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Finance & Development is published quarterly in English, Arabic,Chinese, French, German, Portuguese, and Spanish by the InternationalMonetary Fund and the International Bank for Reconstruction andDevelopment, Washington, DC 20431, USA (DSPS 123-250). Secondclass postage is paid at Washington, DC and at additional mailingoffices. • English edition printed at Lancaster Press, Lancaster,PA. • English edition ISSN 0015-1947. • Opinions expressed in arti-cles and other material are those of the authors; they do not necessarilyreflect Fund or Bank policy. • New readers who wish to receiveFinance & Development regularly should apply in writing to Financé &Development, International Monetary Fund, Washington DC 20431,USA, specifying the language edition and briefly stating the reasons fortheir request. • The contents of Finance & Development are indexed inBusiness Periodicals Index, Public Affairs Information Service (PAIS),and Bibliographie Internationale des Sciences Sociales. An annualindex of articles and book reviews is carried in the December issue.

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©International Monetary Fund. Not for Redistribution

December 1984/Volume 21/Number 4

Finance &Development

A quarterly publication at the International Monetary Fund and the World Bank

Wanda Tseng 2 The effects of adjustmentAdjustment has costs; the alternatives may be more costly

Ibrahim shihata 6 Increasing private capital flows to LDCsThe Bank's proposed multilateral investment guarantee agency

Jacques Artus 10 Are real wages too high in Europe?In comparison with North America and Japan

Parvez Hasan 14 Adjustment to external shocksEast Asia's success examined

Ahsan Habib Mansur 18 Determining the appropriate exchange rate in LDCsA practical approach based on backward- and forward-looking analysis

Dona/ Donovan 22 Nature and origins of debt-servicing difficultiesWhat the experience of 22 LDCs suggests

Bretton Woods at fortyAndrew Kamarck 26 The World Bank and development: a personal perspective

The World Bank 29 Toward sustained developmentA joint program of action for sub-Saharan Africa

Kenneth Friedman 31 Sustaining recovery, reviving developmentand Balwant Garcha The 1984 Annual Meetings of the Fund and the Bank

A/a/em A. Sherbiny 34 Expatriate labor in Arab oil-producing countriesThe outlook for labor migration

Somchai Richupan 38 Measuring tax evasionAn introduction to measurement techniques

Michael Cernea 41 Can local participation help development?Yes, according to the Mexican experience

Montague Yudeiman 45 Agricultural lending by the Bank, 1974-84A review of policies and the portfolio

48 BooksMonetarism; innovation and growth; transfer of technology; rural development;local organizations; unemployment; and Latin America's automobile industry;reviewed by Alessandro Penati, Frederick Moore, Carl Dahlman,Leif Christoffersen, Ridley Nelson, James Blalock, and Shahid Yusuf

52 Letters

53 Index for Volume 21 (1984)

The Editor welcomes views and comments from readers on the contents of the journal.The contents of Finance & Development may be quoted or reproduced without further permission. Due acknowledgement is requested.


The Fund lends (in the context of stand-byor extended arrangements) to membercountries facing balance of payments dif-ficulties, subject to certain conditions. Theseconditions are designed to ensure that theFund's financial assistance supports theimplementation of policies that will enablethe borrowing country to achieve a viablebalance of payments position and to repaythe Fund within a reasonable period oftime. A viable balance of payments positionis normally conceived of as a current ac-count deficit that can be financed by normalcapital inflows and that can be sustainedwithout restrictions. The application of con-ditionality has for a long time been a sourceof controversy; at times it has been arguedthat while conditions might achieve someimprovement in the balance of payments,they often involve excessive costs in termsof other important objectives. In particular,it has been suggested that conditionalitymay retard economic growth and worsenincome distribution.

In discussing the "costs" of adjustment,it must be recognized at the outset that, inpractice, many countries request Fund as-sistance when their balance of paymentssituation has become unsustainable. Bal-ance of payments difficulties reflect imbal-ances in the economy, typically when acountry maintains a level and structure ofaggregate demand, as well as an associated

2 Finance & Development I December 1984

_setjof-product and factor prices, that arenot compatible with its productive capacity.While imbalances may be supported for atime through external borrowing, contin-ued reliance on such borrowing may wellresult in a debt burden of unmanageableproportions. The ensuing debt-servicingdifficulties may, in turn, lead to reducedaccess to, or even withdrawal of, foreignfunds, and thus harm growth prospects.

In this situation, adjustment that limitsclaims on a country's resources to thoseavailable is inevitable, whether imposed byfinancial circumstances or through an or-derly process of adjustment. The under-lying factors contributing to payments im-balances vary from country to country but,in general, adjustment aimed at restoringbalance of payments viability entails policymeasures in two broad areas. If imbalancesare attributable to excessive domestic de-mand, adjustment policies including fiscaland monetary measures would aim to bringthe level and growth rate of demand intoline with the level and growth rate ofproductive capacity. Where the imbalancesare attributable to an inadequate growth insupply because of structural weaknessesreflecting price distortions in the economy,policies would aim to improve the alloca-tion of resources so as to strengthen theproductive base of the economy. Price dis-tortions are frequently reflected in an ov-ervalued exchange rate, and low or evennegative real interest rates, a situation thatdiscourages domestic savings, distorts in-vestment decisions, and makes exports un-competitive. Measures to correct price dis-tortions seek to improve savings andinvestment and induce a shift of resourcestoward the export sector. Such measuresalso promote a liberalization of the ex-

change and trade system where this hascontributed to a misallocation of resources.In some sense, these two sets of measuresoverlap—most policies have an impact onboth demand and supply—but as the ef-fects of supply measures may require timeto materialize, demand restraint is oftenneeded while the conditions are establishedfor an expansion of supply.

Since adjustment therefore usually in-volves a reduction in aggregate demand,changes in relative factor and product prices,and a shift in resource allocation, costs arenecessarily entailed—for example, in termsof reduced consumption, scaled-down in-vestment, or temporary displacement oflabor. But, as explained later, these costsmust be measured against the costs of notadopting timely adjustment policies or ofeffecting adjustment in a disorderly way,both of which could impose an even moresevere burden. As adjustment is post-poned, distortions become entrenched andit becomes increasingly costly, in economic,social, and political terms, to rectify them.Moreover, if adjustment is delayed toolong, it will eventually occur through aforced reduction in imports or other ad hoccrisis measures not consistent with longer-term development.

Contributory factors

Some balance of payments difficulties areoutside the control of the authorities. Thishas been evident in the recent period ofunusually difficult conditions in the worldeconomy, which included the surge inenergy prices, historically high interest ratesin world financial markets, and the globalrecession. However,as mentioned earlier,external payments difficulties are also fre-quently closely linked to deficiencies in

The effects of adjustment Adjustment has costs but the costs of not adjusting may well be higher

Wanda Tseng


domestic economic policies, generally inthe areas of demand management, externaldebt, and pricing.

Excess demand stemming from publicsector deficits is frequently a cause of bal-ance of payments difficulties and meritsparticular attention. These deficits may re-flect a variety of factors, including the risingrole of government in the economy, ex-penditures related to overambitious devel-opment plans, the tendency for consumersubsidies to increase as officially mandatedprices lag behind costs, and poor manage-ment and inflexible pricing policies in pub-lic enterprises. A widening budget deficitoften puts mounting pressure on monetarypolicy if, as often happens, deficits areprimarily financed by borrowing from thebanking system. This may result in exces-sive credit creation, which will tend to raisedomestic prices and lead to a balance ofpayments deficit if the exchange rate re-mains fixed. A large public sector deficitmay also, by raising interest rates or other-wise preempting financial resources, "crowdout" the resource needs of the privatesector, thereby adversely affecting privateproduction and investment. (For a moredetailed discussion of this topic see "Privateinvestment in developing countries" byMario I. Blejer and Mohsin S. Khan in theJune 1984 issue of Finance & Development.)

Apart from its direct effect on the balanceof payments, excess demand may also in-duce a reallocation of resources that gen-erates additional pressures on the balanceof payments. As domestic costs and pricesrise relative to foreign prices, changes inrelative profitability cause resources to flowto the sectors that produce primarily non-traded goods, so that export and import-competing sectors contract relative to ag-gregate output, and further weaken thebalance of payments.

Excess demand is frequently financed byexternal borrowing. Unless this is under-taken under adequate surveillance, thereis always the danger that it may be inamounts and on terms that exceed theeconomy's debt-servicing capacity. In par-ticular, excessive reliance on short-termborrowing on commercial terms will worsenthe maturity structure of debt, making thecountry vulnerable to changes in the lend-ing attitudes of commercial banks and cre-ating the possibility of a sudden emergenceof debt-servicing difficulties.

Balance of payments difficulties are oftenassociated with pervasive price and costdistortions resulting from the impositionof controls on a wide range of prices—generally on consumer and producer pricesof strategic importance to the economy—and exchange rates and interest rates main-tained at levels inconsistent with economic

values. These controls impair the efficiencyof resource allocation.

Rigidities in pricing policies distort eco-nomic incentives and thus damage theproductive potential of the economy. Pricesmaintained at artificially low levels erodedomestic savings, discourage production,and may result in excessive subsidies thatthus impose a growing burden on budg-etary expenditures.

Rigidities in exchange rate policy oftenresult in overvalued exchange rates. Thisundermines the profitability of the exportand import-competing sectors, with ad-verse effects on growth and the balance ofpayments. Overvalued exchange rates alsoweaken the confidence of holders of thedomestic currency, leading to capital flightin various forms, including outflows oc-curring through underinvoicing exports andoverinvoicing imports, that add further tobalance of payments pressures. In suchcircumstances—as exports stagnate, im-ports rise, international reserves dwindle,and capital flight increases—the authoritiesare often forced to resort to stringent importand exchange controls that become cum-bersome to administer and lead to furtherdistortions in resource allocation. The typ-ical situation is characterized by shrinkingimports of vital intermediate and capitalgoods, faltering domestic production, andrising unemployment.

Interest rates affect the current accountof the balance of payments by influencingthe domestic savings-investment process.Many developing countries administer in-appropriately low interest rates that hinderthe mobilization of domestic savings anddiscourage investment. In countries withrudimentary financial markets, artificiallylow interest rates impede the developmentof financial intermediation by diverting sav-ings away from financial institutions—through which they can be channeled toproductive investment—into unproductiveuses, such as hoarding or the purchase ofreal estate. At the same time, the scarcityof financial savings often leads to the con-trol and rationing of credit, resulting in anallocation of available funds that is rarelyefficient. Moreover, interest rates that arenot internationally competitive—when ad-equate account is taken of anticipatedchanges in exchange rates—discouragecapital inflows and produce further incen-tives for capital flight, thereby also weak-ening the capital account of the balance ofpayments.

"Costs" of adjustment

The summary review of factors contrib-uting to imbalances pinpoints the areaswhere corrective action is needed to restorea viable balance of payments position within

a reasonable period of time. Correctivepolicies, of course, must be tailored to thenature and size of the balance of paymentsproblem, the institutional setting and or-ganization of the economy, as well as theeconomic and social priorities of the coun-try. But such policies, whose objective isto adjust the economy to the realities of animbalance, do have certain costs. The costsmost frequently mentioned in discussionsof Fund conditionality are those relating togrowth and income distribution. These costsdepend on the size and pace of the requiredadjustment, which, in turn, depend on theavailability of financing and the speed withwhich the problems are identified and tack-led. Clearly, the sooner the problems areaddressed and the larger the amount ofsuitable financing available, the more grad-ual and therefore less "costly" the processof adjustment.

Since the restraint of aggregate demandplays a prominent role in adjustment, its"costs" deserve particular discussion. Ifexpenditures are already unsustainable,demand restraint necessarily involves aus-terity; where they are not, and only therate of expenditure growth needs to bekept within control, an expansion in de-mand could be permitted. However, wherethere are wage and price rigidities, therestraint needed is often sizable and mayhave adverse short-term consequences forreal output and employment. Devaluationof an overvalued currency has been citedearlier as an effective instrument for im-proving the efficiency of resource allocationand export competitiveness; it can alsomitigate the short-term effects of demandrestraint. By raising the relative price of thetraded goods sector, devaluation not onlyprovides incentives to expand output andemployment in this sector, but also inducesa shift of domestic demand to the non-traded goods sector and domestic factorsof production.

Demand restraint policies need to takeinto account the source of aggregate de-mand, whether public or private, and itscomposition, whether consumption or in-vestment. Both aspects are relevant for theperformance of the economy, especially inthe longer term. In the short run, con-sumption expenditures, particularly thoseof the public sector, are often difficult toreduce because of political considerations.But if, in such a situation, investmentexpenditures have to be curtailed, long-term growth may be affected adversely.For this reason, in cases where excessdemand stems from the public sector andwhere the public sector investment domi-nates total investment in the economy, theadjustment program must, in spite of thedifficulties involved, aim to generate public

Finance & Development/December 1984 3


sector savings to ensure that the neededscale of investment financing is availabledomestically.

The distributional repercussions of re-ductions in government expenditure de-pend on where the specific cuts are made.Frequently, economies are made in subsi-dies, wages, and salaries, precisely becausesuch expenditures have a way of absorbinga significant portion of government ex-penditures. The costs of adjustment arethen borne by the beneficiaries of subsidyprograms, who are often the urban poor,and wage and salary earners employed inthe public sector. It is important to note,however, that while subsidies are generallyintended to redistribute income to the poorand encourage industry with low cashwages, they have often discouraged agri-cultural production by depressing producerprices. In this way they have added to theburdens of the rural poor and contributedto undesirably rapid urbanization that couldnot be supported by the existing social andeconomic infrastructure. Hence, reductionsin subsidies could, in fact, favor the ruralpoor by providing them with higher agri-cultural prices. (For a review of some ex-perience on this topic, see "Stabilizationprograms and income distribution," byOmotunde Johnson and Joanne Salop, Fi-nance & Development, December 1980.)

Excess public sector demand could alsobe addressed by raising additional reve-nues. The immediate burden of taxation inmany developing countries tends to fall onthose engaged in modern sector activities,producers of exports, and consumers ofimports. An attempt to raise governmentrevenues would tend therefore to affectthese groups adversely.

Reducing the rate of credit expansion isanother means of restraining excess de-mand. Aggregate credit measures are oftensupplemented with selective credit policiesthat restrict credit expansion more for non-priority sectors. Credit restraint affects bor-rowers according to their access to alter-native sources of funds. Usually, aggregatecredit restraint tends to favor large, well-established, producers and consumers inthe urban sector at the expense of smallerproducers and consumers in the rural sec-tor. Selective credit controls, by reallocatingaccess to funds toward favored prioritysectors, could either reinforce or reducethese distributive effects.

The aim of measures to restructure de-mand and to enhance supply, includingexchange rate devaluation and the ration-alization of prices under administrativecontrol, is to improve the structure of rel-ative prices, particularly between tradedand nontraded goods, so as to induce ashift of demand and production toward the

4 Finance b Development I December 1984

traded goods sector. The shift in resourceallocation requires that factors of produc-tion be adapted to new productive activi-ties. In the process of adjustment, laborand capital in contracting sectors may betemporarily displaced as they are retrainedor retooled to enter expanding sectors. The"costs" of transition incurred by factorsengaged in declining sectors are offset bygains accruing to the economy from a moreefficient utilization of resources.

The reallocation of factors of productionacross sectors entails changes in productand factor prices. Because mobility of cap-ital and labor is often limited, factor pricesin the traded goods sector will tend to risein the short term at the expense of thosein the domestically oriented industries. Theeffect of these changes on different seg-ments of the population will depend onthe structure of the economy. In manydeveloping countries, the traded goodssector is dominated by the agriculturalsector, which tends to employ the pooreramong the country's population. Hence,in these countries the improvement in theterms of trade for the traded sector resultingfrom adjustment will improve incomedistribution.

Adjustment may also affect the distri-bution of income through additional chan-nels, particularly if it is successful in re-ducing inflation and if financial stabilityexerts a positive influence on growth anddevelopment. A reduction in inflation tendsto benefit poorer groups because they gen-erally tend to have the least access to assetswhose values rise with inflation and aremost likely to hold their savings in moneyform. These groups are often the least ableto secure effective indexation of their wages,although they may receive minimum wages.

The distributional aspects of adjustmentare determined by the social and politicalpriorities of the country concerned, subjectto the constraints it faces. The Fund hasno mandate to act in this field. Its principaltask is to assess whether the adjustmentprogram it is supporting is compatible withthe restoration of a viable balance of pay-ments situation which, in turn, is linked to

Wanda Tsengis an economist in theExchange and TradeRelations Department. Shereceived her PhD from theUniversity of Maryland andworked at the U.S.President's Council ofEconomic Advisors beforejoining the Fund staff in2979.

the prospects for sustained growth. But inany case, the distributional effects of ad-justment should be viewed against thepotential medium-term gains in output andemployment that adjustment makes pos-sible by alleviating the balance of paymentsconstraint and improving allocative effi-ciency that could provide support for pol-icies to improve income distribution.

Adjustment has effects on internationaltransactions as well as on the domesticeconomy. As mentioned earlier, countriesfacing balance of payments difficulties oftenresort to direct controls on foreign exchangeand trade. Exchange restrictions normallyentail requirements that exporters surren-der foreign exchange at the official rate,coupled with schemes for the allocation offoreign exchange, multiple currency prac-tices, external payments arrears, and bilat-eral payments agreements. Trade restric-tions typically involve tariffs and quantitativerestrictions on imports. These restrictionshamper all international transactions andreduce the gains accruing to all countriesfrom the international exchange in mer-chandise, services, and capital, althoughthey tend to be more damaging to thecountry that imposes the restrictions. Thusthe reduction of controls, under an adjust-ment program, will improve economic ef-ficiency and promote world trade, althoughsome particular groups (such as those whowere in a position to secure import licenses)will stand to lose by it.

One purpose of the Fund is to assistcountries to correct balance of paymentsdifficulties without resorting to measuresdestructive of national and internationalprosperity. The adoption of a comprehen-sive adjustment program supported by theFund, by providing a clear indication ofthe domestic policies to be followed andthe objectives sought, often serves as acatalyst for capital flows from sources otherthan the Fund, such as commercial banksand donor countries. The availability offinancing allows the authorities of the coun-try in question to design and implementadjustment over a period and in a mannerthat is more orderly and usually less re-strictive than one dictated by the shortageof financing. In this way, the Fund helpsthe country to achieve a balance betweenadjustment and financing over a periodthat would allow the benefits of adjustmentto materialize. This is not to say that theshort-term costs can be eliminated withfinancing. What financing provides istime to adjust; this reduces the severityand disruptions resulting from abruptadjustment.

An economy that is expanding on anunsustainable basis inevitably tends to ex-perience a reduction in growth in the im-


mediate period after demand managementcreates a framework conducive to the mo-bilization of domestic savings and invest-ments. Moreover, policy measures to en-sure appropriate pricing, such as thoserelating to interest and exchange rates,increase the efficiency of resource alloca-tion, particularly of investment. In thisway, the prospects for growth can be en-hanced even if investment is reduced inthe short run. Over the medium term, theeventual resolution of the balance of pay-ments constraint permits growth on a moresustained basis, which, in turn, increasesboth real consumption and savings. Ad-justment that promotes a liberal exchangeand trade system is also conducive to thegrowth of world trade. Expansion in worldtrade, by providing new markets, eases theconditions for growth and the balance ofpayments performance of countries adopt-ing adjustment policies.

In perspective...

The costs of adjustment must be meas-ured against those of not adopting timelyadjustment policies. Without correctivepolicies, which form the core of a Fund-

supported adjustment program, continu-ing internal and external imbalances willeventually run into a financing constraint.Not only will international reserves be de-pleted, but international creditworthinesswill also be eroded, leading to reducedaccess to, or even a withdrawal of, foreignfunds. In this critical situation, the adjust-ment that is forced on the country couldbe even harder to bear socially and politi-cally, as well as being seriously disruptiveto the economy. When the balance of pay-ments problem reaches crisis proportions,the associated imbalances are so great thatsevere adjustment is required. This adjust-ment often takes the form of measures tosuppress the disequilibrium such as restric-tions on foreign exchange and trade, whichdisrupt trade flows, interrupt the extensionof normal trade credits, reduce the availa-bility of imports, and create incentives forcapital flight. Such disorderly adjustmentimposes severe costs on the country. Thelack of access to financing and the associ-ated shortage of needed imports disruptproduction and vitiate the prospect formedium-term balance of payments viabilityand growth.

The costs of adjustment, therefore, mustbe seen in perspective. In the short run,the costs are the unavoidable sacrifices thataccompany the correction of an unsustain-able situation. Delayed or disorderly ad-justment imposes even more severe costson the country and jeopardizes the pros-pects for medium-term balance of pay-ments viability and growth. The supportprovided by the Fund mitigates these costsby encouraging the timely implementationof corrective measures and by making fi-nancing available. Over the medium term,with the attainment of balance of paymentsviability, adjustment contributes to the fullrealization of a country's growth potential,permitting higher levels of savings andconsumption. The effects of adjustment onincome distribution are difficult to gener-alize. It can be argued that in many devel-oping countries, the policies that are desir-able from the viewpoint of adjustment alsoprovide the potential for improving incomedistribution. Finally, adjustment in theframework of a liberal exchange and tradesystem enables all countries to benefitfrom the efficient allocation of worldwideresources.

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Increasingprivate capital flowsto LDCsAn examination of the proposed multilateral investment guarantee agency Ibrahim F. I. Shihata

The share of developing countries in for-eign direct investment is small, perhapsless than 30 percent of the total. The volumeof this small share has also declined inrecent years from more than $17 billion in1981, according to the highest estimates, tosome $10 billion in 1983. The higher finan-cial returns that an investor often receivesfrom investing in developing rather thandeveloped countries have not changed thispicture, due in part to the prevailing per-ceptions that investing in developing coun-tries usually entails greater noncommercialrisks. So important are these perceptionsthat quite often even investors from de-veloping countries, when given the choice,tend to invest in developed countries de-spite awareness of the smaller profits andmore complex regulatory requirements oftenencountered there.

The effects of this decline in the volumeof foreign investment and the continuedproblem of capital flight have been aggra-vated by the serious fall in commercial banklending to developing countries as a group(net transfers—a concept used by the WorldBank to denote net flows less interest pay-ments—dropped from $16 billion in 1981to -$21 billion in 1983) and by a declinein official development assistance. Morethan at any previous time, there seems tobe a need to improve the investment climatein developing countries and stimulate greatercommercial flows to them. In addition,there has been a growing realization amongdeveloping countries that foreign privateinvestment, under appropriate conditionsand safeguards, can produce net gains. The

This article is based on a more detailed paper bythe author that will appear in Political Risksin International Business, edited by ThomasL. Brewer (New York, Praeger, forthcoming).

complex relationship between investors andtheir hosts has become more balanced withthe growing importance of developingcountries in the world economy and theevolution of substantive and proceduralrules for the treatment of foreign invest-ment. It is in this context that the Bank hasrevived its proposal to establish a multilat-eral investment guarantee agency.

Governmental guarantees against non-commercial risks in foreign countries arenot new; their origins lie in the exportcredit schemes that European countriesadopted in the 1920s. The United Statesestablished a national program in 1948,guaranteeing U.S. investments in WesternEurope against restrictions on the conver-sion of currencies (transfer risk), and grad-ually expanded it to cover investments indeveloping countries against all politicalrisks. Similar programs have now beenadopted by other industrial countries andsome semi-industrial countries, with manyof them combining these programs withtheir previously established systems of ex-port credit insurance.

In the late 1950s a proposal was made toestablish an international agency that wouldinsure foreign investors against noncom-mercial risks. Although the Bank, at therequest of the OECD's Development As-sistance Committee, assumed responsibil-ity for the matter in 1961 and produced anumber of elaborate studies and draft con-ventions in the late 1960s and early 1970s,the establishment of such a multilateralagency did not materialize.

Citing the need "to improve the invest-ment climate—for potential investors andpotential recipents alike," A. W. Clausen,the President of the Bank, took the initiativeto revive the proposal in his first addressto the Fund-Bank Annual Meetings in 1981.As a result of detailed studies undertakenby the Bank and informal discussions by

its Executive Directors, the management ofthe Bank formulated a new plan. Thisversion differs in many respects from pre-vious proposals in which the agency wouldhave no share capital and would haveconducted operations exclusively on behalfof sponsoring member countries. The newfeatures—which include a primary relianceupon share capital, a willingness to lever-age this capital, and a greater role for thehost countries—should give the agencybroader scope in which to operate andgreater flexibility, thus making it of partic-ular interest to developing countries. TheBank is currently in consultation with mem-bers prior to a formal presentation of thisproposal to its Executive Board.

Nature and scope

The basic objective of the proposed newmultilateral agency is to encourage greaterflows of resources to productive enterprisesin developing member countries by guar-anteeing foreign investments against non-commercial risks. The agency would, inaddition, furnish information on invest-ment opportunities, prepare studies, giveadvice to its members on formulating andimplementing policies toward foreign in-vestment, and cooperate with other inter-national organizations engaged in relatedareas. The agency's operations would bebroadly delineated in its convention, elab-orated in its policy rules, and more preciselydefined in its contracts of guarantee. Thiswould permit it sufficient flexibility toadjust coverage to changes in investmentarrangements and gradually expand oper-ations as it built up financial reserves andgained experience.

Covered risks would encompass non-commercial events that affect an investor'srights, including the three traditionally rec-ognized political risks: (1) the transfer riskresulting from host government restrictions

6 Finance & Development/December 1984


and delays in converting and transferringlocal currency; (2) the risk of loss resultingfrom host government action or omissiondepriving investors of control over or sub-stantial benefits from investments; and (3)the risk of loss resulting from armed conflictor civil unrest. (Other specific noncom-mercial risks may also be covered underthe joint request of the investor and thehost country.) General nondiscriminatorymeasures, such as those normally taken bystates to regulate economic activity, are,however, not included unless they resultin breach of legal commitments. In all cases,guarantees would be confined to measuresintroduced or events occurring after a con-tract had been concluded. Transfer riskseems the obvious candidate for wide cov-erage; under present circumstances it is themost relevant from the viewpoint of inves-tors, and probably least likely to evokepolitical objections from the host countries.

Although the agency would focus pri-marily on direct investment, eligible in-vestments could include any other transferof assets, in monetary or nonmonetaryform, for productive purposes. The scopeof eligible investments could be expandedas the agency's resources increase and itbecomes better able to develop its risk-measurement rules. At the outset the in-vestment covered might include equity par-ticipation and equity-type loans; eventu-ally, it could also encompass profit-sharing,service, management and turnkey con-tracts, arrangements concerning industrialproperty rights, international leasing ar-rangements, and arrangements for thetransfer of know-how and technology. Itmight even cover straight project loans,portfolio investments, and some forms ofexport credits. Coverage would be limitedto long- and medium-term arrangementsthat involve productive new investments,including new transfers of foreign exchangeto modernize, expand, or develop existingenterprises. Reinvested earnings, whichcould otherwise be transferred abroad, couldalso be deemed new investments.

The agency would charge premiums andfees for its services, the structure and levelof premiums to be determined by its board.Revenues would be allocated, in order ofpriority, to (1) cover administrative ex-penses; (2) pay claims of insured investors;and (3) a reserve fund. Initially, however,the agency would have to rely on its mem-bers in meeting its administrative expend-itures and paying whatever claims mightarise under contracts of guarantee.

There would eventually be separate win-dows for two types of operations: guar-antees issued on the basis of the agency'sown capital and reserves, and guaranteesissued for investments sponsored by mem-

bers. The latter would be issued by theagency on behalf of the sponsoring mem-bers who would carry the ultimate financialburden of the sponsored guarantees on apro rata basis. The proposed $1 billion initialcapital would be subscribed by all mem-bers, with only a small portion (10 percent)paid in and the remainder kept under callto meet obligations that could not otherwisebe met through paid-in capital and retainedearnings. The agency's operations wouldbe financed through its capital and reservesuntil it reaches the ceilings designated byits board. Such ceilings would include ageneral limitation of up to five times capitaland reserves, as well as country ceilingsrelated to the volume of investments orig-inated from or carried out in one membercountry. Once a ceiling is reached, theagency could start the second windowoperations based on sponsorship; here theagency basically would act as the agent ofthe sponsoring countries and hold a sep-arate sponsorship fund. This would receivethe premiums of sponsored guarantees andpay for administrative costs and claimsresulting from them, complemented in thisrespect by calls on sponsoring members.

Additionality

One basic concern raised about the pro-posed agency is whether it would, in fact,increase investment flows. Additional flows

would result when guarantees attract in-vestments that would not have taken placeotherwise. Although it is impossible toquantify potential additional investments,there are strong indications that multilateralguarantees would encourage otherwisehesitant investors by providing a betterinvestment climate.

Investors' calculations to maximize prof-itability usually involve two components,risk and return. Any perceived improve-ment in the risk profile could lower therate of return required by the investor toundertake the investment ("hurdle rate").If noncommercial risk is associated with aninvestment, an investor can expect to re-duce this hurdle rate in return for a guar-antee that diminishes risk. As the premiumthat the investor would pay for such aguarantee would reduce the return fromthe investment, additionality could ensuewhenever the reduction in the hurdle rateexceeded the premium.

Concern over noncommercial risks hasbeen reflected in the creation of nationalinvestment guarantee schemes and under-scored by the rapid growth of the privatepolitical risk insurance market and the po-litical risk analysis profession over the lastdecade. A study for the U.S. OverseasPrivate Investment Corporation concludedthat in about 25 percent of the cases itexamined, investments would not have

Salient features of the proposed multilateral investmentguarantee agency

Membership: open to all Bank members and Switzerland.Entry into force: when 15 (10 developing) countries join and furnish part of initialcapital subscriptions.Organization: council of governors, board of directors, and president and staff.Council delegates general authority to board, but retains vote on admission, changes incapitalization, amendments, and suspension or liquidation of operations. President hasresponsibility for ordinary business.Subscribed capital: share capital, initially $1 billion, is open-ended and increasedwith new membership. Individual subscriptions negotiated on the basis of ability to

W-Sponsorship: in addition to operations based on share capital and reserves, membersmay sponsor investments for guarantee, incurring loss-sharing liability for them onpro rata basis with other sponsoring members.Relationship with national agencies: cooperative arrangements using their admin-istrative support, facilitating communication between them.Relatipnship with private risk insurers: cooperative arrangement to leverageunderwriting capacity, diversify risks, maximize administrative efficiency. Reinsuressome of its portfolio with private insurers and co-insures large investments.Payment of claims: investor first required to seek administrative remedies in hostcountry. Agency assesses claims, provides for prompt payment. Disputes submitted toarbitration, unless the parties agree on other methods.Voting: Members classified for voting purposes only as home or host countries; eachgroup allotted the same number of votes. Important decisions require approval by aspecial majority.



taken place without a guarantee; in 18percent, investments would have pro-ceeded without a guarantee; and in theremaining 57 percent, although there wasno decisive evidence, a guarantee did ap-pear essential in many instances.

"Qualitative additionally" can also occurwhen a guarantee offered by an interna-tional agency, even if not essential for theinvestment to be undertaken, has an impacton the structure of the investment. Thiswould be the case when, as a result of theagency's evaluation, investments are madefor longer periods of time or with greaterbenefits to the host country. It may alsoensue from changes in the mix of foreigninvestors: if a guarantee plays a larger rolefor small- and medium-sized investors thanfor large transnational corporations, hostcountries might be able to gain more tech-nology adapted to their needs and morelabor-intensive investments.

Some developing countries could alsobenefit as home countries of investments,since an agency would accord their nation-als investing abroad protection that is lack-ing at present. This aspect is gaining im-portance with increased investment flowsamong developing countries.

Links to national programs

With all DAC member countries oper-ating their own national investment guar-antee programs, is an international agencynecessary and would it increase effective-ness? It is estimated that less than 20percent of net investment flows from DACmember countries to developing countrieswas guaranteed under national programsduring 1977-1981. According to OECDsources, only an estimated 9 percent of theexisting stock of investments was coveredat the end of 1981. The various nationalprograms are utilized in different degrees,varying from more than 50 percent (Japan,Austria and, possibly, Korea) to less than5 percent (most European programs). Thesmall percentage of coverage by nationalagencies cannot be taken as evidence ofthe lack of need for guarantees. Recentcontacts with investors prove the contrary;there is a potential demand for investmentguarantees that is not met by the nationalprograms, due mainly to constraints in-herent in the national approach to invest-ment insurance (lack of risk diversification,emphasis on nationality and national in-terests, and limited financial and appraisalcapacities).

