CATALOG NO. 4 This paper is prbpared for staffuse and is not for publication.The views expressed are those ofthe author and not necessarilythose of the Bank.

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

INTEKIATIONAL DEVELOPENT ASSOCIATION

Economics Departmnt Working Paptr 14o. 46

Project Appraisal in Inflationary Codditions

June 4, 1969

This paper discusses some general difficulties inproject appraisal under inflationary conditions and howthey might be overcome. The paper presents evidence of

large fluctuations in relative prices apparently attribut-able to inflation. Hence, it is pointed out, currentmrket pr:ices are a poor measure of social value in that

ce and either long-run average market prices or worldprices must be used in economic rate-of-return calculations.Large price fluctuations also require a more careful examina-tion of financial incentives and riskiness as viewed by

participants in a project. Finally, inflation requirespolicy measureo to assure the financial viability of a pro-

ject. Fixed interest rate charges which do not adequatelycompensate lenlders for the devaluation of money, wouldrequire subsidization of financial intermediaries and cause

misallocation of capital. The paper discusses altemativemethods for adjusting interest rate charges to take account

of inflation.

The author of the paper is now with the University of

Oxford, Institute of Ii)zonomics and Statistics, nigland.Most of the paper was written while the author was a staff

member of the Economics Departmnt of the IBRD.

Sector and Projects Studies DivisionPrepared by: Sanjaya Lal).

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TABLE OF CONTENTS

Page No.

PART I. INTRODUCTIoN **..... a...................... 1

The Nature and Incidence of Inflation .............. 1

The Characteristics of Sustained Inflation ......... 2

PART II. PROBLEMS CREATED BY INFLATION IN PROJECT APPRAISAL ..... 7

A. Economic Appraisal ............................ 7

The ShadoV Pricing Problem ................. 8The Risk Bvaluation Problem .................. 9Some Approaches to the Problems ................. 9

B. Financial Appraisal ............................... 11

Predicting Market Prices .................... 12Real Wage Changes .................. 12Trade Price Changes ............................ 13Utility Price Changes ...................... 13The Unpredictable Pace of Inflation ......... 14The Case of Regulation of Prices ................. 15

PART III. PROBLEMS CREATED BY INFLATION IN LENDING THROUGHINTERMEDIARIES . ... ,. ...... ................... 16

A. The Damaging Effects ......................... 16

B. Four Possible Remedies ..................... 17

Subsidy Protection ............................... 17Higher Interest Rates .................. 18Shorter Lending Periods ........................ 19Adjustzent of Terms of Inflation ................. 19

Objections to Value Linking ............. ..... 20Choice of Index .............................. 21Gold or Foreign Exchange Index ................. 22Specific Price Index ......................... 23Wage Index ........................... *. .* 24General, Cost-of-Living or Wholesale Price Index 24

Putting Index into Practice .................... 25

C. SPum y .. .. . .. .e ..................... " . I ** §ee * .......v ** 26

TABLES AND FIGURE

Table 1. Brazil: Rates of Change in Prices .................... 2Table 2, Brazil: Index of Changes in Relative Prices .......... 3Table 3. Argentinaa: Annual Rates of Change in Prices ... O-*.... 5Figure 1. Brazil: Index Qf Changes in Relative Prices .......... 4

Bibliography

PART I. INTRO I

The Nature and Incidence bf Inflation

1. Inflaltion is a widespread phenomenon today,, defined as a generaland sustained rise in a country's pxice level. It affects developed aswell as underdeveloped countries and tends to dig itself into the economicorganism in such a way that it becomes extremely difficult, and sometiresquito painful, to handle. In this paper, we will not be concerned with thecauses or effects of inglation in general, but only its effects on theevaluation and opdratiLon of projects.

2. Nor will we deal with sporadic inflation cr hyperi:nflation; wewill concern ourselves with the kind of inflation which follows some semblanceof a pattern or sequence. In these cases the worst effects of inflationhappen in the early stages where the institutions and economic habits of thecountry have not adapted to living with continuous price increases. Thestruc ture of investment and savings, the pattern of demand and the distribu-tion of income are most aIkew during this phase and it is clearly impossibleto predict future behavior with any hope of accurazy. But once the economyhas settled down to liviing with inflation, behavior starts to conform tomore stable patterns and long-term economic forces reassert themselves. Dis-tortions are always present, and the struggle to keep abreast of the fallingvalue of money never abates,, but the strains and stresses become institu-tionalized and predictable to some extent. In the long run, this institu-tional3iz&-fi.O constitutes the strongest force in the perpetuation of inflation.

