structural adjustment
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Structural Adjustment. CHAPTER 23. 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) - PowerPoint PPT PresentationTRANSCRIPT
Reinert/Windows on the World Economy, 2005
Structural Adjustment
CHAPTER 23
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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
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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
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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
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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
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Table 23.1. Traded Goods vs. Non-Traded Goods
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Figure 23.1. Ghana’s PPF
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Internal and External Balance
Internal balance All resources are efficiently employed
External balance Consumption and production of tradable goods
are equal
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Figure 23.2. Internal and External Balance
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Figure 23.3. External Imbalances
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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
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Figure 23.4. A Current Account Deficit
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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
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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
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Figure 23.5. Adjustment via Demand Reduction
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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
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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
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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
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Figure 23.6. Adjustment via Demand Reduction and Switching
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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
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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
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Figure 23.7. Adjustment Under Resource Immobility
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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
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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
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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?
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The Order of Economic Liberalization—Ghana
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
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The Order of Economic Liberalization—Ghana
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
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The Order of Economic Liberalization—Ghana
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
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The Order of Economic Liberalization—Ghana
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
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The Order of Economic Liberalization—Ghana
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
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Figure 23.8. Range and Magnitude in Adjustment/Liberalization
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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
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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