The proposed agency would complementnational programs rather than compete withthem. It would be designed to enhance riskdiversification, contribute additional ap-praisal capacity, and overcome gaps re-sulting from different terms, conditions,

and administrative practices of the variousnational agencies. To achieve this comple-mentary role, it would focus on the follow-ing operations:

• Guarantee, or co-guarantee with na-tional agencies, investments in countrieswhere the national agency is already heav-ily exposed.

• Guarantee investments from membercountries that do not have a national in-vestment guarantee program.

• Guarantee investments that, thoughsound, are not eligible for a nationalguarantee.

• Guarantee types of investments (e.g.,service contracts) or risks (e.g., breach ofhost government undertakings) not cov-ered under the respective nationalprograms.

• Co-guarantee large investments withnational agencies, thus mitigating risk con-centrations for both the national and themultilateral agency.

• Guarantee, or co-guarantee with na-tional agencies, multinationally financedinvestments, permitting uniform protec-tion to all co-investors.

• Guarantee low-risk projects in high-risk countries (most national investmentguarantee administrations are not fullyequipped to assess risks on the basis ofproject-related criteria).

• Provide reinsurance of national in-vestment guarantee agencies, in particularof tranches of large investments and partof large host country exposures. In thisway the agency could enhance its own riskdiversification and that of the reinsurednational agencies.

Financial viability

The agency must become self-sustainingover the medium term. Administrative ex-penses and claims would have to be metthrough premium revenues and returns oninvested reserves. The experience of na-tional investment guarantee programs ofOECD countries sustains this expectation:as of December 1983, their aggregate netpayments on claims (claims not recoveredfrom host countries) amounted to just 16.4percent of their aggregate premium reve-nues. The dramatic expansion of privatepolitical risk underwriting over the lastdecade also indicates that it has been aprofitable business.

Nonetheless, the agency might not quicklybecome self-sufficient, as the term is under-stood in insurance economics, because po-litical risks cannot be readily calculated byconventional actuarial criteria. The pro-posed financial structure would ensure thatclaims would be paid even if losses ex-ceeded premium revenues. These would

be met through calls on shareholders orsponsors, as the case may be.

Obviously, the agency's ability to payclaims without recourse to such calls wouldlargely depend on its premium structure.While a variation of premiums accordingto actual loss potential would serve thefinancial interests of the agency, differen-tiation by host countries might give rise topolitical difficulties. To reconcile these twoaspects, the agency could differentiate byproject rather than by host country. Thiswould follow the practice of all major pri-vate U.S. political risk insurers and theOverseas Private Investment Corporation.Private insurers in the United States, forexample, have quoted premiums rangingfrom 0.75 to 7 percent per annum forinvestments in the same host country. OPICconsiders 12 different factors to rate expro-priation risks and another 11 factors to ratearmed conflict risks. Aspects such as thehost government's attitude toward theguaranteed investment are also considered.While the transfer risk is normally associ-ated with the foreign exchange liquidity ofthe host country, investments generatingexport revenues might not be affected bythe general balance of payments problemsof a host country. Premiums would reflecta variety of considerations and most dif-ferences would relate to economic ratherthan political factors.

Voting arrangements

Most international financial institutions,such as the World Bank, are donor agenciesthat transfer funds on their own accountto developing countries. The proposedagency would, by contrast, only guaranteeinvestments made by third parties in de-veloping member countries. It would em-phasize the importance of stable invest-ment conditions rather than provide financialintermediation. As a consequence, its pro-posed voting structure differs from that ofa typical financial institution where votingis primarily linked to capital contributions.Voting in this context would reflect anemphasis on building mutual confidenceand policy cooperation within the agency.

The proposed allocation of equal votingpower to home and host countries as groupsis intended to reflect the focus on policycooperation between host and home coun-tries. A requirement of special majoritiesfor decisions of particular financial signifi-cance would provide an advantage to largercontributors, reflecting the financial natureof the agency.

A distinction between home and hostcountries as groups would be confined tothe allotment of voting rights. Votes wouldnot be cast in groups but by individualgovernors or directors according to the



merits of each case; in effect, it is expectedthat decisions would be taken by consensusin most cases. Home and host countrieshave a common interest in a well-balancedvoting structure, since such a structurewould ensure the agency's credibility andsuccess.

Relations with host countries

Since the agency would underwrite onlyinvestments specifically approved by thehost country for that purpose, any involve-ment or potential for a dispute with a hostcountry would be confined to investmentsguaranteed by the agency with the fullconsent of the host country. Where theagency compensated an investor under thecontract of guarantee, it would assume onlythe substantive rights that the investor hadacquired. Subrogation, assumption of thelegal rights of the compensated investor tocollect damages, could thus achieve nothingmore than the assignment of an existingclaim from the investor to the agency.

Host country approval could eventuallyresult in international arbitration of a dis-pute between the agency and a membercountry. The jurisdiction would be limitedto disputes between the agency and amember state related to a guaranteed in-vestment. It would not endow a privateinvestor with procedural rights under in-ternational law.

The convention establishing the agencywould not include substantive rules withrespect to the treatment of guaranteed in-vestments. Any bilateral agreement be-tween a member and the agency would beconcluded by mutual consent and no mem-ber would be under obligation to enter intosuch an agreement. The convention couldnot conflict with the Code of Conduct of

Transnational Corporations currently un-der negotiation within the framework ofthe United Nations, nor could it conflictwith bilateral investment protection treatieswhereby the contracting parties give recip-rocal assurances on the treatment of theinvestments of the nationals of a party inthe territory of the other. In particular, amultilateral guarantee would not affect thevalidity of an investment protection treaty;it would add to it.

Multilateral guarantees, though normallyavailable for foreign investment only, wouldnot in themselves discriminate against do-mestic investment, since they would pro-tect only existing rights rather than createnew rights for the investor vis-à-vis the hostcountry. A transfer risk occurs because aforeign investor must rely on the ability torepatriate invested capital. In an expropri-ation, the guarantee would assure the in-vestor only adequate compensation in aforeign currency; it would not protect againsthost governmental actions as such. Foreigninvestment would remain subject to hostgovernmental regulation, as would domes-tic investment.

The agency and the Bank

As proposed, the Bank would not havean institutional stake in the agency orassume responsibility for its operations.Although the agency would presumablyenter into a cooperative agreement with Q

the Bank to benefit from its services and 2cut down its own costs, the only direct role °envisaged for the Bank is that its Presidentwould act as chairman of the agency's boardof directors. The interests of Bank membersthat do not wish to join the agency would inot be affected. The initiative to create amultilateral agency has, nonetheless, been

taken by the Bank's management; it is beingdiscussed by the Bank's Board, and itsvarious aspects are being studied by Bankstaff. This is consistent with the Bank's roleas a catalyst in the promotion of foreigninvestment.

The experience of several national in-vestment guarantee schemes in developedcountries should point to the need for amultilateral agency to support and supple-ment their work through reinsurance andco-insurance activities and the provision ofinsurance where protection by nationalschemes is unavailable or inefficient. It ishoped that the mutual interests involvedwould enable the Bank to bring the pro-posed agency to fruition in the near future.Although not a substitute for concessionalflows or for new lending by commercialbanks, foreign direct investment from de-veloped as well as from capital-exportingdeveloping countries should be encouragedto promote development efforts. An ade-quate financial protection provided througha multilateral agency may well prove tobe the most timely step required in thisdirection.

Ibrahim F.I. Shihatafrom Egypt, is VicePresident and GeneralCounsel of the Bank andSecretary-General of theInternational Centre forSettlement of InvestmentDisputes. A graduate ofCairo University andHarvard Law School, he haspublished extensively.

Legal and Institutional Aspects of the International Monetary System:

Volume II, Selected Essays

By Sir Joseph GoldThis volume of legal essays reproduces, with slight revisions, 16 papers contributedby the author to books and periodicals published originally under auspices otherthan those of the International Monetary Fund. A Supplemental Note is attached tomost chapters to provide more recent information on matters of detail.The author, who is now Senior Consultant to the Fund, was formerly GeneralCounsel and Director of the Fund's Legal Department.

Price: Volume II, US$40.00; Volume I (published in 1979), US$17.50

Special Price for both volumes: US$50.00•̂ ••̂ B

To order, please write:Publications Unit, Box A-844, International Monetary Fund, 700 19th Street N.W., Washington D.C. 20431, Telephone: (202) 473-7430

Finance & Development I December 1984 9


A comparative study of wages in manufacturing in Europe, North America, and Japan

Jacques R. Artus

The failure of the major European countriesto create new jobs during the past decade,with the resulting emergence of doubledigit unemployment rates, is often blamedon unduly high wages. Observers pointout that, especially in manufacturing, thereal wage rate defined from the employer'sstandpoint—that is, including all labor costsand divided by value added rather than byconsumer prices—tended to grow fasterthan labor productivity. This led to a risein the share of labor costs in value addedand a decline in the share of incomes goingto capital (see Chart 1). By contrast, therise in labor's share of value added wasmuch more limited in the United Statesand Canada and their success with jobcreation much better. The share of laboralso rose significantly in Japan, but from avery small base.

The evidence concerning the rise in thelabor share (from a base level associatedwith a satisfactory employment situation),while suggestive of excessively high wages,is hardly conclusive. In particular, the in-creased share of labor costs in Europe could

equally well have been warranted by long-run changes in production techniques orin the structure of the manufacturing sector(shifting, for example, from capital-intensive to labor-intensive techniques orindustries), in the relative scarcity of laborvis-à-vis capital, or in the relative price ofenergy. Similarly, the accompanying un-employment could have been quite unre-lated to real wage levels; it could have beenthe result of higher turnover rates andincreased regional and skill mismatches, orof a deficiency of aggregate demand. Beforejumping to conclusions that have majorimplications for policy, one needs to givethe evidence further scrutiny.

This article is based on an empirical studythat sought to determine whether recentchanges in the shares of labor in valueadded were caused by the factors listedabove, and would therefore not impede areturn to "high" employment, or by ri-gidities in labor markets that kept the realwage rate above the marginal productivityof labor at high employment. Actual realwages in manufacturing in Canada, France,

Germany, Italy, the United Kingdom, andthe United States were compared withestimates of the "warranted" wages—thatis, the real wages calculated to be consistentwith high employment of labor, given theexisting capital stock. The comparisonshowed that in France, Germany, and theUnited Kingdom, the real wage rate wasindeed higher than the level compatiblewith high employment after about 1970. InCanada and the United States, this was notthe case. For Japan and Italy, the resultswere less conclusive.

In considering these results, it is impor-tant to take the limitations of the studyinto account. First, it was narrowly focusedon the manufacturing sector, where labormarket rigidities are particularly prone topreventing an adjustment of real wagerates. In most other sectors, including ag-riculture and services, competitive forcesnormally play a greater role in determiningwage rates, and they contain a high pro-portion of self-employed, which blurs thedistinction between labor and capital costs.Nevertheless, it would be desirable to con-


Arc real .wagyRÉtoo high in Europe?


sider also these other sectors, particularlygiven the growing importance of the serv-ices sector in industrial countries. Second,the study viewed the capital stock as given("exogenous"); no attempt was made toexplain investment. Thus the possibility ofa vicious circle in which a disequilibriumreal wage rate reduced investment, whichin turn reduced the growth of the war-ranted real wage rate, was outside the scopeof the study. Third, goods prices, includingprices of manufactures, intermediate inputsused in the manufacturing sector, and con-sumer goods, were also viewed as exoge-nous. This last assumption implied that theexchange rate was given—a point withwider implications elaborated on later.

Method of analysis

Two models were used as a basis for theestimates of the warranted share of laborand the corresponding warranted realwage rate. Model A assumed a constant-elasticity-of-substitution production func-tion relating capital and employed labor (inman-hours) to value added. The innovativeelement in this model was that it madeallowances not only for changes in the rateof "disembodied" productivity growth—that is, in the growth of real value addedthat did not appear to be directly relatedto measured increases in labor or capitalinputs—but also for changes in the relativeweights of labor and capital. The recogni-tion that these weights could, and indeedprobably did, change in the longer run asproduction techniques and the structure ofthe manufacturing sector evolved was con-sidered important for the validity of theresults.

Model В extended the production func-tion to incorporate energy as a specificfactor. While it seemed safe to assume thatthe prices of raw materials did not affectthe capital-labor ratio, it was not sensibleto rule out the effects of energy prices.Specifically, the model allowed for the pos-sible complementarity between energy andcapital; as a result, a marked increase inthe relative price of energy could leadentrepreneurs to increase their demand forlabor, and decrease that for the composite"capital-energy" input.

For both models it was assumed that, onaverage, labor was paid its marginal prod-uct during the second half of the 1950s andduring the 1960s, periods for which therewas no reason to expect that the real wagerate was out of equilibrium (except in Japanwhere it was possibly too low). Under this

; critical constraint, the parameters of the| two production functions were estimatedI for 1955-82. The estimated parameters wereÍ then used to calculate the warranted labor

shares and real wages, not only for thesecond half of the 1950s and for the 1960s,but also for the 1970s and early 1980s whenthe equality between the real wage rateand the marginal product of employedlabor may not have held, and when evi-dence suggested that the high-employmentlabor supply was considerably larger thanthe actual amount of labor used.

Parameter estimates

Focusing first on model A, the estimatesfor the simple production function showedthat the rate of disembodied productivitygrowth increased during the 1960s, but fellback during the 1970s and early 1980s inall countries except Germany (where therate was constant throughout the period).These results corroborated other findingsthat a significant part of the decline in thelast decade in the rate of growth of outputper man-hour was not accounted for by alower rate of capital accumulation. Thisconclusion held even when the rate ofcapital accumulation was adjusted down-ward to take account of the rise in pollutionabatement investment and the prematureobsolescence of capital stock resulting fromthe two waves of energy price increases.Cross-country differences in the rate ofgrowth of disembodied productivity werequite stable. For the past three decades,this rate tended to be about 3 percentagepoints higher in Japan and 2 percentagepoints higher in France and Italy than inthe United States, Canada, and the UnitedKingdom. Germany, by maintaining a con-stant rate, moved from the low-growthgroup during the 1960s and early 1970s tothe middle group during the last ten years.

Apart from these findings, which hadobvious implications for the warrantedgrowth of real wage rates, the estimatesalso showed that the relative weight on thecapital stock tended to increase. This wasnot surprising. The tendency for a gradualincrease in the capital-intensity of produc-tion techniques has been evident for a verylong time, and this, ceteris paribus, wouldcall for a rise in the share of capital costsin value added and therefore a decline inthe labor share. To put it differently, thewarranted growth rate of real wages wasless than the growth rate of output perman-hour. However, the data suggestedthat the tendency was interrupted during1971-82 in Japan. A possible reason wasthat the structure of production changedmarkedly in Japan during this period asindustries requiring a high level of rawmaterials and energy imports, many ofwhich were also capital intensive, werede-emphasized.

The elasticity of substitution betweenlabor and capital was lower than one in all


Chart 1Actual labor share of value

added in manufacturing, 1955-821

Source: IMF dala.'Labor shares of value added at factor cost, net ofinventory appreciation.


Chart 2Deviation of actual from

warranted real wage rate, 1955-82 '

countries (a result that matched the find-ings of most other studies). The importantimplication of this low substitutability wasthat a rise in the capital/labor ratio wouldtend to increase the warranted share oflabor in value added. When the ratio roserapidly, as it did in the 1960s, this effectcould be more important than the effect ofthe gradual increase in the relative weightof capital, and the warranted labor sharecould then increase. When investment waslow, as in the 1970s and early 1980s, theinverse could happen.

The estimated values of most of theparameters of model В were in line withthe corresponding estimates in model A.For example, the relative weight of thecomposite capital-energy input increasedgradually, while the elasticity of substitu-tion between labor and the capital-energyinput was less than one. An interestingdifference, however, was that the reductionin the rate of disembodied productivitygrowth between the 1960s and the laterperiod was smaller in the second model,but generally not much smaller. Thus, evenwhen the reduction in the use of energythat was achieved during the past ten yearswas explicitly taken into account—as it wasin model В—there was still a sizable unex-plained reduction in the rate of growth ofdisembodied productivity. Consequently,the increase in energy prices and the fol-lowing process of economizing on the useof energy could not be blamed for a largepart of the decline in disembodied produc-tivity growth. A further interesting resultwas that the data supported the hypothesisthat an increase in the price of energy didoften warrant some rise in the price of laborrelative to the price of capital.

Warranted, actual wages

Chart 2 shows the estimated wage gapscorresponding to the two models, with thegaps expressed as the deviations of actualfrom warranted real wage rates as a percentof the latter. For France, Germany, and theUnited Kingdom, as well as Japan, the twomodels yielded a wage gap of 12-16 percentfor the early 1980s. For the United Statesand Italy, model A produced a gap of about5 percent, while model В showed no sig-nificant gap. For Canada, model A sug-gested no gap, while model В suggestedthat the real wage rate was, if anything,low.

These results were broadly similar tothose derived by simply looking at thedeviations of the actual labor shares fromtheir historical averages during the secondhalf of the 1950s and the 1960s as a measureof disequilibrium in wage costs. Neverthe-less, some of the differences were far fromnegligible.

For example, for the United Kingdomand, especially/ for Italy the warrantedlabor share was estimated to have beenhigher during the 1970s and early 1980sthan during the preceding period, so thatthe simple approach based on an assumedconstant warranted share exaggerated themagnitude of the disequilibrium in recentyears. For Japan, the estimates based onthe simple approach were found to be evenmore misleading. The actual labor sharerose rapidly in the first half of the 1970s,mainly in 1974-75, and then stabilized,suggesting that Japan adjusted much betterto the second wave of oil price rises thanto the first. What the results of the studyshowed, however, was that the early jumpwas not a severe problem; it started whenthe actual share was significantly below thewarranted share, it was largely related tothe presence of temporary labor hoarding(i.e., a delay in firing labor), and there wasa gradual increase in the warranted shareduring that period because of the rapidincrease in the capital/labor ratio. By con-trast, during the late 1970s and early 1980slabor hoarding was slowly reduced and thestability of the actual share hid a deterio-ration of the underlying position. More-over, the warranted share stopped risingbecause the growth of the capital/labor ratiodecelerated sharply.

Further differences with the simple ap-proach were apparent in the results derivedfrom model B. Mainly for the United States,Canada, and Italy, the hypothesis thatenergy and capital were complementaryled to results that were more favorable tolabor. Namely, the estimate of the war-ranted real wage rate was higher and con-sequently the estimate of the wage gap waslower—in Canada it was even negative.One of the main reasons for this findingwas the relatively large increase in the shareof energy costs in the total cost of manu-facturing production in those three coun-tries during the past ten years. The reasonsfor this large increase differed. In the UnitedStates, the rise in the price of energy relativeto the price of labor and capital was espe-cially large; in Canada, the decline in energyuse was less than in other countries; whilein Italy, manufacturing activities were par-ticularly energy (and oil) intensive. Therewas also a relatively large increase in theshare of energy costs in Japan, but it wasmore easily absorbed than in the precedingthree countries because of the small initiallabor share. Nonetheless, the results ofmodel В were somewhat more favorable tolabor even in Japan.

Given the sizable margin of error in thedata on some of the important variablesused to derive the above results, they weretested (using a systematic sensitivity anal-


Source: IMF data.'A positive number indicates that the actual realwage rate (measured in terms of the relevant value-added deflator) exceeds the real wage rate that isconsistent with the chosen high - employmentnorm.


ysis) and found to be relatively robust tovariations in the estimates of the grosscapital stocks and the high-employmentlabor inputs.

In all countries except the United King-dom, the adjustment to the deceleration inthe growth of the warranted real wage ratein terms of consumer prices was consid-erable, with the rate of growth of the actualreal wage rate declining by 2 percentagepoints or more from 1956-69 to 1979-82.So, it would be an exaggeration to say thatthe rate of growth of the real wage ratewas rigid. In fact, there was a great deal offlexibility, but not always enough. In Japanand the United Kingdom, for instance, theactual real wage rate grew in terms ofconsumer prices at a rate of 2-3 percentduring 1979-82 instead of declining in linewith the warranted rate. For France andGermany, the other two countries wherethere is currently a large gap, the growthof the actual real wage rate was kept nearlyin line with the low growth of the warrantedrate in recent years. The study suggestedthat the problem for these two countrieswas not so much a systematic tendency forinertia in the adjustment of real wages tosupply shocks, as a failure to reverse theunwarranted increases in real wages of theearly and mid-1970s. At least for France,these increases had as much to do with thewage explosion of the early 1970s as didthe supply shocks of the mid-1970s.

Conclusions

The study showed that, at least as far asmanufacturing was concerned, there arestrong reasons to believe that in France,Germany, and the United Kingdom thereal wage rate has been too high in recentyears, in the sense of being incompatiblewith high employment. In contrast, it hasnot been too high in the United States andCanada, although there may of course besome problems in specific industries. Therewas no evidence of a real wage problem inItaly but poor data prevent firm conclusions(see box). For Japan, the large increase inthe labor share observed in the 1970s didnot appear to have been fully warrantedby concomitant changes in the factors con-sidered in the study. At the same time, theinitial labor share was so small that thisincrease may have been less of a problemthan it was in Europe.

The estimates of the warranted real wagerates on which these conclusions werebased must be regarded as tentative, for atleast three reasons. First, it was difficult tomeasure the actual flows of labor and cap-ital services and, a fortiori, the high-employment labor supply in manufactur-ing. The sensitivity analysis showed thatthe order of magnitude of the estimates is

Measurement issues

The author's more detailed discussion of these issues is contained in his article, 'TheDisequilibrium Real Wage Rate Hypothesis—An Empirical Evaluation," IMF Staff Papers,June 1984. For France and Italy, national accounting figures on nominal value addedincluded inventory appreciation—which accrues neither to fixed capital nor to labor. ForFrance, the figure* were adjusted by using data on inventory appreciation for thenonagrtcultunu economy; for Italy, an even rougher adjustment was made. Estimates ofthe shares in value added of capital and labor, particularly for Italy, may thus be subjectto sizable error. Flema oftíbor and cepita! services: following а standard approach, this studyu*«d serie« on man-hoar» worked (except for the United States where only series onman-hours paid werf available) and on the gross capital stock as proxies for the unavailabledata on the actual flow» of labor and capital services. But even these proxies entailedmeasurement problems; the study attempted to adjust for these, but some distortions,especially in the capital stock data, may well have remained. The main problem with themeasurement of the actual Sow of labor services was that the available data on man-hours did not reflect the level of education and technical expertise of the work force. Inthe present context, however, the author concludes that the problem is likely not to betoo severe because those changes occur only gradually.

relatively robust to plausible variations inthe values taken by these variables; never-theless, the resulting uncertainty is far fromnegligible. Second, the estimates sufferedfrom a number of country-specific prob-lems. Finally, an aggregate productionfunction for a whole economic sector is aninherently crude empirical tool because theconditions necessary for aggregation overfirms and industries are never fully satis-fied, particularly if workers are not paidtheir marginal products.

While these limitations mean that theestimates are far from precise, they do notimply that the estimated wage gaps forFrance, Germany, and the United Kingdomreflect statistical artifacts. There is moreuncertainty for Japan because of the lackof a fully adequate base period, but it isdoubtful that this problem can completelyexplain the measured gap. A major factorconfirming that the order of magnitude ofthe gaps is right is the evolution of un-employment. Unemployment can be clas-sical (caused by an unduly high real wagerate), structural (caused by turnover andby regional and skill mismatches), orKeynesian (caused by a deficiency of ag-

Jacques R. Artusfrom France, is an AssistantDirector of the ResearchDepartment; he joined theFund staff in 1969. Mr.Artus has a BA from theUniversity of Paris and aPhD from the University ofCalifornia at Berkeley.

gregate demand). All of these types canalso occur together. Thus, one should notexpect a close cross-country correlation be-tween the overall unemployment rate andthe size of the wage gap. However, byearly 1984 the unemployment rate in France,Germany, and the United Kingdom wasbetween 5 and 7 percentage points aboveour estimate of the structural rate for theearly 1980s, and this gap does not seem tobe declining. In contrast, the unemploy-ment rate was only 2 to 3 percentage pointsabove the structural rate in the UnitedStates and Canada, and the spread wasdecreasing from month to month. In Japan,the economic and social system is such thatthe rise in unemployment has been quitemoderate; nevertheless, employment inmanufacturing fell 4 percent from early1974 to 1982. This is striking, partly becausethe total labor force increased by 9 percentduring this period and partly because, asrecently as the 1960s, employment in man-ufacturing was rising three times faster thanthe growth of the labor force.

These results are particularly worrisomewhen viewed against the background ofthe developments in exchange rates ofrecent years. The extremely sharp appre-ciation of the U.S. dollar and the Canadiandollar vis-à-vis the other major currenciesover the past four years is likely to havehad important effects on the profitabilityof manufacturing exports—decreasing ex-port profitability in the United States andCanada and increasing export profitabilityin the other countries. It is thus very dis-quieting that, despite these developments,it is still in Europe, and possibly in Japan,that there is a real wage problem for themanufacturing sector as a whole, ratherthan in the United States and Canada. ED

Finance 6- Development /December 1984 13


Adjustment to external shocksWhy East Asian countries have fared better than other LDCs

Developing market economies of East Asiahave survived the turbulent internationaldecade since the 1973 oil price increasebetter than most other developing coun-tries. Nevertheless, the deep internationalrecession of 1982-83, the steep rise in in-ternational interest rates, and the furtherincrease in energy prices after 1979 havehit many economies in the region extremelyhard. For the group as a whole, GDPgrowth declined to less than 5 percent perannum during 1980-83. But its average of7 percent over the past decade was stillmarkedly better than the 4 percent averageannual growth achieved by all developingcountries. Even though the external debtburden has increased in East Asia, theincreases have been less than elsewhereand borrowing capacity will be generallyless of a constraint on future growth.

During the last two decades most EastAsian countries have experienced out-standing social and economic progress.GNP per capita growth during 1960-82 wasdistinctly above average, except in the Phil-ippines. At the same time, food supplieshave improved, and the incidence of ab-solute poverty has fallen in almost all coun-tries. Impressive gains in welfare, meas-ured by increased life expectancy, reducedinfant mortality rates, and higher adultliteracy rates, have been made. Finally,East Asian countries have been relativelymore successful in transforming the struc-ture of their economies, in developing hu-man capital, and building up institutions.

The seeds of this successful adjustmentcan be traced to the very policies that

promoted rapid growth in the 1960s. Thisarticle discusses these policies in the largemarket economies of East Asia (Indonesia,Korea, Malaysia, the Philippines, and Thai-land), outlines the external shocks theyhave faced, and analyzes their generallysuccessful pursuit of economic adjustment.

Factors in rapid growth

Development results from the complexinteraction of a number of historical, polit-ical, cultural, economic, and social factorsand is unique to each country. However,there are a number of common elementsin the dynamic growth of the East Asianeconomies. First and most important ispolitical continuity and generally stronggovernment commitment to development;second is their strong emphasis on edu-cation; third, their export orientation; fourth,their concern with agriculture; and, fifth,their mobilization of large volumes of do-mestic and foreign savings. These havebeen associated with a pragmatic economicmanagement that has relied considerablyon market forces, used selective and rela-tively effective state interventions, and hasbeen flexible and, on the whole, responsiveto changing international conditions. Fi-nally, knowledgeable and sustained tech-nocratic leadership has been available todesign and implement desired economicpolicies.

There has, of course, been considerablediversity among the countries in terms ofthe speed and level of their developmentand the effectiveness of their policies. Some

Parvez Hasan

of the current economic difficulties beingfaced by the Philippines, for instance, aredue not only to political factors and a verydifficult international economic environ-ment but also to less-than-firm economicmanagement under which resource mobi-lization needs have been neglected, con-sumption growth maintained notwith-standing a sharp deterioration in terms oftrade, and a growing investment programfinanced by relatively short-term borrow-ing. Still in the overall perspective of de-veloping countries and in terms of macro-economic indicators, the performance ofthe Philippines during the last decade hasbeen, if anything, somewhat aboveaverage.

Foreign trade orientation

Almost all East Asian economies havebeen more open than either an averagemiddle-income country or a typical indus-trial market economy, and the rapid growthof their foreign trade sectors is perhaps themost well-known feature of their devel-opment. Many factors have contributed tothis vigorous export expansion, but thegrowth in their manufactured exports hasemerged as the most dynamic, and willcrucially influence whether or not exportswill continue to grow faster than nationalproduct. The outstanding success of Koreain exporting manufactured goods is rec-ognized. But exports of manufactured goodsfrom the Philippines, Malaysia, and Thai-land have also risen—at rates averaging20-30 percent per annum for a decade.Even in Malaysia, where exports of petro-



leum, timber, rubber, and palm oil havealso risen dramatically, manufactured ex-ports have accounted for over 35 percentof incremental export earnings over thepast decade. As a result, the structure ofexports has undergone a major change inall these countries.

In expanding their exports of manufac-tured goods, the East Asian countries havetaken advantage, first of all, of favorableinternational developments. World eco-nomic activity has shown sustained growthduring the last two decades, and worldtrade has grown substantially faster thanoutput, greatly facilitated by liberalizationin the industrial countries. In addition,these countries have been able to increasetheir market share by export promotionpolicies—such as the maintenance of real-istic exchange rates, the avoidance of dis-crimination against exports, or the com-pensation of exporters for a bias in favorof domestic industry.

These countries have also benefited fromwider markets and technology transfer.International trade has been an importantsource of information on new products,new designs, and new production pro-cesses. For capital-scarce countries, the con-centration on labor-intensive manufacturedexports with low capital/output ratios hasprovided important opportunities for max-imizing output and employment per unitof investment. Finally, the discipline ofinternational markets has been generallybeneficial for economic policies.

Agricultural performance

Although manufacturing has clearly beenthe leading sector, the contribution madeby high agricultural growth in these coun-tries—sustaining overall growth, direct andindirect job creation, strengthening the bal-ance of payments, and poverty allevia-tion—is not fully appreciated. The homemarket for manufactured goods has beencrucial, and the rate of growth of agricul-tural production and incomes has been animportant determinant of the rate of ex-pansion of this market.

The agricultural performance of manyEast Asian countries has been truly out-standing. Over the last two decades, agri-culture in Korea and Indonesia has grownby almost 4 percent per annum. In Malay-sia, the Philippines, and Thailand, annualgrowth rates have been close to 5 percent.Increased irrigation, improved crop vari-eties, and greater use of fertilizer havetypically been the most important sourcesof agricultural growth. Government agri-cultural programs and policies, emphasiz-ing incentives and investments, have inmost cases combined with responsive anddynamic private sectors to offset the effect

of increasing population pressure on landresources.

Crop diversification (as in Thailand, Ma-laysia, and the Philippines) and improvedproductivity in existing crops in responseto less favorable price prospects (like rubberin Malaysia) have been vital for sustainingagricultural growth. This needed policiesthat permitted output to adjust relativelyquickly to shifting comparative advantageand new economic opportunities.

The surge in investments, which resultedin a tremendous expansion of physical andsocial infrastructure and human and in-dustrial capital has, on the one hand, fueledthe high GNP growth rates and, on theother, has itself been financed by rapidlyrising incomes. Whereas in developing

forces. This has two aspects. First, the stateenterprise sector is, and has remained,relatively small, and has been largely con-fined to energy-related activities. Second,price distortions have been relativelylimited.

In developing countries, there is a grow-ing body of evidence on the benefits ofusing prices to reflect scarcities and en-courage growth. The issue of price distor-tions has been widely researched and wasa special focus of the World Bank's 1983World Development Report. Thailand, Korea,Malaysia, and, somewhat surprisingly, thePhilippines were among the relatively fewcountries where key economic prices (theexchange rate, wages, interest rates, andpower rates) were not too out of line with

Growth performance(Average annual growth rates, in percent)

Country/territory

Hong KongIndonesiaKoreaMalaysiaPhilippinesSingaporeThailandMiddle income

countries

GNP percapita

1960-82

7.04.26.64.32.87.44.5

3.61

GDP1970-82

9.97.78.67.76.08.57.1

5.4'

Agri-culture

1970-82

na3.82.95.14.81.64.4

3.02

Manu-facturing1970-82

na13.414.510.66.69.39.9

6.52

Merchandiseexports1970-82

9.4

4.4

20.23.87.9na9.1

2.62

Inflation1970-82

8.619.919.37.2

12.85.49.7

12.82

countries as a whole, the investment rateas a percentage of GNP rose from around20 percent in 1960 to 24 percent in 1982,the corresponding increase in the marketeconomies of East Asia was from 12 to 27percent. Foreign capital inflows have beenan important source of financing, but 80-85 percent of gross investment in recentyears has been met from domestic savings.Typically, at least a quarter of the incomesarising out of the growth process have beensaved. The most dramatic rises in domesticsaving rates have been in Korea (from 1 to22 percent between 1960 and 1982) and inIndonesia (8 to 23 percent). Maintenanceof attractive returns to savers through pos-itive real interest rates, developed financialinstitutions, and attractive opportunitiesfor private investment have been amongthe factors responsible for the excellentrecord of domestic resource mobilization.