If a project is to be undertaken under circumstances of erraticand sudden inflation, the best solution is to assume constanit relative pricesand relinquish all hope of accurate forecasting. Experience does not provideany guide in such cases and a priori reasoning is irrelevant. Hyrperinflationfalls into the same category) since norrmal market relations cease to existand prices change wildly. We will confine ourselves to cases wihere inflationshave long histories and where it is unlikely that they will come to quickends.

4. In the underdeveloped world, there is a set of countries thatsuffers from very high rates of inflation, over 10 percent per annum in thelast decade: Argentina, Brazil, Chil.e, Colombia and Uruguay.l/ There areother countries in which price rises are lower or less sustained: Ghana,India, Peru and Vietnam are good examples. There are yet others whose econo-mies experience mild spurts of price increases occasionally, but cannot beregarded as inflationary in a real sense. And there are countries whichhave suffered from hyperinflation, where the monetary system degenerates intochaos and ultimate breakdown: Indonesia until recently is a case in point.

1/ If we take 1958 as the base year, we find that the cost-of-livingindices had risen by late 1967 to 1360 in Argentina, 3990 in 3razil,767 in Chile,, 259 in Colombia, and 2040 in Uruguay.

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5. In this study, we shall focus mainly on the first grup, thehigh-inflation countries, a1 in Latin A-r.-ca. In these countrios inflationhas existed long enough for its effects to .-cor', fully apparent, and itmay reasonably be expected to contimn7i for gone -ears to come -a"thoutcompletely dying out or accelerating into hyperizflation.

6. For the purposes of this paper, projects may be divided into twobroad types: direct investments and loans to intermedi.t e instituwions forrelending to some selected sector of the economy. Though inflation Createsdifferent problems for these two types of projects, all problems arise fromthe changes in relative prices that typically occur during an inflationeryprocess. If all pxices rose at exactly the same rate, incluaCing the rate ofinterest and the value of deferr.ed pVments, -here would be no problem at a2lpsince in real terms the situation mould be identical to one of cozn1;stent prices.But when relative prices change, problems arise for projects tat conWist ofdirect investment, from the leads and lags of various prices and from thedistortions they cause, both for economic and for financial appraisal; forprojects consisting of lending to financial intermdiaries, problems arisefrom the fall in the real value of future paymnts relative to their currentvalue, a-nd from the decline in the real rate of interest relative to the valueof capital.

The Characteristics of Sustained Inflation

7. The tables below illustrate the changes in relative prices inBrazil during the period 1960-66. Table 1 shows annual percentage changesin some selected prices, while Table 2 shows the relative changes in theseprices in index form.

Table 1: Brazil: Rates of Change in Prices(Annual Averages - Percent)

Cost Wholesae Prices Construc-of Total Agr-~icutue tion GeneralLDIving (ec. Coffee) (excl. Coffee)_ InduJStrial Cost Pri.ces

1960 29.3 3l.5 41.3 23,5 17.4) 28.81961 33.4 40.3 38.1 42,5 43.a 37.31962 516 50.1 57.0 44.9 42.3 51.71963 70.5 76.4 69,3 83.4 88.1 73.71964 91.7 81.3 79.2 83,3 82.3 90.81965 65.7 53,6 b Jo 615 69.8 57.11966 41.3 39.8 4c..2 32.0 36.6 38.0

Source: Getulio Vargas Foundation, given in Economic Growth of Brazil, Probleamand Projects, IBRI), Vol. II, Sectionec2, Tale 5 (October n31967).

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Table 2: Brazil: Index of Chan es in Relative Prices

Agriculture/ Industry/ Agricillture/ Construction/Indus.1 ry General General General

1960 jL96 73 140 511961 100 100 100 1001962 141 77 108 701963 92 100 80 1031964 1o6 81 85 781965 81 96 77 1041966 171 74 127 82

8. The indices from Table 2 are illustrated graphically in Fgure 1.Clearly the relative price ch'anges are fairly substantial, especially foragriculture/industry. Even the least fluctuating line, industry/general,shows changes of 15-25 percent from year to year; all the others show changesof much greater magnitude, 5-50 perxoent for agriculture/general and 25-50percent .2or construction/general. Relative price changes of this magnitudeare almst certainly due in part to inflationary pressures; ordinary market'orces in stable conditions do not create relative changes of this order yearafter year.

