Class 5 structural adjustment policies of and lending for developing countries 2018

Class 5 Structural Adjustment Policies of and Lending for Developing Countries 1.. Structural Adjustment 1 Definition of Structural Adjustment SA SA is defined as a market-oriented econ

Class 5 Structural Adjustment Policies of and Lending for Developing Countries

1 Structural Adjustment (1) Definition of Structural Adjustment (SA)

SA is defined as a market-oriented economic reform process that aims at restoring a sustainable balance of payments, reducing inflation, and creating the conditions for sustainable growth in per capita income

Owing to the second oil shock in 1978/79, the “Foreign Debt Problem” of non-oil producing developing countries emerged During the early years of the crisis, Multilateral Development Banks (MDBs) and international commercial banks regarded this Third World Debt Problem as a liquidity problem Soon after, however, they realized that the problem was deep-rooted and was rather a solvency problem

In order to solve this problem, then, the MDBs undertook several initiatives to help reform the economic structures of the developing countries through the formulation

of Structural Adjustment Policies (SAP) and Structural Adjustment Lending (SAL)

(2) Structural Adjustment Policies (ⅰ) Stabilization and Adjustment Structural adjustment policies have two main characteristics: “stabilization (short-term measure)” and “adjustment (long-(short-term measure).” These characteristics are explained by using the simple national income equation as follows

Y = C + I + G + X – M - (1) where C is consumption, I is investment, G is government expenditure, X is exports and M is imports

Replacing (C + I + G) by A; namely, A = C + I + G, we obtain an equation

Y – A = X – M - (2)

The equation (2) above tells that, when expenditure A exceeds production Y, its

difference is equal to deficits in the balance of payments In order to correct the situation, then, two kinds of policies and policy measures are considered

a Reduction of Expenditure A: A total demand contraction policy - through

fiscal and monetary tightening, macroeconomic imbalances are adjusted in a short period of time This is ‘stabilization’ Local currency devaluation is also

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1978

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loan(s)

one of the measures

b Increase in Production Y: Real economy strengthening policies - various

incentive measures for producers such as reduction and abolishment of price control, trade liberalization, lesser government intervention (privatization of public enterprises and deregulation), and improvement of investment climate These policies and policy measures are meant to introduce and expand competitive markets to utilize and allocate resources effectively and efficiently This is ‘adjustment’

Table 1 Characteristics of Structural Adjustment

Stabilization Adjustment Macroeconomic orientation

Short-term

Demand side orientation

Finance-oriented (Monetary/ Fiscal)

Microeconomic orientation Medium- and Long-term Supply side orientation Real economy orientation

(3) Structural Adjustment of Major Sectors through Sectoral Reforms

The IMF and the World Bank introduced conditional lending for structural

adjustment in the early ’80s The IMF primarily dealt with stabilization and the World Bank with adjustment However, as the IMF stepped into the adjustment arena and the World Bank stepped into the stabilization arena, it is often difficult to identify clearly which policies and policy measures belong to which institutions Three major (representative) sector reforms were sorted out in relation to policy/policy-measure conditionalities and are set-in below

(ⅰ) Public Sector Reform - Improvement of the tax collection regime, tariff/price increase in public utilities, re-examination of public investment programs, devaluation of local currency, privatization of state enterprises and monopolies, reforms of the public sector in terms of its size, role, functions and structure, and

so on

(ⅱ) Trade Sector Reform - abolition of ‘artificial’ quota, low and uniform tariffs,

and so on

(ⅲ) Financial Sector Reform - interest rate liberalization, regulatory and legal

reforms (tightening of risk exposure limits, establishment of tighter capital adequacy ratio, strengthening of accounting standards, broadening the scope of audits of the banks, imposition of stringent reporting requirements, improvement

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of on-site and off-site supervision of banks by the central bank, and so on), financial restructuring (shake-ups in the top management positions, recapitalization of the banks where liquidity was low, cleaning-up of non-performing assets, and so on), institutional restructuring (establishing of new institutions, mergers and liquidation of banks and divestiture of public sector shareholding in banks, and so on), and capital market creation (stock exchange) (4) Sequencing and Speed of Structural Adjustment Policies

Sequencing:

When implementing structural adjustment policies, one should recognize that there are various kinds of trade-offs between policy objectives and performances This, in turn, implies that policies have to be selected carefully and executed in a manner of optimal sequencing

(ⅰ) Devaluation of local currency results in an improvement of the trade balance

On the other hand, however, it increases the budgetary burden of foreign currency denominated debt services and, at the same time, causes inflation through higher import prices in terms of local currency