Role of economic policies

In the final analysis, the huge success ofthese countries is the result of effectiveeconomic policies. By and large, they haveplaced considerable reliance on market

opportunity costs, where protection ofmanufacturing or export taxation on agri-culture was generally moderate, and whereinflation was kept within limits. Thesecountries were notable for keeping ex-change rates competitive, which contrib-uted significantly to their export success.

While prices do matter for growth, theBank's analysis suggested that price dis-tortions explained only a part of the vari-ation in growth performance among coun-tries in the 1970s. The rest was the resultof other economic, social, political, andinstitutional factors. It is not the absenceof state interventions but rather the selec-tivity and effectiveness of their use thatdistinguished the market economies of EastAsia from many other developing coun-tries. The strong policy and investmentsupport provided for agricultural systems,human resource development, and exportzones was the key factor in acceleratedeconomic development. In Korea, the Gov-ernment was also successful, at least untilthe mid-1970s, in encouraging the devel-opment of heavy industries such as ship-building, and it has provided an important


Source: World Bank, World Development Report 1984.Note: na denotes data not available. 1 Weighted average. 2 Median.


Stimulus for technology-based develop-ment by promoting research and devel-opment institutions.

Macroeconomic management in East Asiahas also been characterized by (1) a basicstability and predictability of major policies;(2) given these, a high degree of policyflexibility and a quick responsiveness tochanging economic circumstances; and (3)very close attention to the integration ofeconomic policies, leading to a considerablecohesion in overall development strategies.These, in turn, have been influenced bycontinuity of political and economicleadership.

External shocks

These factors have enabled East Asia tocope with a series of external shocks since1973 relatively well. The 1973 oil priceincrease meant a loss of GNP of 5.8 percent,4.4 percent, and 3.4 percent, respectively,for Korea, Thailand, and the Philippines,the three major oil importing developingcountries in the region. New oil price in-creases during 1979-80 added a furtherburden—ranging from 6 percent of GNP inKorea to 3.7 percent in the Philippines—tothe balance of payments. For all threecountries, the additional rise in oil pricesin 1979 came at a time of weakening inter-national demand for their exports, and—for all countries except Korea—of a sharpdeterioration in the non-oil commodity termsof trade. Last but not least, real interestrates shot up sharply in 1981-83, as nominalinterest rates rose and international infla-tion declined; these imposed an additionaldebt burden of 3 percent of GNP per annumin Korea and around 2 percent in thePhilippines.

Indonesia has been faced with an ad-justment problem of a different kind. Higheroil prices after 1973 meant a gain of 9percent of GNP over 1973-75; from 1978-80, the terms of trade gain, arising mainlyout of higher oil prices, was equivalent to14 percent of GNP. But since 1981 net oiland gas revenues, after an increase of over$6 billion between 1978 and 1980, fell by$4 billion in 1983 and will rise very littleduring 1984 and 1985. Malaysia, which hasan export-to-GNP ratio of over 50 percent,has witnessed great instability in exports,whose purchasing power expanded at anaverage annual rate of 9 percent during1973-80 but dropped by 6 percent perannum during 1980-82. The reduction inthe real value of exports amounted to adecline in GNP of over 10 percent over thethree-year period.

These huge swings were a consequenceof openness, and reflected the recent greatvolatility in the international prices of rawmaterials and energy and in interest rates.

In contrast, industrial countries suffered aloss of 2 percent of GNP with each of theoil shocks. The surprise is not that growthin these East Asian countries slowed to 3percent per annum during 1982-83, butthat it continued at all. The great resilienceof their economies in the face of suddenand unexpected changes can be traced totheir determined pursuit of structural ad-justment policies related to energy pricesand production, investment, and exportsover the last decade.

Structural adjustment

Energy. Korea, Thailand, and the Phil-ippines are heavily dependent on importedoil; in 1980, energy imports accounted forthe great bulk of their commercial energyconsumption and for about one third oftotal imports in each. Before 1973, depend-ence on imported energy was growingrapidly. It is hardly surprising, therefore,that the fivefold rise in real petroleum pricesduring the last decade has entailed majordomestic adjustments in these countries.Reducing dependence on imported energyis now an important objective of nationalpolicy in all three countries, and reduceddependence on imported oil a secondaryobjective. To achieve these, actions havebeen taken to reduce the growth of de-mand, increase the supply of domesticenergy, and diversify the sources of energyimports.

Considerable progress has already beenmade, especially since 1979. The volumeof oil imports has decreased somewhatduring the last few years, only partly be-cause of the overall economic slowdown.Pricing policies, particularly in Korea andthe Philippines, have been the most pow-erful instrument in reducing domestic de-mand for energy. In Indonesia, where do-mestic oil prices have historically been low,average prices have been raised over three-fold since January 1982. Energy prices notonly affect the final demand but stronglyinfluence the pattern of future output andexpenditures, including the structure oftransport. Scaling down or eliminatingenergy-intensive industries has been animportant corollary of sharply increasingdomestic energy prices.

Energy conservation and demand man-agement have been combined with majorefforts to increase domestic production ofenergy, particularly in Korea (through itsnuclear program), the Philippines, (throughthe development of geothermal, coal, andhydro resources), and Thailand (throughthe expansion of natural gas, lignite, andhydroelectric power).

The programs for expanding domesticenergy production are generally well-conceived. But investment requirements of

energy development remain very large,notwithstanding the recent general down-ward revision of power investment pro-grams, and will put a major strain onresources. Net import substitution in en-ergy should have higher priority than re-duction in dependence on imported oil,particularly if switching between importedfuels requires heavy capital outlays.

Trade. Despite being faced with moredifficult balance of payments positions andsluggish growth in international trade since1980, the market economies of East Asiahave not turned inward. All have continuedto emphasize export development and havestrengthened export incentives.

Some countries have initiated efforts toreduce protection for domestic industrythrough tariff reductions and import lib-eralization. The Korean government, forinstance, has decided to carry out a majorreform of the import tariff system to pro-mote further the competitiveness of Koreanindustries. Korea has also liberalized for-eign investment to promote industrial ef-ficiency to accelerate technological devel-opment. In the Philippines a major programof tariff reductions, import liberalization,and reform of the industrial incentive sys-tem was initiated in 1980, though it hassuffered a setback in the last year due tothe debt crisis.

The push to increase the attractivenessof exports and to reduce the domesticprotection of industry has not been easypolitically, in light of the sluggish worldtrade. In East Asia, as elsewhere, there isgenuine internal debate on the extent ofstate support required for industrialization.Further, liberalization of imports and re-duced protection for industry, while essen-tial for improving efficiency, could meetincreasing resistance even in East Asiancountries if the protectionist pressures inthe developed world continue to grow andif world trade does not resume its healthygrowth. Efforts to liberalize imports havealso implied additional risks as foreignexchange resources have become scarcer.Fortunately, manufactured exports fromthese East Asian countries have held uprelatively well during the recent deep reces-sion, expanding at an average annual rateof 13 percent during 1980-83, comparedwith 5 percent for developing countries asa whole. This suggests that its better do-mestic policy environment governing ex-ports continues to be a significant factor inEast Asia's greater success in exporting.Needless to add, this pay-off to export-oriented policies serves to reinforce thesepolicies themselves.

Investment. The speed and flexibility inpolicy implementation have also been dem-onstrated through major downward ad-



justments in the investment program inalmost all East Asian countries during thelast few years. Two examples illustrate thecommon approach.

In Indonesia, a weaker demand for oil,the lower oil prices of early 1983, and asharp decline in non-oil exports as a resultof the deep international recession pro-duced a fundamentally changed resourceoutlook. The Government acted swiftly. Inaddition to allowing sharp increases in theprices of domestic oil and fertilizer in early1983, it devalued the exchange rate inMarch 1983. A comprehensive reassess-ment of the public investment programwas initiated, and imports of capital goodswere reduced by postponing a number ofmajor projects with a high foreign exchangecontent. At the same time, high prioritycontinued to be attached to projects thatcreated employment, supported agricul-tural development, and promoted humanresource development through the expan-sion of social services. These measures havehad a remarkable effect on the balance ofpayments; the current account deficit fellfrom $7.1 billion in 1982-83 to $4.2 billionin 1983-84. To reduce the deficit further,only a limited increase in total investmentis forecast for 1982-85.

Malaysia, traditionally a resource-richcountry, has in recent years faced largepublic sector and balance of payments def-icits. These are partly cyclical but have alsobeen related to a tremendous expansion ofpublic sector activities in recent years insupport of important social and economicgoals. In 1983, concerned with the growingburden of domestic and external debt, thegovernment initiated actions that may re-duce real federal government spending byperhaps as much as 20 percent by 1985.Thus, in Malaysia as in other countries, thefocus has shifted from the sheer size ofpublic sector expenditures to their effi-ciency and effectiveness.

Adjustment costs. These adjustments werenecessary but have not been without cost.In Korea, where the adjustment has alreadyproceeded quite successfully, there waslittle growth in per capita consumption over1979-82, and real wages declined by 8

Parvez Hasana Pakistani, was ChiefEconomist, East Asia andcurrently is Chief Economistin the Europe, Middle East,and North Africa RegionalOffice of the Bank. He has aPhD in economics from YaleUniversity and haspublished widely.

percent during 1980-81. In the Philippines,average per capita consumption is likely tobe no higher in 1985 than in 1980. InIndonesia, average per capita consump-tion, after very rapid growth during 1975-82 (which was nearly 7 percent per annum),will show a small decline over two years,1983 and 1984. Managing adjustment inthese circumstances in such a way thatemployment and incomes of the poorergroups are not seriously affected presentsa tremendous further challenge to the skilland ingenuity of policymakers in thesecountries. Even in Thailand, where con-sumption has continued to expand, nosignificant progress has been made in pov-erty eradication since the mid-1970s.

International support

If the difficult and delicate process ofstructural adjustment is to succeed, thedomestic efforts of developing countriesrequire strong international support. WorldBank forecasts indicate that the annualgrowth in the industrial countries over thenext decade will be nearly 3 percent, sub-stantially below the 4.9 percent of 1960-73, but much higher than the averageannual rate of the last ten years (a littleover 2 percent), which included two seriousrecessions. A sustained recovery in trendgrowth cannot, however, be taken forgranted. It will require continued controlof the growth in demand for energy andof fiscal deficits, reduced international in-terest rates, and greater coordination ofmonetary and exchange rate policies amongthe major countries. Moreover, recovery inthe industrial countries will assist, but notensure, good access to their markets bydeveloping countries; resistance to protec-tionist pressures will also be necessary.Last, but not least, a continued expansionof net commercial bank lending to thedeveloping world will also be crucial.

External debt management issues willrequire especially careful handling by bothborrowers and lenders. The total externaldebt of East Asian economies is less thanone sixth of the total debt outstanding ofdeveloping countries. The burden of debt—measured by the ratio of either total debtor annual debt-service payments to exportsof goods and services—is also clearly lowerin East Asia than in some of the heavilyindebted Latin American countries. But thisburden has nonetheless grown, notwith-standing a more than fivefold growth inthe nominal export earnings of this groupof countries in the last decade, and reflectsmainly hardening of the terms of debt. ForIndonesia, Korea, Malaysia, the Philip-pines, and Thailand, debt-service pay-ments, including interest on short-termdebt, rose from 14 percent of export earn-

ings in 1973 to 20 percent in 1983. Therelative decline in the reliance on flows ofofficial assistance is in itself not undesirablefor countries that show increasing capacityfor self-sustained growth. But this shift hasbeen too sudden and has coincided with aperiod when real interest rates on borrow-ing from financial markets have been veryhigh.

At least in East Asia, the high level ofreal interest rates—and not any failure ofexports or real waste of investment re-sources—is the primary factor behind thegrowth in their burden of external debt.The very high real interest rates on privatelending, estimated at over 14 percent perannum during 1981-83, emerged becauseinflation has decelerated suddenly but in-flationary expectations have not changed.The sharp rise in the value of the dollarhas also added to the real interest burden,since most of the debt is denominated indollars. Without a very substantial declinein real interest rates, the debt problem couldtotally disrupt the development process,even with sustained international recovery.It is simply not within the debt-carryingcapacity of developing nations to pay realinterest rates of say 9-10 percent for anylength of time. Indeed, the wisdom of largeadditional borrowing at such interest ratescan be questioned.

But even with lower real interest rates,the net capital requirements of developingcountries, including those of East Asia, willremain sizable. The Bank has lent over $10billion to the East Asian countries (exclud-ing China) during the last four years (fiscalyears 1981-84). This lending has beendirected especially toward support of struc-tural adjustment programs and policies.The Bank's dialogue with governments oneconomic issues has been extremely activeand there has generally been agreement onbroad directions of policy change and re-form. It is hoped that this dialogue willcontinue, and the real volume of lendingat least maintained for the next severalyears. But the bulk of external capital needsin East Asia will have to be met fromcommercial sources. Provided the inter-national economic trend remains reasona-bly favorable and international interest ratesdrop from the very high current levels,debt servicing will not pose serious diffi-culties in East Asia.

For other Third World countries, thedeveloping market economies of East Asiamay be seen as providing a powerful "dem-onstration effect" through the outward ori-entation of their economic policies, theirreliance on market signals, the stability andpredictability of their macroeconomic pol-icies, and their avoidance of confrontationbetween government and business.



Determining the appropriate exchangeA discussion of issues and methods

Ahsan Habib Mansur

Developing countries have in recent yearsexperienced balance of payments difficul-ties that are, in many instances, attributableto their foreign exchange regimes. Fre-quently, the exchange rate—defined as unitsof domestic currency in terms of one unitof foreign currency—is fixed at an unreal-istic level, while the volume and compo-sition of imports are determined by quan-titative restrictions, which cause resourcemisallocation. To overcome these problemsand reestablish the conditions for reason-able economic growth and a sustainablebalance of payments, many countries resortto adjustment programs that includechanging the exchange rate. However, be-fore a change can be made, the appropriatelevel for the new rate must be determined—this being defined as the level that yieldsa sustainable balance on current account inthe medium term, given suitable monetary,fiscal, and income policies. (Sustainable canbe interpreted to imply that any deficit oncurrent account would be met by normaland autonomous capital flows, sometimesincluding concessionary foreign aid).

Ideally, the exchange rate level shouldbe consistent with a country's desired pro-duction, consumption, and trade and pay-ments structure, including any tariffs, sub-sidies, and exchange controls. In theory,establishing such consistency requires ageneral equilibrium model of the economythat can integrate over time the real pro-duction economy with financial transac-tions and arrive at optimal levels for theexchange rate and other variables. How-ever, such an approach is empirically dif-ficult to apply; in many countries key dataare lacking and it is hard to identify futurepolicy targets. A more practical approachto assessing the appropriateness of an ex-isting exchange rate and identifying a morerealistic rate must therefore be found. Al-though a single country may not have allthe data needed for all the steps, the alter-

natives suggested could provide enoughinformation to make a judgment on anappropriate exchange rate.

The following discussion encompasses amore practical approach, which combinesan assessment of past exchange rate policieswith a forward-looking analysis to identifywhether the prevailing rate is compatiblewith reasonable economic growth and aviable balance of payments position in themedium term. Backward and forward anal-yses are methodologically independent, butconceptually one is the extension of theother and they can be mutually reinforcing.The appropriateness of an existing ex-change rate can be determined on the basisof a country's competitiveness, and thedegree of any imbalance in the externalsector. Forward analysis can then show thesustainability of the prevailing rate by ex-amining the economy's adjustment to ahypothetical change. This should not, how-ever, give the impression that the evalua-tion of appropriateness is mechanical—substantial elements of judgment are alsorequired (see chart).

The adequacy of the prevailing exchangerate level can be estimated in four ways:first, from movements in the variousweighted effective exchange rates, relativeprofitability of productive activities andrelative cost/price developments adjustedfor exchange rate changes; second, fromthe exchange rate movements in the officialand parallel exchange markets, and anydistortions in the exchange rate regime;and third, from past fiscal and monetarypolicies and their implications for domesticaggregate demand and the balance of pay-ments. Finally, medium-term forecasts ofeconomic growth and balance of paymentsperformance in the absence of a change inthe current exchange rate can then suggesta potential need for exchange rate action.While the first three approaches are gen-erally viewed as backward-looking, these

may conceptually be extended as forward-looking in the same way as the last ap-proach can be developed. More definiteconclusions on the last approach can, asmentioned earlier, be derived from theforward analyses based on balance of pay-ments and budgetary projections.

Exchange rate indices

Competitiveness is reflected in three maintypes of indicators: one that shows changesin the country's real effective exchange rate(i.e., the average relative change, adjustedfor variations in prices or costs); one thatreflects relative profitability of production;and indices of prices or costs, adjusted forexchange rate changes. In general, indicesof effective exchange rates can be inter-preted to reflect competitiveness becausewhen the real effective exchange rate of acountry appreciates, its exports become lesscompetitive and imports more attractive.This reduced competitiveness contributesto a deterioration of the trade balance andcauses balance of payments difficulties. Inapplied research work, various aggregatenominal and real indices are used, weightedeither by total trade or by exports or importsindividually according to the purpose ofthe index. However, the use of these in-dices has both theoretical and practicallimitations, and, in general, they shouldonly be taken to reflect the approximaterange of past changes in competitiveness.

Apart from the conceptual difficultiesand the selection of the base period thatwould form the appropriate scale for laterprice competitiveness (a major problem),effective exchange rate indices cannot de-termine precisely which exchange rate wouldminimize balance of payments difficultiesover the medium term. Calculated valuesof these indicators often differ widely andgive imprecise and even contradictory con-clusions. Variations in the weights anddeflators used in constructing these indices

18 finance & Development I December 1984


rate in LDCs

may also often yield significantly differentquantitative results.

Moreover, policies entirely based on ef-fective exchange rate indices may containbiases. Since they are determined by pro-duction in the selected base period, a policyof holding them unchanged to restore un-derlying price competitiveness would re-tain the competitiveness of base-yearproduction—a principle of questionablerelevance in a changing world, if the termsof trade deteriorate. In fact, the exchangerate policy needed to develop new exportindustries may be different from past pol-icies. In addition, for the countries in whichthe real exchange rate appreciates whilethe value of exports increases over time,the index would be biased upward andmight suggest a greater exchange rate ac-tion than is actually needed. No quantita-tive information regarding the extent ofthis bias is available, but it could be signif-icant over time. Notwithstanding these de-ficiencies, real effective exchange rate in-dices provide a basis for calculating theappropriateness of the exchange rate in theaggregative form, as the long-run equilib-rium rate moves in line with the realdevelopments.

Profitability

Indicators of the appropriateness of theexchange rate can be complemented bydetailed studies of domestic production,covering the structure, costs, and compet-itiveness of the latter, and the profitabilityof certain productive activities to indicatewhether domestic production incentivesare adequate. These studies can serve asindicators of external, as well as internal,competitiveness in both relative and ab-solute terms. Sometimes, indices of com-petitiveness are based on sample surveys,but more often they are constructed formajor export categories, frequently relativeto imports and nontraded goods. If export

unit costs of production are not available,proxies can be used. Analysis of indices ofprofitability at the exporter and producerlevel is based on the link between producerand export prices through the exchangerate. In countries where domestic pricesfor exportables are fixed by monopoly trad-ing institutions, the link between the ex-change rate and producer prices is severed.To generate adequate supply, the relativedomestic producer prices of exportablesmay have to be raised, and the tradingorganizations compensated for the conse-quent additional outlays through deval-uation to increase their export returns.

Movements in the constructed nominalor real exchange rate indices discussedearlier are not necessarily similar to themovements in individual profitability in-dicators; changes in profitability are notuniform for every export, but depend onthe variations in real international prices,changes in domestic production costs, andso on. If domestic competitiveness hasfallen, the contribution of different factorsshould be determined before corrective ac-tion is decided upon. While developmentsin real effective exchange rates indicategeneral movements in real export pricesreceived by exporters and producers, ex-amination of profitability should be re-stricted to major products to determinewhether factors other than exchange ratesare the cause of reduced profitability andexport performance. A longer-term dete-rioration in the terms of trade of certainproducts, for instance, may not call forexchange rate action to restore profitabilitybut require diversification of the exportbase. Again, while any significant trend inprofitability indices generally indicates achange in average competitiveness, largedeviations do not necessarily call for acorrective exchange rate action. For manydeveloping countries, where a limitednumber of products account for a large

proportion of export receipts, a commodity-by-commodity analysis can identify howfar changes in the value of exports areattributable to exchange rate fluctuations.One procedure uses a partial equilibriumanalysis based on shifts in the supply and

Testing the adequacy of an exchange rate1

Examine: 1

• Effective exchange rate indices• Profitability• Parallel exchange market• Foreign exchange regime and

associated distortions

H inappropriate:—i

• Change exchange rate and/or otherpolicy parameters

• Start forward analysis

t• Evaluate government budget and

balance of payments:1. Impact of exchange rate on

import prices2. Wage-price adjustment3. Supply response and underlying

resource allocation

t• Given tax and tariff structure, evaluate

budgetary positions• On the basis of specified import and

export behavior, determine theBOP position

t• Determine the sustainability of the

budgetary and BOP positions

Stop if sustainable, otherwise ...

'The initial examination of the prevailing exchangerate should take place simultaneously with the forwardanalysis.

finance & Development/December 1984 19


demand of one commodity and then ag-gregates the results for several, allowinginferences to be drawn about the net gainsor losses for a country's exports. Given thesupplier's responsiveness to price changes,the export receipts from individual prod-ucts can be identified and the significanceof exchange rate changes compared to othervariations can be isolated.

Past regimes and policies

In addition to global indicators of theexchange rate, assessment of competitive-ness should also be based on an analysisof distortions in the economic system thataffect different goods (tradables and non-tradables) in different ways. Experienceshows that when developing countries faceunsustainable payments deficits, they oftenimpose quantitative restrictions on imports.Gradually, as a result of many small ad hocdecisions, rather than overall policy design,the regulations become increasingly com-plex. Many countries, for instance, main-tain overvalued currencies with rigid ex-change controls supported by quotas. Inmany, too, the value and composition ofimports may be determined by import li-censing, and the overall tax structure maybe biased against exports, creating an ap-parent case for export subsidies to correctthe consequent resource misallocation.However, piecemeal solutions, taken to-gether, could be detrimental to overall al-locative efficiency. In general, widespreadinterference with market forces causes mis-allocation of resources and, if it persists,significant damage to the economy. Pay-ments arrears may develop that stronglyindicate a medium- to long-term inabilityto sustain the prevailing exchange rate.

One simple method of establishingwhether the exchange regime is harmingeconomic efficiency is to compare the levelsand movements in indicators of productiv-ity with developments in the trade regime.For some countries it has been found thatthe degree of restriction was associatedwith a high marginal capital/output ratio;in some other cases, a rapid reduction inrestrictions was marked by rapid increasesin the rate of productivity. In another ap-proach, the domestic resource cost of earn-ing a unit of foreign exchange in alternativeactivities can be estimated and treated asan approximate index of their differentreturns. A parallel index that is often usedis the effective rate of protection whichtakes into account protection of inputs aswell as final goods. In spite of some well-known difficulties in the computation andinterpretation of these indicators, they doprovide a reasonable explanation for thewide variations in the social returns todifferent activities in the system. Estimates

of effective rates of protection or do-mestic resource costs are useful when mea-sures to reform a protective regime areintroduced.

A parallel foreign exchange market is oneof the by-products of restrictive exchangepolicies, and its overall size and the spreadbetween the official and the parallel marketrates may indicate the appropriateness ofthe exchange rate. Such a market is sup-plied by unofficial flows of foreign ex-change (arising among others from over-invoicing imports or underinvoicing ex-ports, and unreported inflows of remit-tances), while demand for these flows arisesout of exchange control. Although for manydeveloping countries this market could bequite large, and have a detrimental effecton official foreign exchange reserves, itsoverall size relative to official activities isgenerally hard to determine due to lack ofreliable data. Moreover, caution should beexercised in using the parallel rate as anindicator of the exchange rate adjustmentnecessary to attain balance of paymentsequilibrium, since the parallel market gen-erally reflects the tightness and the effec-tiveness of exchange control. The equilib-rium rate lies somewhere between theparallel and official exchange rates.

If a sizable parallel market exists andspreads between official and parallel mar-ket rates are large, the appeal of a deval-uation is that it allows the authorities toreduce overinvoicing or underinvoicing andattract foreign exchange back to the officialeconomy. Activities attracted out of theparallel market would then be recorded asofficial transactions and may be significantwithout any change in the overall real levelof economic activity, implying immediatepositive effects for the recorded balance ofpayments and the tax base.

In many economies, external paymentsimbalances are closely linked to budgetdeficits, which are often caused by over-ambitious public spending. Developmentsin the balance of payments are not inde-pendent of fiscal and monetary policies,which, if expansionary, may exert pres-sures on the balance of payments and

Ahsan Habib Mansurfrom Bangladesh, is aneconomist in the FiscalAffairs Department of theFund. He was educated atthe Universities of Dhakaand Western Ontario, andjoined the Fund staff in1981.

exchange rate. Various indicators can showthe role of past fiscal and monetary policiesin creating imbalances. These include re-cent developments in the overall budgetdeficit, patterns of expenditure and reve-nue, expansion of net bank credit to thepublic sector, or increases in total liquidity.If fiscal disequilibrium exists, an examina-tion of historical patterns of governmentexpenditure and revenue can indicate ifpast expansionary policies were the cause.Alternatively, a more sophisticated quan-titative analysis may be performed, usingmodels specified so that a change in thebudget deficit affects both private sectorexpenditures and the external current ac-count balance, depending on the empiri-cally observable spending behavior of theprivate sector, the financing of the budgetdeficit, and the stance of monetary policy.The monetary sector can be incorporatedin a manner that makes it possible to modela complete adjustment program. As a sim-ple illustration, the effects of budgetaryadjustments on the current account balancemay be specified as felt through their con-tribution to aggregate demand, to the sup-ply and demand for money. The modelshould contain behavioral equations deter-mining real private sector absorption, pricelevels, exports, imports, and the budgetdeficit.

Forward analysis

The adequacy of the exchange rate levelcannot be determined only on the basis ofpast events; more important is the medium-to long-term prospect of maintaining agiven exchange rate. In this context, it isuseful to look first at the effects of main-taining the same exchange rate and, sec-ond, if this is found inappropriate, at theeffects of a change in the exchange rate onthe balance of payments and the govern-ment budgetary position.

A simple approach to forward analysisis to rely on the traditional elasticities ap-proach, and focus on the responsivenessof exports and imports to changes in theexchange rate. For a small open economy,the outcome then mostly depends on theelasticities of export supplies and importdemand; in the simplest specification, for-eign and domestic prices are predeter-mined. A depreciation of the exchange rate,for instance, changes domestic relativeprices; the supply of exports increases; thedemand for imports falls (the degree de-pending on respective elasticities); and thetrade balance improves.

When projecting the effects of a changein the exchange rate on the balance ofpayments, the budgetary position, and otherperformance indicators, several issues needto be addressed. These issues may cover



the adjustment mechanism—whereby pricechanges affect wages, the supply response,and the underlying reallocation of re-sources—or the consequent internal termsof trade effects, all of which follow anexchange rate action accompanied by ap-propriate demand management policies.(The latter are essential. A devaluation, forinstance, can restore competitiveness to theexport and the import-competing sectors,but the lasting effects of a new competi-tiveness are contingent upon accompany-ing fiscal and monetary restraint.) In ageneral equilibrium framework, the variouseffects of an exchange rate change shouldbe determined simultaneously, while a par-tial equilibrium analysis such as this ad-dresses them sequentially. If the sequenceis repeated, a significant proportion of thefeedback effects can be captured and theapproximation would be close to a generalequilibrium formulation.

Given the information on the respon-siveness of prices and supply, balance ofpayments and budgetary projections canbe made, based on the current rate or, if itappears warranted, taking into account thevarious effects of an exchange rate change.For many countries with exchange restric-tions and an overvalued currency, the "re-cording" effect (of activities attracted outof the parallel market by devaluation) maybe very significant and should not be ne-glected in any adjustment program. To theextent that parallel market activity is sig-nificant but not taken into account in bal-ance of payments forecasts, the resultscould be significantly biased toward a def-icit in the official accounting balance. Sep-arate projections, as mentioned earlier, willbe needed for important categories underthe balance of payments accounts, withmajor emphasis on exports and imports.For those developing countries where afew major primary products play a key rolein export earnings, the commodity-by-commodity approach (described earlier)would be appropriate.

On the basis of the projections for foreignexchange payments and receipts, and forforeign grants and loans, the sustainabilityof the balance of payments position can bedetermined. In this evaluation of sustain-ability, it is also appropriate to considerindicators such as the ratio of current ac-count deficits to gross domestic product

and the ratio of debt-service payments tothe receipts of foreign exchange earnings,given projections for foreign debt.

The objective of forward budgetary anal-ysis is to determine if the governmentbudget would be sustainable after a deval-uation or if additional fiscal adjustmentswill be necessary. Since the emergence ofa relatively large budget deficit normallyleads to excessive money creation in de-veloping countries, adjustment programsshould aim to stabilize the budget deficitat a level compatible with noninflationaryfinancing. If the overall balance is found tobe incompatible with the fiscal targets spec-ified earlier, appropriate fiscal measuresshould accompany the exchange rateaction.

The effects of a devaluation, for instance,on budget revenue depend on the changein the aggregate nominal value of imports,exports, and their composition—all of whichare essentially determined by the responsesof prices and supply discussed earlier inthe context of balance of payments analysis.Institutional arrangements—such as pro-curement, marketing, and price controloperations of government agencies—alsosignificantly influence the budget deficitafter devaluation. Effective subsidies toexporters are reduced as the procurementprices of exports rise, while the oppositehappens if the government subsidizes im-ports. The revenue effect also depends onthe proportion of specific as opposed to advalorem import duties. The budgetary im-pact can be analyzed in terms of price effects(as devaluation changes prices) and incomeeffects (as it induces income changes thataffect tax bases). Price effects include changesin imports and exports, in duties receivedand subsidies paid, in government receiptsfrom abroad, and expenditures to be madegiven the new set of prices. If the govern-ment plans to maintain a certain level ofreal expenditure, for instance, additionaloutlays will be needed as devaluation leadsto higher domestic prices. Debt-servicingobligations of the government should alsobe evaluated at the new exchange rate,and, as a minimum, the impact of theadjustment on the "foreign exchange"budget should be assessed.

Alternatively, the impact of devaluationon the budget can be identified with thecorresponding implications for credit ceil-

ings and the balance of payments target.In reality, balance of payments and budg-etary analysis are interdependent and, tothe extent possible, should be treated assuch. The direction of the effect of deval-uation on the overall budgetary deficit andthe consequent bank financing required bythe public sector is not unambiguous. De-pending on the direction and the magni-tude of the change in the budget deficit,the fiscal implications of the hypotheticalexchange rate can be determined. An ap-propriate exchange rate level should notonly be consistent with a sustainable bal-ance of payments; it should also be in linewith the budgetary position to ensure themedium-term sustainability of the balanceof payments. However, financial stabilityin the public sector operations is importantin its own right, and devaluation shouldnot be treated as a means of attainingbudget balance; changes in the expenditureor tax structure may be needed to reducefiscal imbalances, which will also supple-ment the exchange rate policies.

In conclusionThis article has discussed a number of

simple methods, some of which are widelyused, to assess the appropriate level of theexchange rate for a developing country.The aim was to identify "a sustainable"rather than "an optimum" level of theexchange rate. Although from a theoreticalpoint of view this approach is not as elegantas a fully specified optimization solution,it has some practical appeal, particularlyfor developing countries, where data arescarce.

The adoption of this approach can iden-tify the direction of change, but will notlead to an unambiguous and specific "right"exchange rate level. It should, however,improve the basis for judgments that willalways be required of the policymakers.Economic analysis can convincingly estab-lish that an exchange rate will have to bechanged to a new level within a certainrange if certain economic objectives are tobe achieved. However, the choice of theprecise new level will be influenced byjudgments regarding the mix of associatedpolicies; these judgments are likely to bestrongly influenced by the perceived sus-tainability of the adjustment strategyenvisaged.

Introducing our Chinese editionBeginning with the March 1985 issue, Finance & Development will also be available

in a quarterly Chinese edition to be published in collaborationwith the China Financial and Economic Publishing House, Beijing.



