its policies, are the ones that seek to impose. by way of their control of the policy-making process, their view of economic organization and management. Similarly, these countries have confronted a system wherein, even granting the centrality of a few developed countries in exchange rate arrangements, decisions in this regard are exclusively taken by a narrow set of these countries-this, despite the clear effect of such decisions on the economies of the developing countries (Ferguson ( 1988, p. 230)).

The central point is that widespread adoption of structural adjustment policies advocated by Marquez-Ruarte and about which there can be little disagreement would require coming to grips with not only their technical but also their political aspects, both at national and international levels. Integration of these two aspects requires strong institutional support. Where this is lacking, institutional reform may also be needed.

Let us now turn to the two characteristics that Marquez-Ruarte associates with structural adjustment policies. As noted, the first concerns assigning top priority to financial stability. He examines several dimensions of this stability, including price stability and external viability. He shows that high rates of GNP· growth are


168 MUKUL A. ASHER

correlated with low rates of inflation. His explanation of the casual relationship between the two is, however, rather sketchy. Some elaboration is needed because in the table presented by him showing inflation and growth rates for the 1981-88 period, there are instances when marginal differences in inflation rates are associated with strikingly large differences in growth rates. Thus, inflation and growth rates for the 1 98 1-88 period for Asia are shown as being 8. 7 and 7.3 percent, respectively. The corresponding inflation rate for net creditor countries, however, is only marginally higher at 9.0 percent; their growth rate is only 0.7 percent. Incidentally, the manner in which inflation rates are computed for groups of countries is not clear from the paper. This is relevant because results may be sensitive to the way individual country inflation rates are aggregated.

The author regards the second element of financial stability as external viability. While he rightly stresses the vital necessity of using debt for productive purposes, he does not discuss the present overhang of debt and the impediments faced by developing countries in following sound structural adjustment because of it. That is, effective measures to help many developing countries tackle the burden associated with the present debt overhang may be necessary to enable them to follow needed structural adjustment policies.

He correctly stresses the commitment of the policymakers in Southeast Asian countries to restrained fiscal and monetary policies. This commitment has been maintained even when it required sharp reductions in government expenditure, particularly development expenditure. Thus, in Malaysia the ratio of total expenditure to GDP fell from 40.1 percent during the 1981-85 period to 30.7 percent in 1988, the corresponding ratios of development expenditure to GDP were 13.9 and 6.3 percent, respectively (Asher ( 1 989, Table 1 . 1)).

The need for making public enterprises financially viable as stressed by Marquez-Ruarte has also been recognized in Southeast Asian countries.

The second characteristic of structural adjustment policies stressed by the author is the recognition of the usefulness of the markets. I fully share his view that the market is a powerful mechanism to achieve economic objectives that no policymaker should ignore, and that strict control of trade, production, and investment is, as a general rule, likely to be counterproductive.

1 would, however, like to make three points. first, greater reliance on markets can only be placed by governments that retain capacity to act decisively when the occasion demands. 1 n other words, less reliance on the market could be a sign of a weak not a strong government. It could also be a reflection of a lack of development of


Comment 169

durable and resilient internal institutions and mechanisms. Second, while recognizing the role of the markets, it is also necessary to keep in mind Kermit Gordon's ( 1 975) comment in the Foreword to Okun's book that "the market needs a place and the market needs to be kept in its place" (p. viii). Moreover, in this region's literature, distinction between market and government is not drawn as sharply as in the North American literature. Even in the United States, there are calls for not drawing too sharp a distinction between the two. Thus, Etzioni has remarked: "The irony of the political, social, and psychological philosophies that celebrate the individual to the neglect of the community is that the individual they promote, and in a deep sense assume, is not to be found without a viable community" ( 1 983, p. 25).

The third point concerns the need to ensure that policies ostensibly designed along the lines advocated by Marquez-Ruarte in fact achieve the objectives envisaged. Let me give an example from the privatization program in Singapore. It can be argued that at the end of Singapore's privatization program, the public sector is likely to have a stronger and larger role rather than the smaller role implied by such a policy. This could come about in the following way. Public enterprises in Singapore are generally profitable, and the government has an overall budget surplus. Therefore, when divestment of some of these enterprises occurs without loss of control, then the resulting proceeds are available for further investment. I f this is done in the newer areas where Singapore could develop potential comparative advantage, then the public sector role could become greater not smaller. I n the case of Malaysia, Ng and Wagner have argued that " . . . if the present methods of privatization are not altered, fiscal problems may be further exacerbated" ( 1989, p. 222). This is also contrary to general expectations.

It would be very helpful if Marquez-Ruarte could share his views concerning lessons from the Southeast Asian experiences concerning sequences in which various reforms in trade, financial, tax, and other policies should be undertaken so as to enhance ability for structural adjustment. It would also be helpful to indicate whether he regards structural adjustment as a short- or medium-term process.

It is also relevant to note that designing specific policies that are consistent with the general principles advocated by Marquez-Ruarte is not an easy task. This task is sometimes made even more difficult by a lack of consensus among the professionals involved. Let me illustrate from the area of tax reform. After reviewing more than a dozen papers from very eminent experts involved in design and implementation issues concerning tax reform in many parts of the


170 MUKUL A. ASHER

world, Bates remarks that " . . . for each professional economist who confidently takes a stand on one side of a knotty issue, we note . . . the existence of another who asserts the opposite" ( 1989, p. 4 74). While the extent of disagreement among economists should not be exaggerated, the above observation by Bates does suggest that reform measures need to be situation-specific and that no standardized reform rules and procedures are likely to be adequate.

In conclusion, while the relevance of general principles for structural adjustment in this region advocated by Marquez-Ruarte is not in doubt, the key issues concern how to manage national and international politics of structural adjustment in such a way as to provide both incentives (and disincentives) as well the ability to follow these principles by the developing countries and the detailed designing and implementation of policies consistent with these principles.

