structural adjustment

Reinert/Windows on the World Economy, 2005

Structural Adjustment

CHAPTER 23

Reinert/Windows on the World Economy, 2005 2

Introduction In a fixed exchange rate regime, an overvalued domestic

currency (Mexican peso or Ghanaian cedi) is associated with an excess demand for foreign currency (US dollar or EU euro) This excess demand for foreign currency is often met by the central

bank drawing down its foreign reserves• However, the drawing down process is not sustainable

Can result in a balance of payments crisis In most circumstances, the International Monetary Fund

(IMF) stands ready to assist member countries in dealing with such balance of payments crises

If this assistance involves the member country’s moving into its upper credit trances (which it almost always does), the IMF imposes policy conditionality on its loans


Introduction Beginning in the 1980s, the World Bank began structural

adjustment lending to countries facing balance of payments difficulties Also imposing policy conditionality in the process

Developing countries with balance of payments crises caused by fixed exchange rates or changes in global economic conditions face structural adjustment under the supervision of IMF and World Bank Effectiveness of these structural adjustment programs has been

source of a significant amount of disagreement among international economists

Chapter develops your understanding of structural adjustment


Traded and Non-Traded Goods

Imagine that you are an international economist advising the Ghanaian government on their approach to structural adjustment. Need to simplify the complexities of the adjustment processes to

clarify your own thinking and to communicate with government representatives

Useful first step is to distinguish between traded goods and non-traded goods

In the Ghanaian context, you might imagine the followingTraded Goods• Petroleum• Gold• Cocoa• Food

Non-Traded Goods• Tailoring• Auto repair• Education• Health Services


Differences Between Traded Goods and Non-Traded Goods

Prices of traded (non-traded) goods are determined in world (domestic) markets For Ghana the price of petroleum is a world price denominated in US dollars The price of tailoring, on the other hand, is a domestic price, denominated in

cedis For traded goods, domestic consumption and domestic production can

differ in value, causing a trade surplus or deficit However, domestic consumption and domestic production of non-traded

goods must be exactly the same in value Can represent the supply side of this economy with a production

possibilities frontier (PPF) Depicts the combinations of output of traded goods and non-traded goods

that the economy can produce given its available resources and technology Given the available resources and technology, Ghana can produce

anywhere on or inside the PPF


Table 23.1. Traded Goods vs. Non-Traded Goods


Figure 23.1. Ghana’s PPF


Internal and External Balance

Internal balance All resources are efficiently employed

External balance Consumption and production of tradable goods

are equal


Figure 23.2. Internal and External Balance


Figure 23.3. External Imbalances


External Imbalances If consumption is at CTD, consumption of

traded goods exceeds production of traded goods along vertical axis Implies Ghana has a trade deficit

If consumption is at CTS, production of traded goods exceeds consumption of traded goods along vertical axis Implies Ghana has a trade surplus


Figure 23.4. A Current Account Deficit


A Current Account Deficit If inflows on capital account begin to

disappear, difficulties arise Suppose direct and portfolio investment

decline (foreign savings falls) Still possible for Ghana to maintain its current

account deficit by drawing down its foreign reserves• However, this situation is not sustainable

Can last only as long as the central bank has foreign reserves to sell


A Current Account Deficit What could you advise Ghana to do?

Recognize that external imbalance problem comes from the demand for tradable goods being too high

• Suggest that Ghana engage in demand reduction to reduce the demand for tradable goods

• Significant limitation--demand reductions typically cannot be confined to traded goods alone

In most instances, demand falls for both traded and non-traded goods

External balance adjustment via demand reduction has been achieved at the expense of internal balance


Figure 23.5. Adjustment via Demand Reduction


Implementation of Demand Reduction Policies

Economist Francis Stewart (1995) studied the ways in which demand reduction policies have been implemented in many countries of the world and their impacts on the poor in those countries Her conclusions

• Demand restraint has unambiguously negative effects on the poor

Demand-reducing policies include Cuts in government expenditure Rises in taxation Reductions in real wages and credit restraint


Implementation of Demand Reduction Policies

What else could you suggest to the Ghanaian government? In principle at least, a country can achieve

external balance and maintain internal balance• The key according to economist Max Corden (1986) is

To have two instruments as the demand reduction instrument is not enough

Also need a switching policy Implemented by a change in the nominal exchange rate


A Current Account Deficit Devaluation or depreciation of the domestic currency

causes an increase in the domestic (cedi) prices of both imports and exports If Ghana were to devalue the cedi, there would be an increase in the

relative price of tradable goods or a decrease in the relative price of non-tradable goods resulting in

• Increased incentive to produce traded goods• Decreased incentive to consume traded goods

Both effects tend to reduce the trade deficit Ghanaian firms switch their production towards traded

goods Ghanaian consumers switch their consumption away from

traded goods A successful adjustment program must combine both

demand reduction and switching elements


Figure 23.6. Adjustment via Demand Reduction and Switching


The Structuralist Critique Structural economists argue that we must account

for structural diversity of developing economies undergoing balance of payments crises and adjustment programs Productive resources may not be mobile between sectors

• For instance, certain barriers can prevent productive resources in Ghana from moving freely to the traded sector from the non-traded sector

Urban workers in the non-traded sector might face a number of barriers (e.g. culture and family ties) to relocating to rural areas to increase the supply of agricultural products