(ⅱ) Trade liberalization upgrades domestic productivity through international competition On the other hand, it increases imports and deteriorates the trade balance/current account balance In addition, lower tariff rates reduces the tariff revenue of the government

(ⅲ) Abolition of price controls creates internal competitive markets which determine

price levels However, in quite a large number of developing counties it tends to cause inflation through resulting price hikes

(ⅳ) Financial liberalization promotes efficiency of the financial system However, it reduces long-term institutional lending for capital investment and increases short-term commercial lending Interest rate liberalization tends to increase interest rates and in turn reduce investment

(ⅴ) Cuts in government spending often result in reductions in public works investment projects, affecting the state of the developing country’s infrastructure Cuts thereby reduce growth prospects

Speed: The Big Bang versus Gradualism

Developing countries’ experience with the process of structural adjustment has frequently posed the question of how to time the policy changes that economic reformers try to implement In the early ’90s, two different approaches to this issue

of timing were widely debated On one side of the argument were the advocates of

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the “big bang” approach They insisted that comprehensive stabilization and liberalization measures should be introduced immediately at the start of the reform process and implemented as fast as possible They were the advocates of speed and stealth in a top-down style reform The classic example of this is the reforms carried through by Lescek Balcerowicz in Poland between ‘90 and ‘92 The supporters of the big bang in Eastern Europe and the former Soviet Union were, however, influenced by unacknowledged political considerations They detected a very brief window of opportunity to demolish the economic structures that underpinned state socialism, before disillusion with “capitalism” set in

On the other side of the argument were the advocates of gradualism They pleaded for the stretching out of the reform measures over a long time period They reasoned that this would ease the pain of the adjustment process, allow time to develop a political consensus in support of the reform process and thus make it more politically sustainable To this plea, the “big bangers” retorted that any procrastination would add to the total costs of adjustment and would, contrary to the rationale for gradualism, make the whole adjustment process less politically viable,

by allowing opponents of reform time to marshal their forces of political obstruction The World Bank and the IMF stood on the side of “Big Bangers”, while Japan stood on the side of “Gradualismists”

(5) Social Safety Nets

Social Safety Nets are non-contributory transfer programs targeted in some manner

to the poor or those vulnerable to poverty and shocks Social Safety Nets play a well-recognized redistributive role which is supported strongly by moral philosophy, expressed in many different ways They also play a productive role in helping households to manage risk and assist in their own livelihoods, in helping prevent the intergenerational transmission of poverty and in allowing societies to make more efficient choices in macro, trade, labor and other sectoral policies Though less well recognized, this productive role is a very important part of the justification for safety nets (excerpt from the World Bank, refer also to Galbraith’s

The Good Society)

Structural adjustment policies are known to produce repercussions which call upon the various measures found within Social Safety Nets In the long run, structural adjustment contributes to economic growth However, in the short run, it causes hardships on the poor and vulnerable, while it contributes to economic stabilization The following cases illustrate some impacts on the poor and

must remember

vulnerable

When the exchange rate is devalued, necessity imports become more expensive Cuts in government spending in sectors such as education and health may give raise

to infant mortality rates and reduce literacy more painfully on the poor and vulnerable Entry and near entry-level public sector employees are the first to lose jobs when public enterprises are privatized and government spending cuts take place

The issue of social safety nets associated with structural adjustment has long been discussed from the very first economic adjustment loan extended to Bolivia

by the World Bank in 1980 Social safety nets have increasingly become an integral part of the structural adjustment policies Some other international development organizations such as UNDP, ILO, WHO and UNICEF have also discussed the issue repeatedly In 1987, UNICEF published a report entitled “Adjustment with a Human Face,” which dealt with the negative impacts of structural adjustment policies/programs on health and education Since then, the social safety net has become an important factor, namely, a “must” in structural adjustment policies/programs

Today, it is said that social dimension of adjustment (SDA) is a part and parcel

of structural adjustment policies/programs

(6) Ownership of Structural Adjustment Policies

Needless to say, the ownership of SA policies/programs rest in the hands of developing countries Without positive support from the general public of the developing countries, policies/programs cannot be implemented The SA policies/programs need to be secured by the governments of the developing countries The World Bank and IMF should not and cannot sit in the driver’s seat

2 Structural Adjustment and International Financial Assistance

(1) Needs for International Financial Assistance

Why does structural adjustment require international financial assistance? Generally speaking, there exists a considerable time gap between formulation of policies and accrued impacts In order to bridge this gap, the quick-disbursement type financial assistance from external sources is indispensable

(ⅰ) Public Sector Reform - It takes time to reconstruct the revenue-expenditure system to balance the budget During this period, developing country governments tend to increase their budget deficits, which in turn need to be financed by donors