BIBLIOGRAPHY

Asher, Mukul G., "A Comparative Overview of ASEAN Fiscal Systems and Practices," Fiscal Systems and Practices in ASEAN: Trends, impact and Evaluation, ed. by Mukul Asher (Singapore: Institute of Southeast Asian Studies, 1989), pp. 1-18.

Bates, Robert, "A Political Scientist Looks at Tax Reform," in Tax Reforrn in Developing Countries, ed. by Malcolm Gillis (Durham: Duke University Press, 1989), pp. 473-91 .

Etzioni, Amitai, A n Immodest Agenda: Rebuilding America Before the Twenty-First Century (New York: McGraw-Hill, 1983).

Ferguson, T., The Third World and Decision Making in the lnUrnational Monetary Fund (London: Pinter Publishers, 1988).

Gordon, Kermit "Foreword" to Arthur M. Okun, Equality and Efficiency: The Big Tradeoff (Washington: The Brookings Institution, 1975), pp. vii-x.

Ng, C.Y., and N. Wagner, "Privatization and Deregulation: An Overview," ASEAN Economic Bulletin (March 1989), pp. 209-23.

Toye, John, Dilemmas of Development (Oxford: Basil Blackwell, 1987).


9

Successful Strategies for Structural Adjustment

GOSAH ARYN

Arter decades of development efforts, countries once called backward or undeveloped find themselves not too beuer off than before. Setting out with strong determination to eradicate poverty and bring about income equality, and after drying up foreign financial assistance, they have only been able to marginally narrow the gap between themselves and the economically advanced countries. Today, they are still classified euphemistically as developing countries. Only a few have been promoted to the rank of "upper middle-income" group by the World Bank. Included in this group are the Asian newly industrializing economies comprising Korea, Taiwan Province of China, Hong Kong, Singapore, and Malaysia-to name only those in east Asia.

In attempts to advance their development prospects, countries have pursued various policy reforms. While the timing may be different, most adopted the inward-looking strategy of import substitution in their early phase of development, taking advantage of the existing domestic demand for consumer products in the drive toward industrialization. After finding out that import substitutability had been exhausted and that their trade and payments positions had not improved, they gradually turned to a more outward-looking approach.

With a more open economy resulting from the outward-looking strategy, development prospects would depend very much on world developments. In particular, the last fifteen years have generally been a difficult period for developing countries with an open position, as the world economy has been both erratic in its growth and quite volatile in its financial market.

· The author acknowledges the assistance ol Chotechuang Teerakajornchote in data gathering and Chanpen Lawsiripaiboon for secretarial help.

171


172 GOSAH ARYA

Looking at statistics reported in Table 1 , the world output growth, which averaged almost 5 percent a year in the 1960s, slowed to an annual average of 3. 7 percent in the 1970s, and declined to about 2.5 percent a year for the period 1980-87. Within the decade of the 1970s, annual growth was not at all smooth. It was the first time in recent history that industrial countries experienced a negative growth rate, sending the world economy into a deep recession. The 1980s also started off with a prolonged recession, lasting over a couple of years. World trade, which reached a peak in terms of growth in 1974, stagnated during most of the early 1980s; while the two oil shocks in 1973-74 and 1979-80 added percentage points to the world inflation, the dwindling oil market of the mid-l980s led also to difficulties for oil exporting nations. Recorded high rates of interest in the early 1980s not only prolonged the world recession that followed the second oil shock but also added to the debt-servicing burden of debtor countries. Meanwhile, industrial countries, also affected by world developments, not only became more protective of their industrieswhich had an effect of reducing world trade-but also reduced their official financial outflows upon which developing countries depend for financial assistance.

This unfavorable international environment has made economic adjustment a strenuous task. To raise the level of income and to spread the fruit of development to the majority already require a great deal of struggling and the right combination of policies, but to have to cope and contend also with the adverse world economic condition, an extra effort is inevitable and policies need to be constantly mended. Appropriate policies for development become ever more crucial than before if countries are to overcome problems without much disruption to their long-run growth path.

In this paper, the patterns of development and domestic adjustment of selected developing countries in east Asia in the midst of changing world economic conditions are discussed. The purpose is to examine the conditions underlying the success of these countries in implementing their adjustment strategies. The economies chosen for the study include the four newly industrializing economies of Hong Kong, Taiwan Province of China, Korea, and Singapore, and the ASEAN-4, namely, Indonesia, Malaysia, the Philippines, and Thailand.

PERFORMANCE

Despite international economic turmoil in the 1970s, Hong Kong, Taiwan Province of China, Korea, and Singapore, which had much earlier endorsed an export-led growth strategy, had maintained a

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174 GOSAH ARYA

fairly high rate of growth, registering about 8 to I 0 percent a year on average. Only with the prolonged world recession in the early 1980s did their growth rate slow down to 6 to 8 percent between 1980 and 1987. Even with this low rate, their economic performance surpassed that of all nations combined by a wide margin. Although the ASEAN-4 were slow in adopting the outward orientation, they were able to maintain a relative high rate of growth throughout the 1970s compared with the rest of the world. The good performance was extended into the early 1980s, despite the world economic downturn, with a growth rate ranging from over 3 percent a year for the Philippines to almost 7 percent a year for Malaysia. I n the face of the slackening oil market of the mid-1980s, oil exporting ASEAN countries could not keep up with the good performance and grew at a rate below the world average. The Philippines, passing through political turmoil, had a negative rate of growth for the period 1984-87 (Table 2). Only Thailand survived the international economic disturbances of the 1980s and enjoyed high growth.