9. For an inflationary economy, such wide swings are only to beexpected. Aftedr all, inflation is a process of constant friction and compe-tition between different sectors of the economy, each endeavoring to maintaino: increase its real share of national income, and it is kept alive simplybecause one or another sector has fallen behind and is trying to catch up.It is probably safe to assume that in the long run, no sector is really leftbehind in terms of its real price falling below the others, but in the shortterm, some prices tend to lead and others to lag, with no clearly discerniblepattena in the timing and extent of leads and lags.

10. ITe exceptions to this picture are created by certain instit-utionaland administrative pressures which tend to make certairn important prices lagbehind others while other prices lead or lag in an erratic or cyclical manner.

11. Public Utility Prices. These seem in most cases to be adjustedrather less often and to a lesser extent than would be required if they wereto keep pace with the general inflation. The ma^In reasons for this are thegovernient's desire to prevent the spread of inflation and the rigid institu-tional arrangements for changing rates. Adjustments are occasionally madeto bring public utility prices in line with inflation, but on the average theytend to lag. In fact, the subsidization of public utilities is a major forcein the perpetuation of inflatic_:,

9961 596T V6I C96T a96T '196T Q9671

. . . . . . . . . .. .. z2

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12. Corltrolled Pricesa In a similar, misguided, attempt to controlinflation governments sometimes impose price contk'ol on commodities consideredas essential (like foOd); these controls can be &kintained over long periods,usually to the detriment of production and ia*-restment in the contmlledsector. Without contmrls, the price of food is in many cases one of theleading prices in inflatibns, especially when the agricultural sector is notexpanding rapidly enough to keep pace with demand.

13. Rate of Interest. In institutional money markets, the rate ofintere ge la bdehind the rate of inflation, sometimes to the extentthat long-term lending is completely choked off. In non-institutional. markets,the r'ates adjust to inflation, but such markets are quite narrow and confinedto fairly short-term transactions.

14. Rate of Ex'cange. Most highly inflationary countries, with therecent exile adjust the rate of exchange only periodically tothe declining value of the domestic currency. Between the devaluations, con-sequently, the rate lags behind the i.flation and the currency rapidly becomesovervalued.

15. While these kin2s of prices tend to lag behind the general pricelevel, others lead or lag impredictably. As the tables above show, the cyclesare not of even amplitude, as they are determined by a host of forces, suchas: rate of inflation, the relative strength of the sectorj the cost anddemand factors, the success of the harvest, and other normal market forceswhich would cause relative price changes in any case. The table below showsfor Arge--f-.: the cyclical fluctuatiorn in real wages and the lagging tendencyin the rate of exchange.

Table 3: Arentina: Annual Rates of Change in Prices(Percen')

ForeignCost of Nominal ExchangeIiving Wages Rate1958 32 47 301959 114 68 651960 27 17 51961 14 25 01962 28 25 371963 24 25 2219614 22 30 11965 29 35 201966 32 33 23

Source: Economic Position and Prospects of Argentina, Table 13, IBRD,Novembe-r 21., 129&7.

16. The exact nature of relative price changes is of crucial importancieto project evaluation. In the next two parts of this paper we shall considertwo distinct problems in project appraisal and implemaentation: in Part II we

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shall discuss the difficulties created by iiflat-ion for the economic andfinancial appraisal of projects consisting of dc_roct investmts; in Part IIIwe shall discuss the difficultes created by inflation for projects thatinvolve lending to financial intermediaries.

PART II. PROBLEMS CREATED BY IiNFLATION IN PRDJECT APPRATSML

17. There are two aspects of project evaluation which are relevant tothe present problem: the appraisal of economnic merit; and the appraisal offinancial viability. The appraisal of economic merit consists of balancingthe true costs of the project against its true beftefits to the economy as awhole, allowing for the passage of time by discounting. The appraisal offinancial viability consists of projecting the future monetary revenues andexpenditures, and the consequent monetary returns to the beneficiary. Theformer determines whether the investment is justified from the point of viewof the economy as a whole; the latter shows whethdr the entity responsiblefor the operation of the project can be financially viable in the long run.Mhe two kinds of appraisal present di-fferent problems under inflationaryconditions.