Nature and originsof debt-servicingdifficultiesSome empirical evidence Donal J. Donovan

The recent increase in the frequency andseverity of external debt-servicing difficul-ties experienced by many developing coun-tries has prompted numerous assessmentsof the nature and causes of the problems.Several economic factors, assigned varyingdegrees of importance, have frequentlybeen held responsible; these include, amongothers, a deterioration in the external termsof trade, the recession in industrial coun-tries and an accompanying rise in worldinterest rates, inappropriate economic anddebt management policies on the part ofdebtors, and unforeseen and abrupt changesin lenders' behavior.

These assessments tend to remain couchedin rather general qualitative terms and, inmost cases, do not appear to have beenbased upon explicit quantitative investi-gation. An empirical approach could beuseful, however, in clarifying the bases forthese views. Why, for example, have somedeveloping countries clearly experiencedconsiderably more severe debt-servicingdifficulties than others? And to what extenthave the sources of the debt problemsdiffered among developing country sub-groups that exhibit relatively more homo-geneous economic characteristics?

An analysis of the evolution of majoreconomic variables for the group of 22 non-oil developing countries that rescheduledtheir debts on a multilateral basis during1981-82 sought to provide an empiricalbasis for assessing the role of the economicfactors frequently cited as contributing tothe emergence of the debt-servicing prob-

lems. Thus the study examined, in turn,the role of certain exogenous factors (namely,terms of trade changes, the world reces-sion, and changes in concessional aid flows);aggregate macroeconomic variables (the ex-ternal current account deficit, the volumeof exports and imports, the rate of economicgrowth, and the domestic rate of inflation);major economic policy indicators (the growthof domestic credit and the money supply,some partial indicators of fiscal trends, andmovements in the real effective exchangerate); and finally, variables relating to debtmanagement policy (which included therate of growth and maturity structure ofoutstanding debt, the composition of ex-ternal borrowing, and—incorporating theeffects of changes in world interest rates—trends in debt-service payments). The ev-olution of these variables was assessedduring the five-year period ending withthe year before the rescheduling occurred.

The analysis dealt only with the aggre-gative outcome experienced on average byrescheduling countries and thus masks dif-ferences in individual country behavior thatmay be quite significant. However, twosubgroups of rescheduling countries weredistinguished: those that had not reliedsignificantly on external borrowing on com-mercial terms (Group I) and those that had(Group II).

Group I consisted largely of low-incomesub-Saharan African countries that had re-lied very substantially on external financingfrom official sources. It included the CentralAfrican Republic, Liberia, Madagascar, Ma-

lawi, Senegal, Sudan, Togo, Uganda, andZaire, as well as Guyana and Pakistan. Atthe end of 1981 each of these countries hadless than 25 percent of its disbursed externalmedium- and long-term public debt con-tracted at variable interest rates. On aver-age, the proportion of the group's debtincurred at variable interest rates was 9percent.

By contrast, the 11 remaining countriesthat rescheduled debts—Group II—hadmuch greater recourse to international fi-nancial markets. Apart from Nicaragua, theproportion of their debt incurred at variableinterest rates averaged 52 percent. Withthe exception of Romania and Yugoslavia,all were in Latin America or the Caribbean(Argentina, Bolivia, Brazil, Chile, CostaRica, Ecuador, Jamaica, Mexico, and Nic-aragua). Compared with Group I, they hadhigher real income levels, a more diversi-fied export base, and generally fewer re-strictions on external current and capitaltransactions. (An additional country, Po-land, rescheduled its debt during this pe-riod but was not included in this studybecause the relevant data were not readilyavailable.)

To assess the factors that might helpexplain the relative incidence of debt dif-ficulties, the data for the reschedulingcountry groups were contrasted for thecorresponding time period with those of acomparator group—those non-oil devel-oping countries that did not reschedule theirdebt in 1981-82. For each variable, a separateaverage was calculated for rescheduling



and nonrescheduling groups. The median,rather than the mean, was employed inorder to reduce the distorting effect thatoutlying observations might have had.

While not necessarily implying a causallink, the analysis nevertheless yielded use-ful evidence on those common elementsthat may have been present among thegroup of countries that encountered par-ticularly severe difficulties. However, sev-eral qualifications ought to be noted. First,the general inferences drawn for a groupcannot be applied to individual countries.Second, the analysis dealt only with majorrnacroeconomic variables susceptible toquantitative analysis; thus, the roles playedby microeconomic policy variables notreadily quantifiable (for instance, inappro-priate pricing or investment decisions) ornoneconomic variables (such as politicalfactors or regional "contagion effects"—that is, a situation where problems in onecountry affect lenders' perceptions of theentire region) were not addressed directly.Third, a clear-cut conceptual distinctionbetween countries that did and those thatdid not formally reschedule their debtsduring a given period did not necessarilyexist; for example, informal "unilateral"rescheduling (most commonly reflected inthe accumulation of arrears) may occur.Fourth, several countries not included inthe 1981-82 rescheduling group subse-quently did reschedule their debts; thus,any conclusions are relevant only to theincidence of rescheduling that actually oc-curred in the period under review. Finally,the analysis generally concentrated on

Chart 1External current accountdeficit relative to GDP1

Chart 2External trade indicators1

Source: Data base underlying the World Economic Outlookexercise.

Data shown are derived from medians of individual coun-try data for each group.

measurable aspects of debtor country be-havior, although the conclusions take intoaccount some important aspects affectingthe perceptions of lenders.

FindingsThese qualifications notwithstanding, the

study did shed some light on the extent towhich certain factors may have been as-sociated with the debt-servicing problemsof the developing countries (considered asa group) that entered into a rescheduling.The main empirical findings were as fol-lows:

• Analysis of exogenous factors sug-gested that so far as changes in the termsof trade, export demand, and net conces-sional aid flows were concerned, resched-uling countries on average were not af-fected any more adversely by internationaleconomic disturbances than were the coun-tries that did not reschedule. Indeed, tothe extent that the data indicated differ-ences, Group II rescheduling countries, incontrast to the general tendency for coun-tries in the comparator group, appeared tohave experienced on average some slightimprovement in their external terms oftrade in the periods prior to rescheduling.With regard to concessional assistance,Group I reschedulers also appeared to faresomewhat better than those that did notreschedule.

• Macroeconomic performance in gen-eral, however, differed considerably be-

tween the two rescheduling groups. Whilethe lower-income countries (Group I) hadoverall a somewhat larger external currentaccount deficit to GDP ratio than average(Chart 1), a striking feature of their externalperformance was stagnant or declining realexport growth accompanied by sharp cut-backs in imports (Chart 2). In turn, thiswas associated with very low overall ratesof economic growth and relatively highinflation (even on the basis of official priceindices).

By contrast, the ratio of the externalcurrent account deficit to GDP for GroupII rescheduling countries tended to besomewhat less than that of comparatorcountries. Over the entire five-year periodprior to rescheduling, the real growth ratesof both their exports and imports weresomewhat lower than the average. In theyear immediately prior to the rescheduling,these countries experienced on average anoticeably faster export growth, a signifi-cant reduction in imports, and a slowdownin economic growth. The ratio of theircurrent account deficit to GDP, however,remained roughly unchanged. Reschedul-ing countries in this group also had con-sistently higher inflation rates than theaverage—a difference that increased sig-nificantly over time (see table).

Economic growth, inflation, andexpansion in money supply(Change in percent, annual average)1

Sources: IMF, data base underlying the World EconomicOutlook exercise and International Financial Statistics.

1 Data shown are based on medians of individual countrydata for each group.

2 In a small number of instances, changes in GNP havebeen used instead.

3 Based on end-period data; where consumer prices forend-December are not available, series for the fourth quarterhave been used instead.

Finance & Development /December 1984 23

Years prior to rescheduling

Group 1Resched.Nonresched.




5 3

Real GDP 2

1.9 1.15.4 4.9

4.3 3.14.8 4.1

Consumer price

11.7 13.410.8 11.7

23.8 29.414.3 16.9

1

-0.54.2

1.73.3

3

16.412.6

33.113.7

Money and quasi-money



22.9 22.219.2 17.7

31.9 32.022.8 22.3

27.916.5

35.920.3

Source; IMF, data base underlying the World EconomicOutlook exercise.

Data shown are medians of individual country data foreach group. In a small number of instances, ratios to GNPhave been used instead.


• So far as other macroeconomic policyindicators were concerned, both resched-uling country groups experienced morerapid rates of expansion in total credit, netcredit to government, and the money sup-ply than their comparators (see table).Available partial indicators also suggesteda somewhat more expansionary fiscal stancethan average, especially in the case of thelower-income group (Group I). Group IIrescheduling countries also experienced asizable appreciation in their real effectiveexchange rates in the years prior to the onein which the rescheduling occurred (Chart3). While a considerably smaller recordedreal appreciation was noted for Group I,this may well have understated the appre-ciation that actually took place, due to anunderestimation of inflation by official con-sumer price indices. In the case of GroupII rescheduling countries, indirect evidencealso suggested that a substantial amountof unrecorded net capital outflows oc-curred—a phenomenon, moreover, that in-creased over time.

• On debt management policies, twofindings were particularly striking. First,while the evolution of total medium- andlong-term external public debt was not very

Chart 3Effective exchange rate indicators1

Source: Fund staff estimates.'Data shown are medians of individual country data for

each group.Calculated on the basis of trade weights for major trading

partners. An increase in the index indicates a relative realappreciation of the currency.

3Refers to end June of the year of the rescheduling.

dissimilar between rescheduling and non-rescheduling countries, there was for theformer group a marked deterioration in thematurity structure of external debt owedto commercial banks. This deteriorationwas most noticeable when the evolution ofshort-term debt was viewed against indi-cators such as available international re-serves (Chart 4), exports, or imports. It wasespecially marked for Group II countriesthat rescheduled their debts during 1982,for whom short-term commercial bank debtwas of particular quantitative significance.

Chart 4Short-term commercial bank debtrelative to gross official reserves

plus unused bank credit commitments1

Sources: Bank for International Settlements, The MaturityDistribution of International Bank Lending; and IMF, interna-tional Financial Statistics and data base underlying the WorldEconomic Outlook exercise.

Debt with a remaining maturity of one year or less owed toforeign commercial banks.

2Data shown are medians of individual country data foreach group.

Such an excessive recourse to short-termdebt—which in many cases reflected a post-ponement of needed adjustment in the faceof reduced access to medium- and long-term financing—meant that these countrieswere particularly vulnerable to unforeseenchanges in lending behavior. Second, re-scheduling countries exhibited higher thanaverage (and rising) reliance on debt owedto private creditors and/or contracted atvariable interest rates (Chart 5); they weretherefore prone to be affected more ad-versely by the worldwide increase in inter-est rates.

Chart 5Proportion of debt contracted

at variable interest rates1

Years prior to rescheduling (period t)

Source: World Bank, Debtor Reporting System.Debt owed to private suppliers and financial institutions.

Data shown are medians of individual country data for eachgroup.

Overall assessment

The findings of the study thus suggested,albeit tentatively, that some distinctive fea-tures did increase the incidence of debt-servicing difficulties for particular countrygroups. For the lower-income reschedulingcountries (Group I), the adverse impact ofexogenous factors appeared, on average,to have been a little less than is sometimessuggested. Rather, a major underlyingsource of their severe debt-servicing prob-lems appeared to have been their weaker-than-average economic performance in termsof real export growth, inflation, and eco-nomic growth. These trends, besides con-tributing directly to foreign exchange pres-sures, undoubtedly served to erode theconfidence of lenders and donors alike.Moreover, to the extent that possible sig-nificant reasons for the above shortcomingscould be identified, inadequate demandmanagement and exchange rate policieswere likely to have been contributing fac-tors in many cases.

The overall assessment of the possiblefactors underlying the difficulties experi-enced by the higher-income rescheduling coun-

24 finance & Development/December 1984




tríes (Group II) was somewhat more com-plex. So far as the macroeconomicperformance and policies of the group onaverage were concerned, over the entireperiod reviewed, the trends in the externalcurrent account (in relation to GDP), realexport growth, and economic growth per-formance did not appear to have beenstrikingly different from those experiencedby the comparator country group. Indeed,in the year immediately preceding that ofthe rescheduling, rescheduling countriesappeared to have had, on average, a turn-around in some aspects of their externalposition, namely, trends in real exportsand imports. At the same time, some slow-down in the rate of domestic economicactivity occurred.

Despite these changes, however, the ex-ternal current account deficit as well as netmedium- and long-term external borrow-ing—both measured in relation to GDP—actually rose slightly on average for thegroup in the year prior to the rescheduling.An important contributing factor to thisoutcome was probably the adverse impactof the rise in worldwide interest rates onthe servicing of the existing stock of debt.This reflected, in turn, the relatively greaterreliance (compared to nonreschedulingcountries) that rescheduling countries hadon variable interest borrowing. In the yearprior to rescheduling, two important eco-nomic variables, namely, the rate of do-mestic inflation and the real effective ex-change rate, moved in a clearly unfavorabledirection, while at the same time, substan-tial evidence indicated a marked increasein capital flight.

Nevertheless, since the Group II re-scheduling countries were faced with for-eign borrowing needs (measured in relationto their GDP) not on average very differentfrom those of other countries, why werethey unable to obtain the amounts of for-eign financing required, so that resched-uling was precipitated? Unmeasurable po-litical and regional contagion effects mayhave played some role (as well as the factthat the average outcome concealed a range

of diverse individual experiences), but sev-eral additional aspects involving the per-ceptions of commercial bank lenders duringthis period need to be considered.

First, from the perspective of creditors,the absolute size of borrowing needs ratherthan financing requirements in relation tothe debtor country's GDP is likely to havebeen of crucial importance. Thus, althoughother smaller nonrescheduling countrieshad higher deficit/GDP ratios, it was prob-ably inevitable that the prospect of havingto continue to provide several countries inthe rescheduling group with unprecedent-edly large amounts—not only in the im-mediate period but also for several yearsahead—would in any event have soonbegun to run counter to lenders' portfoliobalancing considerations. This aspect isparticularly relevant in view of the priorsharp rise in international bank lendingrelative to domestic lending and the con-centration of bank claims in a number ofimportant borrowing countries.

Second, concern over the absolute sizeof borrowing needs was probably greatlyreinforced by the sharp fall in world infla-tion and in inflationary expectations in theearly 1980s. Thus, even had the deficits ofsome of the largest debtors hitherto beenjudged marginally sustainable, the fall inworld inflation and the associated shift topositive real interest rates were likely tohave caused lenders to reappraise whatconstituted a sustainable deficit from the

Donal Donovanan Irish citizen, is currentlyAssistant Chief, ExternalFinance Division, Exchangeand Trade RelationsDepartment. A graduate ofTrinity College, Dublin, hereceived a PhD from theUniversity of BritishColumbia before joining theFund staff in 1977.

viewpoint of the borrowers' medium-termdebt-servicing capacities. This considera-tion was probably accompanied, moreover,by a realization on the part of lenders thattheir loanable resources (i.e., deposits) wouldgrow far more slowly in an environmentof reduced inflation.

Third, all of these developments coin-cided with some particularly unfavorable(and well publicized) aspects of debtorcountry performance, including, for ex-ample, accelerating domestic inflation anda significant real appreciation of the ex-change rate. These factors were likely tohave contributed directly to the phenom-enon of capital flight, while at the sametime undermining lenders' confidence inthe future ability of the borrowers to containexternal imbalances even within their pres-ent levels (thus further affecting adverselytheir judgment as to what constituted asustainable path of external borrowing).

Finally, it is also clear that the debtmanagement policies of the Group II bor-rowing countries were an important addi-tional element that greatly aggravated thedifficulties. A distinguishing feature of theexperience of these countries was the factthat large-scale recourse to short-term com-mercial bank borrowing had caused a verysharp deterioration in the maturity profileof their external debt. To a considerableextent, this increased reliance on short-term debt was symptomatic of their un-derlying problems, reflecting, in many cases,a reduction in access to medium- and long-term financing sources. Nevertheless, oncethe reassessment of lending attitudes onthe part of commercial banks became wide-spread, these countries were left highlyvulnerable to a sudden withdrawal of fundsor even simply to a slowdown in the rateof growth of new lending. Thus, while thefact that the underlying situation was un-sustainable would probably have becomeapparent in any event, there can be littledoubt that inadequate debt managementpolicies of borrowing countries greatly con-tributed to the abruptness and severity withwhich the 1981-82 crisis unfolded. """"

1̂ л§\!!Щ]© 0̂1(1Ш1Ш is available on microfilm fromUniversity Microfilms, P.O. Box 1346, Ann АгЪог, MI48106, USA, and on microfiche (English only) fromMicrophoto Division, Bell and Howell Company, OldMansfield Road, Wooster, OH 44691, USA


Finance&


This is the final article in our series commemorating the fortieth anniversary ofBretton Woods. Andrew Kamarck was with the World Bank for 28 years, holding anumber of senior positions in the institution. Since retiring from the Bank, he hasbeen Associate Fellow at the Harvard Institute of International Development. Inthis strictly personal perspective, he reflects about the Bank's past efforts to promotedevelopment, including some of the obstacles it has faced, and the important role ithas to play in the future.

The World Bank and development:a personal perspective

Andrew M. KamarckEconomic Advisor on Europe and Africa (1952-64),

Director of the Economics Department (1965-71), and Director of the Economic Development Institute (1972-77)

The World Bank has been, and is, a remark-able, pragmatic institution, with an out-standing capacity to learn from experience.Since it was created 40 years ago, its poli-cies and organization have evolved almostcontinuously to help member countrieshandle the multitude of different problemsthat arise during the course of develop-ment. Initially, it paid little attention to aca-demic economic development theory, mak-ing its decisions instead on the basis ofwhat the staff found to be the real problemsin the field and on what experience taughtwas effective in handling them. For manyyears, the Bank did not even make much ofan effort to disseminate the results of itsrich operational experience, knowledge,and research. But beginning with the crea-tion of a strong central economics depart-ment by George Woods in 1964, by the late1970s the research staff had been built up tothe point that some of the published workappeared to be largely academic in nature.The recent change in emphasis to increase

The six articles and the Milestones chronol-ogy in the series Bretton Woods at Forty havenow been published in a collection (English only)available without charge from Finance &Development, International Monetary Fund,Washington, DC 20431, USA.

economic capacity within the operationaldepartments is a return toward earlierpragmatic practice.

A dominant theme of the history of theBank has been the almost continuousgrowth of its resources and operations.Since the beginning of Eugene Black's termas President in mid-1949, lending by theBank family (IBRD, the International De-velopment Association, and the Interna-tional Finance Corporation), grew in realterms at a rate fluctuating around 10 per-cent a year. This rate held for the EugeneBlack-George Woods period that ended in1968, when no special emphasis was put onexpanding lending per se, as well as for thesubsequent McNamara years when highpriority was placed on achieving lendingtargets, and it has been true so far of theClausen era. The recent cutback in the sizeof the Seventh IDA Replenishment, if itproves more than a temporary anomaly,would mean a fundamental change in thistrend. However, while the provision of ex-ternal resources to its member countries re-mains a necessary function of the Bank, it isarguable whether some of its other activ-ities (discussed later) do not now make aneven more vital contribution to economicdevelopment in its member countries. Be-cause Bank loans and IDA credits are reck-oned in numbers, while the other contribu-

tions of the Bank are harder or impossibleto quantify, the lending story is wellknown. This article will therefore tendrather to emphasize the latter to redress theoverall imbalance.

Evolution of lending

The early emphasis of the Bank was onloans for building up infrastructure. Thiswas not based on any abstract theory ofdevelopment but on the fact that in theearly years after World War II, the con-straint on development in the Bank's mem-ber countries was a lack of capacity inrailroads, ports, roads, and electric power.Because of the Great Depression and WorldWar II, there was little investment in infra-structure for over a decade and much of theexisting capacity had run down. With thehigh demand from the postwar prosperityof the industrial world, the commodity-producing sectors of many of the Bank'smember countries were able to increasetheir output faster than their infrastructurecould handle it.

For many of the major borrowers in thisperiod (the temperate zone countries ofNorthern and Southern Europe, Japan, andAustralia), the role of the Bank was rela-tively straightforward. All that was neededwas the provision of some capital to financeeconomically justifiable infrastructure proj-



ects and occasionally a quiet agreement onmeasures to improve macroeconomic poli-cies. The rest was in place. These countriesalready possessed a dynamic cultureoriented toward material progress; an edu-cated, trained, labor force; and an entrepre-neurial, market-oriented economic struc-ture. The existing known technology of theindustrial world was applicable and easilytransferable to them. Further, these coun-tries had already evolved the national unityand effective government bureaucracyneeded to provide the national leadershipand cohesion for a continuing process ofeconomic growth. Success was not only at-tainable but—since the countries involvedwere mostly democracies with govern-ments receptive to the needs of theirpeoples—growth was likely to benefit all.By the 1960s, most of these countries nolonger needed to borrow from the Bankand had clearly become part of the indus-trial world.

The Bank discovered that, in the coun-tries that continued to need help, many ofthe prerequisites for development that exis-ted in the countries that had been earlyborrowers could not be counted on. Theprocess of development in these countries,therefore, demanded a much more complexresponse than simply providing externalcapital. For example, when groundnutswere being heaped into pyramids in North-ern Nigeria because the railway did nothave the capacity to carry them to theports, lending priorities were relativelyeasy to assess. But once the railway couldcope with the existing commodity-producing capabilities of the economy,new problems began to emerge. Lendingcould and did continue to allow the infra-structure to keep pace with the commodity-producing sectors. But beyond this, it be-came clear that help was also needed toaccelerate growth in these sectors and to cre-ate new industries and new initiatives.

A logical consequence was the creationof the IFC in 1956 to aid private entrepre-neurs in industry. In agriculture, the Bankbegan to experiment with a wide gamut ofinnovative projects. It also established closerelationships with the Food and Agricul-ture Organization, including the recruit-ment of special FAO staff to work with theBank (and this substantially improved theperformance of the whole FAO organiza-tion). As a result, the total of Bank (andIDA) resources devoted to agriculture andrural development has, for some years, ex-ceeded that going into any other majorsector.

But making capital available to industryand agriculture was not the whole answer;there had to exist economic demand for it.And here education played a crucial, if

long-term, role. After Tunisia had becomeindependent and joined the Bank in thelate 1950s, a Bank mission found that toimprove growth, an expansion of educa-tion was needed to stimulate entrepreneur-ship, to train workers, and to secure all theother unquantifiable benefits that educa-tion could bring to the transformation of aneconomy. Thus, the Bank entered the fieldof financing education.

The Bank's involvement with traininggovernment officials arose from a similarconcern. As early as 1955, it was clear thata strategic factor in the relative perfor-mance of different countries that were oth-erwise roughly comparable was the qualityof economic management within the gov-ernment. The Bank, as a result, establishedthe Economic Development Institute tohelp train senior government officials. Be-ginning with an initial course of 14 partici-pants, it took 14 years to train the first thou-sand. By the end of the 1970s, this total wasbeing surpassed each year in courses run orcosponsored by the EDI in Washington andin member countries around the world.

Even with these new programs in indus-try, agriculture, education, and training, itwas apparent by 1960 that for many poorcountries development was going to be soslow that they could not take on much debton the usual Bank terms. The IDA was con-sequently created.

Limits

Since the 1970s, it has been increasinglyobvious that the Bank is still seriously con-strained in what it can do to help develop-ment in many of its member countries. Thefirst major problem is that most of its cur-rent borrowers are tropical countries,where much of the existing knowledge andexperience of the industrial temperatezones is not applicable. Tropical agricul-ture, for instance, is very different fromagriculture in temperate zones, and thefirst need is to expand research on thoseparticular characteristics that affect its de-velopment. In 1971, the Bank took the initi-ative to set up the comprehensive Consul-tative Group on International AgriculturalResearch in partnership with the FAO andthe United Nations Development Program.While the institutes financed by CGIARhave already made a substantial con-tribution to agricultural output in thetropics, progress in agricultural researchand its dissemination to farmers is slow.

A major and special limit on growth inthe tropics is disease. Not only are tropicaldiseases and predators of crops and live-stock more virulent than those in the tem-perate zones, but human diseases are too.The tropics are also subject to most of thetemperate zone diseases but these are more

difficult to resist where heat permits afaster multiplication of both the vector andthe disease organism. The house fly (whichspreads the baby-killing bacillary dysen-tery and other diseases) becomes an adultfour times faster at 30 degrees Celsius thanat 16 degrees. The speed of multiplicationof the malaria parasite within the host mos-quito also increases directly with heat. Fewtropical diseases have been brought undercontrol; in fact, the research effort neces-sary to achieve control has barely started.Only in 1975 was a coordinated interna-tional effort begun, with the active partici-pation of the Bank, to try to discover, de-velop, and apply new technologies for thecontrol of six of these tropical diseases.

The lack of knowledge on how to copewith the tropics is not the only factor thatlimits how much the Bank can help devel-opment in its member countries. Whilethey are unmeasurable and vary betweencountries and cultures, the limits on thehuman and institutional capacity to adaptto the strains and changes mandated byrapid economic development are the sec-ond major constraint on development. Forexample, most of the Bank's current bor-rowers are newly independent countrieswhere the institutional framework is se-verely tested by the stresses that growthinduces in shifting economic power amonggroups and among regions. Developmentrequires, as a minimum, peace, sufficientpersonal security, and a tolerable adminis-tration of justice. Stable, firm governmentstructures that are able routinely to handleshifts of power without violence are opti-mum for people to work, invest, and planfor the future. Acquiring this capability incountries still engaged in creating politicaland social cohesion requires time and can-not be drastically accelerated.

Similarly, where low levels of educationand training hamper development, thepace may be held down by how fast peoplecan learn and acquire new skills. It may bedelayed if governments choose to turn theirbacks on modernization, as they have insome countries, and destroy or expel theirmodernizing elements; in such cases, anactual retrogression in living standardsmay result. In some other countries wheredevelopment had been rapid, social andpsychological stresses have stimulated thegrowth of movements opposed to eco-nomic progress that are having a percep-tible effect on government policies.

Another limit on development is thegrowth rate of population, which is stillvery high in most borrowing countries.This means that a rate of economic growththat was adequate for early borrowers likeFinland to bring real increases in livingstandards is swallowed up in present bor-



rowers by an expansion in population, withlittle perceptible improvement in their in-comes. Robert McNamara and the Bank inthe 1970s helped immensely in focusing theattention of many countries on the needto try to bring down the rate of populationgrowth. This is a good example of whenthe Bank has made a major contributionthat was not reflected in the lending pro-gram. Perceptible progress is clearly beingmade—the population growth rate is drop-ping in many countries—but this, too, isvery slow.

With the growing realization that eco-nomic development was going to take avery long time in the poorest countries andthat its impact on social conditions couldnot be disregarded if the necessary popularsupport were to be maintained, RobertMcNamara proposed that the objective ofdevelopment should be changed fromgrowth to growth with income redistribu-tion toward the poor. The policy of theBank became one of emphasizing povertyalleviation while helping economic growth.The Bank has not, however, gone so far asto make meeting the basic needs of thepoor the major objective. That is, it remainsan economic development rather than aninternational income redistribution agency.In any case, there has never been a satis-factory definition of what basic needs are orwho is to determine them: the peoplethemselves or experts? Nor is it clearwhether satisfying basic needs today con-tributes to economic development (helpingsmall farmers may stimulate growth morethan assisting landless laborers); even if itdoes, is it the most cost-effective way ofencouraging growth?

The limitations discussed above were es-sentially unavoidable, but another limitingcondition on development in the 1980scould perhaps have been avoided. This isthe enormous external debt that somecountries accumulated, mostly during the1970s, and which they can only continue toservice at the cost of constricting their in-vestment and holding down or actually re-ducing standards of living. The situation isreminiscent of a problem faced by the Bankin the first years of its operations. Duringthe 1920s, the inexperience of U.S. invest-ment bankers and the euphoria of the timesled to overborrowing by a large number ofgovernments and, to widespread defaultsin the 1930s. Until well into the 1950s, theability of the Bank to help some countrieswas inhibited while they painfully nego-tiated settlement of their defaults. In the1970s, commercial bankers flush withOPEC deposits repeated the history of the1920s that had been forgotten.

As a direct result, by 1984, several of theBank's member countries were faced with

such overwhelming external debt servicethat only a continuous process of resched-uling (and in some cases the extension ofnew loans to cover the interest due)allowed them to avoid default. These coun-tries are having to throttle their economicgrowth, impose politically difficult burdenson their people, and their capacity to un-dertake new borrowing to finance needednew investment has been severelyimpaired.

The future

With all these limitations, what is the fu-ture for the Bank? Many futures are possi-ble, none is certain, and about all that onecan do with some assurance is to identifyforces and trends that will shape events.Most of the countries that rely today on theBank for help are mainly those that have, ashas been indicated above, much moresevere obstacles to overcome than thosecountries that developed successfully inthe last 40 years. Economic progress inmany of the lowest-income countries isgoing to be painfully slow for many yearsto come. However, whether the ultimateconstraints are external or internal, there isa limit on what the provision of capitalby the Bank can do to accelerate theirdevelopment.

In the 1950s, the Bank made an impor-tant contribution to helping countries copewith the external debt problems left overfrom the 1930s. And now it is trying, incooperation with the Fund, to help coun-tries make necessary adjustments on acase-by-case basis. If the international eco-nomic environment is favorable, some ofthe large debtors may consequently be ableto resolve their debt problems. But if it isnot favorable, the Bank at some point mayhave to be called on to play a larger role—and be provided with the necessary re-sources and powers to do so—in workingout, in cooperation with the Fund, longer-term solutions to the present debt over-hang. As a long-term lender, the Bank iswell qualified to work out whatever provesnecessary. If governments are prudent andact soon, matters may be handled morecalmly; if not, action may have to be takenprecipitously with possibly very seriousimplications.

In addition, some arrangement will haveto be made to take up some of the slack inthe resource contribution to the developingworld that was made by the commercialbanks. This should entail a large increase inthe lending capacity of the Bank as well asin its leadership role in mobilizing otherfunds for its borrowers. Governmentslearned a long time ago that in their domes-tic operations banks are too vital to be left

unregulated. One lesson that industrialcountries may draw from the present exter-nal debt situation is that the benefits of theinternational operations of commercialbanks could be greatly enhanced if lendingwere channeled through consortia headedby the Bank (or one of the other interna-tional financial institutions) that can pro-vide the leadership, analysis, and judg-ment that the commercial banks cannot.

The need for IDA assistance will remaingreat for the foreseeable future. Since mostgovernments that contribute to IDA agreeon this, it is unlikely that the decrease offunds in the Seventh Replenishment willstart a new trend. The support and leader-ship of the Bank in identifying and encour-aging research on those obstacles specificto the tropics that make development of thepoorest countries so difficult will also con-tinue to be crucially important.

Since good economic management iscentral to economic progress, the Bank willundoubtedly find it necessary to empha-size strengthening this aspect of its devel-opment work. In the early years of its lend-ing to the well-established nations of thetemperate zones, the Bank often made asubstantial contribution to improving theoverall allocation and use of resourcesthrough better macroeconomic policies.With its later borrowers, the Bank usuallyfound that concrete progress could beachieved better by concentrating on the useof resources at the micro or project level.Emphasis on projects will undoubtedlycontinue to be needed in many countries.However, in the emerging industrial coun-tries, macroeconomic policies that influ-ence the broad allocation and managementof resources within the economy demandmore attention, and this was the focus ofmuch of the Consultative Group work overthe years. In these countries, the Bank islikely to need to give still higher priority tomacropolicy issues in its lending and nego-tiations. Growing emphasis on structuraladjustment and sector loans or othermacropolicy packages is indicated. Thenew location of EDI within the operationalcomplex of the Bank shows that the con-tribution of training to improving economicmanagement at the micro and macro levelshas been recognized to be as important adevelopmental tool as the provision of cap-ital finance in the future policies of theBank.

The Bank continues to be one of the mosteffective organizations in the world. Its ex-perience and its able personnel are un-matched. Its creation and successful recordare unique in world history. It is impossibleto believe that governments will neglect tomake growing use of the capabilities ofsuch a splendid instrument. ED



Toward sustained developmentA joint program of action for sub-Saharan Africa

The World Bank released its third report on sub-Saharan Africa in September 1984,accompanied by proposals by President A. W. Clausen on specific steps that the Bankintends to take to assist African development. The report was presented to the Devel-opment Committee at its meeting in Washington, DC in conjunction with the AnnualMeetings of the Fund and the Bank.