While all countries under consideration have adopted industrialization as a strategy to develop their economy, the rate of industrialization of the newly industrializing economies has been quite remarkable. With the exception of Singapore and Hong Kong whose economies are largely nonagricultural, the share of manufacturing to total output rose sharply in the past three decades at the expense of agriculture. The proportion of manufacturing to gross domestic product (GDP) stood at 43.7 percent for Taiwan Province of China in 1987, and 35.1 percent for Korea in 1985, rising from the 1970-79 average of 36.2 and 24.6 percent, respectively (Table 3). The substantial increase in the manufacturing share of output was made possible by the high rate of growth of manufacturing output that outpaced the rate of increase in GDP. The Korean manufacturing sector grew at a remarkable rate of almost 18 percent a year during the period 1970-79, and almost 10 percent a year for the period 1980-87. Taiwan Province of China also had its manufacturing sector growing at a fairly high rate, registering over 1 3 percent a year in the 1970s and almost 9 percent a year in the 1980s. On the other hand, the importance of agriculture as measured by its share of GDP fell by about 50 percent in the past two decades. This is attributable to very low growth in their agricultural sector.

Among the ASEAN-4, Indonesia attained the highest rate of industrialization, judging from the increase in the share of manufacturing in output over time. Starting with a small manufacturing base, Indonesia increased the importance of the manufacturing sector from a little over 9 percent of GDP in the 1970s to 16.4 percent in 1984-

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Successful Strategies for Structural Adjustment 177

86. For others, the growth rate of the manufacturing sector outweighed that of GDP by only a small amount, thus the proportion of manufacturing output to GDP had not remarkably increased, compared with that of the newly. industrializing economies. Malaysia, with the broadest industrial base among the ASEAN-4, appears to have slowed its pursuit of industrialization. The share of manufacturing output in total output stagnated in the I 980s to about 25 percent, as the growth of its manufacturing sector outpaced that of GDP only marginally. Despite a deceleration in the growth of the manufacturing sector in the I 980s, Thailand shows a trend of renewed industrialization in recent years.

The increase in manufacturing share of output in the ASEAN-4 had been at the expense of the agricultural sector whose share had a clear, declining trend. But in spite of that, the agricultural sector still remains important in the economies of the ASEAN-4-about equally important as the manufacturing sector when measured by share in total output. In Thailand, the share of agricultural sector in GDP was just outweighed by that of the manufacturing sector since the beginning of the 1980s, while in Malaysia this took place in the middle of the 1980s. For others, the agricultural sector is just behind but approaching the manufacturing sector in share of total output.

In the countries under consideration, sectoral share other than that of agriculture and manfacturing shows a striking increase only in Singapore and Thailand. This comes at the expense of their agricultural sector and is due to the growth rate of this "service" sector, which is high relative to GDP growth rate.

As the structure of production had undergone a rapid transformation, employment also registered a change associated with the change in structure. The percentage share of agricultural employment in total employment exhibits a fall, while nonagricultural sectors experienced an increase in the share (Table 4). Not only did the newly industrializing economies have a lower percentage of agricultural employment than the ASEAN-4, but their employment structure also changed in favor of nonagricultural activities at a faster rate. By the end of 1987, Korea, the most agricultural country among the newly industrializing economies had only less than a fourth of its labor force engaged in agricultural activities. As for the ASEAN-4, Malaysia has about one third of its employment in agricultural activities, the lowest percentage of agricultural employment in the region; Malaysia also experienced the fastest change in employment structure. On the other hand, about two thirds of Thai employment activities are still engaged in agriculture.

The growth of exports of newly industrializing economies and the

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ASEAN-4 has been very fast and greater than the world total. Korea and Indonesia had an average rate of growth of almost 50 percent a year in the 1970s (Table 5). In the face of prolonged world recession in the 1980s, Korea and Hong Kong still maintained a high export growth, over 20 percent on average during 1980-87. Others performed twice better than the world average of about 5 percent in the 1980s. It should be noted that, other than for Indonesia in the mid-1980s, the growth of exports substantially outpaced that of GDP, leading to an increase in export share in GDP. Owing mainly to the softening of the oil market, Indonesian and, to a lesser extent, Malaysian exports were affected in the late 1980s.

The high rate of growth of total exports was made possible by a rapid growth of manufacturing goods, especially so-called machinery and transport equipment for the newly industrializing economies and Malaysia in the recent period. In fact, an examination of export composition reveals that exports of the newly industrializing economies had increasingly comprised machinery and transport equipment (Table 6). Over one third of the merchandise exports of Korea and Singapore was in this category in 1 984-87; the figure was only 1 5 percent for Korea and 21 percent for Singapore in the 1970s. Malaysia also enjoyed a rapid increase in machinery and transport equipment, whose export share rose to 22 percent in 1984-87, rising from 5 percent in the 1970s.

Primary exports consisted of over half of non-oil exports in the 1980s for Malaysia and indonesia, discounting oil trade. For Indonesia, the figure for primary commodity exports was 55.6 percent of all non-oil exports in 1984-87, down from 88 percent in the 1970s. While the importance of primary exports for Thailand is declining, it still constitutes a significant source of foreign exchange earnings for the country, accounting for over half of all merchandise trade.

In sum, despite the unfavorable international setting, developing economies in east Asia have a remarkable performance in terms of growth and transformation. Variations in the development performance among economies under consideration seem to depend on the extent to which exports are relied upon as an engine of growth, among other things. A positive association exists between export growth and the aggregate income growth among economies involved. ' Moreover, there is a high positive correlation between rate of structural transformation and export growth. 2 High rate of growth is also

' The simple correlation between average export and income growth is 0.92. 2 The rate of structural transformation is taken to be the ratio of percentage change in the

share of nonagricultural value added in GOP and the growth of GOP. The correlation of the average rate of transformation over the period 1971-87 and the average rate of growth of export over the same period among the economies under analysis is

· 0.7025.

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182 GOSAH ARYA

associated with a switch of agricultural labor force to industrial activities. A high and steady rate of growth could be better maintained if the industrialization process were accompanied by sturdy growth in the service and agricultural sectors. While the world environment was not conducive to trade, economies that diversified their exports to cover wide ranges of products were able to withstand the external impact better than others. Thus, it is the domestic economic structure and international developments that determine to a large extent how an economy performs.