18. A distinction has been made in this paper between three kinds ofprices: market prices, shadow prices and real prices. Market prices areclear enough. Shadow prices refer to values irmputed to various goods andfactors based on their true value (or opportunity cost) to the economy. Realprices stand fo.r market prices corrected for inflation, in other words, formarket prices stated in temLs of constant value, and not for opportunitycost or shadow prices as defined above. The discussion of economic appraisalhas been conducted in terms of shadow prices, and that of financial appraisalin terms o.- real prices.

A. Economic- ppraisal

19. The deterniination of the economic merits of a project from thepoint of view of an aid donor or a government depends on thL. balancing ofbenefits derived by the whole economy from the project against the true costsof the investment and operation of the project. These benefits and costs canbe read off directly from the market if market prices show correctly the truevalue of goods and the opportunity cost of factors (i.e., their shadow prices).The conditions theoretically required for market prices to correspond exactlyto shadow prices are very stringent - full employment, perfect competition,perfect mobility, and the like - and are not found in the rea;L world. However,xmless there is special cause to believe that market prices are grossly dis-torted, one can perfectly well use them in project appraisal, since the effortof making minor corrections is probably not juCtified by the rewards of some-what better project appraisal. Where there are large distortions, say,massive unemploymeent or heavy indirect taxation, market prices can be adjustedto get a closer approximation to the shadow prices. There are many problemsfacing this sort of adjustment, but in principle they can be accepted asdesirable.

20. Let us now a6suxie, first, that soma rmugh but acceptable techniquesexist for assigning shadow prices (not in a linear programming sense) to afew obviously distorted market prices under stable conditions; second, thatsufficient knowledge of the long-texrm forces in the econoty exists for theproject evaluator to forecast market or shadow prices (wiichever is used)over the life of the project; and, third, thaat the risk and uncertainty in-herent in these forecasts are also calculable. In efect., we assume th.At agood project evaluation is possible if the country i questioon is not suffer-ing from inflation.

21. Now introduce a state of high and prolonged in2flation, one whichhas been in existence long enough for all sectors and institutions to adaptto it, and which is expected to continue for some time to come. The projct,evaluator now faces the follow.ing difficulties caused specifioally by Lif latio.n.The Shadow Pricing Problem

22. First, in terms of the calculation of present shadow prices, a hardenough task in the best of conditions, there are two new problems. Inflationcauses market prices to diverge even more from shadow prices than otherwiseby its erratic effect on the relationship between prices. It is clear fromthe kaleidoscopic nature of price elationships in the short term that theserelationships at any particular point of time will be quite different fromthe relationships that would obtain under price stability. The calculationof shadow prices under stability is largely based on the correctioon of a fewmarket prices, tuie unchanged ones being accepted as being more or less correct.In inflation, the relationship of prices would differ widely, depending on thearbitrary time chosen to evaluate the project, and the number of prices to becorrected would probably be much larger than with stability.

23. Inflation causes not only changes in relative prices but also inunderlying economic conditions of the economy. It is well known that inflationhas several undesirable effects on the structure of an economry, mainly on thelevel and form of savings, the pattern of investment, exports and imports.!/It would be beyond the scope of this paper to discuss these effects. It needonly be said that they render shadow pricing even more difficult than before,especially with regard to prices such as the rate of exchange, the rate ofinterest and the structure of interest rates, ad the prices applying to con-ptrollei pxoducts.

24. For the calculation of future shadow prices, inflation has twocorresponding effects. Insofar as Mprediction of the relevant shadowprices depends on the prediction of market prices, with or without correction,inflation creates enormous difficulties >¢ uLe inflation makes the predictionof marhet prices almost impossible. Even Inflation causes no structuraldistortions and even if the long-tenr trends of the basic economic factors(savings, investment, trade, productivity, etc.) were known, the prediction of

1/ The literature on this subject is vast. For a brief discussion seeStanley Please's draft study, "Value Linking of Domestic Bond Issues",IBRD, Economics Department, January 2, 1969.

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nMarket prices would be impossible for periods longer than one to two years.l/And since proper poject evaluation should make year-to-year projections offactors that affect the project over its entire life, inflation confinesthe evaluation to ianferior results.