Here is a summary based on excerpts from the report and Mr. Clausen's statement-

Economic and social conditions in sub-Saharan Africa began to deteriorate in the1970s, and continue to do so. Gross do-mestic product grew at an average of 3.6percent a year between 1970 and 1980, buthas fallen every year since then. Withpopulation rising at over 3 percent a year,GDP per capita in 1983 is estimated to beabout 4 percent below its 1970 level. Ag-ricultural output per capita has continuedto decline, so food imports have increased:they now provide about a fifth of theregion's cereal requirements. Much indus-trial capacity stands idle, the victim offalling domestic incomes, poor investmentchoices, a failure to develop export oppor-tunities, and a lack of foreign exchange formaterials and spare parts. After the im-pressive start following independence inbuilding infrastructure, education, andhealth services, progress is faltering andmay be reversed by a shortage of funds.Many institutions are deteriorating, bothphysically and in terms of their technicaland financial ability to perform efficiently.Although the picture varies from countryto country, even those with good recordsin the 1970s now face serious difficulties.In short, the economic and social transfor-mation of Africa, commenced so eagerlyand effectively in the early years of inde-pendence, could be halted or even re-versed. And these problems are not shortterm.

Is it possible to look with hope towardthe future? The World Bank, in its reportsAccelerated Development in Sub-Saharan Af-rica: An Agenda for Action (1981) and Sub-Saharan Africa: Progress Report on Develop-ment Prospects and Programs (1983), has an-swered with an emphatic "yes." The po-tential for rapid growth exists. Althoughsome areas are prone to drought and othernatural hazards, most countries have alarge agricultural potential. Some have oilor other mineral resources. The shortageof educated and experienced people, whichwas a major barrier to development formost countries at independence, has beeneased. More important, leaders in sub-Saharan Africa increasingly recognize the

need to revise their development strategies.As the 1983 report noted, some countriesare introducing policy and institutional re-forms (see Finance & Development, March1984). However, progress remains inade-quate, both in terms of the number ofcountries in which reforms are being madeand in terms of their scale and speed ofimplementation. Similarly, aid donors haverecognized the need to adjust their pro-grams to support these reforms more ef-fectively, but their response has also beeninadequate. They have typically failed tocoordinate their programs so as to providethe well-focused support that governmentsrequire.

Like its two predecessors, the 1984 reporton sub-Saharan Africa reflects the wide-spread and growing concern about eco-nomic conditions in sub-Saharan Africa.While it reiterates the main theme of itspredecessors—the need for domestic policyreforms to accelerate growth—it has severaldistinctive features:

• It places more emphasis on strategiesfor donor assistance. While the reform ofthe policy and institutional framework withineach country is crucial, domestic reformscannot be fully effective unless they aresupported by appropriate levels and typesof external assistance.

• It stresses the key role of a better useof investment—both domestic and foreign.This requires appropriate pricing policies;adequate national management capacity,supplemented by technical assistance; anda more active role for nongovernmentalinstitutions and the private sector.

• It analyzes the growing debt-servicingburden of sub-Saharan countries in thecontext of their overall requirements forforeign exchange.

• It draws attention to the long-termconstraints on development—populationgrowth, human resource development,technological change, and the erosion ofnatural resources (such as deforestationand desertification). Unless these issuesreceive continuing and increased attention,whatever the short-term problems, devel-opment in the region will continue to be

frustrated, leading to what the EconomicCommission for Africa has called a political,social, and economic "nightmare" by theturn of the century.

In placing high priority on assisting thegovernments of sub-Saharan Africa to re-think their development strategies, theWorld Bank is not, of course, alone. Inaddition to regional bodies such as theEconomic Commission for Africa, the Af-rican Development Bank, and the Organi-zation for African Unity, many other or-ganizations and institutions have also givenAfrica's critical problems special promi-nence in their work. The United Nations'Secretary-General has taken an initiative tomobilize support from the internationalcommunity, and many UN agencies, bilat-eral donors (including the European Eco-nomic Community), and nongovernmentalorganizations have also placed Africa's needsat the top of their respective priority lists.Although views on timing and prioritiesmay still differ, the emerging consensusdwarfs remaining areas of dissent. More-over, delay in taking action, whether bygovernments or by donors, can no longerbe justified on the grounds of major disa-greements in diagnosis and prescription.

The 1984 report contains a number ofkey recommendations for action to addressthe roots of development problems southof the Sahara, while recognizing the widevariety of conditions that exist in the region.It proposes a flexible package of actions ina framework designed to increase the con-fidence of both African governments andthe international community that a sustainedcommon effort will produce results. The im-pact of some actions can be immediate;others will take longer to mature. They aredesigned to be taken in addition to theinternational action urgently needed to helpmeet emergency requirements for food aidand other humanitarian assistance.

The action program consists of six mainelements:

(1) Design and implementation of na-tional rehabilitation and development pro-grams by African governments to increasethe efficiency of the use of financial andhuman resources.

(2) Greater support by donors for pro-grams that address long-term developmentconstraints.

(3) Increased donor flexibility and fi-nancing for policy reforms.



(4) Higher priority in funding programsfor operations and maintenance to utilizeexisting investments and infrastructurefully.

(5) More effective use of externalassistance through improved donorcoordination.

(6) Actions to maintain net capital flowsto sub-Saharan Africa at least at 1980-82levels in real terms.

These actions are far-reaching but willnot happen by themselves. Many Africancountries need assistance to formulate re-vised development strategies, new policies,adequate sector programs, and modifiedpublic investment priorities and programs.Donors need better information on aidflows to individual countries, clearer defi-nition of requirements, more specific state-ments of investment needs and policy ob-jectives, and improved fora in which tocoordinate actions and responses.

The Bank's roleThe Bank is only one of the organizations

that must be of assistance. The processdescribed in the report is a collaborativeone including the major bilateral donors,the EEC, the AfDB, UNDP, and others.However, as the report notes, the need for

action is urgent, and the Bank proposes totake steps to augment its capacity to assistthe countries in sub-Saharan Africa and tosupport, to the extent desired by the otherparticipants, efforts to improve the qualityand quantity of aid. Specific proposals pre-sented by President A. W. Clausen includeexpanding the number of effective Con-sultative Groups in sub-Saharan Africa (fromthe present 9-12 to 15 or 16 in the future)and strengthening the staff working on thearea, both at headquarters and in the res-ident missions. The number of residentmissions will also be expanded.

The Bank will also:• Undertake consultations with donors

immediately to explore ways and means tocoordinate its assistance more effectively,define their policy responses to the pro-posals in the report, consider the supportthey may provide to the financing of thepreparation of sector programs and theservices of Consultative Groups, and con-sider how resources can be mobilized tohelp countries in sub-Saharan Africa makefuller use of existing capacity, ensure moreefficient investment, and support programsof change;

• Expand support for agricultural re-search in Africa at the regional and subre-

gional levels to strengthen local capacityfor generating the technology neededto increase the productivity of Africanagriculture;

• Establish a special project preparationfacility to help member countries preparesound investment proposals, consistent withtheir development priorities, for financingby other donors; to expand the assistancenow provided for the preparation of proj-ects for Bank financing; emphasize, in theuse of available resources, assistance togovernments in the establishment of publicsector investment monitoring programs;

• Having increased Africa's share in IDA,continue to give Africa the highest priorityin the allocation of scarce IDA resources;

• Expand lending programs to Africa tothe maximum extent feasible, consistentwith prudent management of Bank port-folio risks and the existing debt problemsof the African countries; and

• Make every effort to help African coun-tries that so desire to improve the invest-ment climate for foreign private investors,including the expansion of the operationsin Africa of the International Finance Cor-poration and the continuation of Bank ef-forts to establish a multilateral investmentguarantee agency.

Toward Sustained Developmentin Sub-Saharan Africa:A Joint Program of ActionThis third report on sub-Saharan Africa reiterates a main theme of twoearlier reports—the need for domestic policy reforms to accelerate growth.Looks at: »past uses of development aid »donor assistance strategy »use ofinvestment »the growing debt-servicing burden »long-term constraints ondevelopment »overcoming constraints

Still AvailableAccelerated Development in Sub-Saharan Africa: AnAgenda for Action and Sub-Saharan Africa: ProgressReport on Development Prospects and Programs

"It paints a stark picture of an entirecontinent spiralling down towardsdisaster, with economies slumping, lessfood being produced and the popu-lation doubling by the end of thecentury."

Geoffrey Lean, The Observer,September 23, 1984

"Reforms can't be forced on thesecountries by outsiders. But they can beencouraged by offers of aid and goodadvice. The World Bank is extremelyskillful at tying them together, andkeeping them tied."

Washington Post editorial,September 25, 1984

Please send me:Tbward Sustained Development in Sub-Saharan Africa: A JointProgram of Action, $6. Specify language: DEnglish OFrenchDSpanishAccelerated Development in Sub-Saharan Africa: An Agenda forAction, $6. Specify language: DEnglish DFrenchDSub-Saharan Africa: Progress Report on Development Prospectsand Programs, Free. Specify language: DEnglish DFrenchDCatalog of Publications 1984, Free.Enclosed is my check for $ (or equivalent currency).Charge to my DVISA DMaster CardDAmerican Express(Credit cards accepted only by World Bank Publications, Washington. D.C.)Number Expiration Date

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Sustaining recovery,reviving developmentThe principal themes of the 1984 Annual Meetingsof the Boards of Governors of the Fund and the Bank

Kenneth S. Friedman and Balwant S. Garcha

The mood at the 1984 Annual Meetings(held in Washington, DC, on September24-27 and chaired by Noburu Takeshita,Minister of Finance of Japan) reflected theprogress since the 1982 Toronto Meetingsin reviving the world economy. Yet therewas clear recognition that even though thedeepest and longest recession since the1930s was over, a number of the problemsin both developing and developed coun-tries had yet to be addressed.

The tone for the Annual Meetings wasset at the meetings of the Fund's InterimCommittee and the joint Bank-Fund De-velopment Committee on September 22and 23, respectively. In their reports to theCommittees, Fund Managing DirectorJacques de Larosière and Bank PresidentA. W. Clausen indicated that in 1984 U.S.economic growth would be substantiallystronger than expected, and that the econ-omies of the rest of the industrial worldwere continuing to revive. While con-sumption spending had earlier providedthe main impetus for economic expansion,there had recently been a welcome resurg-ence in expenditure on fixed investment inthe major industrial countries. Inflation hadbeen contained, and international trade hadrebounded strongly. Moreover, in 1984 thecombined current account deficit of thenon-oil developing countries was expectedto fall to less than half of the 1981 level.This development, together with an in-crease in exports, suggested that theimport-compression phase of the adjust-ment process in developing countries waswinding down and attention should nowshift to improving the prospects for re-newed growth and balanced development.

However, there were also areas of con-tinuing and growing concern. In many

industrial countries, particularly in WesternEurope, the process of recovery was fragileand unemployment continued to be veryhigh. The persistence of high real interestrates could endanger a sustained and morebroadly based recovery and compound thefinancial constraints faced by the heavilyindebted developing countries. Concernwas also expressed about the current ac-count imbalances of some industrial coun-tries and the sustainability of the presentpattern of international capital flows. Fi-nally, the present drift toward protection-ism could hinder the world recovery andimpede the smooth functioning of the in-ternational trading and financing system.

Economic growth in much of the devel-oping world had been severely stunted.Among the poorest countries in Africa, percapita income continued to decline alarm-ingly. And the widespread need to adjustseemed to have slowed down the devel-opment process in indebted developingcountries. There was concern also that theextent of progress that could be made bydeveloping countries would depend on thepolicy measures taken by developed coun-tries in fiscal, monetary, and trade areas.

In their plenary statements, Governorsreaffirmed the strategy to sustain recoveryby maintaining steady medium-term poli-cies designed to contain inflation, restoreeconomic and financial balance, improvethe functioning of markets and allocationof resources, and preserve a stable eco-nomic environment for private sector de-cision making. A number of Governors alsoexpressed support for the Fund's flexiblecase-by-case approach to the debt problem.

Speakers stressed the importance of re-ducing the fiscal deficit in the United Statesto relieve pressure on interest rates and to

Michèle lannacci for F&D

sustain noninflationary growth. Other in-dustrial countries were urged to maintainpolicies to boost private sector confidenceand vitality, provide adequate markets fordeveloping country exports, and sustainthe world economic recovery when therecent very high U.S. growth rates startedto decelerate. Moreover, improved eco-nomic efficiency would help the industrialcountries resist protectionist pressures.

Governors welcomed the encouragingprogress in developing countries that hadundertaken courageous and determinedadjustment programs. It was generally ac-knowledged that support for those pro-grams by the Bank and the Fund had helpedmembers restore confidence, discouragecapital flight, and attract foreign capital,thus laying the foundation for renewedand sustainable growth. Other countries,however, still suffered from unacceptablyhigh inflation rates, stagnant export earn-ings, and inadequate new capital inflows.

In this context, Governors urged theBank and the Fund to work even moreclosely together, within their respectiveareas of competence, to restore the credit-worthiness of debtor countries and en-courage a policy environment conducive toeconomic growth.



Many Governors expressed concern thatpervasive and persistent poverty was stillsmothering the hopes of millions. The sit-uation not only suggested the urgency ofdomestic reforms but also underlined theneed to strengthen the mechanisms forspreading the recovery to the developingworld. Against these considerations, thetrend signaling declining net transfers be-tween developed and developing countrieswas an alarming development to manyGovernors, who stressed the need to re-verse it by encouraging voluntary privatecapital flows, mobilizing official develop-ment assistance from bilateral donors, andincreasing the flow of concessional andnonconcessional resources through multi-lateral channels, especially the World Bank.In addition, emphasis was placed on mo-bilizing direct private investment and oncreating an appropriate policy environmentfor that purpose in developing countries.Many Governors noted that the burden ofadjustment had fallen most heavily on thedeveloping countries in the form of cut-backs in national incomes and imports.While all countries had been forced, in oneway or another, to accommodate to thenew evolving environment, it was recog-nized that there was some room still forsharing the burden of global adjustmentmore equitably.

On trade, a number of Governors wel-comed the suggestions for a new round ofmultilateral negotiations under the aegis ofthe GATT to address the question of non-tariff barriers and other matters of concernto developing countries. In the meantime,all countries were urged to roll back existingprotectionist barriers and eliminate tradedistortions. It was generally agreed thatthe Fund and the Bank could play animportant role in encouraging tradeliberalization.

The role of the Fund

The need to strengthen and broaden theworld economic recovery was clearly re-flected in Governors' comments on the roleof the Fund. Many concurred with oneGovernor who stated that "it is essentialthat the Fund be enabled to carry out itssurveillance function more effectively. Thisis all the more important in that the futurepath of the recovery may be very muchaffected by policy choices in the industrialcountries." The major industrial countries,many speakers stated, should appreciatethat their policies were instrumental increating an international environment inwhich developing countries could increasetheir exports and smoothly service theirforeign debt. The Fund should, therefore,encourage industrial countries to maintain

a steady policy stand with a medium-termfocus designed to achieve noninflationarygrowth, expand markets for developingcountry exports, and eliminate protection-ist measures, while reducing inflationaryexpectations and real interest rates.

Noting that debtor countries themselveswould invariably have to bear the mainburden of adjustment, a number of Gov-ernors stressed the importance of Fund-supported programs in helping those mem-bers to make a variety of crucial policychanges. It was also important, somespeakers added, to recognize the consid-erable social and political difficulties facedby borrowing countries in meeting theconditions placed on the use of Fund re-sources. Others stressed that the adoptionof adjustment programs approved by theFund had been instrumental in assistingmembers facing critical debt problems torestore confidence and move into a positionto regain positive economic growth. SomeGovernors underscored the need for theFund to maintain the case-by-case approachto debt problems in coming months, andto continue to play its role in coordinatingthe efforts of debtors and creditors in tack-ling the serious debt problems that remainin a number of developing countries. Therecent progress in multiyear reschedulings,which the Fund had actively supported asan important step toward a medium-termapproach to the debt problem, was gen-erally welcomed by Governors. Speakersstressed that the Fund itself would have tocontinue to make its own financial re-sources available to members making cru-cial adjustments. They therefore welcomedthe significant improvement in the Fund'sliquidity since the 1983 Meetings, as a resultof the increase in quotas under the EighthGeneral Review, the modification and en-largement of the General Arrangements toBorrow, and the completion of an associ-ated arrangement with Saudi Arabia andother major borrowing arrangements.

Speakers devoted considerable attentionto the Fund's policy on enlarged access toits resources, adopted in 1981 as a tempo-rary response to the particularly difficultcircumstances in a number of membercountries. At its September meeting theInterim Committee agreed that, since manymembers continued to face difficult pay-ments problems and serious uncertaintiesremained about the prospects in the me-dium term, the enlarged access policy shouldbe continued in 1985 with somewhat loweraccess limits than in 1984.

Some Governors stressed that, as one ofthem said, "the modest reduction in theaccess limits [for 1985] underscores thetemporary character of the enlarged accesspolicy but is not in practice expected to

affect materially the Fund's ability to pro-vide appropriate amounts of balance ofpayments support to member countries."They also stressed that the cumulative ac-cess limits would be sufficient to permitmembers that had used large amounts ofFund resources relative to quota to useadditional resources, if necessary. The ac-cess limits, and the enlarged access policyitself, are to be reviewed annually in thelight of all relevant factors, including themagnitude of members' payments prob-lems and developments in the Fund's li-quidity position.

There was general support for the InterimCommittee's view that the access limits forthe special facilities should remain un-changed in 1985. Some Governors, notingthe recent decline in most commodity prices,stressed the importance of the compensa-tory financing facility as a source of rapidfinancing for countries facing temporaryexport shortfalls due to factors beyond theircontrol.

Most Governors considered that therewas a long-term global need to supplementexisting international reserve assets throughan allocation of SDRs. In their opinion, anallocation would not only strengthen theworld economy and the international mon-etary system—in part by bolstering thereserves of countries facing debt-servicingproblems—but also be consistent with theobjective of enhancing the role of the SDRas a reserve asset. Some speakers, however,felt that the existence of a global liquidityshortage had not been demonstrated, ai |an allocation would, therefore, not be pe. imissible under the Fund's Articles оAgreement. While recognizing that somemembers' reserves were inadequate, theystressed that the problem should be dealtwith through adjustments in economic pol-icies and the provision of conditional fi-nancing rather than through an allocationof SDRs. Governors agreed that the issuesinvolved in an allocation should be furtherexamined by the Executive Board.

Role of the Bank, IDA, and IFC

As Governors took stock of the role ofthe Bank, the International DevelopmentAssociation, and the International FinanceCorporation in a changing environment,the needs of the developing world and theresources that could be made available formeeting those needs were uppermost intheir minds.

The Bank, in their view, had shownconsiderable flexibility in responding to thenew situation. It had reoriented its lendingthrough special action programs, increasedsupport for structural adjustment and pol-icy reforms, and provided more technicalassistance.



They were gratified that agreement hadbeen reached on an $8.4 billion selectivecapital increase for the Bank, a $9 billionSeventh Replenishment for IDA (IDA7),and a $650 million capital increase for IFC.But there was general disappointment withthe size of the Seventh IDA Replenishment,especially considering the increased needsof sub-Saharan Africa and the need toaccommodate China in the list of eligibleIDA recipients. From the $16 billion origi-nally proposed, the replenishment waswhittled down to a level that was 25 percentbelow IDA6 in nominal terms and evenlower in real terms. Efforts to raise anadditional $3 billion through a Special Fundhad thus far been unsuccessful because ofburden-sharing concerns. Nonetheless, anumber of Governors lent their support toreviving the case for supplementary fi-nancing at the time of the mid-term reviewof IDA7, as suggested by Canada.

Governors were concerned about theBank's own capital requirements as well.Many thought that while the selective cap-ital increase was timely, it was below thelevel called for under the principle of par-allelism with the Fund's quota increaseunder the Eighth General Review. As theysaw it, while the selective capital increasehad permitted a partial adjustment of therelative standing of member countries inthe IBRD's shareholding, it did not providea basis on which the Bank's operationscould grow at an appropriate pace. There-fore, it was time, in their view, to startdiscussions on a general capital increase asa natural outcome of the current exami-nation of the Bank's future role. One view,however, was that the central objective ofthe latter exercise should be to explore howthe Bank with its existing capital base couldhave a greater impact on the developmentprocess, and not necessarily to make thecase for additional capital. Many Governorsnoted that the selective capital increase hadresulted in a diminution of the votingpowers of developing countries and sug-gested that the situation ought to be cor-rected in the course of a general capitalincrease.

Against this background, Governors tooka close look at the immediate tasks aheadfor the Bank Group and sought to providesome tentative guidance on the Bank'sfuture role, with emphasis on two areasfor priority attention. It was generally agreedthat (1) the Bank should continue to playa central role in addressing the problemsof sub-Saharan Africa; and (2) the Bankmust continue to play an important role—in coordination with the Fund—in helpingthe debtor countries regain creditworthi-ness and resume economic growth.

Governors expressed grave concern aboutthe situation in Africa, the subject of a newWorld Bank report entitled Toward SustainedDevelopment in Sub-Saharan Africa: A JointProgram of Action (see page 29 of this issue).The proposed program received wide-spread support, and the Bank was urgedto explore with other donors the mobili-zation of additional resources for sub-Saharan Africa, as soon as possible. Gov-ernors noted that concessional assistancecontinued to be the only significant sourceof financing for the region's low-incomecountries. Moreover, many were now fac-ing growing debt-service payments on loanscontracted earlier. In the absence of anincrease in fresh transfers, their debt-service requirements would result in a de-cline in their net resource flows. The Bank'sAction Program for Africa had brought thissituation into sharp focus, and the neednow was to seek ways to ensure that thenet flows to the region are maintained atleast at their 1982 levels.

Concerning the still ongoing adjustmentprocess and balance of payments difficul-ties in a number of heavily indebted de-veloping countries, Governors made sev-eral suggestions, including the possibilityof extending the Special Action Programbeyond its originally proposed time frame,raising the 10 percent ceiling on the shareof nonproject lending, and continuing thepresent emphasis on outward-oriented pol-icies in the Bank's dialogue with developingcountries. It was further suggested that theBank should introduce country loans bothfor five-to-seven year balance of paymentssupport, as well as for addressing long-

Kenneth S. Friedmana U.S. citizen, is a memberof the Secretary'sDepartment of the fund. Hewas educated at The JohnsHopkins University and TheGeorge WashingtonUniversity.

Balwant S. Garchafrom India, is with theSecretary's Department ofthe Bank. He holds graduatedegrees from NagpurUniversity (India) andColumbia University. Beforejoining the Bank staff heworked for U.S. businesspublications and the UnitedNations.

term constraints in agriculture, health, andpopulation.

There was general agreement amongGovernors on the need to focus Bank lend-ing on the poorest and the least developedcountries, as well as for a shift to a medium-to long-term country strategy. Several Gov-ernors also stressed that the Bank, the IFC,and the developing countries themselvesshould do more to attract direct privateinvestment and that, to that end, the Bankshould continue its work on a multilateralinvestment guarantee agency.

Several Governors referred to the pop-ulation issues raised in the latest WorldDevelopment Report and commented thatunless rapid action were taken on popula-tion growth, vast numbers of people inAfrican and other developing countrieswould remain locked in poverty.

Conclusion

As the Meetings drew to a close, it wasclear that the past two years had beenmarked by considerable success in revivinggrowth in the industrial world. The rapiddeterioration in the debt situation had beenchecked, too, and some non-oil developingcountries had halted the decline in theirliving standards. The Fund and the Bankhad played an important role in thatprocess.

It was recognized that further progressin resolving the major problems still facingmember countries would depend on thepolicies pursued by national and interna-tional policymakers. The final outcomewould also depend on the political will ofthe international community to supportbalanced global economic growth with theneeded capital flows—a task that wouldrequire ever greater support of the multi-lateral development and financial institu-tions. Ongoing consultations at the highestministerial levels would facilitate a positiveoutcome in both respects.

Recognizing the need for such a dialogueon the key policy issues confronting theworld economy, Governors looked forwardto the meetings of the Interim and Devel-opment Committees in the spring of 1985,when discussions are due to be held onthe monetary, financial, trade, and devel-opment aspects of international coopera-tion—through the Fund and the Bank—tosupport sound global economic growthwithin a medium- to long-term framework.

As the Chairman of the 1984 AnnualMeetings, Mr. Takeshita, summed it up:"We have confirmed the need to come togrips with the tasks remaining before uswith as progressive a spirit as ever andfurther cooperation in order to translatethe brightening prospect for the worldeconomy into reality."



Expatriate labor inArab oil-producingcountries

Will the momentum of inflows continue?

Naiem A. Sherbiny

The waves of labor migration that flowedover the Middle East during the 1970screated significant changes not only in theeconomies and societies of the region butalso in perceptions of their future. Thephenomenon confounded analysts andconfronted them with unusual challenges.Even though many now tend to discountthe likelihood of a repeat of this experienceduring the 1980s, analysis suggests that,barring some economic disaster, expatriatelabor flows are likely to continue to growthroughout the 1980s, at least for somecountries.

Based on an assessment of their economicperformance during the 1980s, this articleattempts to assess the near-term (1985) andmid-term (1990) prospects for immigrationinto Saudi Arabia, Iraq, Kuwait, the UnitedArab Emirates, and Libya—the largest usersof migrant labor in the Middle East andNorth Africa. The analysis, which by ne-cessity is aggregative, focuses on a com-parison of total labor requirements (de-mand) with domestic labor availabilities(supply). Shortfalls in supply in the labor-importing countries are taken as indicatorsof the potential size of expatriate laborinflows.

Economic growth; labor demand

With limited labor and skill endowments,most Arab oil exporting countries devel-oped during the 1960s and early 1970s byimporting increasing numbers of workerswith specialized skills. Following the 1973explosion of oil prices and revenues, eco-

nomic growth accelerated in these coun-tries. The resulting large increases in laborrequirements triggered a massive rise inthe import of skilled and unskilled workersthroughout the rest of the 1970s.

The oil exporting countries face a rela-tively "soft" international oil market in the1980s, in which prices will be less buoyantthan they were in the 1970s, and the pros-pects for oil revenues less bright. In thefive Arab countries identified above, oilrevenues have declined in varying degrees,and in some cases substantially from theirrecent peaks. Because of the war with Iran,Iraq lost 61 percent of its oil revenuesbetween 1980 and 1983. Losses by othercountries during the same period were 36percent for the U.A.E., 52 percent for SaudiArabia, 50 percent for Libya, and 42 percentfor Kuwait. The extent to which such de-velopments are likely to affect future eco-nomic growth, and consequently their de-mand for expatriate labor, differs fromcountry to country.

An important limit on growth for manyoil exporting countries during the 1970s

was their absorptive capacity. By 1982-83,however, financial constraints began toemerge. This does not imply imminentfinancial crises, but rather a slowdown intheir investment expansion and economicgrowth from the unprecedented rates ofthe late 1970s. The extent of the slowdownremains an open question and depends ondomestic policies. The expansion of theexpatriate labor force could, according toone assumption, halt completely—limitinglabor imports to the replacement of return-ing expatriates. Economic growth per capitawould then have to depend almost exclu-sively on productivity improvements. Thiswould prove disruptive to national devel-opment in the oil countries. It seems morelikely, however, that there will be somegrowth in the size of the expatriate laborforce, the extent of which will depend ondevelopment expenditures and their sec-toral allocation, as well as demand fromthe private sector including households.

But even if growth slows, it is likely tocontinue to hold total demand for labor inabsolute terms above the domestically



available supply in many oil countries. Onereason is investment lags. Because capitalformation takes time, sometimes longerthan seven years, investment expendituresare made for several consecutive yearsbefore new capital assets (infrastructure,factories, etc.) are completed. In nearly allthe oil exporting countries, investment ex-penditures rose throughout the 1970s andpeaked in the early 1980s. The drop inconstruction employment of the early 1980swill be somewhat compensated for by alater expansion in labor needed for opera-tions and maintenance, admittedly with adifferent skill mix, as more and more ofthe capital assets become operational.

Another reason why a major slowdownin the expansion of employment is notlikely is the considerable dependence ofthe private sector on growth-related com-mercial and construction activities. In anumber of the oil countries, local entrepre-neurs, merchants, and businessmen con-stitute an important pressure group. (Evenwhere such groups have less influence,much of the construction activity in gov-ernment projects is subcontracted to thelocal private sector.) Moreover, in oil ex-porting countries with relatively small pop-ulations, the presence of a large communityof expatriates has given a boost to thedemand for both consumer goods andhousing. In 1980 the ratio of expatriates tototal population ranged from 15 percent inLibya, to 31 percent in Saudi Arabia, 59percent in Kuwait, and 72 percent in theU.A.E. For these reasons, local resistancefrom business and commercial interests toreducing labor inflows is likely to increasein response to any sharp slowdown ineconomic growth.

A third reason why migration may con-tinue is the new "boom induced" expan-sion in household employment. Evidencefor this trend comes from Kuwait, SaudiArabia, and the U.A.E. In Kuwait, forinstance, it appears that between 1970 and1980, household workers represented asteady share of about 20 percent of theexpatriate labor force. Since householdworkers were predominantly (about 95 per-cent) expatriate, and since the foreign laborforce was then growing fast, this meant asubstantial increase in the numbers of ex-patriate household workers in the country.Where family status is measured by thenumber of household assistants employed,the demand for these workers is not likelyto diminish in the short run.

Finally, many oil exporting countries inthe Middle East have built sizable inter-national financial reserves in recent years,which will provide some protection againsta major slowdown of their economic growth,and therefore in employment. Especially

noteworthy is the annual income that isgenerated from a careful investment ofthese reserves in international financialmarkets. The importance of this factor mustnot, however, be exaggerated; accumulatedreserves can only finance part of the annualexpenditures on imports or capital forma-tion if they are not to be run down tooquickly. Most of the financing will have tocome from current revenues, including in-come from the reserves.

Expatriate labor in perspective

With the possible exception of Kuwaitand Libya, the data base on expatriates israther shaky. The figures presented in thisarticle are rough approximations. But theydo indicate general trends, which is theconcern of this article. As Table 1 indicates,whether measured in percentages or ab-solute numbers, the increase in the expa-triate population in the oil countries hasbeen remarkable. An analyst looking at thesituation in 1960, with at most some 170,000expatriates in the collective work force ofthe oil exporting countries, could not haveprojected that by 1970 some 500,000 work-ers would be added to their ranks, raisingtheir ratio in the work force from 1 out of20 to 1 out of 7. Significantly, this wasduring the pre-oil boom decade of the1960s. Similarly, looking at the situation in1970 and making a projection for the decadeahead, few would have suggested that infive years expatriate workers would addabout 760,000 to their ranks, and that bythe end of the decade, they would add afurther 1.58 million. Yet, all this happened.In the period of a single decade, expatriateworkers increased by 2.34 million. By 1980,one out of three employed persons in thesecountries was an expatriate, and in somecountries, the ratio was significantly higher.

Although the growth and levels of the1970s cannot provide a meaningful guidefor the 1980s, as suggested earlier theyestablished a momentum that appears to

be continuing through the early 1980s. Thepotential can best be assessed for eachcountry separately, based on a medium-growth scenario, representing a course be-tween the most and least optimistic as-sessments of future growth. (The projec-tions reported should not be interpreted asderived from medium-term plans of theindividual countries. Some countries donot have such plans. Where they exist,they tend to be, broadly speaking, state-ments of policy objectives which may ormay not be achieved. The projections arebased instead on the sources cited in thebox.)

Country situations

Saudi Arabia. The ratio of expatriates inthe work force of Saudi Arabia has risendramatically in recent years: from 1 out of10 in 1960, to 1 out of 4 in 1970, and to 1out of 2 in 1980. These increases occurredduring a period when the rates of growthof non-oil GDP, employment, and produc-tivity were also accelerating. In absoluteterms, increments in employment exceededthe increment in the Saudi labor supply,which explains the increasing numbers ofexpatriates into the Saudi labor market.

A striking feature of the Saudi economyin recent years is that realized growth ofnon-oil GDP has consistently exceeded itstargets:

Percentage annual growth of non-oil GDP

Target Actual

First Plan (1970-75) 9.8Second Plan (1975-80) 11.2Third Plan (1980-85) 6.2

10.513.08.9 (1980-83)

During 1980-85 the associated expansion intotal labor requirements is likely to be about6 percent a year. For the Fourth Plan period(1985-90), the target growth is still beingdebated. However, the course of Saudi de-velopment during that period is likely toproduce a growth of non-oil GDP in therange of 6-7 percent, and a growth of em-

Expatriate ratios in the

IraqKuwaitLibyaSaudi ArabiaU.A.E.

Overall average ratio

Expatriate work force

Table 1work force of selected Arab oil exporting countries

I960

—

732

10

5

0.167

(In percent)

I965

—

786

1715

9(In millions)

0.328

I970

—

74162767

14

0.655

I975

271334084

23

1.413

I980

1478345389

37

2.997


Sources: See box.


ployment of about 5 percent per year. Inboth cases, the resulting rates exceed thelikely growth rate of the Saudi labor supply,estimated at 3.1 percent during the decade.The gap between the potential supply andthe likely demand of labor will probably bemet by employing additional expatriates,estimated at about 630,000 during 1980-85and a further 680,000 during 1985-90.