EFFECTS OF EXTERNAL DISTURBANCES

Underlying the economic performance of the countries under analysis is a whole slew of developments, both positive and negative, and both domestic and international. The domestic factors influencing the performance include policy measures adopted by the authorities in an effort to develop the economy and in response to external disturbances. This will be dealt with in the next section. In this section, attempts will be made to decompose and quantify various external factors that have an effect on the economic performance of countries.

To proximate the extent of a changing world economic environment, the "shock and response" model utilized by the World Bank3 in a series of studies will be adopted here. Although the model is fairly simple and straightforward, and not without weaknesses, it can conveniently describe the impact of changing world economic conditions on a country's economy as reflected in the developments of its current account, and at the same time, it aptly provides an overview of how the country responds to the disturbances.

The model attempts to decompose the external shocks or the overall impact of changing world economic conditions on the domestic economy into three components: the terms of trade effect, export volume effect, and interest rate effect. Tables 7 and 8 provide the calculation results for the economies under consideration for the period between I973 and I987.

For oil exporting countries, external shocks were favorable. The effects of shocks on Indonesia amounted to 8 percent of its GDP on average during the period I973-86. The effect accounted for 3 percent of GDP for Malaysia during the same period. In 1986, when the international oil market collapsed, the beneficial effect of world conditions on oil exporting countries was reduced somewhat. For oil

3 Balassa (1980 and 1981) see also Balassa and others (1981 ).


Hong Kong

Successful Strategies for Structural Adjustment

Table 7. Total Shocks as Percentage of GOP

1973-79 1980-83

-8.9 -5.8

Taiwan Province of China 0.9 -0.4

Korea -0.0 -4.4

Singapore -24.9 - 31 . 1 Indonesia 8.9 8.2

Malaysia 3.6 0.5

Philippines -3.4 -5.8

Thailand -2.6 -7.5

1 Average for 1984-86.

183

1984-87

- 1 .3'

6 1

2.0

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7.21 4.8'

- 1 .6

-5.4

importing countries and regions, Korea and Taiwan Province of China apparently suffered from the two oil price increases but the favorable effects from the increase in both prices and quantity of their exports quickly outweighed the effect from the oil price rises. While the external shocks average out positively for Taiwan Province of China during the period 1973-87, they were unfavorable for Korea, amounting to about 2 percent of GDP.

Singapore, whose economy is fairly open, was the most affected by the external disturbances, with a magnitude amounting to over one fourth of GDP. For Hong Kong, the Philippines, and Thailand, the average adverse effects of external disturbances ranged between 4 percent and 6 percent of GDP. Regardless whether the countries are oil importing, the external shocks seem to be more intensive in the 1980s than in the earlier period.

The chief cause of external shocks appears to come from changes in the terms of trade and, in more recent years, the increase in the rate of interest. The oil price increases, and the world inflation that followed, affected the terms of trade of the countries and regions under consideration. While the effect was favorable to oil exporting countries, it outweighed the increase in export prices of others for the period up to 1983, resulting in adverse developments in the terms of trade. In recent years, when world inflation subsided and oil prices declined, the terms of trade effect turned out to be favorable for the newly industrializing economies, except Singapore.

With the exception of the Philippines, the high and increasing rate of interest, especially in the 1980s, negatively affected all countries and regions under consideration. The interest effect ranges from 2 percent of total shocks for Singapore to over 100 percent of total shocks for Korea for the 15-year period ended in 1987.


184 GOSAH ARYA

Table 8. Balance of Payments Effects of External Shocks

(In percentage of total shocks)

Terms of Trade Export Volume Interest Rate Effect Effect Effect

Hong Kong 1973-79 -27.3 -70.8 - 1 .9

1980-83 -78.6 - 1 5.6 -5.7

1984-86 45.5 - 1 35.8 -9.6

Taiwan Province of China 1973-79 - 146 3 261.3 - 1 5 0

1980-83 - 1 1 16.9 1342.5 -325.5

1984-87 1 1 2.3 -5.9 -6.3

Korea 1973-79 -23804 2514.7 -2344 1980-83 - 1 1 9 1 57.9 -38.8 1984-87 62.6 89.9 - 52.5

Singapore 1973-79 -526 -46.9 -0.5 1980-83 -77.0 - 21 .5 - 1 .5 1 984-87 -59.7 - 34.2 -6.1

Indonesia 1973-79 1008 8 3 -9.0 1980-83 1 1 4.0 3.2 - 1 7. 1

1984-86 1 1 7.8 9.8 - 27 .6

Malaysia 1973-79 1 57.9 -49.4 -8.5 1980-83 466 6 -244.7 - 121.9

1984-86 1 1 8 2 17.2 -354

Philippines 1973-79 - 1 23.2 1 6.0 7.2 1980-83 - 1 235 10.1 1 3 5 1984-87 - 1 76.5 3 6 730

Thailand 1973-79 - 1 37.3 45.8 -8.5

1980-83 - 1 05.6 16.4 - 1 0.8

1984-87 - 1 04.7 18.0 - 1 3.3

Note: Negative sign indicates unfavorable effect. Figures may nol add up owing to rounding.



Hong Kong, Singapore, and Malaysia in the early period under analysis suffered from sluggish demand for their exports. On the other hand, Taiwan Province of China and Korea had been able to enjoy increasing world demand for their products to the extent that the negative terms of trade effect was either outweighed or mostly offset. Indonesia, the Philippines, Thailand, and Malaysia in recent years also gained substantially from increasing world demand for their exports. Thus, contrary to the widely held view that the prolonged recession in the developed countries and the increased adoption of a protectionist stance had been responsible for the recent payments difficulties of developing countries, the figures provided in Table 8 indicate that the negative effect was not experienced by all countries in their balance of payments developments but was felt most by those with large entrep6t trade.

POLICY RESPONSES

Depending on the seriousness of the problem and the constraint imposed on the economy by its structure and the like, a combination of policies was adopted to counteract unfavorable developments.

In the model, five possible responses to disturbances are identified, namely, expending greater effort to increase export share, import substitution, import savings, debt adjustment, and finally, additional external financing to withstand the disturbances. Table 9 summarizes the extent to which these various strategies were utilized in response to external shocks.