25. The stru&tural distortions caused by severe inflation occur notjust once; they coittinue as long as the relationships betweean differentprices keep changing. We chose the assumption of a pmlonged inflation;short bursts of inflation create even greater problems because the economydoes not have time to adapt to inflationary conditions or to learn to livewith them. The worst distortions, in inventory speculation, real estateinvestment, absence of long-tenn investment, capital fl,ights, foreign exchangerate overvaluation and others, occur in the preliminary stages of inflation;after some experience of inflation these distortions, thiough never eliminated,are reduced. The degree of disbortion varies from country to country, depend-ing on how variable the rate of inflation is, how rapidly relative priceschange, and how the economy develops. In any case, the continuolus structuralchanges caused by prolonged inflation have to be accounted for in predictingshadow prices over the project's life. This fact compounds all the problemsmentioned above.

The Risk Evaluation Problem

26. For the calculation of ri sk and uncertainty, inflation also createsdifficulties, because there is little experience on which to base the sub-jective probJbilities of different outcomes. In stable economies the projectevaluato:r cs sorne idea of the likelihood of the market behaving in certainways, based on his experience and knowledge of changes occurring in relevantfactors; in highly inflationary economies the market is intrinsically ei.raticand no amount of knowledge can enable one to predict prices and costs farinto the future or to know the probability of different prices and costs.

Some Appaches to the Problems

27. What can be done then to evaluate the economic cosbs and benefitsof prospective irnvestments? There is no solution which is completely satis-factory; the very nature of the problem is such that, inflation or no inLflation,a lot of guessworkl is involved. Inflation merely serves to compound thedifficulties and increase the risk of error in all the calculations; it doesnot rule out the calculations altogether. We may suggest some simplificationswhich reduce the problem to more manageable pmportions.

28. First, we must be careful to distinguish in the calculation ofeconomic benefits between projects where benefits are normally representedadequate2y by market prices (agricultural and industrial projects where theoutput is freely sold in competitive markets), and those where the benefitsare usually not properly shown by market prices (public utilities, educationand so on). For the former type of project the evaluation of benefits consists

1/ See, Section B, "Predicting Market Prices,t pages 12-15.

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of predicting market Drices, and adjustiing them for the fall in the valueof money; this is discussed in Section B. For the latter we have nothingnew to suggest as far as the quantification of extra-mrket benefit goes;the ca:Lculation of market benefits, insofar as this consists of e stimatingrevenues from regulatedprices, is also discuss6d in Sectioni B.

29. The calculation of the true costs of a project under high inflationhas to deal with the difficulties of r ativ rc dstortion and structuraldistortion described above.

30. Relative price distortion should be corrected by some means ofshadow pricing. It is mere'ly another cause of market divergence from realconditions and accordingly should be corrected i-n the same way as over-pricedlabor, over-valued exchange rate, negative -rates of interest, or under-pricec.public utilities. It is not necessarily true that Piflatioii always causesmarket prices to diverge more from shadow prices than a stable economicsituation does; the problem arises more from the fact that the divergenceitself is haphazard and constantl;y changing as the re1ative prices shiftaround from year to year. The structure of relative prices, if constant,

shows the value of each factor and comaodity relative to all others in themnost convenient and direct form; if the structure is inconptant, each relativevalue has to be calculated separately.

31. All methods of shadow pricing are at this stage imperfect, althoughthey are unddoubtedly being improved, and all of them face various conceptualand statistical problems. Perhaps the simnplest to apply is the one suggestedby I. M. D. Little and J. l4irrlees in Manual of Industrial Project Analysis nDeveloping Countries, Volume II, O.E.C.D.. 1969, which uses international pricesfor all goods whlch are traded or reduced to traded inputs, and imputes pricesto non-traded inputs like labor.

32. Labor costs can be worked out by a complicated fonmula which takesinto account the loss in production in the sector from which it is drawn,the ccst in terms of increased co4sumption from the wages paid, and the costof settling the workers on the project site. It can be put roughly halfwaybetween a zero shadow wage rate and the nominal wages paid.

33. All this is for present costs. For predicting future costs, theconstantly changing pattern of relative prices needs to be reduced to long-term trends, based partly on a projection of trends in international pricesand partly on knowledge of the real factors in the economy. Shadow wagescan, for instance, be assumed to rise in line with labor productivity; theterns of trade of agriculture in relation to industry 6an be forecast frompast trends; the price of power can be fc: ^.st on the basis of the cost ofproviding it in the future, in real termn the international prices of its

inputs ani.' expected rise in shadow wages; and so on. The essence of the wholeprocedure is that relative price changes which are temor4ry abberat#ons shoul4not enter into true cos'ts, while the relative price changes caused by under-lying economic forces should be taken into account by any means possible.