Kuwait. Unlike the other oil exportingcountries, Kuwait's oil-related prosperitygoes back to the 1950s. By the early 1960s,the ratio of expatriates in the total workforceincreased to 75 percent, the highest in theoil countries throughout the 1960s. Sincethen, that ratio remained in the vicinity of75 percent. Significant economic changestook place in Kuwait during the 1970s,although the growth of non-oil GDP re-mained at around 9 percent throughout thedecade. Employment expansion acceler-ated considerably during 1975-80, produc-ing a decline in the overall annual averageproductivity. This expansion changed thepopulation composition further in favor ofexpatriates. Censuses in 1970 and 1975showed the share of expatriates to havebeen stable at 53 percent of the total pop-ulation. However, the 1980 census showedthe ratio had increased to 59 percent.

In the early 1980s, because of the declinein oil revenues, the financial crisis triggeredby the collapse of the parallel stockmarket (Suqal Manakh), and the threat

to desalination plants caused by the oilspill associated with the Iran-Iraq war, theauthorities became more interested inconsolidation and stabilization than ineconomic growth.

Fortunately, however, the income fromits overseas investments began to assumeincreasing importance, a development notexperienced to the same extent in any otheroil exporting country. In 1977, Kuwait'sinvestment income was $1.3 billion, about15 percent of its oil revenue; by 1982 it hadreached $5.7 billion, more than 70 percentof its oil revenue. This increase is likely toinsulate Kuwait's development efforts fromthe adverse effects of possible future re-ductions in oil revenues. The medium-growth scenario underlying this paper pos-tulates a 7 percent growth in non-oil GDPduring the 1980s, producing an expansionin total labor requirements of 5.4 percent,well above the likely growth rate of Kuwaitilabor supply (of 3.5 percent). Again, thegap could well be closed by additionalexpatriates, estimated under these assump-tions at 124,000 during 1980-85 and a fur-ther 164,000 during 1985-90.

United Arab Emirates. Major oil discov-eries were responsible for the formation ofthe U.A.E., which was heavily dependenton expatriates from its early days. Thecountry's growth experience during the1970s was unique, with one of the highestper capita incomes in the world, it was

MethodologyThe data used in the study from which this article is derived have 1980 as a commonbase year, and their sources are listed below. Estimates of population and labor, andtheir recent growth rates, are used to construct future profiles of national or domesticlabor supply. To estimate future requirements of manpower, several variables and theirrecent growth rates are used: (1) non-oil GDP at constant factor costs;(2) employment; and (3) average labor productivity, defined in terms of value addedper employed person per year. Expatriate labor requirements in a given country for agiven year are measured by the excess of projected manpower requirements overdomestic labor supply for that year. Three growth scenarios underlie the projections:high, medium, and low. The results discussed in the article are based on the mediumscenario.

Source«Actuel рмУопгмлс«: Annual statistical abstracts and bulletins from governments of Iraq, Kuwait, Libya,Saudi Arabta.and the U.A.E.; World Bank Reports on Kuwait (July 1981) and Libya (June 1978); andSiragekJin, Sherbiny, and Serageldin, Saudis in Transition (Oxford University Press, 1984).

Pro/ectton«; Chapters on Iraq by G.T. Abed and A.A. Kubursi, on Kuwait by M.S. Marzouk, and onSaudi Arabia by N.A. Sherbiny in N.A. Sherbiny (editor), Manpower Planning in the Oil Countries (JAIPress, 1981); World Bank Report on the U.A.E. (May 1978); Libya, Secretariat of Planning, PreliminaryStudy of the Long-term Development Prospects (August 1979).frifwcountry mlgrmOon: Ismail Serageldin et al., Manpower and International Labor Migration in theMiddle East and North Africa (Oxford University Press, 1983); J.S. Birks and C.A. Sinclair, InternationalMigration and Development in the Arab Region; (International Labor Office, 1980); I. Saadedin andM. Abdel Fadil, Intíqal Al-lmala Al-Arabia (Center for Arab Unity Studies, 1983); Nader Fergani, AI-ШЦгаBai Haft (Center for Arab Unity Studies, 1983); Naiem A. Sherbiny, "Expatriate Labor Flows to the OilCountries in the 1980s," Middle East Journal (Autumn 1984); Ismail Serageldin and J.A. Sooknat,"Migration and Manpower Needs in the Middle East and North Africa 1975-85," Finance & Development(December 1980); Zafer Ecevit & K.C. Zachariah, "International Labor Migration," Finance & Development(December 1978).

employing the most labor-intensive tech-nologies available. During 1975-80, non-oil GDP expanded at 14.1 percent andemployment increased at 13.3 percent. Un-derlying this high rate of employment ex-pansion were two factors. First, most per-sonnel decisionmakers were themselvesexpatriates from labor-abundant econom-ies, and thus tended to choose technologieswith which they were familiar and to em-ploy large numbers of workers. Second,there was a near total absence of coordi-nation among the seven Emirates of theUnion in matters of labor importation.

The medium-growth scenario underlyingthis article postulates the growth of non-oil GDP to be 7 percent during 1980-85and 6 percent during 1985-90. The associ-ated expansion in total labor requirementsis 4.4 percent and 3.4 percent, respectively.Under the circumstances, additional, ex-patriate employment would continue toexpand by 120,000 during 1980-85 and by109,000 during 1985-90. Even limited shiftsin the choice of technology toward rela-tively less labor-intensive methods wouldproduce lower rates of employment expan-sion than postulated. This result, however,would imply institutional changes, whichare difficult to effect.

Iraq. Traditionally a large net labor ex-porter, Iraq became a large net importer oflabor in the late 1970s, a development notpredicted by any of the previous interna-tional migration studies. Expatriates wereemployed well before then, mostly provid-ing highly specialized skills, but the raticof foreign workers in the total work forcewas less than 1 percent throughout theearly 1970s. The oil boom helped finance ahealthy growth of non-oil GDP during1970-77 of 10.4 percent a year, which wasassociated with an employment expansionof 2.6 percent. Reliable and consistent dataon the Iraqi economy for the 1970s aredifficult to obtain, and after 1977 onlyqualitative information is available. How-ever, it appears that prompted by abundantfinancial resources, Iraq adopted a liberalmigration policy that gave Arab labor spe-cial privileges (neither entry visas nor workpermits were required). By 1980, it is esti-mated that expatriate workers numberedabout 500,000, of which 340,000 were Egyp-tians. The mobilization for the war withIran has probably withdrawn substantialnumbers of Iraqis from the civilian workforce. To bridge the gap, immigration ofArabs, particularly from Egypt, has prob-ably accelerated.

The war has restricted further the amountof economic information available. In-formed estimates indicate that in the shortrun, in spite of a transitory financial liquid-ity problem, immigration into Iraq is highly



likely to continue to make up for the labordisplaced by war mobilization. In fact,through 1983 the numbers of immigrantswere estimated to exceed the numbers ofemigrants. The flows may have reversedin 1984, though understandably this isuncertain. It is conceivable, however, thatduring 1980-85 as a whole, Iraq will haveadded another 400,000 expatriates to theranks of the employed. Whether the post-1985 period will see continued war or be-come years of reconstruction, it is clear thatIraq has become one of the largest importersof expatriate labor. Once the war is settled,economic growth could accelerate, possiblysignificantly, in association with a majorreconstruction effort. Notwithstanding therelease of Iraqi labor to civilian employ-ment, the needs of the national economymay warrant keeping those expatriateworkers already there, and possibly evenexpanding their numbers.

Libya. Although the structure of Libyannon-oil GDP did not change dramaticallyduring the 1960s and 1970s, the nationalitycomposition of the population and workforce did. Unlike most other oil countries,economic growth in the late 1970s in Libyaappears to have decelerated. The brief armedconflict with Egypt in 1977 seems to havehad a lagged effect on the withdrawal ofEgyptians, who then comprised the major-ity of expatriate workers. Taking the 1970sas a whole, the estimated annual growthfor non-oil GDP was 12 percent and foremployment 6.3 percent, implying a pro-ductivity growth rate of 5.5 percent perannum. Of special interest is the large shiftin crude participation rates of expatriates(i.e., in ratio of expatriate labor to theexpatriate population). This rate rose from35 percent in 1965 to 60 percent during the1970s, a situation not experienced in anyother Arab oil producing country. Thisreflects, in part, the exodus of the residentItalian population and, in part the largeinflow of transient workers, mostly Arab,with many fewer dependents.

Projected growth of Libyan non-oil GDPin the 1980s is rather modest comparedwith its earlier performance: 8 percent dur-ing 1980-85 and 6 percent during 1985-90,according to the medium-growth scenario-underlying this article. The associatedgrowth in total labor requirements is about4.5 percent and 3.3 percent, respectively,implying a significant slowdown in pro-ductivity growth to 3.5 percent and 2.5percent, respectively. Even though the rateof growth of labor requirements during1985-90 is likely to fall below the growthof Libyan labor supply, the absolute num-bers of expatriate labor will probably con-tinue to grow. The increment, however,will be declining. According to the medium-

Table 2Incremental expatriate labor flows to selected Arab oil

exporting countries 1

(In thousands)

ActualCountry 1970-75

Kuwait 37Libya 145Saudi Arabia 349U.A.E. 168

Total 699Iraq 2 80

1975-80

16369

679251

1,162410

Projections1980-85

124

90633120967400

1985-90

164

40680109993n.a.

growth scenario, Libya is expected to addabout 90,000 expatriates to its work forceduring 1980-85, but only about 40,000 dur-ing 1985-90.

In the aggregate

The differences between the total laborrequirements and projected domestic laborsupply are assumed to be covered by ex-patriate labor. According to the medium-growth scenario, the inflow of expatriateworkers is projected to increase throughoutthe 1980s in all countries. The incrementsare shown in Table 2. To place the projec-tions in a proper perspective, estimates ofactual flows during the 1970s are includedin the table. (The results of the low- andhigh-growth scenarios are not discussed inthis article.)

Table 2 indicates that despite a generalslowdown in economic trends, the stock ofexpatriate labor in the oil countries is likelyto increase in the 1980s by roughly thesame amounts (in absolute terms) as it didduring the 1970s. The importance of coun-tries as markets for expatriate labor in 1990is likely to be generally the same as in 1980:Saudi Arabia will probably be the largestfollowed by Kuwait, the U. A.E., and Libya,in that order. In relation to one another,however, the relative sizes of these marketsare likely to change. The uncertainties aboutthe Iraq-Iran war make it difficult to project

Naiem A. Sherbinyя U.S. citizen, studied

economics at Cairo

University and theUniversity of California at

Berkeley. He is in the

Energy Department of theBank. Earlier he was in the

Europe, Middle East and

North Africa Projects

Department.

quantitatively the size of labor imports intoIraq. Iraq will, however, probably keep itsranking throughout the 1980s as the secondlargest labor importer after Saudi Arabia.Barring some economic catastrophe, theratio of expatriates in the total work forceof most individual countries is likely toincrease in 1990 as compared to 1980: inSaudi Arabia from 53 percent to 62 percent,in Kuwait from 79 percent to 82 percent,and in Libya from 34 percent to 37 percent.No significant change is expected in theexpatriate labor ratio in the U.A.E. (whichis already 90 percent). As to Iraq, only aguess can be made that the expatriate laborratio would probably exceed 20 percentduring the 1980s.

The total size of migration flows into thefive countries during the 1970s was about2.35 million expatriate workers, implying apopulation mobility of about 4.70 millionpersons. Underlying these estimates is acrude participation rate for expatriates ofabout 50 percent. Excluding Iraq, the cor-responding figures are 1.86 million and3.80 million, respectively. This was un-precedented and captured the attention ofanalysts and policymakers alike. The pres-ent analysis reveals that, in the absence ofmajor economic disruptions in the oil coun-tries, substantial inflows of expatriates dur-ing the 1980s are quite possible, even likely.While the analysis is based on the medium-growth scenario, results of the low-growthscenario are useful in providing a range forthe estimates. Thus, excluding Iraq, theestimate of expatriate labor flows rangesbetween 0.9-1.0 million during 1980-85.The same is projected during 1985-90. Forthe decade as a whole, the total rangesbetween 1.8-2.0 million. These levels areabout the same as those of the 1970s whichwere thought to be almost unrepeatable. IfIraq is included in these projections, theestimates for expatriate labor flows, andtheir associated population mobility, maywell surpass those of the 1970s. |§D


Sources: See box.n.a. denotes not applicable.1 Based on the medium-growth scenario for non-oil GDP.2 Included for comparison.


MeasuringA brief description of the major techniques

Somchai Richupan

Tax evasion is a worldwide phenomenon;it exists wherever there are taxes. A highdegree of tax evasion can sharply reducethe value of tax incentives and affect allo-cative behavior; create artificial biases inmacroeconomic indicators, which may leadto inappropriate policy responses; retardattempts to monetize economies in devel-oping countries; and affect income redis-tribution. It is not the existence of taxevasion, but its extent that is a cause ofmajor concern for tax policymakers and taxadministrators. Thus, measuring the sizeof tax evasion is useful because it givespolicymakers some idea about the reliabilityof their policy analysis and the expectedeffectiveness of their policy prescriptions.However, the direct measurement of taxevasion is inherently difficult—both be-cause its illegal nature requires secrecy andbecause conceptual problems make it hardto define—but the traces that tax evasionleaves can be analyzed and to some extentmeasured. Since these traces are manifold,many measurement approaches have beenused, resulting in as many estimates. (SeeThe Underground Economy in the United Statesand Abroad, edited by Vito Tanzi (Lexington,MA, USA, D.C. Heath and Company, 1982).

Some conceptual issues

Two major conceptual issues arise inconnection with tax evasion. The first issuearises from the fact that two concepts oftax noncompliance are used, one empha-sizing its legality and the other its effect on

revenue production. The first concept makesa distinction between tax avoidance andtax evasion. Tax avoidance is legal but taxevasion is not.

The second concept does not emphasizethe differences between evasion and avoid-ance. This is because both have the sameeconomic effects on government revenue,on taxpayers' after-tax income, and on fiscalequity. Both can be considered alternativeways of coping with high tax rates andboth are interdependent because significantand well-known tax avoidance could in-crease tax evasion.

The second conceptual issue arises be-cause two estimates are used as proxies fortax evasion: the estimate of the under-ground economy and that of tax noncom-pliance. In fact, these two estimates aredifferent because the former measures in-come or products that are unaccounted forin official gross national product figuresbut the latter measures income unreportedor underreported in tax returns. Althoughboth estimates deal with unaccounted in-come, one is unaccounted for in the na-tional income accounts, while the other fortax purposes.

However, in the absence of better esti-mates, estimates of the underground econ-omy can be used as proxies for tax evasion,because all underground economic activi-ties are generally not reported to tax au-thorities and thus are in violation of taxlaws. Since estimates of the undergroundeconomy are based on GNP data, they

evasion

involve some overestimation of underre-ported income because they include incomelegally not subject to tax. This can be takencare of by applying the average tax rate tothe estimates. But the estimates also involvesome underestimation from excluding un-reported or underreported income from"above-ground" activities, and this cannotbe adjusted for. It is a shortcoming of theestimate that should be explicitly described.

The monetary approach

The monetary approach to tax evasionorginated from attempts to measure thesize of the underground economy. It hasthree variants: the fixed-ratio, the currency-denomination, and the currency-equation.

The fixed-ratio variant assumes that thereis a monetary ratio (such as the ratio ofcurrency to demand deposits) that, withoutthe underground economy, would haveremained constant over time, and that therewas a "golden" period in the past whenno underground economy existed. To ap-ply this variant, the golden period has tobe selected and its monetary ratio estimatedand compared with the ratio in the periodof interest. If the latter is higher, this excessmoney is presumed to be the result of theactivities of the underground economy. Bymaking assumptions about the income ve-locity of the money, the estimate of thesize of the underground economy is made.

This variant is criticized because there isno obvious reason why the monetary ratio


tax


should remain constant over long periods,and because the results are sensitive to thechoice of the initial period. The variant alsodepends on the unrealistic assumptionsthat the velocity of money in the under-ground economy is the same as in the legaleconomy and that the currency turns overat the same rate as demand deposits. Fur-thermore, evidence from major industrialcountries other than the United States in-dicates that the currency ratio is falling overtime. Using the fixed-ratio approach wouldlead one to conclude that countries suchas Italy and the Netherlands have experi-enced large contractions in their under-ground economies, which is unlikely to betrue. Similarly, the currency ratio has beenfalling steadily in India since 1950, and thefixed-ratio variant approach yields non-sensical results, such as a negative blackeconomy in many years.

The currency-denomination variant as-sumes that the underground economy isassociated mainly with the use of bills ofcertain denominations. The estimate of thesize of the underground economy is basedon the change in the number of such bills.

This variant has two weaknesses. First,with real growth and a relatively highinflation, large bills do not appear to be aslarge as they once were and use of themcan be expected to increase without signi-fying an increase in the underground econ-omy. Second, large U.S. bills are used fortransactions and for store of value in foreigncountries, therefore the increase in thenumber in circulation can also be due toan increase in foreign holdings rather thanin underground economic activities.

The currency-equation variant assumesthat underground activities are the directconsequence of high taxes and that cur-rency is used mainly for carrying out suchtransactions or for storing wealth accu-mulated from such transactions. The basicidea is to specify a demand for currencyequation that allows one to measure theeffect of tax changes on that demand. Theequation is estimated and two estimatesfor currency holding are made, one whenthe tax variable is zero and the other whenit is not. The difference between the twoestimates of currency holding is called the"illegal money." And the difference be-tween Ml and illegal money is taken to bethe "legal money." The income velocity ofmoney is derived by dividing GNP by legalmoney and the size of the undergroundeconomy is obtained by multiplying illegalmoney by this velocity. The amount ofincome tax evasion is derived by assumingthat the incomes in the underground econ-

; omy would have been taxed at the same¡average rate as income in the regulareconomy.

Like the other two, the weakness of thisvariant is that it assumes equal velocity forlegal and illegal money. Moreover, thisestimate, as Tanzi, the originator, noted,underestimates tax evasion because it onlytakes account of evasion associated withcurrency use and with the undergroundeconomy. Many forms of tax evasion existthat have nothing to do with currency usageor with underground economic activities,such as claiming nonexistent exemptionsor exaggerating deductions. Nor does thisestimate include income from criminal ac-tivities, or noncriminal income that is illegalbut not induced by high taxes, such asincome of illegal aliens.

The physical input approach

This approach assumes a stable relation-ship between some physical input—usuallyone that is widely used throughout theeconomy for which aggregate output andconsumption data are reliable—and na-tional output, making due allowance forchanges in technology and output mix. Thedifference between the estimated size ofthe economy based on such a relationshipand the reported GNP is attributed to theunaccounted economy. This approach isused to estimate the underreported na-tional income of India, assuming a stablerelationship between electric power andnational output.

The weakness of the physical input ap-proach is its basic assumption that there isa fixed relationship between some inputand aggregate output. For instance, in thestudy mentioned, the stable link betweenpower consumption and national output isdifficult to justify. National output can beincreased in a number of ways withoutincreasing electricity input. Moreover, sinceelectricity is not just an intermediate prod-uct, but a final consumption good as well,changes in its relative usage need not sig-nify an increase in the underground econ-omy. Furthermore, conservation measures,which have no relation with the unac-counted economy, can also affect electricityconsumption. Similar problems exist withthe choice of any input that is required toshow a stable relationship with GNP.

The labor market approach

This approach originated in Italy wherethe official rate of labor force participationhas decreased drastically since the late1950s, while unofficial estimates of the rateshave been much higher. This discrepancysuggests that a sizable number of workersfind their gainful employment in unre-ported activities. The approach is to esti-mate the unaccounted employment by asurvey. Then the size of the unaccountedeconomy is estimated on the basis of the

unreported employment figures and theaverage productivity of labor.

The main shortcoming of this approachis that it accounts for income from laboronly and not from capital. Moreover, theestimate depends crucially on the assump-tions made concerning the labor productiv-ity in both the accounted and unaccountedsectors of the economy.

The gap approach

The basic idea of this approach is tocompare income reported in the tax returnsand income in the national income ac-counts. For the comparison to be meaning-ful, the national income statistics must bederived from sources other than, and in-dependent of, the income tax authorities.Deductible exemptions and allowances aresubtracted from the personal income in thenational accounts and the remaining totalcompared with that reported in the incometax returns. The difference is the "gap"that is presumed to be the tax-evadedincome.

There are at least three major difficultieswith this approach. First, in a number ofcountries national income accounts are de-rived from tax data. Second, the personalincome concept of the national incomeaccounts includes all income accrued topersons whether large or small, taxable ornontaxable, while income reported in taxreturns is only taxable income that is greaterthan the basic exemption. Thus, part of thegap may be due not to evasion or noncom-pliance but to income that is legally unre-ported. Third, some items—for example,some kinds of capital gains—are includedin taxable income but not in personal in-come. There are also differences in thetreatment of depreciation that make thetwo numbers noncomparable.

Legal tax potential approach

Unlike the first four approaches, the legaltax potential approach does not estimatetax-evaded income but the amount of evadedtax. This approach takes it for granted thatthe official national income figure is correctand is a good basis for income tax calcu-lation. The evaded tax is defined as thedifference between the legal and the real-ized tax potentials, that is, the differencebetween the amount of revenue that wouldhave been raised if all legal tax liabilitieshad been paid and the amount of taxactually collected. The approach estimatesthe legal tax potential by adjusting theofficially estimated national income for theexemptions, allowances, and deductions torender it comparable with the taxable base.Based on an assumption about incomedistribution that is derived from the officialsurveys of the household income and ex-

Finance Sf Development/December 1984 39


penditure, the legal tax potential is esti-mated by applying the income tax rates foreach bracket. Then the realized tax is sub-tracted from the legal tax potential, obtain-ing the amount of tax evaded.

The approach has three shortcomings.First, because it assumes that the officialestimate of the national income is correct,it does not measure the tax-evaded incomeomitted in the official GNP. Second, theapproach measures tax noncompliancerather than tax evasion. This is not onlybecause the approach does not distinguishevasion and avoidance, but also because itincludes taxes uncollected for whateverreasons—which may be inefficiency in taxadministration as well as taxpayer igno-rance. Moreover, the fact that the legal taxpotential is compared with the collectedrather than with assessed tax implies thatthe estimate includes the amount of reve-nue loss at the stage of collection. Thus,even though the true amount of income isdeclared and proper tax assessed, if theassessed amount is not collected, it is stillconsidered as evasion. Third, the estimatedepends heavily on the assumption con-cerning the distribution of income basedon household surveys, whose reliability isgenerally questionable.

The survey approach

Here, the basic idea is to obtain infor-mation on the income of the taxpayersthrough a survey, a source different fromand independent of the tax returns. Thesurvey income is then compared with thereported income in the returns, therebyestimating tax noncompliance. The weakpoints of this approach are that it is subjectto sample bias, sample error, and the prob-lem of reliability of the data.

The constant tax ratio approach

This approach applies the tax-to-GDPratio of a "representative" year to the GDPof the year under study to arrive at anestimated tax for that year. A representativeyear is one in which tax evasion is consid-ered minimal. The difference between theestimated tax and the actual tax is then theevaded tax.

But this is not a measurement of totaltax evasion but rather a measurement ofadditional tax evasion and the deteriorationof tax administration. Further, the crucialassumption of this approach is a constanttax/GDP ratio. This assumption is accept-able if the tax elasticity is unity or if thereis no significant change in the tax ratestructure or in the composition of GDP. Iftax elasticity is greater than unity, wheneither the nominal or real income increase,the so-called "bracket-creep" will drive theratio up and the approach will underesti-

mate tax evasion. With tax rate increase,this approach will underestimate tax eva-sion, and vice versa. If the composition ofGDP changes so that taxes rise without anincrease in the tax rate, then the approachtends to underestimate tax evasion, andvice versa. Moreover, the result is sensitiveto the selection of a representative year.Assuming that there is no significant changein the tax structure and in GDP composi-tion, if the selected representative year hasa high tax-to-GDP ratio, the approach tendsto show relatively sizable tax evasion, butthe estimate will be closer to the actual sizeof tax evasion, and vice versa. This ap-proach is good as a tool to detect thedeterioration in tax administration. It is apowerful argument in showing that thereis a substantial decline in tax-administrativeefficiency when there is a decrease in taxcollection.

Special amnesties

In the approaches discussed so far, taxevasion is estimated indirectly through in-formation from sources other than the taxreturns. Under this and the following twoapproaches tax evasion is measured usinginformation in the tax returns. In somecountries, for example, in Argentina, India,and Thailand, special tax amnesties havebeen offered more than once in recenthistory. Under these amnesties, taxpayersare induced to declare their actual incomein exchange for a withdrawal of their lia-bility to fines or other penalties, and, insome cases, for a special low tax rate. Forthese countries, it is possible to measurethe size of tax evasion by examining taxreturns filed during the amnesty period.However, amnesties, if repeated, are prob-ably counterproductive, and their conse-quences are too far reaching to permit theiruse as just a way of measuring evasion.

Moreover, this approach measures onlypart of the income evaded, because despitethe benign conditions some taxpayers stillprefer not to make use of amnesties. Thisis because, even if amnesty conditions are

Somchai Richupanfrom Thailand, is aneconomist in the FiscalAffairs Department. Holdinga PhD from the Universityof florida, he taught atThammasat University andworked in Thailand'sMinistry of Finance beforejoining the Fund staff in1982.

extremely favorable, once the taxpayer hasregistered with the tax authorities, a regulartax, still considered too burdensome, hasto be paid; and because if amnesties areoffered more than once, some taxpayerswill risk delaying reporting their income inexpectation of a new amnesty at a laterdate.

Special audits

The Taxpayer Compliance MeasurementProgram is designed by the U.S. InternalRevenue Service to measure tax compliancein the United States through detailed auditsof tax returns. (See James S. Henry, "Non-compliance with U.S. Tax Law—Evidenceon Size, Growth, and Composition," IncomeTax Compliance: A Report of the ABA Sectionof Taxation Invitational Conference on IncomeTax Compliance, Reston, VA, USA, March1983.) Unlike regular field audits, TCMPsare line-by-line audits performed by expe-rienced examiners on a nationwide strati-fied random sample, typically of 50,000taxpayers. Samples are drawn from a pop-ulation of taxpayers who have filed taxreturns and are stratified by reported in-come grouping. From the TCMP audits,the amount of tax for which the taxpayerswill be liable if they comply "exactly" withthe tax laws is determined. And from theamounts, a ratio called Voluntary Compli-ance Level is calculated. This is the ratio ofself-assessed taxes to total tax liability asdetermined by the TCMP.

The major weak point of the TCMPcompliance estimate is that the TCMP sam-ples are drawn only from the populationof tax returns filed and do not include thenonfilers. Thus, those who do not filereturns, whether their income derives fromlegal or illegal activities, are out of theTCMP consideration entirely. The exclu-sion of the nonfilers is the major reasonfor the low TCMP estimate of nonreportedincome. To correct the weakness resultingfrom the exclusion of nonfilers, the InternalRevenue Service introduced the TCMP Plusapproach, which modifies the TCMP bysupplementing the TCMP data with infor-mation from law enforcement agencies.

Overview

Many people may feel that it is nonsenseto attempt to measure the size of either taxevasion or the underground economy.However, this article has shown that atleast a number of methods are available.Although none of the methods discussedis perfect, each emphasizes a differentaspect of tax evasion or the undergroundeconomy, and each has its own strengthsand weaknesses. It is important that usersof the estimates are aware of their pros andcons. HD



Can local participationhelp development?Mexico's PI DER program shows it can improve the selection andexecution of local development projects

Michael M. Cernea

The participation of beneficiaries in devel-opment projects is frequently advocatedbut seldom put into practice. Developmentpractitioners could, with some justification,suspect "local participation" as being sim-ply a fashionable slogan. One way to per-suade them of its merits is to point toempirical evidence. A sequence of threeWorld Bank-assisted rural developmentprojects in Mexico provides some.

The Programa Integral para el DesarrolloRural (PIDER) channels central funds tolocal communities for investment in small-scale irrigation, livestock, fishery ponds,rural roads, village social infrastructure,and so on. Local participation was con-ceived as a way of improving the qualityand effectiveness of these investments. Inmany cases, decision making without theinvolvement of the beneficiaries misdi-rected funds, while the participatory ap-proach succeeded in improving their allo-cation. Where the latter approach has beentaken, the local communities participate inselecting priority investments; in better mo-bilizing local resources for developmentpurposes; in implementing projects; and inmonitoring the performance of agenciesand contractors working on the projects.

The benefits of popular participation inthe selection and execution of investmentsdo not often lend themselves easily toquantification or aggregation, because of

the problems inherent in comparing a proj-ect with participation to the hypotheticalsituation without it. Yet close examinationof various cases indicates that the economicperformance of projects with local partici-pation is superior. Some of the benefits,however, will remain forever "invisible,"since the amount saved from farmersscreening out unsuitable projects is veryreal, although uncomputed. In sum, theopportunity cost of not involving farmersis unaffordable; the penalty is reducedeffectiveness and increased failure rates.

Need for participation

Mexico's PIDER was designed as a na-tionwide program to finance investmentsat the community level in low-income,underdeveloped rural areas. Located withinthe Federal Secretariat of Programming andBudgeting, PIDER does not execute theinvestments itself, but coordinates the ac-tivities of many technical agencies in im-plementing PIDER investments. Over thecourse of the decade ending in 1983, Mexicospent some two billion dollars under theprogram in 139 areas or "microregions"—all of them regarded as "poverty pockets."The program has reached more than 9,000communities, with approximately 12 mil-lion inhabitants.

PIDER funds are not invested in a hand-ful of large, high-cost projects, but in agreat number of small productive or social-infrastructure projects, tailored to the needs

of small villages or even to subgroupswithin these communities. It is of para-mount importance to identify, from thelarge number of possible local investments,those that will make the best use of localresources and those that are of the highestpriority for local needs. Soon after thebeginning of the program, however, itbecame clear that nonlocal officials andplanners did not have the necessary localknowledge to select and design projects ofthis type.

The sad story of a village diversion damin Baja California Norte is a telling exampleof the deficiencies of conventional ap-proaches to planning. Several days of tor-rential rains completely destroyed the ElChocolate dam wall. The floodwaters sweptaway many irrigation wells and severalfruit tree plantations, some of which werePIDER investments. The experts who hadbeen responsible for the dam's constructionexplained to the central inquiry team thatits collapse was an act of fate; the plannershad consulted the hydrometric series forrainfall and surface run-off for the previous15 years. The inquiry team, however, alsoconsulted the villagers. Their answer wasthat the experts had not paid attention tolocal experience. The oldest villagers re-called clearly that 30 years earlier it hadrained for two complete days, and thestream had risen to a level two metershigher than the maximum calculated bythe experts.



The decision to organize beneficiary par-ticipation in the selection and execution ofPIDER projects was, therefore, not moti-vated just by political or humanitarian rea-sons but also by the need to improve theefficiency and technical and economic qual-ity of investments. Little knowledge wasavailable at the outset on how small ruralcommunities could participate in the iden-tification, planning, design, and executionof local projects. In cooperation with aresearch center studying rural development(CIDER), PIDER set out to design a socio-logical methodology for involving benefi-ciaries' participation, based on understand-ing the groups involved in, or left out from,the process of investment planning.CIDER's sociological approach also com-prised a sequence of planning experimentsand actual pilot applications, followed byrevision and improvement of the proposedmethodology. Thus, PIDER and the re-search center moved the participation issueaway from the area of ideological exhor-tation to the realm of concrete proceduresapplicable by project and agency staff.

From the premise that officials do notnecessarily have a better perspective thanthe local people on the latter's problemsand best interests, PIDER's participatorymethodology aims to introduce the farmers'perspective into selecting and planninglocal investments. One example will illus-trate what the farmers' perspective meansand how it can differ from the planner'sviewpoint. The technical planners in aPIDER area received from a village—andpromptly rejected—a written request thatwas, they thought, both illogical and waste-ful for an investment fund to build a dancehall. After the rejection, however, a re-search team, intrigued by the application,decided to visit the village that had pro-posed the unsuitable expenditure. It foundthat many of the farmers in that villagewere musicians. Their musical reputationwas so good that on Sundays and holidaysrural inhabitants from the surrounding areacame to dance on improvised, open-airgrounds. Most of the local council membersfelt that a dance hall would be the best wayto attract more visitors and sell local prod-ucts, thus bringing in money and gener-ating employment. The research team con-cluded that the application for a dance hallwas more justified than many of the whiteelephants included by "experts" in PIDERprogramming.