Domestic production may be highly dependent on imported intermediate and capital goods

• Devaluation of the cedi raises domestic prices of these traded goods


The Structuralist Critique Demand reduction can include lost productive

investments Often achieved by reducing government expenditures

• However some government expenditures may be necessary to support private investment and production

• In the structuralist view, public and private investments are complementary

Adjustment often takes place under negative foreign savings (capital outflows or capital flight) Not simply a matter of regaining external balance but of

generating a trade or current account surplus to accommodate a capital account deficit


Figure 23.7. Adjustment Under Resource Immobility


Structuralists’ Recommendations

Depends on the country in question—however, generally structuralists would call for Measures to ensure that key productive investments are

not sacrificed in demand reduction Import quotas and export subsidies to reduce trade

deficits in order to require lower nominal exchange rates—preventing inflation and poverty problems

Government involvement in allocating scarce foreign exchange

Foreign debt forgiveness to prevent the necessity of generating large trade surpluses


The Order of Economic Liberalization

Typically, adjustment programs designed by IMF and World Bank include a number of kinds of market liberalization Exchange rate depreciation or devaluation Reductions in government expenditures

• Including reduction in public sector workforces, elimination of agricultural and industrial subsidies, and elimination of food and medical subsidies

Wage controls to reduce demand and to prevent inflation Elimination of import quotas and export taxes Reduction of ad valorem tariffs to “moderate” levels of 10-15% Privatization of state-owned enterprises Liberalization of domestic financial markets

Has been a tendency for the IMF and World Bank to call for the implementation of the above components all at once


The Order of Economic Liberalization—Ghana

Suppose that Ghana faces a balance of payments crisis such as that described in the previous sections Financing the current account deficit by selling foreign exchange

reserves Central government is running a deficit

Additionally, suppose Government owns some enterprises on which it depends for some

revenue Government restricts imports using a set of quotas Exchange rate is fixed

How should the steps Ghana will take in alleviating the balance of payments crisis and securing sustainable adjustment be ordered?



First: Seek a means of securing central government revenue through a broad-based tax Government accounts are in deficit Government may be called upon to lower trade taxes and sell its

enterprises• Will involve a loss of revenue sources—alternative revenue sources

must be found Possible sources are sales taxes, producer taxes, or value-added taxes

Should be broad-based and set at low rates Increase in tax revenues will lower the government deficit and

Tend to narrow the gap between domestic investment and domestic savings

Position the government for further reforms without precipitating a fiscal crisis

Second: Depreciate or devalue the exchange rate Begins a switching process

• Imports are reduced and exports can expand Tend to reduce the current account deficit



Third: Tariffy quotas on imports of consumer goods and remove quotas on imports of intermediate and capital goods Causes a quota premium equal to amount by which domestic price

of the good increases above world price as a result of quota Converts quota rents into government revenue

• Helps alleviate the government’s budget deficit Removal of quotas on intermediate and capital goods will ensure

that these goods are available to domestic producers• Tend to lower the domestic prices of the goods, offsetting the effect of

exchange rate depreciation and addressing structuralist concerns about declining production

• Any tariffs on these goods should be set very low Fourth: Selectively begin to privatize government-owned

enterprises



Fifth: Liberalize the foreign direct investment component of the capital account Edwards (1984) concludes capital account should be

liberalized only after current account is liberalized• Capital account can be divided into

Direct investment Ownership and control of physical capital

Portfolio investment Ownership alone of government bonds, corporate equities,

corporate bonds, and bank deposits Long-term Short-term Tends to be highly volatile

Makes sense for a country to begin liberalization of the capital account with direct foreign investment



Sixth: In preparation for an eventual liberalization of the domestic financial industry and the capital account, develop an effective system of bank regulation Banks in developing countries

• Predominate the provision of financial services• Pose the most serious threat to financial stability due

to their inherent instability• The prevention of financial crises requires a well-

developed system of banking supervision Pay attention to capital adequacy requirements, auditing,

loan policies, and degree of foreign borrowing



Rodrik (1990) argues that, where a conflict between idealized adjustment policies and the economic and political sustainability of these policies exists Idealized policies must be compromised

• Welfare benefits of liberalization policies such as privatization and the removal of trade restrictions must be weighed against potential costs in terms of sustainability

Introduced a distinction between the range and the magnitude of policy reform programs

• Range relates to the number of areas in which reforms are to take place

• Magnitude refers to the degree of change in any particular policy


Figure 23.8. Range and Magnitude in Adjustment/Liberalization


Adjustment and Development

Ghana has been participating in a structural adjustment process since 1983 However, Ghana’s health and education statistics and

human development overall are disappointing What do you, as an advisor to the Ghanaian government

make of this? • Adjustment involves restructuring domestic production away from

non-traded goods and towards traded goods For non-traded goods such as tailoring and auto repair, this is

perhaps no great loss For non-traded goods such as education and health services,

however, the future human capital of the country is compromised In turn, compromises long-run growth


Adjustment and Development

The challenge is to help the government achieve adjustment without sacrificing productive human investments that are essential for long-run growth and development

Additionally, productive government investments that are complementary to private investment must also be maintained where possible Otherwise, adjustment will be achieved at the expense of

development

structural adjustment

Documents

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consumption of traded

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domestic consumption

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