It appears that, in general, greater weight was given to external financing in response to the shocks. This may be because the real adjustment fell short of the need to adjust or the shocks were perceived to be temporary. On the other hand, adjustment in external indebtedness was not a measure generally adopted in the face of rising world interest rates. This may be because the effect of high and fluctuating interest rates was small compared with other external shocks or because a good proportion of external debt was concessionary with fixed rates of interest and long grace periods. Dependence on external financing and failure to adjust external indebtedness would lead to accumulation of foreign debt.

In real adjustment, the authorities resorted to either a reduction of domestic demand that lead to import savings or import substitution rather than an increase export share. Singapore, Thailand, and Taiwan Province of China when faced with unfavorable external shocks relied mainly on belt-tightening by moderating the growth rate to reduce demand for imports. Although enjoying favorable

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188 GOSAH ARYA

external developments, Malaysia opted also for a moderation in its growth process. The adjustment in income in response to shocks, or the lack of it, was basically the result of a combined exercise of fiscal and monetary policies. Detailed discussion on macroeconomic management is given in the next section.

Import substitution strategy was adopted on occasion by all countries and regions under examination but to a lesser extent than import savings strategy. While policy measures associated with the strategy will be discussed in more detail in the next section, it should be noted here in passing that import substitution can take place through the market mechanism without policy interference. This is because as import costs in terms of foreign currency rise as a result of inflation abroad, domestic production becomes feasible and may be expanded, with demand deviating toward local products.

Increase in export share was also adopted on occasion but to a lower order of importance; Korea was the exception; export penetration was the only real adjustment taken when faced with negative external disturbances. Hong Kong also adopted this strategy together with import savings in the early 1980s.

ALTERNATIVE STRATEG IES FOR ADJUSTMENT

Developing countries usually start their industrialization by introducing an import substitution policy. The policy operates normally through a structure of protection and other tax incentive systems. This has an effect of generating a gap between domestic and foreign costs, enabling the local industry to enter into or to sustain the operation. The cost-price difference can also result from a depreciation of a currency, which increases the import cost in terms of domestic currency unit. Import substitution can also take place through the market mechanism without policy interference. As import cost in terms of foreign currency rises as a result of inflation abroad, domestic production becomes feasible and can expand, while demand deviates toward local products.

Theoretically, when goods, which were previously imported, are domestically produced, there should be import savings amounting to factor costs used in production. These savings would contribute to an improvement in the balance of payments. However, in actual practice, import substitution policy almost always leads to a deterioration in the balance of payments of the country adopting the policy. This is because in the early stage of import substitution, there could be a sharp increase in imports of plants and equipment leading to a current account deficit. The problem may not be serious insofar as



the deficit is financed by a surplus in the capital account. The only time that a payments deficit could become a problem is when import substitution entails an investment beyond the capacity of the country to raise foreign capital or when the imported plants and equipment do not function smoothly as expected.

Under import substitution, the balance of payments could also deteriorate owing to a rapid increase in domestic demand, which leads to an increase in imports over and above the savings of the import substitutes. As industrialization through import substitution involves typically assembling imported components and raw materials, the value added in the production process is small. On the other hand, the industrialization process has an effect of raising domestic consumption to a level higher than before. Thus, it is likely that the import savings from the substituted products could be little compared with the increase in overall imports resulting from an increase in mcome.

The newly industrializing economies and the ASEAN-4 have all engaged in import substitution to industrialize, but the extent of engagement and the kind of industry has varied in each. Table I 0 shows the average duties imposed on imports of ASEAN countries. Although the degree of protection can be better described by other statistics, such as effective rate of protection, the simple average tariff rate can also reAect the degree of protectionism to a certain extent. Indonesia had the highest tariff rate in the region, averaging almost 33 percent in 1980. Being an open economy pursuing a free trade policy, Singapore levied only a minimal average rate of 6 percent on its imports. In comparison, Malaysia had low import duties on average; its tariff rate for consumer goods was second highest in the region.

Table 10. Simple Average of Import Duties in ASEAN

(In percent)

Indonesia Malaysia Philippines Singapore Thailand

1980 1982 1982 1983 1983

Primary goods 14.9 3.5 23.6 0 1 19.8 Intermediate goods 24.9 17.0 26.6 8.6 27.0 Capital goods 20.0 6.5 22.0 0.3 23.7 Consumer goods 65.6 63.8 42.2 9.5 49.4 Transport equipment 27.4 19.3 20.9 2.0 22.4 Other 17.2 10.6 27.7 0.0 13 1

Total 32.6 25.0 29.2 6 4 30.7

Source: Philippines Tariff Commission. Tariff Profiles in ASEAN: An Update.


190 GOSAH ARYA

From the structure of import tariffs, the rate applied to consumer products appeared to be the highest for all countries. These high tariff rates reflect the degrees of protection enjoyed by industries producing consumer products. As import substitutability of consumer goods is exhausted, countries have moved to the next stage of import substitution by getting into production of goods other than consumer goods. This is especially true for the Philippines and, tO a certain extent, Thailand and Indonesia. The tariff structure indicates that industries other than light manufacturing also receive a fairly high degree of protection.

As noted earlier, increasing dependence on an industrialization strategy that uses import-accompanied import substitution has resulted in deficits in the current account balance of oil importing countries. To the extent that the deficits can be financed by capital inflows, the pressure on the balance of payments is released; however, this may not be the case. As the ability to borrow abroad depends on the estimates of the debt-servicing capacity of the country, authorities tend to control foreign exchange and limit imports. This was true for the Philippines and Thailand in the early 1980s. The measure caused further distortion in their economies, leading to a shaky investment climate.

Recognizing that substitution possibilities have been exhausted, policymakers have adopted more of an outward-looking export promotion strategy. However, the main issue in promoting export industries is to identify those industries in which the country has or could develop comparative advantages vis-a-vis the rest of the world. In most developing countries with well-endowed natural and human resources, it goes without saying that the comparative advantages should lie in industries utilizing those resources to the utmost; however, to find out which industries have the greatest comparative advantages as export industries, one has to convert all prices into international prices and compare per-worker income industry by industry.