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such as MDBs and bilateral aid organizations

(ⅱ) Trade Sector Reform - It takes fairly a long time to increase exports, while it does not take much time to increase imports During a trade sector reform period, LDC governments try not to lower domestic economic activities, resulting in a similar level of imports on par with previous years The foreign exchange gap may thereby increase, which in turn needs to be financed by donors such as MDBs and bilateral aid organizations

(ⅲ) Financial Sector Reform - In order to strengthen the banking sector, huge funds are generally needed LDC governments must supply needed funds by making the most use of external sources such as MDBs and bilateral donor organizations Government revenue shortage caused by restructuring of the banking sector often need to be replenished by funds borrowed from MDBs and bilateral aid organizations

(2) World Bank’s Structural Adjustment Loan (SAL) and IMF’s Extended Credit Facility (ECF)

The World Bank started its SAL operation in 1980 and newly introduced the SECAL operation (Sector Adjustment Lending) in 1983 The former covers the entire economy and the latter deals with specific sectors such as public, trade, and finance SAL and SECAL are referred to as non-project lending/loan (or program lending/loan)

In collaboration with the World Bank, IMF introduced SAF (Structural Adjustment Facility) in 1986, and SAF was enforced into ESAF (Enhanced Structural Adjustment Facility) in 1987 In 1999 ESAF was replaced by Poverty Reduction and Growth Facility (PRGF) as the World Bank employed a new lending policy based on the “Poverty Reduction Strategy Paper.” In January 2010, PRGF was replaced by Extended Credit Facility (ECF)

One of IMF’s concessional lending arrangements to low-income countries is ECF (former PRGF) which is underpinned by comprehensive country-owned strategies, delineated in their Poverty Reduction Strategy Papers (PRSPs) In recent years, the largest number of IMF loans had been made through the PRGF The interest rate levied on PRGF was only 0.5%, and loans were to be repaid over a period of 5 ½ – 10 years, while in the case of present ECF, 0% interest rate and 10 (5½) years repayment period

Similarly to the World Bank and IMF, regional MDBs such as AsDB, IDB and AfDB have been providing low-income countries structural adjustment loans

Bilateral aid organizations used to co-finance with MDBs

(3) Cooperation between IMF and the World Bank

Prior to the ‘70s, the IMF policy prescription for a balance of payments deficit was

a temporary infusion of foreign capital to meet currency shortfalls or currency devaluation where deficits had become chronic The Bretton Woods conference assigned the task of supervising foreign exchange flows exclusively to IMF, accordingly there was little overlap between IMF and World Bank activities Thus IMF remained responsible for balancing external accounts through macroeconomic adjustments, while the World Bank influenced domestic production through the microeconomic policy Events during the past three decades, however, have reduced the mutual exclusivity of these roles Oil price shocks, falling exports, declining terms of trade, and capital flight experienced by developing countries made it clear that Third World trade imbalances had become structural in nature

To improve the status of developing countries vis-à-vis the developed countries’ trading partners, IMF deemed it necessary that Third World countries adopt stabilization policies to lower inflation, improve the efficiency of internal markets and institutions, lower domestic government spending, and review public investments, in addition to reforming their exchange-rate regimes By becoming involved in these related negotiations, IMF extended its activities into areas that had traditionally been within the sphere of influence of the World Bank Similarly, the Bank came to recognize that promoting domestic GNP growth would require consideration of external factors Consequently, the World Bank’s structural adjustment programs began to include provisions for enhancing the international competitiveness of domestic products through the reform of trade policies and exchange-rate regimes Thus in an analogous manner, the World Bank has intruded into the domain of the IMF

Since maintaining equilibrium on external accounts is not conducive to long-term economic growth, IMF and World Bank policies have not always been consistent with each other The remarkable similarity between the IMF conditionality and World Bank structural adjustment policy is the result of a convergence in approaches that occurred during the ‘70s and ‘80s There is a growing recognition that the successful resolution of both external and internal problems requires the simultaneous coordination of macroeconomic and microeconomic policies This has led to greater cooperation between the World Bank and IMF and a blurring of the distinctions in their respective roles (See

Todaro’s Economic Development, Seventh Edition, p.574)

More specifically, the World Bank when preparing a PFP (Policy Framework Paper) for a member of developing country establishes a tri-party working team (IMF / World Bank / Developing Country) to formulate the paper in a coordinated manner In preparing a PRSP (Poverty Reduction Strategy Paper), too, IMF and the World Bank staff work together to support the LDC government Incidentally, a PRSP is obligatorily formulated only for IDA countries and HIPCs in place of a PFP