Three planning phases

The central aim of PIDER's approach tolocal participation is to bring the plannersand decision makers out of their officesand into the concerned communities. There,in consultation with villagers and through

a joint assessment of local potential, avail-able options, and perceived needs, thepriorities are sorted out and investmentproposals are formulated and readied forsecondary screening, technical prepara-tion, and final funding.

The methodology recommends a se-quence of three phases: (1) field communityassessment, (2) preliminary programs, and(3) final programs. In each phase, the rolesof technical agencies and local groups arecarefully defined. Specific procedures en-sure that both the sociological and thetechnical aspects of investment planningare taken into account. They prescribe whatmust be done at the grass-roots level andalso what technical-economic feasibilityanalysis should be undertaken by the spe-cialized agencies.

Several activities must be carried outduring the first phase of field assessment:data are collected regarding the population,infrastructure, and resources in the area;an assessment is made of past programs;each selected locality is examined physi-cally; meetings are held with local groups;investment proposals are chosen; and anassessment report is prepared of the pro-posed strategy. The planning team beginswith a familiarization trip through the vil-lage when it also informs the residents ofthe objectives of the study. A survey isthen conducted orally of local needs andpriorities, using a broad spectrum of in-formants. Meetings with the communityare the next step, when either selectedissues are discussed with separate groupsor all the information of community interestis discussed with a large group.

In Oriente de Morelos, for instance, threedifferent consulting groups were estab-lished for a regular investment program-ming exercise: farmers with irrigated land,those with rainfed land, and those withwage earnings. As might be expected, in-vestment priorities were different for thethree groups. Those with irrigated landemphasized the need for technical assist-ance and marketing; those with rainfedland gave priority to irrigation; and thosewith no land but cash earnings proposedinvestments that did not involve landown-ership, such as agro-industry and hog farms.

Not surprisingly, investment requestsput forward by farmers during such fielddiagnoses are often different from thoseproposed by the technical experts. This iswhere getting the farmer's perspectiveproves crucial. A significant example canbe drawn from an investment planningexercise in Baja California Sur. The expertsfrom the Department of Agriculture andLivestock responded to the farmers' re-quests for breeding from Zebu cattle—alocal breed—by recommending the pur-

chase of Swiss cattle, on the basis that across of Swiss and the local Chinampo cattlewould raise meat and dairy yields. Thevillagers nevertheless insisted on the Zebu.During the public meeting a heated argu-ment ensued, which ended only after onedetermined farmer described his past ex-perience with the imported Swiss cattle.Following the recommendation of the ex-perts, he had purchased two Swiss breed-ing cows from his own funds. One diedduring the first dry season; the other wasso sick he had to keep it in his home. Thefarmer observed that during the dry season,local cattle have to eat the topmost leavesoff the bushes, walk enormous distancesto find water, and at times are reduced todrinking seawater. The Swiss cattle withtheir short legs, he said, could not get foodand water in this way; the Zebu, whichhave long legs, could. This explanationended the argument about which cattle tobuy with the new PIDER investment.

The second phase—preliminary pro-gramming—is the direct responsibility ofthe technical agencies. They must also makea careful economic and technical analysisof the investment proposals, to ensure thatthey are technically feasible and economi-cally profitable. During phase three—finalprogramming—the individual proposals areconsolidated into the local PIDER programaccording to a set of strategy criteria for in-tegrated area development. (For more detailson these see A Social Methodology for Com-munity Participation in Local Investments, WorldBank Staff Working Paper, Number 598.)

Implementation and financing

Once priority investments and projectshave been selected, and implementationbegins, local participation is also important.Although PIDER has been somewhat slowto take advantage of it, significant progresshas been made recently in working outinnovative and effective procedures. Localparticipation in the actual execution of aninvestment is of exceptional importance formobilizing supplementary financial andphysical resources. This takes on a specialurgency in circumstances of financial re-straint, when the state funds that fuelPIDER are constrained or slow to arrive.

PIDER has worked out arrangementsunder which local communities contributeto the total cost—in cash, in labor, or inlocally available materials—of PIDER-fundedprojects. The amount of the local contri-bution varies by the type of project. Forproductive projects, PIDER has set a levelof 10 percent of the value of the publicinvestment; for potable water systems andthe construction of public buildings, thelocal contribution is set at 15 percent of thetotal investment; for village electrification



projects, it is between 5 and 15 percent oftotal investment, according to a quota sys-tem based on local economic levels; forhousing improvement projects, at least 50percent of the total cost of the work israised locally through labor, cash, or localmaterials.

A standard agreement form (Acta de Ac-ceptation de la Comunidad) has been devisedto formalize the commitment to such cashor labor contributions. It is signed by PIDERand the intended beneficiaries before theproject begins. Although this standardagreement is often not sufficiently refinedto reflect the different needs and varyingcontributory abilities within heterogeneouscommunities, formalization of both agencyand community obligations is a step for-ward in institutionalizing the participatoryapproach.

An example may help clarify the mech-anism of local resource utilization. Withthe help of PIDER, La Marina, a fisherycooperative with a membership of 54 fish-ermen in the state of Tamaulipas, devel-oped a new shrimp farm. The total invest-ment required was about 39.1 million pesos.The standard agreement signed by thecooperative and PIDER provided for aPIDER investment grant of 13.2 millionpesos, while the membership was to con-tribute a total of 26 million pesos; of thistotal, about 2 million pesos were to becontributed immediately and directlythrough cash, labor, and materials (repre-senting about 5 percent of total costs, or15 percent of the public investment). Thiswas above the share set by PIDER forimmediate local contributions to productiveprojects. The additional funds, totaling about24 million pesos, were a credit to be repaidby the cooperative (6.3 million pesos inshort-term and 17.6 million pesos in long-term loans). This credit was also facilitatedthrough PIDER funds, but was to be repaidgradually out of the cooperative benefits,thus increasing resource utilization andbuilding up the fishermen's equity.

The beneficiaries' financial contributionto this project was remarkably high. With-out PIDER's financial and technical assist-ance, however, it could not have takenplace: PIDER provided the working capitalfor nets, engines, pond construction, andmade possible the credit as well. Benefitsaccruing to the fishermen were estimatedto be seven times the local minimum wage;however only about 50 percent is to bedistributed to the membership. The rest isto be used by the cooperative for reinvest-ment and credit repayment.

This type of mobilization of local eco-nomic resources extends the consultationprocess carried out in the planning stageto a more concrete level of participation.

And participation in execution sets thestage for when PIDER hands over projectsentirely to beneficiaries.

Monitoring by beneficiaries

Participation is also of crucial importancefor monitoring the physical execution ofPIDER investments by contractors or stateagencies. The involvement of local com-munities in selecting and executing invest-ments is logically complemented by em-powering them to monitor executioneffectively.

There is wide agreement that there hasbeen much waste in many of PIDER's earlycommunity projects—through cost over-runs and incomplete or "complete" butunusable projects. The dismal state of rou-tine administrative monitoring, which didnot involve the beneficiaries, was revealedduring the mid-term analysis of the Bank'sfirst loan to PIDER, when it appeared thatits central management had lost track ofthe correct numbers and sites of many localprojects and a full-scale inventory had tobe undertaken. One of the most efficientways to curb this waste was to involve localcommunities in monitoring the real prog-ress and quality of projects by workinghand in hand with PIDER administratorsrather than following the usual pattern ofadministrators working alone.

Achieving efficient participation in mon-itoring requires that village communitiesbe regularly informed about the objectives,execution timetables, and costs of localinvestment programs. Beneficiaries have aparticular advantage in their ability to con-trol and monitor construction and delivery,since they are always on the spot. There-fore, PIDER and its sponsoring ministryhave insisted on formalizing the obligationof all agencies to provide information tobeneficiaries on the schedule, costs, char-acteristics, and completion dates of projects(an obligation not all these technical agen-cies were too happy to fulfill). Knowingwhat they should expect (and when) fromthe various local projects, and from the

Michael M. Cerneais Sociology Adviser in theWorld Bank. He holds aPhD, has taught sociology,and was a Fellow at theCenter for Advanced Studiesin Behavioral Sciences atStanford, and at theNetherlands Institute forAdvanced Studies.

contractors in charge of executing them,enables the direct beneficiary groups toreport to PIDER staff on the physical prog-ress and qualitative adequacy of these works.

The interests of both planners and ben-eficiaries require that when investmentsare wasted, construction is delayed, orquality is sacrificed, those responsible shouldbe taken to task. However, more parochialinterests frequently prevail, and monitor-ing project implementation seems to beinherently conflict-prone. Local political in-fluence is felt much more often duringproject monitoring than in project formu-lation, and it is all too easy to excludeentirely politically weak communities fromimplementation procedures. The reluc-tance of many technical staff or agencies torelease information on execution timetablesis an attempt to circumvent effective mon-itoring by the beneficiaries and to hamperthe grievance mechanisms. Therefore, pro-viding communities with formal rights tomonitor PIDER-financed projects is an im-portant step in actually empowering com-munities to participate.

Constraints on participation

Among the rural development projectsassisted by the Bank, the three PIDERprojects stand out as some of the mostsystematically concerned with participa-tion. Within Mexico itself, compared toother large-scale development programs,PIDER has achieved, by and large, a muchhigher degree of participation than the"normal" programs. Nevertheless, despiteits large-scale efforts and undeniableachievements, the experience with partic-ipation also teaches some sobering lessons.

To begin with, constraints on the scopeof local participation are inherent in thevery body and routines of the huge appa-ratus of the bureaucracy—a leviathan thatis not easy to turn around. In any country,a bureaucracy is reluctant to absorb andpractice new approaches. Obstacles to par-ticipation range from institutional to socio-cultural, from technical to logistical—thespectrum is seemingly endless. Every agencyhas them; they are likely to be recurrentand are unlikely to disappear after onlyone successful first round with a newapproach.

Second, cultural constraints to promotingparticipation are often overlooked, but theyare nonetheless a major slowing factor. Aspecific expression of these constraints isthe reactions of the army of technicians,planners, bureaucrats, and others who, inthe case of PIDER, are called upon toembrace a new style of planning and in-teract with new (for them) clients. PIDERis addressing this limitation by training thestaff of executing agencies in participatory



programming. Realism and actual experi-ence, however, suggest that this limitationcannot be removed by training alone. It isimportant in reorienting the bureaucracyand in learning the lessons of experience,but agency commitment to the new ap-proach and firm enforcement and moni-toring by PIDER management are criticalvariables as well.

A third problem frequently encounteredis that participation in investment decisionmaking and execution is politically andculturally sensitive. The allocation of in-vestments does not occur within a politicalvacuum—on the contrary, it usually takesplace within a highly politicized environ-ment. Openly or surreptitiously, groupswith vested interests are likely to opposethe involvement of the poor, marginal, andsmall farmers in making decisions andsetting priorities. While introducing parti-cipatory programming is, in effect, an at-tempt to empower the local communitiesand to transfer to them some authority overresource allocation, the overall power struc-tures and authority systems remain thesame. They are beyond PIDER's reach andobjectives. Therefore, popular participation

in investment selection and execution hasto operate under the constraints of existingrural political structures.

Finally, community participation mustbe self-perpetuating, not dependent onvisits by outsiders. Where community-basedgroups and organizations do exist and actcollectively, this may not be a problem.But, to sustain participation in the longrun, PIDER should explore ways to helpbuild more stable structures within the localcommunities. Such structures—farmers'organizations, cooperatives, associationsetc.—would be a powerful means forfostering both community participationin government-sponsored actions andmore assertive productive and marketingactivities.

The participatory approach is not yetgenerally applied, even by PIDER; it isbeing extended gradually to more PIDERareas. While the formulation of the parti-cipatory methodology is a major step for-ward, PIDER is still far from having allcurrent local investments planned and im-plemented in this way. There is still muchwaste to trim and there are many failuresto correct. The high staff turnover and the

frequent administrative reorganizations ofPIDER jeopardize the continuous enforce-ment of, and adherence to, the new par-ticipatory planning methodology. Evenwhere the approach is applied, it does notrun smoothly, unhampered by bureaucraticroutines, and at times application is notconsistent with the intentions of the meth-odology. Given the large size of the PIDERprogram, it is only to be expected that awider use of the approach will require yearsto achieve. However, as the quantitativeand qualitative evidence on the new ap-proach gradually accumulates, there is awidespread feeling that the participatorymethodology marks a major step forwardin the effective design and implementationof local development projects.

Because of its innovativeness, its achieve-ments, and its difficulties, the PIDER ex-periment in Mexico provides a useful lessonfor development planners elsewhere. Theparticipatory methodology reflects Mexicanconditions and institutional settings and,while it cannot be extrapolated wholesaleto other environments, it does offer, mutatismutandis, relevant lessons that are appli-cable more generally.

Discusses:

• production of agriculturalcommodities

• transforming commodities tofoods

• marketing to meet the needs ofconsumers

• how food systems function indifferent environments

• policy interventions that canimprove access to food

Food Policy AnalysisC. Peter Timmer, Walter P. Falcon, and Scott R. Pearson

An innovative attempt to link issues of food production and consumption. Stresses theneed to understand the food system in order to solve the hunger problem.

"[The authors] have undertaken a very ambitious project: to treat in one volume the micro and macro aspectsof food policy in a fashion useful to both market economies and socialist countries. Do they bring it off? In theopinion of this reviewer, they do."

Don PaarlbergPurdue University

from a review in The American Journal of Agricultural Economics, February 1984

Analyzes the behavior of food consumers and producer households, the effects of macroeconomicforces on the performance of the food system, and the role of markets in linking household issues inthe micro sector to policy issues in the macro economy.The Johns Hopkins University Press/The World Bank

Please send me:DFood Policy Analysis (Stock No. JH 3072,

hardcover, $25)D Food Policy Analysis (Stock No. JH 3073,

paperback, $12.95)DCatalog of Publications 1984. Free.Enclosed is my check for $(or equivalent currency).Charge to my DviSA DMaster CardLU American ExpressCredit cards accepted only by World BankPublications, Washington, D.C.

Number Expiration Date

Signature

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Address

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Country

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Return to:World Bank Publications or World Bank PublicationsP.O. Box 37525 66, avenue d'lena,Washington, D.C. 20013 USA 75116 Paris, FRANCE


>̂ * Food Policy Analysis ̂^̂ received the 1984 Quality -<ч,^̂ of Communication Award

_^r from the American ^J^_ Agricultural Economics ^>J

**7 . Association. x


Agricultural lending by the Bank,1974-84A retrospective analysis

Montague Yudelman

The World Bank and the International De-velopment Association continue to be themajor source of external resources for ag-ricultural development in the tropics. Infiscal years 1974-84 the Bank provided twothirds of the multilateral aid and nearly onethird of all official development assistancefor agricultural development. The Bankinvested about $33 billion in agriculturalprojects that drew a total investment of$90-100 billion in 1974-84. The largest sin-gle borrower for agriculture from the Bankwas India ($4.5 billion), followed by Mexico($2.5 billion), Indonesia ($2 billion), Brazil($1.3 billion), and Romania and Yugoslavia($1 billion each). It may be a coincidence,but agricultural performance in these majorborrowers was reasonably successful. In-dia, of course, also dominated borrowingfrom IDA for agriculture; its borrowing waslarger than that of the rest of the IDAclients combined. In recent years there wasonly one significant change in the order ofborrowers by size—in fiscal year 1984 Chinabecame the eighth largest borrower foragriculture from the Bank, and second onlyto India from IDA.

The Bank's agricultural lending wasdominated by three categories of projects—irrigation, multisectoral area developmentprograms, and rural credit; these accountedfor 70 percent of all commitments in thepast ten years. About one third of allagricultural investment—more than $1 bil-

lion a year—was for irrigation, accountingfor about one quarter of the increase in theirrigation capacity of developing countries,which was a significant factor in their in-creased rice and wheat production, espe-cially in South and East Asia. The Bank-financed projects encompassed both sur-face and groundwater irrigation. Possiblythe Bank's greatest contribution to irriga-tion work was to help in the enormousexpansion in the number of public andprivate tubewells in South Asia as well asin the promotion of surface irrigation onthe subcontinent. Recently, an increasingnumber of projects have been concernedwith rehabilitating and improving the man-agement of irrigation systems. The risingreal costs of bringing new land under irri-gation led to an increase in projects pro-viding technical assistance for improvedwater management, thus ensuring that therewill be an adequate return on previous andcurrent investments in this area.

Area development programs tended touse multisectoral approaches (coveringroads, education, and health etc.) to raisethe productivity of large numbers of farm-ers—usually those with small farms. Thistype of project was developed, for example,in Indonesia, North East Brazil, NorthernNigeria, and Central Africa. Over the yearsthere was a tendency to reduce the scaleand scope of these projects and to focusmore on raising productivity and agricul-tural output than on providing a wide rangeof services.

In the past decade the Bank continuedto make substantial loans to national creditinstitutions to help raise the productivityof farmers, especially those with small- andmedium-sized holdings. The largest singleloans made for this purpose were to Indiaand Mexico. The loans passed on to localcredit intermediaries were to help groupsof farmers finance infrastructure and tohelp individual farmers acquire inputs,such as livestock and equipment. Bank-sponsored credit programs assisted at least20 million farmers, many of them withsmall- and medium-sized holdings, to ac-quire technologies that raised their yields.

Among the relatively smaller segmentsof the Bank's agricultural lending program

World Bank and IDA commitments foragriculture and rural development by

region, fiscal years 1974-84(In millions of dollars)

Source: World Bank data.1 Europe, Middle East, and North Africa.2 Includes $42 million for countries that had graduated from

World Bank lending by 1974.


East AfricaWest AfricaEMENA 1

Latin AmericaEast AsiaSouth Asia

Total

1974

120.981.0

191 .02

223.5189.5150.0955.9

1979

198.6174.1636.0405.0566.4541.7

2,521.8

1984

106.9503.4514.0856.9503.9956.1

3,441.2


was a substantial increase in investmentsin research and extension, although to-gether they accounted for less than 10percent of lending for agriculture. Thereare now 13 national research projects underway and 7 in preparation, mostly in Africa;there are also more than 60 extension proj-ects currently in operation. The rapid build-up in national research projects emergedfrom a growing appreciation that interna-tional research bodies (such as the multi-donor Consultative Group on InternationalAgricultural Research organized and man-aged by the Bank) had to be complementedby national efforts. There was also a rec-ognition of the need for appropriate tech-nologies for the humid tropics, the semi-arid tropics, and the peculiar climatic andagricultural conditions that prevail in muchof Africa. In my view, the availability ofsuitable technologies for different agrocli-matic zones is as important as price incen-tives in the struggle to increase output.

One of the more disappointing featuresof the Bank's agricultural lending programhas been the slow growth of forestry proj-ects. Despite early successes, especially insmall-scale forestry, that followed a rapidstart in 1979-82, the Bank is well behindits objective of having a billion dollar pro-gram over 1981-84. Unfortunately, the cur-rent international financial crisis and theensuing budgetary constraints forced manygovernments to downgrade the importanceof forest development as an element intheir energy plans. Fisheries developmentis also lagging well behind the Bank's earlierprojections, because of the absence of localopportunities in the Bank's area of prior-ity—small-scale fisheries based on artisans.

Current portfolio

An examination of the Bank's agriculturallending portfolio for fiscal year 1984 revealssome general characteristics that may pre-sage its future development.

• First, the number of agricultural proj-ects is declining, while the volume of lend-ing is increasing. With a rise in the averagesize of Bank projects, there is an increasingpolarization of small and large projects. Forexample, in fiscal year 1983, close to 20percent of the projects were below $10million, while 20 percent were $100 millionor more; the percentage of loans below $10million rose from 14 to 18 percent overfiscal years 1978-83, while loans above $100million rose from 6 to 19 percent over thesame period. Out of the 68 projects, 13accounted for more than half of the $3.8billion loaned. Nearly all the loans below$10 million were in Africa; the loans above$100 million were notably in the Bankregions of Europe, Middle East, and NorthAfrica; Latin America and the Caribbean;

and South Asia. This distribution reflectsthe differing absorptive capacities amongregions.

• In 1983, both the Bank and IDA fi-nanced a record proportion of the localcosts of agricultural projects. Some 15 per-cent of Bank loans and 45 percent of IDAcredits were for local costs—a reflection ofthe shortages of complementary resourcesin member countries, especially in thosethat borrow from IDA.

• About a quarter of the loans weresectoral, that is, they included finance foragricultural sector policy adjustments. Theincrease in policy-related issues linked to

Total Bank and agricultural andrural development (ARD) lending,

fiscal years 1974-84

project loans is very noticeable, in line withthe changing nature of the Bank's deep-ening involvement in the process of agri-cultural development.

• Cofinancing from official channelsamounted to $520 million supporting 27projects in agriculture; 58 percent of thecofinancing came from bilateral sources and40 percent from multilateral sources. Thetwo regions with the largest amount ofcofinancing were South Asia and East Af-rica. Primarily because of the high risks inagriculture perceived by the private sector,there was very little cofinancing from pri-vate sources despite the Bank's emphasison encouraging private capital flows.

Past prognoses examinedLooking back on the experience with

agricultural development over the past twodecades, one can see that a great deal was

written about famines and other impendingagricultural catastrophes in the 1960s and1970s. They did not happen. Similarly,there were gross miscalculations about theexpected "food deficits" in developingcountries, especially just before the WorldFood Conference in 1974. A major errorwas to misjudge a short-term drop in Indianproduction as a trend—hence the projectedestimation of a food shortage among poorcountries of up to 100 million tons or more.Not many predicted the upsurge in pro-duction of wheat and rice in South andEast Asia; nor did many foresee the declinein grain prices that took place in the pastdecade.

Ten years ago few experts foresaw thehigh price and income demand elasticitiesof grain, the ensuing explosive growth ininternational trade, and the ability of theglobal market to handle it. The "necessary"conditions for food security—as presentedin 1973—have not come to pass. There isno wheat agreement, no international foodsecurity agreement, no global compact ongrains. Nonetheless the market (no doubthelped by good weather in major devel-oping countries) has worked very effec-tively to buffer the food supplies of mostdeveloping countries. Growth in world graintrade has doubled in the past ten years toover 200 million tons—helping in the betterdistribution of food surpluses. No oneforesaw this explosion in trade.

Despite dire warnings, the oil crisis di ¡not inhibit increased production in th< iUnited States, the most energy-intenswagriculture in the world. The rise in fueiprices had a subtle and pervasive effect onthe pattern of production within the UnitedStates but did not lead to a dramatic changein its relative advantage in production costsover the rest of the world, because U.S.farmers adjusted to higher fuel prices.

Contrary to expectations, the Green Rev-olution did not displace small farmers—the evidence seems to be that where agro-climatic conditions were favorable, the smallfarmers, after a time lag, adopted the newtechnology as readily as large farmers. Adecade ago, the debate was about theimpact on distribution within regions ofadopting the new varieties; it was notrecognized that the principal beneficiariesof the high-yield revolution would be low-income consumers. Nor was it fully appre-ciated that the income differences amongproducers would largely be regional—rice-and wheat-producing areas under irriga-tion would prosper, while neighboring re-gions without water would not.

Finally, it would be fair to say that veryfew experts foresaw in 1974 the emergenceof the European Economic Community asan agricultural power or that the U.S.S.R.—

46 Finance & Development /December 1984

Source: World Bank data.


once a major grain exporter—would be theworld's largest grain importer in the 1980s.The impact of growing incomes in thedeveloped world was underestimated—thetremendous increase in grain-fed meat con-sumption, in particular, was not foreseennor was the fact that a third of all the grainproduced would be used for animal feed,as it is now. These structural changes inglobal agriculture have had a profoundimpact on the operations and stability ofinternational food markets.

Lessons for the Bank

The Bank learned many things from itsown experience with agricultural lendingover the past decade. It is now widelyappreciated that macroeconomic policiesare important; projects seldom work in ahostile policy environment. This appliesboth to market and nonmarket economies.In addition, projects must extend far be-yond the provision of infrastructure. Effectsat the farm level have to be anticipated andsupported, frequently through financingrecurrent costs. Partial evidence that thislesson has been learned is that ten yearsago few on the Bank's agricultural staff hadfirsthand knowledge of the training andvisit system in agricultural extension; now,it is in place in 60 Bank projects.

On a different plane, Bank staff now talkless about reaching the "poorest of thepoor." But they have learned that strategiesto reach the low-income small farmer haveconsiderable merit and are feasible wherethere is a supportive government and areasonable institutional environment. Withinthe reasonably successful small-farmerstrategy, the Bank has come to appreciatethe elusiveness of an important component:participation by local communities in thedesign and implementation of agriculturalprojects.

Another lesson that has to be repeatedoften is that agroclimatic conditions are stilla most important factor in agricultural proj-ects; some environments may simply beunsuited for high-yielding agricultural pro-duction. Further, there has to be a discrim-inating approach in view of both climatic

Montague Yudelmana U.S. citizen, was Directorof the Agriculture and RuralDevelopment Department inthe Bank from 1973 until hisretirement in September1984. He is now aDistinguished Fellow at theWorld Resources Institute inWashington, DC.

Feeding the hungryWith over 200 million tons of grain in reserves globally, the world has a better overallsupply of food today than it has had for decades. These reserves are enough to meet 20percent of current global consumption needs. Although in the past decade world foodproduction has grown faster than population, there are still areas of hunger andmalnutrition. Shortages exist most notably in sub-Saharan Africa, where production hasbeen stagnant. But, as mentioned in the text, no world food crisis of the kind presagedin 1973 is expected to occur; sub-Saharan Africa, for example, could meet its needs withonly 6 percent of the grain traded internationally.

In 1973, a reduction in the production of grain by the United States coincided with amassive crop failure in the U.S.S.R. and a poor monsoon in Asia. This triggered a "worldfood crisis." In contrast, despite a reduction of food production in the United States in1983, no food crisis is imminent. Bangladesh, India, and Pakistan, as well as manydeveloped countries, all have had record harvests. There are, however, problems ofdistribution (both physical and economic), since production increases have not all beenin the highly populated low-income countries.

In spite of the fact that global food production is growing faster than population andthat tentative data indicate a reduction in the proportion of world population that isundernourished, the actual number of malnourished may well have increased over thelast decade. This is because, in some countries, population growth has outpaced foodproduction, and many people are simply too poor to acquire enough food to meet theirminimal nutritional needs. In Bangladesh, for example, despite a sustained and impressiveincrease in food production over the past five years, a conservative estimate is that lessthan 10 percent of the population is adequately nourished.

To meet the nutritional needs of growing populations, the Bank has shifted its attentionfrom a narrow focus on the production and supply side to the demand side and the foodsystem as a whole. Also, there is less of a preoccupation with identifying the locationand nature of the vulnerable groups in each country. The current emphasis is on makingthe marketing chain more efficient while, at the same time, ensuring that there are specialprograms to reach those outside the purview of the marketing system. Within the Bankthere are now a growing number of projects, especially in Latin America and East Asia,that are intended to improve marketing mechanisms and make them more efficient; thereare also several special programs, notably in India and Indonesia, intended to makenutritious foods available to disadvantaged groups.

The world's population has increased by over one billion since the World FoodConference of 1973, which portended a catastrophe that has not occurred. However, noone can afford to be complacent—the world's population will most surely increase byanother 2 billion people by the year 2000. The growing demand for food can be metbecause of the great potential for further increases in yields, in even the most populouscountries such as China and India. At the same time nutrition levels could be improvedby special interventions. But these depend primarily on reducing poverty, through broad-based development efforts.

and institutional conditions. What worksin Malaysia or Korea will not necessarilywork in Haiti or Chad; or, more signifi-cantly, what works in Haiti will not nec-essarily work in Chad.

The question of agricultural developmentin much of Africa needs to be reviewed inlight of the fact that it is now apparent thatthe preconditions for accelerated agricul-tural development are not currently presentin much of the continent. The Bank and itsmember countries will need to invest heav-ily in creating these conditions—investingin human development and basic infra-structure. At the same time, there will haveto be emphasis on reducing recurrent ex-penditures and, within the Bank, morefocus on actually implementing agriculturalprojects in Africa than in other regions.

Finally, it must be recognized that theBank is entering a period of constrainedresources. Bearing in mind the tremendousincreases in population on the horizon, weshould expect an era in which an improve-ment in the efficiency of management oflabor, capital, and natural resources is em-phasized. There should emerge a muchgreater emphasis on efforts to raise returnson past and future investments, throughgreater attention to design, operation andmaintenance, cost recovery, and appropri-ateness of technology. Doing things thesame old way will not suffice. The Bank'sagricultural staff will need to approach thenew challenge with creative solutions forthe next decade, and recognize that thesewill involve much more monitoring andflexibility than in current projects. ED



Books

Marc A. Miles

Beyond MonetarismFinding the Road to Stable Money

Basic Books, New York, 1984, xv + 270 pp., $16.95.

George Macesich

The Politics of MonetarismRowman & Allanheld, Totowa, NJ, USA, 1984, viii +158 pp., $26.50 (cloth), $14.50 (paper).

In October 1979, the U.S. Federal ReserveBoard shifted the focus of its policy, placinggreater emphasis on preannounced quan-titative targets for monetary aggregates. Thisdate is often seen now as the beginning ofa "monetarist" experiment, even though ac-claimed monetarists have frequently disas-sociated themselves from the policies of theFederal Reserve. New books by Marc Milesand George Macesich are among the latestcontributions to a stream of literature thatthis policy shift has generated.

Miles opens his study by reviewing thevarious criticisms of monetarism that haveappeared in the literature, including the dif-ficulties in testing the causal relationshipbetween money and economic activity, theimpact of offshore financial markets andfinancial innovations on the conduct of mon-etary policy, and the problem associatedwith the definition of money in an openeconomy. A reader not acquainted with de-velopments in monetary economics will cer-

tainly find this section very useful. Miles thendiscusses what he regards as the failure ofthe Federal Reserve's monetarist stance.He argues that nearly five years of mone-tarism have not succeeded in eradicatinginflationary expectations, the main evidencebeing the high interest rates that have pre-vailed since 1980. Not many economists,however, would endorse this interpretationof recent interest rate developments.

As an alternative to the current policy,Miles advances a proposal for a new mon-etary regime that, unlike monetarism, wouldensure lasting price stability. A central bank,the author argues, should stabilize both theprice of a commodity basket traded in finan-cial future markets and a long-term interestrate. Under such a price rule policy, themonetary authorities' commitment to pricestability would be clear-cut, and, therefore,always credible. In addition, unpredictableshifts in the demand for money would au-tomatically be offset by changes in the quan-tity of money supplied, without affectingprices or interest rates. Regrettably, theproposal is stated as a self-evident truth andthe author provides neither a sound theo-retical framework nor solid empirical evi-dence to support it.

The word monetarism is perhaps the onlything that Macesich's and Miles' books share.Macesich proposes to "provide a systematic

interpretation of money within the frameworkof political economy." Whatever expecta-tions this sentence induces, I am afraid thereader will be disappointed. The greater partof the book simply repeats well-known ar-guments that have been at the core of themonetarist-Keynesian controversy for thelast 30 years. Macesich explains how mo-netarists and Keynesians differ in their viewsabout the determinants of inflation; the slopeof the Phillips curve; the viability of discre-tionary monetary policies; the efficacy offiscal and income policies for macroeco-nomic stabilization; and the viability of moneygrowth rules. On the whole, this comparesunfavorably with existing surveys of themonetarist-Keynesian controversies, suchas those of Johnson (1970), Lucas (1980),and Tobin (1980). Likewise, the concisehistory of economic thought (from Cantillonto U.S. President Ronald Reagan's supply-side economics) that Macesich provides isof little value—too concise for scholars andtoo inaccessible for other readers. In hisfinal chapter, however, the author addressesthe core of his subject—discussing alter-native monetary regimes and evaluating thehistorical experiences with them. While thisis by far the most interesting part of thebook, its 25 pages are, unfortunately, prob-ably not sufficient to gratify the reader.

Alessandro Penati

P.M. Scherer

Innovation and GrowthSchumpeterian Perspectives

MIT Press, Cambridge, MA, USA, 1984, x + 297 pp.,$35.

The basic theme of this collection of reprintedpapers ought to be of special interest todevelopment economists: "... technologicalchange has had, and will continue to have,"Scherer asserts, "much more of an impacton material well-being than the niceties ofstatic resource allocation to which micro-economists devote most of their attention."In pursuing this theme, each paper attemptsto test hypotheses derived from threeSchumpeterian propositions: technologicalinnovation provides dynamics to capitalisteconomies through "creative destruction";economic growth has primarily resulted fromtechnological progress; and the factors mostconducive to technological innovation arethe expectation of monopolistic quasi-rents

and favorable market structures. The rigorwith which these hypotheses are formulatedand the persistence with which they areexplored—in econometric models or empir-ical case studies—is a particular virtue ofthe analyses.