As comparative advantages are determined by international prices, any policy measures that create domestic price distortion have an effect on the comparative position of the country in the world market. Such policy measures are commonly found in most developing countries. I f these policy distortions could be removed or corrected, then it is conceivable that the list of potential export industries would be enlarged.

Normally, policy measures adversely distorting comparative cost advantages include trade restrictions, overvalued exchange rates, and factor prices that have been set artificially above the market prices.



In general, these policy instruments exist in support of an importsubstitution policy, as in the case of trade restriction and overvalued exchange rate, or for political reasons, as in the case of a high wage rate. To effectively pursue an outward-looking export orientation strategy, it is necessary to dismantle or at least to offset these measures, as they are biased against exports.

By reducing the demand for imports, trade restrictions through tariffs and quotas would raise domestic prices of import-competing products relative to nontradables and exportables, thus, encouraging a switch away from production for exports and home goods. Thus, the reduction or removal of tariff and quantitative restrictions imposed on foreign trade would provide incentive for the production of export goods.

On the exchange rate, overvaluation of domestic currency weakens the competitiveness of domestic products in the world market and encourages imports. Through its effect on user cost, overvaluation paves ways to an increase in investment with high import content, which is not likely to be commensurate with the country's factor endowment. Moreover, overvaluation would lead to aggregate dissaving as it induces purchases of imported consumer goods. It also weakens the confidence of domestic currency holders, leading to capital flight in one form or the other. Thus, an adjustment in the exchange rate to better reflect its appropriate value would not only encourage exports but would also set an economic environment in its proper perspective.

The World Bank reported the extent of various price distortions existing in selected countries in the decade of the 1970s (Table 1 1). Although exchange rates were generally free from distortion, developments in the 1980s indicate that several countries were not able to adjust their exchange rate in line with their trading partners in a timely manner. For instance, by mid-1983 it was long recognized that the Thai baht had been out of line, but it took until the end of 1984 for the Thai authorities to realign the currency. Their experience in devaluating the baht two years earlier involved a change of the government. Meanwhile, stop-gap measures, such as credit control, were employed against deterioration in the current accounts. As a result, many businesses were denied formal sources of funds and the investment climate deteriorated sharply.4

In pursuing export-oriented strategies, a macroeconomic environment conducive to industrialization and growth is a requisite. This is because trade liberalization and promotional measures cannot be

• Uathavikul and others (1987), pp. 41-56.


192 GOSAH ARYA

Table 1 1 . Price Distortions

Exchange Factor Pricing Product Pricing Rate Capital Labor (Inflation)

Korea L M L M Indonesia M M L M Malaysia L M M L Philippines L M L L Thailand L L L L

Source: World Bank, World Development Report 1983 (New York: Oxford University Press, 1983).

Note: L = Low distortion: M = Medium distortion.

effective in encouraging exports and raising growth if macroeconomic policies are inconsistent and destabilizing. Once the economic environment is conducive to investment and growth and liberalization has taken place, promotional measures in favor of export industries could then be effectively implemented.

It should be mentioned that there has been some skepticism with regard to the appropriateness of outward-looking, export-oriented strategies in an unstable world environment. The prolonged world recession in the early 1980s and the weak recovery through the midl980s seem to support the skepticism. On the other hand, uncertainty with regard to world developments, as many more developed economies are facing domestic economic difficulties, coupled with increasing protectionism on the part of more developed economies in recent years, would make the export-led strategy unreliable for developing countries.

It cannot be denied that export-led strategy depends, as the name implies, on world developments. The performance of countries adopting this strategy during world economic turmoil shows that they fared better in terms of growth and stability than those who did not. Performance varied among the countries themselves, but this is attributable to the extent of structural rigidities existing in the economy and the ability of the economy to take advantage of positive developments during the world recession, for example, low world inflation, abundant supplies of raw materials, and declining interest rates.

The success of an adjustment program depends on how well supply responds to the incentive given by the program. Thus, macroeconomic variables, such as interest rate, wage rate, and exchange rate are important in this respect.

In the economies under analysis, domestic capital markets are commonly segmented, as accessibility to credit by, and cost of credit



to, borrowers varies. Large firms and investors with established credit ratings are normally able to secure funds from formal financial institutions. Small-scale investors depend largely on informal sources of funds for needed capital. Higher risk and administrative cost per Joan are often cited as reasons for market segmentation.

Capital costs in formal and informal markets also vary. In the formal banking system, there exist interest rate ceilings and credit controls designed to keep the cost of borrowing low as a stimulus to investment. On the other hand, in the informal financial sector the cost of funds reflects market forces.

Capital market segmentation tends to result in large firms making investment decisions toward capital-intensive products and a production structure of the economy with a rise in capital/labor ratio as firm size increases. While this may not be appropriate for countries that depend on imported capital goods and are short of foreign exchange, the policies that lead to a rise in capital cost for large firms or a subsidy to small firms may also have drawbacks.

It is true that raising the official interest rate or the cost of capital may induce more efficient use of scarce capital resources and at the same time encourage a shift toward labor, but it is not clear whether such benefit would outweigh the loss that would be incurred from a poor investment climate and restrictive policy resulting from the rise in the interest rate itself. On the other hand, subsidization or direct allocation of capital to small firms or investors may not lead to an increase in output, as the capacity to efficiently utilize capital of small firms may be limited. The end result may be a sheer increase in capital/output ratio with no significant increment in output.

The appropriate policies here would be to facilitate and strengthen linkages between formal and informal money markets. Suggestions in this regard include a penetration of banking services in the area where such services do not exist, a credit guarantee scheme to insure loans t·' �mall and risky borrowers, greater acceptance of credit instrumc,�ts of the informal sector, and promotion of various discount houses and leasing activities. Once strengthened, these linkages would also act as effective transmission mechanisms of financial and monetary policies.

