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ECONOMIC POLICY SIMULATOR. COUNTRY 1

Original written by professor Gayle Allard at IE Business School.Original version, 13 May 2005. Last revised, 23 October 2008.

Published by IE Business Publishing. Mara de Molina 13, 28006 Madrid, Spain.2005 IE. Total or partial publication of this document without the express, written consent of IE is prohibited.

JUGGLING DEBT AND DEVELOPMENT: EXPERT ADVICE FOR A PRESIDENT

It had been a particularly hard day at the office, and the tall man in a rumpled business suit closedthe door, lowered the blinds and took the phone off the hook in an effort to clear the confusion ofthe moment and set his thoughts in order. The events of the day spun around his mind as he sankinto his chair. This morning it had been the announcement that the unions, once his most loyalallies, would join in a mass protest against his pension reform plan. Before lunch, there was the callfrom the International Monetary Fund requesting an urgent meeting to discuss why he had failed tomeet the targets of his stabilization plan. In the afternoon, the latest inflation figures two fullpercentage points above what his advisors had expected were released, and the currency,already reeling from the recent U.S. decision to raise interest rates, took a beating on internationalmarkets. Then the representative of the business organization requested an audience to expressconcern over government plans to liberalize international trade. And he had just walked out of ameeting where he and his top cabinet members debated for more than four hours over how to cutgovernment spending in order to bring down a budget deficit that continued to defy control.Unsurprisingly, there was no agreement; no one would be the first to volunteer to cut the budget ofhis ministry.

How could a picture that looked so bright only months ago, when he had sailed into the presidencyby popular landslide, turn so dismal, so fast? The crowds that packed the streets to welcome himon the day he took office had believed that he could perform the miracle of reducing widespreadpoverty and severe inequality while inspiring confidence among foreign investors, whose funds thecountry so badly needed. The tumult of the crowd had been music to his ears. He, too, had waitedall his life for this opportunity. And in the first months, even in difficult negotiations with foreignbankers and multilateral institutions, he had clung to his optimism. There was a way to achievesocial justice while keeping the country financially solvent. It only required a person with enoughcharisma, enough heart, enough imagination and enough confidence from the people of this

country. It could be done.

And here he was now, watching his illusions collapse one after another. Maybe the critics wereright. Maybe a large, poor, half-industrialized but still backward country like this one has to make achoice between serving social needs and serving foreign investors and banks. Maybe the jugglingact just cant be performed.

His eye alights on the report on his desk that was handed to him this morning, with officialprojections for the main economic indicators 1. There is some good news: GDP growth is beginningto bounce back after near-zero growth last year. This should make a dent in an unemployment ratethat is intolerably high to a president who promised jobs for the masses. The dark side of thepicture is that inflation, always lurking in the background, is likely to turn out higher than the 4% his

1 See Table 1 in the Statistical Appendix for full information on the main economic indicators in the previous and currentyears (Year 4 is the current year), and projections for the next two years (Years 5 and 6).

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government had hoped for. And the budget deficit looks like it will also overshoot the target set inthe IMF agreement.

The patterns he sees in the data are not new. Over the past four years, the country had alsoalternated between slow growth and high inflation, always accompanied by high unemployment

rates. Economic experts had explained that the root cause of the high inflation and highunemployment was the countrys lack of good infrastructures to support the strong growth neededto create jobs. In the transport and power sectors, bottlenecks are encountered whenever real GDPgrowth accelerates past 3.5%-4%, and these bottlenecks generate immediate pressure on prices.The experts estimate that to avoid these bottlenecks, investment has to be sustained at between22% and 25% of GDP. Last year, total investment was just over 18% of GDP, with about 11% ofthat figure coming from foreign investors.

How different the future of this country had appeared when it first began to industrialize, some fourdecades ago! Then it was widely perceived as the great promise of the 20 th century. Import-substitution policies had given it a strong middle-technology industrial sector which still attractssome foreign investment, but which never fulfilled the dream of being able to compete oninternational markets. Now, rising labor costs and fierce competition from other developingcountries, particularly in Asia, have made the industrial sector even less competitive, and somebusinesses in the vulnerable footwear and textiles sectors are actually relocating production toChina in order to compete. Where export growth is now strongest is in commodities, due to soaringChinese demand, and while the rising prices and strong sales are welcome last year this countryshowed its first trade surplus in several years--, the change seems to turn back the clock on thedream of finally joining the club of industrialized economies 2.

Still, it seems it would be possible to juggle the pressure of Chinese competition, domestic socialneeds and scarce financial resources if only the country were free of debt. But the high foreign debtis its starkest reality. In those optimistic years when it appeared that everything was possible for adeveloping country like this one, both clean and corrupt governments had obtained huge loans tofinance development from overly optimistic international bankers. With the economic slowdowns of

the 1970s and 1980s and the rise in international interest rates and dollar values, the size of thedebt relative to GDP had exploded, and nearly half of it 45% this year was owed to foreigners.This means that developments on international financial markets are now the governments mostpressing concern. Hong Kong is so far away, yet a run on the Hong Kong dollar could easilyproduce a collapse of this countrys currency. And negotiations with the IMF over stretching out therepayment of the debt owed to foreign bankers are the single most important factor in determiningthe governments economic policy.