3 Conditionality

(1) IMF and World Bank Conditionality

Conditionality is defined as economic policies or structural reforms that developing member countries agree to follow as a condition for the use of IMF and World Bank resources (loans) and are often referred to as performance criteria or benchmarks A borrowing country of any IMF facility is requested to pursue macroeconomic (macro-fundamentals such as inflation, budget deficits and foreign payments deficits) stabilization policies spelled out in the IMF Stabilization Program which consist of “Letter of Intent”, “Memorandum of Economic and Financial Policies” and “Technical Memorandum of Understanding” As a matter of fact, IMF conditionalities are spelled out in Memorandum of Economic and Financial Policies There are four basic components of conditionalities to the typical IMF stabilization program

(ⅰ) Abolition or liberalization of foreign exchange and import controls

(ⅱ) Devaluation of the official exchange rate

(ⅲ) A stringent domestic anti-inflation program consisting of (a) control of bank credit to raise interest rates and reserve requirements; (b) control of the government deficit through curbs on spending, especially in the areas of social services for the poor and staple food subsidies, along with increases in taxes and public enterprise prices; (c) control of wage increases, in particular ensuring that such increases are at rates less than the inflation rate (i.e., abolishing wage indexing); and (d) dismantling of various forms of price controls and promoting freer markets

(ⅳ) Greater hospitality to foreign investment and a general opening up of the economy to international commerce

An IMF loan is disbursed in a few tranches against a periodical (3 to 6 months)

review of indicative targets and quantitative performance criteria as well as

structural performance criteria and benchmarks (Specific targets and criteria are obtainable from the IMF Letter of Intent and related documents)

On the other hand, the World Bank’s structural adjustment lending is a

quick-disbursement and policy-based lending The Bank’s adjustment loan is normally disbursed in two to three times The first disbursement is made when

a borrowing country formulates basic plans/programs for short-term stabilization and long-term structural reform The second and the third are made when further decisive policy measures to carry out the plans/programs are determined according to schedule Thus, the World Bank conditionality consists

of these conditions for disbursements

(2) Critical View on Conditionality

It has been argued from various angles that IMF/World Bank conditionality did not lead to the expected outcome This issue can be reviewed from the theoretical as well

as the operational aspect

(ⅰ) Excessive bias on market mechanism

Structural adjustment policies are based on market-oriented neo-classical economics and, therefore, the following scenario forms a base for structural adjustment policies

Market-oriented economy functions if excessive government intervention is

eliminated

Private sector economic activities are then activated as the environment for

private sector businesses is improved

As a result, investment and production increase Exports, in turn, also

increase owing to improved international competitiveness

Owing to the virtuous circle of investment, production and exports, the

economy starts its sustainable growth

It is questionable if this scenario works fully or not However, if it does, for

example, the scenario leads to the conclusion that an industrial policy for infant industry development (or “an infant industry development policy”) should never

be introduced in developing countries

In relation to the argument above, the ineffective and unrealistic World Bank conditionality is often observed Some cases are presented below

Case 1 Trade liberalization induced massive inflow of cheap textile goods from

India and Pakistan, which almost destroyed the textile industry, one of a few industries, of Kenya and Tanzania

Case 2 Privatization of state-owned monopolistic marketing boards in African

countries resulted in promoting private sector wholesale monopolies Case 3 Privatization of a parastatal cotton corporation in Togo caused a reduction

in extension and technical services, resulting in the reduction of cotton production

Case 4 Privatization of the parastatal bus company in Sri Lanka upgraded service

quality but at the same time increased bus fare As a result, a large number

of poor people in rural areas lost access to bus services

There are still many developing countries where the markets themselves and the market mechanism are not well-established In such countries, the neo-classical economic scenario described above is far from their reality In such cases, the government, therefore, has to play a much more important role in promoting economic growth

(ⅱ) Operational issues

a Uniformity of conditionality and lack of global consideration

IMF’s uniform prescription of stabilization program has long been argued

Case-by-case and country-by-country prescription is definitely required

One case of inadequate coordination of World Bank conditionalities has been

witnessed in the production cacao in developing countries A World Bank mission

to Ghana recommended the government of Ghana to increase cacao exports through devaluation Other missions promoted the same recommendation to other cacao producing countries such as Brazil, the Ivory Coast and Ecuador As a result, the cacao price dropped considerably worldwide All those countries lost substantial economic income and foreign exchange earnings mainly due to the World Bank recommendation

b Abrupt and disorderly prescription

The Big Bang approach of IMF and the World Bank produces mixed results This

approach works for macroeconomic and financial reforms for short-tern