Resembling capital market segmentation, the existence of wage differentials between formal and informal sectors tends to reinforce factor market distortion and leads to a rise in the capital/labor ratio as firm size increases. Evidence indicates that labor market intervention through minimum wage requirement and mandated fringe benefit affects by and large the formal and large-scale enterprises, while small and informal enterprises escape through lax enforcement.


194 GOSAH ARYA

Thus, the wages of large industries are consistently above those of small enterprises whose wages are more likely to respond to market forces and closely approximate the opportunity cost of labor. The distortion would lead to lower large-firm employment than would be the case in a neutral policy environment.

In a study of employment growth in seven countries adopting export-led strategy,5 it was found that Barbados, Jamaica, and Trinidad and Tobago had little employment growth induced by the growth of their export. On the other hand, the newly industrializing economies, which had maintained a tight wage policy, had substantial export-led employment growth, and hence, had been able to utilize the "unlimited" supply of labor in the growth process.

As countries adopt industrialization as a means to promote growth and development, the importance of their agricultural sector tends to be overlooked. The treatment applied to agriculture in many developing countries is a paradox: while advanced countries subsidize and protect their agricultural sector, other developing countries not only tax the sector but also subject it to low prices. Where agriculture accounts for a large share of the overall production, there is a positive relationship between economic growth and agricultural growth. Thus, it is unlikely that sustained economic growth can be achieved without expansion in the agricultural sector.

Development based on agriculture could benefit not only from growth in itself but also from increased employment that agriculture would generate and from the income redistribution that would result. Moreover, the agricultural sector could provide input to the manufacturing sector while demanding in return input for its own production. Of equal importance, the sector as a whole constitutes a household demand for industrial consumer goods and services, upon which the manufacturing sector could flourish. Also, in view of a much lower import content of agricultural production compared with manufacturing production, scarce foreign exchange can be conserved with development based on agriculture. And as noted, agricultural growth with its intersectoral linkage with the rest of the economy could generate broad-based and self-sustained economic development.

While it is true that agricultural exports are subjected to developed country protectionism, manufacturing exports, as seen earlier, are also dependent on the international business cycle. In view of the adverse external environment experienced in recent years, foreign trade in manufacturing goods alone cannot be reliably counted on as an engine of growth. Thus, diversified exports that include

$ Fields (1984). pp. 7�83.



agricultural goods could ensure better export performance and sustained growth in trade.

CONCLUDING REMARKS

Country experiences have indicated that successful structural transformation has been associated with the adoption of export-oriented industrialization. It is, however, dangerous to generalize that an outward-looking strategy is the one that should be adopted by developing countries. This is because the world economy may not be able to support the increased volume of trade. The entry to the world market may not be as easy as experienced by such countries as the newly industrializing economies. Not only is total demand likely to grow slowly, but stiff competition among countries will make market penetration more difficult than before. Moreover, new protectionism through nontariff barriers in more developed countries has been increasing. This will make it increasingly difficult for countries to enter markets in developed countries.

Although export can still be regarded as an engine of growth, it may not be applicable to all at the same time. Thus, growth may partly have to be internally driven; the importance of internally generated growth should not be overlooked. As noted, in countries where agriculture has an overwhelming weight in the economy, growth may be sought by developing agricultural activities and agrobased industrialization. While export-oriented strategy involves a selection of potential industries and a specific set of industrial policy measures to help make winners out of those industries, the reliance on internally generated growth requires a broader industrial policy. This is what may be called the policy for general industrialization as against an export-oriented industrialization policy.

It should be noted that the export-oriented strategy, like the import substitution strategy, involves a high degree of government intervention, starting from the selection of industries, providing support, and guiding and directing their development. This is a big task for the government. The success of the stragety depends partly on how well the government can manage the complexity of industrial development. In the face of increasing competition in the world market and the need for broader industrialization, greater participation of private activities may be required. This calls for a market-oriented approach and greater reliance on private initiatives.

A successful adoption of an outward-looking strategy is associated with dismantling trade barriers, reducing price distortions, and stabilizing the macroeconomic environment. Thus, the role of the


196 GOSAH ARYA

government in promoting growth and facilitating transformation should concentrate on setting up the stage as required in the adoption of export-oriented strategy and on maintaining sound and flexible macroeconomic policies.

SELECTED BIBLIOGRAPHY

Ahn, Choong-Yong, "Economic Development of South Korea, 1945-1985: Strategies and Performance," paper presented at TDRI-KDI Joint Economic Seminar on Structural Adjustment and Trade Policy (Bangkok, 1987).

Balassa, Bela, "The New Industrializing Developing Countries After the Oil Crisis," World Bank Staff Working Paper, No. 437 (Washington: World Bank, October 1980).

---, "The Policy Experience of Twelve Less Developed Countries, 1973-1978," World Bank Staff Working Paper, No. 449 (WashingtOn: World Bank, August 1981).

---, and others, The Balance of PaymenL� t.Jfec� of Extenud Shocks a.nd of Policy Responses to these Shocks in Non-OPEC Develaping Countrits (Paris: OECD, Development Center Studies, 1981).

Chandavarkar, A.G., 'The Informal Financial Sector in Developing Countries: Analysis, Evidence and Policy Implication" in Report on the SemiMr on Unorganized Money Market in the SEACEN Countries (Malaysia, 1986).

Dervis, Kemal, and P.A. Petri, "The Macroeconomics of Successful Development: What are the Lessons?" Macroecanomics Annu.al (National Bureau of Economic Research, I 987).

Fields, G.S., "Employment, Income Distribution and Economic Growth in Seven Small Open Economies," Econamic journal (Oxford, England), Vol. 94 (March I984), pp. 74-83.

James, W.E., S. Naya, and G.M. Meier, Asian Development: Economic Success and Policy Lessons (Madison, Wisconsin: University of Wisconsin Press, 1987).

Kaplinsky, Raphael, ed., ThiTd World Industrialization in the 1980s (Frank Cass, 1984).