The debt had overshadowed every argument during his cabinet meeting this afternoon. With suchpressing social and economic needs, every minister had reasons to demand to at least be able tomaintain spending in his department. The poverty programs, the infrastructure projects to eliminatethose bottlenecks that cause inflation, the need for better schools and universities, better

hospitals, basic sanitation: who can say no to these? Yet he had no choice but to cut publicspending. In fact, his government had kept spending under such strict control that it currentlyshows a primary budget surplus: tax revenues are actually significantly higher than governmentspending before the debt payments are made. But the huge burden of interest payments turns thissurplus into a chronic budget deficit, which has to be financed with additional debt, leading to moreinterest payments, larger deficits, more debt the vicious cycle appears inescapable. And raisingtaxes to reduce the deficit is not an option. Taxes in this country are already quite high fiscalpressure is 36% of GDP--, and raising them could chase away the private capital that it needs sobadly.

What options does he have to bring the economy out of a situation where debt, social needs andscarcity press on all sides? Borrowing from the central bank to finance the deficit is no solution, as

2 See Table 2 in the Statistical Appendix for information on the structure of exports and imports. The United States is thiscountrys largest foreign market.

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he knows; the country has had disastrous hyperinflation experiences in recent years. To declare adebt moratorium is tempting, but he knows how that would hurt the countrys credit rating; severalepisodes of nonpayment of foreign debt in the distant past still haunt potential investors in thiscountry. Foreign direct investment could solve some problems, but investors demand not onlyeconomic stability, but structural reform in order to be willing to invest. This country ranks relatively

low on indicators of internal market freedom and protection of private enterprise, and relatively highon indicators of corruption. 3 And he knows that any structural reforms will be fiercely resisted by theprivileged elites of the economy.

Darkness has fallen as he sits at his desk, overwhelmed by the terrible dilemmas faced by hisgovernment. He is an honest man who loves his country, and his deepest hope was to be able toput it on the road toward greater development and social progress and to lift millions of hiscountrymen out of poverty. But that hope is beginning to evaporate.

Then he remembers an independent economist whom he met at the beginning of his presidency,who assured him that the countrys problems did have a solution. In the euphoria of his first monthsin office, the economists offer of help had not seemed necessary. Now he opens the drawers of hisdesk and searches for the card that was handed to him at that meeting. There it is! He picks up thephone and dials the number.

You are the independent economist who answers the phone that evening. You promise thepresident that you will review all of the data and come up with a coherent economic policy for thenext two years that will address the countrys problems while keeping it financially solvent andpromoting growth. You plan to structure your report to the president as follows:

1.- Very briefly, you will evaluate recent economic trends, noting which aspects of the countrysperformance are normal and which represent departures from conventional models or rules.You will explain any departures.

2.- You will also characterize briefly the economic policies and policy mixes that have been

followed recently; and their consequences on the economy, both those you can observe andthose that you anticipate.

3.- You will rank the countrys greatest constraints, in order of importance.

4.- You will outline a coherent program that addresses those constraints and the governmentsobjectives of economic stabilization, development and poverty reduction.

(You use the attached spreadsheet to experiment with the quantitative effects of your policyproposals before designing your definitive program for the president. The spreadsheet incorporatessimple relationships among the economic variables described above, omitting the impact of tradeand exchange rates.)

You are in your car on your way to the presidents office on the morning you are due to presentyour program, and you hear the news broadcast announcing that the Chinese yuan has beenunpegged from the U.S. dollar, and the dollar is collapsing on international markets. How will thischange your program? You make quick notes in the margins as you approach the presidentsoffice.

As the presidents door opens, you see that it is not only the president who rises to greet you, buthis entire cabinet and staff of advisors. And suddenly you realize how important this presentationis. The future of the country is in your hands.

3 See Table 3 in the Statistical Appendix for some institutional indicators for this country, and their comparison with othercountries or groups of countries.

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S TATISTICAL APPENDIX

T ABLE 1: KEY ECONOMIC INDICATORS

Year 1 Year 2 Year 3 Year 4

(current year)

Year 5(p) Year 6(p)

Real GDP % 4.3 1.3 1.9 0.4 4.1 3.6

Government consumption %GDP 19.1 19.3 20.1 20

Budget balance %GDP -3.4 -3.3 -9.8 -4.9

Inflation (% CPI) 7.0 6.8 8.5 14.7 6.5 5.8

Public debt %GDP 49.4 52.6 55.9 57.4

Labor costs per hour ($US) -16.7 -13.3 3.9

Unemploym ent rate (%) 13.3 11.3 11.7 12.3 11.2

Current-account balance as %GDP -4.0 -4.6 -1.7 0.9

(p) indicates projected values.

T ABLE 2: S TRUCTURE OF IMPORTS AND EXPORTS FOR COUNTRY 1

Major exports % of total Major imports % of total

Transport equipment and parts 16.4 Machinery and electrical equipment 28.2

Metallurgical products 10.4 Chemical products 18.0

Soybeans, bran and oils 9.8 Oil and derivatives 13.3

Chemical produc ts 1.9 Transport equipment and parts 10.8

T ABLE 3: S OME INSTITUTIONAL INDICATORS FOR COUNTRY 1

INDICATOR Score Count ry 1 Score U.S. Score OECD avg.

Protection of property rights (higher=better protected) 4.9 8.2

Regulation of business (higher=less regulated) 5.0 7.7

Freedom to trade internationally (higher=freer) 6.8 7.8

Number of procedures needed to start a business 17 6

Time needed to fire a worker (days) 152 25

Number of procedures needed to fire a worker 14 4