The book is most successful in utilizingcase studies to test theoretical propositions.The essay on the development of the steamengine is delightful. There are also studieson innovation in the ready-to-eat cerealsindustry, the effects of compulsory licensingon innovation in selected industries, andrelationships between the size of the firmand the level of innovative output. The mix-ture of theory, history, and factual datailluminates the rationale for the behavior offirms and industries and the results of theirinnovation. Less successful are the hypoth-eses explored within the framework of econ-ometric models. The assumptions these makeare almost necessarily unreal, not just ab-stract, and too much is subsumed underceteris paribus. Even in these cases, how-

ever, the reader will be led to consideradditional formulations that are worthy ofstudy.

Special mention should be given to thework on the technology matrix (a conceptattributed to Schmookler), which shows theflow of innovations from those industries thatoriginate them (the sources) to those thatbenefit from them (the users). Research,development, and engineering activities cre-ate innovations, but the industries of originare not necessarily the major beneficiaries.The results of innovation are available tomany users and the adoption of innovationscan raise productivity in the using industries.One finding of the analysis is the very heavydependence of most economic sectors oninnovations originating in relatively few man-ufacturing industries (e.g., capital goods).The results of this work indicate the potentialimportance of identifying and supporting thoseoriginating industries that are a key to pro-ductivity growth and economic progress.

Frederick T. Moore



Robert Stobaugh and Louis T. Wells, Jr. (editors)

Technology Crossing BordersThe Choice, Transfer, and Managementof International Technology

Harvard Business School Press, Boston, 1984, x +329 pp., $29.50.

Drawing on a set of shared views on thebehavior of firms, this book reflects theresearchers' association with a pragmaticbusiness school rather than a theoreticaleconomics department. They assume thatmanagement attention is a scarce resourcethat should be allocated where the returnsare greatest; that technology is chosen,transferred, and managed in imperfect mar-kets; that firms differ in how they choose tocompete; and that the structure of the mar-ket, a firm's position in it, and differentinstitutional environments—such as govern-ment regulations and financing possibili-ties—affect choices and decisions ontechnology.

The first group of these studies examineshow managers in foreign and local firmschoose technologies to be used in devel-oping countries. Although the older materialmay be familiar to some, the order of thestudies nicely plots the evolution of thoughtand research at the Harvard Business Schooland demonstrates that each subsequentstudy has generally built on and extended

the findings of its predecessors. Most ofthese studies show that the nature anddegree of competition faced by a manageris a critical variable in the choice oftechnology.

A recent study by Amsalem shows thatanother barrier to the selection of an optimaltechnique is a manager's ignorance of thefull range of available techniques elsewhere.It also finds that even if managers were tochoose the best technology at prevailingfactor prices, a more labor-intensive tech-nology would generally be a better choicefrom the point of view of the country whenappropriate shadow prices are used. Thebook's only study on state-owned firms findsthat the choice of technology in these firmsis based more on bureaucratic process thanon economic criteria, and the critical elementis often the speed with which the project canbe implemented or the influence of externalaid and financial sources.

The middle section examines how multi-national enterprises decide on the channelsthrough which they transfer technology (whylicensing, for instance, might be chosen overdirect investment) and how that choice af-fects the recipient firm or country. Perhapsmost surprising, coming from a businessschool, is a study of joint ventures andtechnology transfer in Iran that suggests that

firms with higher foreign ownership andcontrol impose higher costs on the hostcountry in terms of lower domestic contentin final products, lower share of indigenousmanagement, and higher prices on importedequipment, raw materials, components, andtechnology as compared to their less foreigncontrolled counterparts. The study also sug-gests, however, that greater foreign own-ership and control is associated with greatermanufacturing efficiency, although the evi-dence for this is weaker.

The last section examines how multina-tional enterprises manage their relationshipswith overseas affiliates. This segment in-cludes a systematic study of research anddevelopment investments and an examina-tion of factors determining the locus of influ-ence between headquarters and local man-agement over manufacturing decisions.

This useful and highly readable collectionshould increase understanding of how firmsmake technology choices and how multi-national enterprises make management de-cisions about technology transfer and foreignaffiliates. The last two sections will be par-ticularly valuable for policymakers and oth-ers who want a closer inside view of howmultinational firms make decisions that affecttechnology flows to developing countries.

Carl J. Dahlman

Robert Chambers

Rural DevelopmentPutting the Last First

Longman, London, 1983, 246 pp., $4 (paper).

Pver the last decade, the literature on ruralDevelopment has given increasing emphasisto poverty issues rather than to the organi-zational aspects that tended to dominatemuch of the earlier discussion on this topic.With rural poor accounting for a majority ofthe population in most developing countries,a proper understanding of their condition isobviously important when policies and pro-grams for broad-based national economicdevelopment are being formulated.

This is easier said than done, however.Rural poverty is less visible than urbanpoverty. People in cities are usually betterorganized and more politically active thantheir rural counterparts. Visiting journalists,researchers, government officials, and rep-

resentatives from international agencies tendto spend most of their time in cities. Visitsto the countryside are more infrequent andwhen they are made, it is often during periodswhen conditions are most favorable to suchtravel—for instance, other than during rainyseasons and usually when the full extent ofrural poverty is not easily observed.

With wide experience from sub-SaharanAfrica and South Asia, Robert Chambers, afrequent and highly respected writer on ruraldevelopment, has focused his new book onthe many biases that work against an un-derstanding of the dimensions of rural pov-erty. Decision makers and researchers tendto prefer, he argues, the more traditional"first" concepts, favoring large scale oversmall scale, modern technology over indig-enous knowledge, urban over rural, "hard"sciences over "soft," and the quantifiableover the nonquantifiable. The author wants

a better balance between these conceptsand recommends that in order to achievethis, we may often have to put the "last"first.

This very readable book provides a wealthof references to studies and observationsby others. Contrary to some social scientistswho find rural poverty so discouraging thatcorrective action seems futile, Robert Cham-bers derides such "fatalism" and spells outwhy he believes concrete action to alleviaterural poverty is possible. While one maywish Mr. Chambers had treated these actionissues at greater length, he has written avery worthwhile and stimulating book. Allthose interested in agriculture and rural de-velopment, as well as national policymakersand others who formulate or provide assist-ance to plans and programs for economicdevelopment, should read it.

Leif E. Chrlstoffersen

Milton J. Esman and Norman T. Uphoff

Local OrganizationsIntermediaries In Rural DevelopmentCornell University Press, Ithaca, NY, USA, 1984,391 pp., $35.

This excellent contribution to the subject ofrural development sees local organizationsas the third and neglected corner of a gov-

ernment/private/local organizations triangle.The authors note the quite high failure rateof local organizations and part of the bookis concerned with a statistical analysis offactors contributing to failure and success.Clearly there are enormous problems as-sociated with directions of causation, scalingof attributes, and extrapolation of findingsfrom 150 nonrandom case studies to theentire range of local organizations. But the

authors are refreshingly honest, even to theextent of calling on outside referees to com-ment on their approach.

In any case the book does not, by anymeans, stand or fall on its statistical analysis.A great deal of wisdom is distilled fromreferences to the literature and from theauthors' own field observations. The analysissuggests that the most successful local or-ganizations are those that are best able to



manage their resources, particularly theirfinancial resources. Low correlations be-tween performance and physical environ-ment were found.

The serious reader may first want to skimthrough this book for the flavor and thendelve more deeply into the creative thinkingthat marks its discussion of particular prob-lems of local organizations. The authorsavoid the hands-off attitude, so prevalentcurrently, that argues that local organizationswould be fine, emerging where needed, ifonly governments would leave them alone.Their findings suggest that governments,and donors through governments, can helplocal organizations, particularly with techni-

cal assistance and training, and the!, in anycase, local organizations are unavoidablysociopolitical groupings and a political di-mension is inevitable.

Some criticism is voiced of the "engi-neering" approach to project design of in-ternational donor agencies. This approach,which entails large projects, detailed design,and, too often, inflexible management work-ing to an implementation schedule, is felt tobe particularly inappropriate to projects in-volving local organizations, where excep-tional flexibility is vital. The training and visitsystem of extension work comes in for somecriticism as well. There is a suggestion thatcontact farmers are generally not linked to

a group and their influence with other farmersmay therefore tend to be weak.

To the reader who is less of a specialist,parts of the book may be a trifle heavy. Thelong word is often preferred over the short.It may not be long before a dictionary ofrural development terms is required for theuninitiated. While it is probably unfair to askthat a book covering quite complex issuesand statistical relationships in social sciencebe easily accessible to a layman, it is still alittle sad that the fully literate leader of asmall farmer development group in Nepalwould have to put this book down with apuzzled smile. But most of us are guilty inthis respect. Ridley Nelson

Andrew J. Pierre (editor)

Unemployment and Growth inthe Western EconomiesCouncil on Foreign Relations, New York, 1984, x +142pp., $5.95.

High unemployment is probably the mostimportant problem currently facing Westernindustrial economies. In addition to its directhuman and economic costs, it is destructiveof both domestic and international politicalcohesion. This book examines the unem-ployment situation in the United States andEurope from the perspective of a concernfor the future of the Western political alliance.

In four excellent essays, James Tobin,Raymond Barre, Marina v.N. Whitman, andShirley Williams compare and contrast em-ployment developments on both sides of theAtlantic. They go beyond a dry recitation ofstatistics, however, and offer specific pro-posals to deal with unemployment. Whilethere is a certain amount of agreementamong the contributors on the fundamentalcauses of the problem, their policy prescrip-tions reflect important differences of opinion.These differences chiefly concern the extentto which present unemployment is "struc-tural" or "classical" rather than "Keyhe-sian"—that is, the extent to which strong

economic growth would not, in and of itself,be sufficient to put the jobless back to work.While recent experience indicates that U.S.employment is highly responsive to an ex-panding economy, there is little confidencethat this will be the case in Europe.

James Tobin argues most strongly thatpresent unemployment is a result of deficientaggregate demand and that structural labormarket policies are likely to lead to onlymarginal improvements. He advocates ex-pansion, particularly in Germany and Japan,and suggests the international coordinationof monetary and fiscal policies to stimulatenational growth. He would minimize theinflationary risks of such policies by estab-lishing incentives and guidelines to moderatewage and price decisions.

Although the other authors also see asubstantial part of the unemployment prob-lem as resulting from deficient demand, theyascribe greater importance to structural im-pediments to expanding employment, andto difficulties in applying macroeconomicsolutions. Raymond Barre argues that theEuropean economies have exhibited lessflexibility than the United States in recentyears and therefore have been less suc-cessful in creating job opportunities. In Barre'sview, European labor has been insufficiently

mobile, unemployment compensation toogenerous, investment inadequate, and in-creases in unit labor costs detrimental tocompetitiveness. He recommends restrain-ing increases in wage costs and devotingefforts to improving the functioning of labormarkets and strengthening the competitive-ness of firms.

Marina Whitman contends that faster eco-nomic growth would help to overcome struc-tural rigidities by relieving the budget con-straint on employment programs andencouraging more rapid productivity gains.However, she also sees a need for wagemoderation to restore the competitivenessof certain basic industries. To be successfulin the long run, structural policies should aimless at preserving existing jobs and more atincreasing the flexibility of labor markets.Shirley Williams points out that the UnitedStates and Japan have been quick to exploitnew technologies, which she regards as thekey to future job opportunities. Employmentprospects in Europe could be improved,Williams suggests, by enhancing the dis-semination of technological knowlege andby expanding technical education, as wellas through job sharing, flexible retirement,and a reduction in working hours.

James E. Blalock

Rich Kronish and Kenneth S. Mericle (editors)

The Political Economy of theLatin American Motor VehicleIndustryMIT Press, Cambridge, MA, USA, 1984, xvi +314 pp., $30 (cloth).

Once the growth potential of light industriesis close to fully exploited, developing coun-tries have no choice but to set up policiesto increase capital investment in the indus-trial sector. Many middle-income countrieshave been drawn in this way toward theautomotive industry: it can directly meet

growing domestic demand, provide a pro-fusion of linkages whose effects are quicklyfelt throughout the economy, quicken thetempo of technological assimilation, and,after the industry has matured, become animportant source of exports.

The Brazilian, Argentine, and Mexicanautomobile industries, whose experience fillsmuch of this book, have been in the businessfor several decades now and account forclose to 90 percent of all cars produced inLatin America. In Brazil 12 percent of theindustrial output originated in the automotivesector during the mid-1970s; the figure was10 percent in Argentina and only a little lower

in Mexico over the same period. As a leadingsector par excellence, it exerted a significantdirect and indirect influence on domesticdevelopment trends and more recently onthe export performance.

The papers included in this volume, asidefrom charting the history of automobile pro-duction, describe in detail the strategy eachgovernment pursued in persuading trans-national companies to establish productionfacilities. While there were differences in thedegree to which local content requirementswere imposed and income concentrationpromoted to enlarge the market for cars,each of the countries used a combination of



fiscal incentives, import controls, and repa-triation privileges to push the transnationalcompanies into steadily expanding their op-erations, even though this led to many un-economically sized plants.

Governments were also deeply involvedin the management of labor relations be-tween the companies and their workers,which is the second major concern of thisbook. Labor militancy strongly influencedcosts and the willingness of transnational

companies to invest; when unions, as inArgentina, adopted a tough stance underthe Peronist regime, the industry stagnated.Because governments in Mexico and Brazilwere more effective in curbing unionizationand the coalescence of labor power, the carindustry in these countries was less ham-strung and hence quicker at exploiting exportmarkets in the 1970s.

By and large, the authors are successfulin showing the costs of what they describe

as "dependent development," in terms ofscale economies sacrificed, a concentrationof income distribution, a curtailment of work-ers' rights, and numerous concessions tothe transnational companies. Perhaps suchcosts are unavoidable, given that the trans-national companies control technology andglobal markets, but it is the merit of thisvolume that it documents for other nationsthe nature and extent of these costs.

Shahid Yusuf

Sanjaya Lall et. al.

The New MultinationalsThe Spread of Third World Enterprises

John Wiley, New York, 1983, x + 268 pp., $29.95.

This collection of individually authored studies onthe nature and experience of foreign direct in-vestments by India, Hong Kong, Argentina, andBrazil includes an introductory analytical frame-work and a concluding synthesis by Sanjaya Lall,and covers the country and sector destination,the determinants, and the results of this outwardforeign investment. The studies reveal that thebulk of these investments were made in otherdeveloping countries, though the investments diddiffer depending upon the home country's orterritory's structural characteristics, degree of in-dustrialization, and trade policies. In some casesthe book's interpretations and conclusions varyfrom those of other current research on the emerg-ence of Third World multinationals, but the mainthrust of these differences is that the more that islearned about this complex and dynamic phenom-enon, the harder it is to generalize about itscauses, advantages, and future course.

Nikolai Kondratieff

The Long Wave CycleRichardson and Snyder, New York, 1984, ii + 138 pp., $30.

Most people, including policymakers, are sopreoccupied with grappling with day-to-day prob-lems that they are rarely able to pay attention tolonger-term developments, let alone the very long-term pattern of such changes. Keynes's famous"in the long run we are all dead" has become acliché, but longer-term economic fluctuationshave for many years been the subject of studyand speculation. Recently, in the wake of theproblems that have beset most economies in thepast decade, some have wondered whether wewere not, indeed, in a period of long-term economicdecline. For these people, and for economists ingeneral, the reissue of this classic is welcome.Originally published in 1928, this new translationfrom the Russian by Guy Daniels is clear, elegant,and well presented. All students of economicscome across the "Kondratieff Cycle" at somepoint in their textbooks; the interested now havethe benefit of the complete original thesis in anexcellent translation.

Mathew J. Betz, Pat McGowan, and Rolf T. Wigand (editors)

Appropriate TechnologyChoice and Development

Duke Press Policy Studies, Durham, NC, USA, 1984, xi +164pp., $32.50.

Originating in an interdisciplinary graduate semi-nar on technology in development, this volumediscusses a number of issues, including whyappropriate technologies "either have been ig-nored or, in many cases, have not worked in oneapplication after being successful in another."Five case studies on the adoption of technologiesclose the work and it is in this section that theinterdisciplinary character of the seminar comesthrough most clearly, with sociopolitical factorsoften emphasized more than economic aspects.A primer, suitable for those coming to the subjectfor the first time.

Adda Guecioueur (editor)

The Problems of Arab EconomicDevelopment and IntegrationWestview Press, Boulder, CO, USA, 1984, xvi + 223 pp., $22.

Consisting of papers presented at a symposiumat Yarmouk University, Jordan, in November 1981and summaries of the discussion there, this bookexamines the issue of Arab economic integrationin agriculture, industry, finance, and transfer oftechnology (research and development). Also in-cluded is a review of the contribution of theEuropean Community to Arab development andintegration (the "Euro-Arab dialogue") and a dis-cussion of the obstacles that Arab economicintegration faces. While the book, in the editor'swords, proposes to show that "... economic inte-gration constitutes the only way to self-maintained,introverted Arab economic and social develop-ment," the reader may conclude that such "intro-verted" development is extremely unlikely. As theeditor also notes, "the political will to cooperatehas been negligible" and the Arab countries have"opted for 'market integration' through trade lib-eralization without harmonizing their economicpolicies and without undertaking the requiredstructural changes." The papers are uneven inscope, depth, and analytical sophistication, butthe average standard compares favorably withavailable literature on the subject.

Martin L. Weitzman

The Share Economy

Conquering Stagflation

Harvard University Press, Cambridge, MA, USA, 1984, vi +167pp., $15.

For the industrial countries the past ten yearshave been marked by inflation, unemployment,and slow growth. The often simultaneous occur-rence of these conditions, stagflation, has con-founded policymakers and economists alike. Thisbreezy, bold, and well-written book declares thatby changing one of the key features of the marketeconomy, namely, the system of labor remuner-ation, we would be rid of stagflation and wouldinstead be blessed with a state of permanent fullemployment with competitive remuneration, noinflation, improved working conditions, and themany social and economic benefits that flow fromsuch a happy state. The key to all this would beto tie labor remuneration to the firm's performance,namely, a share system. Such a system alreadyexists, to a degree, in Japan and here and therein other industrial countries, but for all the manybenefits of the share system to be realized, itwould have to be adopted on a much broaderscale. And how can this be achieved? Essentiallythrough a program of national education, a skillfuluse of the tax system, and some governmenthelp. Whether Weitzman's visionary scheme canbestow all the benefits he claims—let alone whetherhis scheme can be adopted—is open to argument,but this small book, addressed to the generalreader, does provide food for thought.

Michael Stewart

The Age of InterdependenceEconomic Policy in a Shrinking World

MIT Press, Cambridge, MA, USA, 1984, ix +192 pp., $15.

A political economist's view of growing inter-national economic interdependence, this book iscritical of policymaking in the major countries,which he believes to be based largely on percep-tions of domestic needs. The author also sees adeflationary bias in national policies that creates asimilar trend in the global economy. To reduce theeconomic and social costs of this bias in OECDcountries—costs that, according to him, includehuge unemployment and long-term environmentaldamage caused by short-term energy and eco-nomic policies—he advocates greater coordi-nation of national economic policies and longer-term structural adjustment. The latter, he feels,will also pull the developing countries out of theircurrent difficulties.



Letters

Eugene Black's contribution

Regarding the two articles on the historyof the World Bank that appeared in theJune 1984 issue, one element of this historyshould, I believe, be underscored. It con-cerns the importance of Eugene Black'scontribution to world monetary coopera-tion. I was a member of the Boards of boththe Fund and the Bank during 1954-59.Thus, I was able to see, at close hand, theearly development of both institutions.

The simple reality, as I see it, is that ifEugene Black had not had the Bank "upand running" by the early 1950s, the fruitof Bretton Woods could have been a lemon!

Both Davidson Sommers and RogerChaufournier have touched upon the pointI am seeking to underline. "A bond marketexpert," Sommers says of Eugene Black."There was an aura of statesmanship andflair about him," Chaufournier remarked.It was the success of Black's bond marketingand on-lending that saved the day!

In this regard, it must be rememberedthat, until 1956, the Fund had demon-strated little reason for its existence. It couldwell have collapsed if Eugene Black hadnot shown to an anxious world that goodcould come from an international monetaryorganization!

Sir Bede CallaghanGordon, Australia

An elastic yardstick

The first two articles in Finance & Develop-ment for June 1984 on the subject of ex-change rates are excellent examples of an-alytical thought applied to a current situation,and the authors are to be congratulated.However, it might also be of value to havea third article on the purpose of exchangerates and how they function in internationalmarkets. While exchange rates are presum-ably used to equate national currencies, isthis being achieved in the most satisfactorymanner? For example, what are the meritsof fluctuating rates without or within offi-cial limits versus fixed rates? And why doesthe market quote buying and selling rates,when in practice transactions are concludedat only one of these quotations? Who ben-efits and loses from the existing system? Ifone accepts that exchange rates are the

means by which national currencies arerelated, as yards are to meters, then itappears that the system of fluctuating ratesis like having an elastic yardstick.

I would also like to suggest an article onthe present position of gold. While the IMFmay be said to have demonetized gold in1976, nearly all central financial institutions(including the IMF) keep a sizable propor-tion of their reserves in gold and recordthis in their balance sheets, using differentvaluations for accounting purposes. On theother hand, most Fund statistics now ex-clude gold. How is the future treatmentand valuation of gold (other than its price)envisaged?

Roland KalivodaLa Roque-Gageac, France

Diversity of views

As a long time reader, I have found Finance& Development of great use in my researchand general education in international fi-nance. As a publication of the Fund andthe Bank (with contributors drawn almostexclusively from those two institutions),Finance & Development can be said to presentthe institutions' worldview. That is one ofyour strengths, but it could also be seen asa weakness by people who disagree withthat worldview.

The encouragement of alternative opin-ions, therefore, is to be welcomed in ajournal that is discussing many controver-sial questions that have no definitive an-swers. Diversity is strength and any pointof view is usually strengthened by debate.

Your decision to publish occasional ar-ticles by invited external contributors is agood one, but I think it should be extended.

Т*К8р~еТ1й£"лсе & Development keeps ongoing for another twenty years.

Marko MilivojevicHalifax, United Kingdom

Public vs private investment

"Private investment in developing coun-tries," by Mario I. Blejer and Mohsin S.Khan (June 1984) attempts to highlight ahitherto lightly traversed area in develop-ment economics; the findings could openthe way for significant readjustments inpublic policy with regard to resource allo-cation. However, I have a few reservationsabout the nature of the aggregative analysisand the policy implications emanating fromsome of their conclusions.

First, I think the authors would agreethat no welfare conclusions can be drawn

from the empirical relationship establishedbetween private investment and real GDPgrowth rates.

Second, it is not clear whether anyattempt has been made to distinguishbetween infrastructural and noninfra-structural investment. If infrastructuralinvestment were narrowly defined to coveroutlays in power, roads, education, andhealth care, etc. (such investment beingsynonymous with public investment in de-veloping countries), a more positive picturemight emerge if such public investmentswere linked to real GDP growth or privatecapital formation.

Finally, in developing countries with ru-dimentary capital markets and a paucity ofinvestible funds, the practice of govern-ment-determined allocation is widespread.To the extent that public investments pro-vide the basis for private investment, the"crowding out" phenomenon is irrelevant.Only where substitutability exists couldthere be a case for action to alter the adverseoutcome of nonmarket allocation pro-cesses. From this point of view, a mean-ingful investigation would be to test theefficacy of private or public investment inthose investment categories (excludinginfrastructural investment) where the pub-lic sector either plays a "leadership" or a"fellowship" role vis-à-vis the private sectorin meeting domestic demand for output. Istrongly feel that empirical findings fromsuch an investigation could offer the scopefor significant realignment of public policyconcerning investments in developingcountries.

Zaidi SattarUniversity of Massachusetts, Boston

Messrs. Blejer and Khan reply:We would generally agree with Mr. Sattar; anydifferences are more questions of emphasis thansubstantive points. We were really quite carefulnot to draw welfare implications from our anal-ysis because we certainly recognize the obviouslycomplex aspects of this issue. Regarding thenature of public investment, we would note thatthe distinction between infrastructural and othertypes of investment was explicitly recognized inboth the theoretical and empirical parts of ourpaper (page 29). Finally, where we would departfrom Mr. Sattar is in relation to the statementthat crowding out is somehow "irrelevant" inmost developing countries. While there may besome ambiguity regarding real crowding out,there is considerable evidence pointing to theimportance of financial crowding out. Our ownanalysis also shows that attempts by the gov-ernment to absorb a larger share of financial(both foreign and domestic) resources wouldtend to have an adverse effect on privateinvestment.



Index for Volume 21 (1984)

ArticlesAdjustment programs in Africa

Justin Zulu and Salen Nsouli March p5Adjustment to external shocks

Parvez Hasan December p14Agricultural lending by the Bank, 1974-84

Montague Yudelman December p45Aid flows: the role of the DAC

Michael Blackwell March p42Are real wages too high in Europe?

Jacques Mus December p10Bretton Woods at forty

Some impressions of the early FundJoseph Gold March p23

Milestones—Bretton Woods,40 years later March p26

The World Bank: from reconstruction todevelopment: An institution emergesDavidson Sommers June p30

The coming of ageRoger Chaufournier June p32

Do we need a new Bretton Woods?Edward M. Bernstein September p5

The institutional evolution ofthe IMF September p7

The World Bank and development:a personal perspectiveAndrew Kamarck December p26

Can local participation help development?Michael Cernea December p41

The Caribbean GroupRobert Kanchuger September p44

The concessionaliry of foreign assistanceDanny Leipziger March p44

Cutting government expenditures in LDCsNorman Hicks andAnne Kubisch September p37

Determining the appropriate exchange ratein LDCs Ahsan Habib Mansur December p18

The effects of adjustmentWanda Tseng December p2

Expatriate labor in Arab oil-producing countriesNaiem A. Sherbiny December p34

External shocks and policy responses insub-Saharan Africa, 1973-78Beta Balassa March p10

Financial supermarkets in the United StatesCharles Collyns andYusuke Horiguchi March p18

Finance & Development: thefirst 20 years June p4?

Focus on small economiesMinistate economies Vicente Galbis June p36Industrial policy in small developing countries

Barend de Vries June p39Small island economies

Benito Legarda June p42The IMF's role in a changing world

William B. Dale March p2The IMF's role in developing countries

Tony Killick and the Editor September p21Increasing private capital flows to LDCs

Ibrahim Shihata December p6Interest rates and exchange rates

Susan Schadler June p7Lessons from East African agriculture

Christopher Walton March p13Mass media in development—an overview

Shuja Nawaz June p44Measuring tax evasion

Some/73/ Richupan December p38Mobilizing finance for development

Moeen Qureshi September p2Nature and origins of debt-servicing difficulties

Dona/ Donovan December p22On the spot—Fund and Bank representatives

in the field Sheila Meehan September p47Population distribution within LDCs

Dennis Mahar September p15Population growth

Nancy Birdsall September p10

Population policy: country experienceMartha Ainsworth September p18

Price distortions and growthRamgopal Agarwala March p33

Pricing and exchange rates in plannedeconomies Гота Gudac September p40

Private investment in developing countriesMario Blejer and Mohsin S. Khan June p26

The private SDRPierre van den Boogaerde June p20

Progress report on Africandevelopment March p17

Prospects for a new "oil dialogue"Jahangir Amuzegar September p28

The realities of economicinterdependence March p28

Sharing knowledge—Bank andFund publications March p48

The stabilizing role of fiscal policySheetalChand March p38

Sustaining recovery, reviving developmentKenneth Friedman andBalwant Garcha December p31

Telecommunications in developing countriesBjom Wellenius September p33

Toward sustained development:A joint program of action forsub-Saharan Africa December p29

Trade strategies and employment in developingcountries Anne 0. Krueger June p23

Whither the exchange rate system?Mom's Goldstein June p2

The World Bank in a changing financialenvironment Thomas Hoopengardnerand Inès Garcia-Thoumi . June p12

The World Bank's currency swapsChristine Wallich June p15

World economy in transitionIndicators of growth March p47Product shares September p49

BooksPedro Aspe Armella, et al. (editors), Financial Policies

and the World Capital Market, reviewed by ManuelGuitian, Mardi p49.

Robert Ballance and Stuart Sinclair, Collapse and Sur-vival, reviewed by Subimal Mookerjee, June p49.

Michael Beenstock, The World Economy in Transition,reviewed by Peter MiovkS, March pSO.

Alec Caimcross and Barry Eichengreen, Sterling inDecline, reviewed by Margaret Gamtsen de Vries,JunepSO.

Robert Chambers, Rural Development, reviewed by LeifChristoffersen, December p49.

iMIIiam R. Cline (editor), Trade Policy in the 1980s,reviewed by Bahram Nowzad, June pSO.

Rudiger Dombusch and Mario Henrique Simonsen (ed-Hors).lnfíatíon, Debt, and Indexation, reviewed by PeterKnight, September pSO.

Hilton J. Esman and Norman T. Uphoff, Local Organi-zations, reviewed by Ridley Nelson, December p49.

Robert J. Flanagan, et al., Unionism, Economic Stabili-zation, and Incomes Policies, reviewed by Jozef Van'tdack, September p52.

David Heald, Public Expenditure, reviewed by Liam Ebrill,June pSO.

Andrew M. Kamarck, Economics and the Real World,reviewed by Bahram Nowzad, March pSO.

Clark Kerr, The Future of Industrial Societies, reviewedby Subimal Mookerjee, June p49.

Arjo Klamer, Conversations with Economists, reviewedby Subimal Mookerjee, September p51.

Rich Kronish and Kenneth S. Mericte (editors), ThePolitical Economy of the Latin American Motor VehicleIndustry, reviewed by Shank! Yusuf, December p50.

George Macesich, The Politics of Monetarism, reviewedby Alessandro Penati, December p48.

Marc A. Miles, Beyond Monetarism, reviewed by Ales-sandro Penati, December p48.

Robert Millward, et al., Public Sector Economics, re-viewed by Robert Roy Schneider, September pSO.

Andrew J. Pierre (editor), Unemployment and Grovrth inthe Western Economies, reviewed by James Blalock,December pSO.

Peter Robson, Integration, Development and Equity,reviewed by Rattan Bhatia, June p5l.

F. M. Scherer, Innovation and Growth, reviewed byFrederick Moore, December p48.

Robert Stobaugh and Louis T. Wells, Jr. (editors), Tech-nology Crossing Boundaries, reviewed by Carl Dahl-man, December p49.

Thomas J. Trebat, Brazil's State-Owned Enterprises,reviewed by Peter Knight, June p51.

Louis T. Wells, Jr., Third World Multinationals, reviewedby Carl Dahlman, March p51.

John Williamson, The Exchange Rate System, reviewedby Hans Schmrtt, March p49.

David Worswick and James Thevilhick (editors), Keynosand the Modem World, reviewed by Bahram Nowzad,September p51.


Finance&Development


Recently Published by the International Monetary Fund. . . .

Taxation, Inflation, and Interest RatesEdited by Vito Tanzi

The nine studies in this book open up a new area of research inthe subject of the monetary and fiscal links in both closed andopen economies. This volume should be of considerable interestto fiscal economists, monetary economists, and specialists ininternational trade and finance.Price: US$20.00 (doth); US$15.00(paper)

Public Enterprise in Mixed Economies:Some Macroeconomic AspectsBy Robert H. Floyd, Clive S. Gray, and R.P. Short

The three papers in this book, which deal with various issuesconcerning public enterprises, are addressed to governmentofficials, academics, and others interested in the operations of thepublic enterprise sector as a whole, or any industrial groupingtherein.Price: US$12.00 (paper)

. . . .a/so now available—two new publications in the Occasional Papers series:

Occasional Paper No. 31 Occasional Paper No. 32

International Capital Markets:Developments and Prospects, 1984By Maxwell Watson, Peter Keller, and Donald MathiesonThis comprehensive study was prepared in the InternationalCapital Markets Division of the Fund's Exchange and TradeRelations Department. Background information for the study wasprovided in part by informal discussion with commercial banks,monetary and bank supervisory authorities, and the staffs of theBank for International Settlements, the European Community, andthe Organization for Economic Cooperation and Development.

World Economic Outlook,September 1984:Revised Projections by the Staff of theInternational Monetary FundThe estimates and projections in this report are the product of acomprehensive interdepartmental review by the staff of the Fundand update those published earlier in the year in OccasionalPaper No. 27, World Economic Outlook: A Survey by the Staff ofthe International Monetary Fund.

Both the above studies are priced at US$7.50, (paper)

Please address orders to: Publications Unit, Box A-844International Monetary Fund700 19th Street, N.W.Washington D.C. 20431 U.S.A.Telephone: (202) 473-7430

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