Lee,Jungsoo, "Domestic Adjustment to External Shocks in Developing Asia," Asian Development Bank, Economic Staff Paper, No. 39 (October 1987).

Uathavikul, Phaichitr, D. Patmasiriwat, and C. Kamheangpatiyooth, "Economic Policy Management in Thailand: Response to Changes in the World Economy 1973-87" a paper presented at the 1987 TDRI Year-End Conference (Thailand Development Research Institute, I 987).

Whang, ln-Joung, "Korea's Economic Management for Structural A�justment in the 1980s," paper presented at TDRI-KDI Joint Economic Seminar on Structural Adjustment and Trade Policy (Bangkok, 1987).

World Bank, World Develapment Repor·t (New York: Oxford University Press, various issues).


Participants, Panelists, and Observers*

MODERATOR Royal Professor Ungku A. Aziz Former Vice-Chancellor University of Malaya Selangor, Malaysia

PARTICIPANTS

International Monetary Fund

Azizali F. Mohammed Director External Relations Department

Richard Hemming Adviser Fiscal Affairs Department

Jorge Marquez-Ruarte Adviser Asian Department

Peter J. Quirk Adviser Western Hemisphere Department

Hong Kong Philip Bowring Editor Far Eastern Economic Review

Indonesia Suhadi Mangkusuwondo Professor of Economics University of Indonesia

*The titles and affiliations listed for participants are those they had at the time of the seminar (June 28-July I, 1989).

197


198 PARTICIPANTS, PANELISTS, AND OBSERVERS

Korea Bongsung Oum Fellow Korea Development Institute

Noh-Choong Huh Director Securities Administration and Audit

Division Ministry of Finance

Malaysia Mokhzani Abdul Rahim Chief Executive lnnovest Berhad

Tan Tat Wai Chief Executive Southern Iron and Steel Works Sdn. Bhd.

Mohamed Ariff Abdul Kareem Faculty of Economics and Administration University of Malaya

Mohammed Munir Abdul Majid Chief Executive/Executive Director Commerce International Merchant Bankers

Berhad

Noordin Sopiee Director-General Institute of Strategic and International

Studies

G.M. Abayaratna Assistant Director The South-East Asian Central Banks

(SEACEN) Research and Training Center

Fong Chan Onn Faculty of Economics and Administration University of Malaya

Suresh Narayanan School of Social Studies Universiti Sains Malaysia

Haji Mohammad Haji Alias Faculty of Economics Universiti Kebangsaan Malaysia


Participants, Panelists, and Observers

Nasaruddin Arshad Associate Professor Dean School of Economics and Public

Administration Universiti Utara Malaysia

Yee Mee Fah Business Editor New Straits Times

Hardev Kaur Associate Editor Business Times

S. Jayasankaran Staff Writer Malaysian Business

Martin Khor Kok Peng Research Director Consumers' Association of Penang

Clifford F. Herbert Secretary Economics Division Ministry of Finance

V.N. Gnanathurai Principal Assistam Director Macroeconomics Section Economic Planning Unit

Mohd. Yusof Ismail Deputy Director Industrial Master Plan Ministry of Trade and Industry

Ahmad Zaini Muhamad Undersecretary International Relations and Minerals

Division Ministry of Primary Industries

Jaafar Ahmad Adviser Economics Department Bank Negara Malaysia

Awang Adek Hussin Senior Assistant Manager Economics Department Bank Negara Malaysia

199



Philippines Bernardo M. Villegas Senior Vice-President Center for Research and Communication

Singapore Mukul Asher Associate Professor Department of Economics and Statistics National University of Singapore

V.V.I. Bhanogi Rao Department of Economics and Statistics National University of Singapore

Thailand Gosah Arya Program Director Thailand Developr!lent Research Institute

Foundation

Tanya Sirivedhin Deputy Director Department of Economic Research Bank of Thailand

PANELISTS

II Sakong (Chairman) Former Minister of Finance Korea

Lin See Yan Deputy Governor Bank Negara Malaysia

Azizali F. Mohammed Director External Relations Department International Monetary Fund

U ngku A. Aziz Former Vice-Chancellor University of Malaya

Teh Kok Peng Deputy Managing Director Monetary Authority of Singapore

Vijit Supinit Assistant Governor Bank of Thailand


OBSERVERS Malaysia

Steven Wong Senior Analyst

Participants, Panelists, and Observers

Institute of Strategic and International Studies

Tan Bok Huat Analyst Institute of Strategic and International

Studies

Lim Kok Cheong Associate Professor Faculty of Economics and Administration University of Malaya

Nik Mustapha Haji Nik Hassan Associate Professor Dean Faculty of Economics International Islamic University

Chan Kwan Hoi Executive Editor Economic Service Pertubuhan Berita Nasional Malaysia (Malaysian National News Agency)

P.Y. Chin Business Editor The Star

Ismail Md. Salleh Associate Professor Faculty of Economics Universiri Kebangsaan Malaysia

Chamil Wariya Editorial Writer Utusan Malaysia

Yong Ming Wan Business Reporter Nanyang Siang Pau

Tumnong Dasri Research Economist The South-East Asian Central Banks

(SEACEN) Research and Training Center

Chan Lai Har Pt·incipal Assistant Secretary Economics Division Ministry of Finance

201



Samsudin Hitam Director Macro Division Economic Planning Unit

Zahid Zakaria Principal Assistant Director Ministry of Trade and Industry

Rosli Haji Mohamed Assistant Secretary International Relations and Minerals

Division Ministry of Primary Industries

Liliana Fidel Hamilton Former Assistant EditOr-I MF Survey Embassy of Spain

Bank Negara Malaysia Kwan Kwong Seong DepULy Manager Economics Department

Tan Wai Kuen Deputy Manager Economics Depanment

Tan Sook Peng Deputy Manager Economics Department

Latifah Merican Deputy Manager Economics Department

Fatimah Wati Mohammad Assistant Manager Economics Department

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