34. In summary, inflation maD~Bs the use of shadow prices more desirablefor project F,ppraisal but makes them more difficult to deterinei. In thepresent statp of the art the problems cannot be :ully solved, but ways can be

found of getting around them or, when necessary, of ignoring them. Theproblems created by the rapidly changing price structure can be resolvedwith reasronable satisfaction. However, project' evaluation under inflationwill be more uncertain, more prone to error, and more based on guesswork thanan evaluation in stable conditions. Morover, this can never be avoided,since inflation is basically a condition of uncertainty and flux.

B. Financial Appraisal

35. The financial appraisa[ of projects show, the viability of theagency operating the investment, except in the case of projects which arenot selling their output commercially, e.g., education. It can also be usedto show the desirability of a project (in ctse8 where economic benefits arenot calculable). The former kind of financial appraisal examines the finan-cial position of the entire entity, a power company or a waterwork authority,for instance, to determine whether it will be able to ran on a financiallysound basis; the latter looks only at the project and isolates its costsand revenues from that of the parent company. Both kinds of financial analysisface the same problems under inflation.

36. In contrast to economic analysis, financial analysis must measurebenefits and costs in market prices. If one views market price swings asboth erratic and short-tern, then in the longer term over the life of the pro-ject they may be expected to cancel each other out without any substantialbias on the total result. Real wages (i.e.,, money wages in constant terms),cannot, foe ;instance, go on fa.ling for a long time; after a few years thelabor unions are almost sure to turn the tables in their favor and get higherincreases thLan the rate of inflation. Similarly, imported goods will getrelatively cheaper during the period before exchange rate adjustment. Thentheir prices will suddernly rise when the currency is devalued, and may tem-porarily overshoot the inflation.

37. In general, it seems vezy likely that the different economic groupswill be pulling and pushing to increase or regain their real incomes, and inthe long xun most of them will end up in their original positions.

38. This does not mean, however, that we can ignore such market priceswJings over the life of a project, because the different periods that makeup the long temr are not equally important to us. Since we discount the future,the latter years have less and less importance, while events in the initialyears (the first five or seven years) carry the greatest weight. So if realwages rise significantly over the first five years and fall thereafter, theweight of rising costs will be larger than that of the subsequent decline.Changes occurring after the first few years of the project's life can beassumed to cancel out or become insignificant. kaile this is not a rigorouslycorrect procedure, it is certainly c,ne which simplifies the problem, yet itdoes not unduly distort the truth. The forecasting problem then boils downto predicting relative changes among the most important elements of cost andrevenue for the first five to seven years of a project's life.

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39. This is the only possible solution for projects that depend

for their income on market prnces, as do those in agriculture and industry.

For project agencies that can regulate the price of their output because of

their monopolistic or legal position (public utility and transport operations),

the solution is sinpler. Let us consider the cases of price prediction and

price regulation in turn.

Predicting arket Prices

40. The difficulties in prediction will vary with the composition of

the goods and services which make up the inputs and outputs of the project

being appraised. We have said that certain prices (public utility and trans-

port rates, interest and exchange rates) tend to lag behind the rate of

inflation in steadily inflati:..g countries (see paragraphs 11-14 The) hese

prices may at times catch up or exceed other prices, but their adjustment is

periodic and in some cases predictable. Other prices tend to lead the general

inflation in certain situations, such as the prices of agricultural commodities

(unless they are put under price control), wages and so on, with the remainder

of the prices tending to rise more or less with' the average. Wages play a

significant role in almost all projects, as does the price of donestically

procured inputs (raw materials, power, transportation). Imports may also be

important, if, for instance, an agricultural project requires foreign fertil;izers

or livestock; so may exports, if the project is inAtended to produce comdities

for export.

41. To simplify the problem, let us assume that all domestic goods

except labor and utilities will rise in price with the general price level -

in other words, their real price will remain constant - unless there is

special cause to expect some comodity to fall out of line. If there is,

we must make the best guess possible regarding its future level, based on the

particular circumstances of the country. Tn some cases, the future level of

such a price may depend upon government policy, in others upon fortuitous

factors like weather; no generalization can be made about them her. So we

are left with the prices that may be expected to change relative to the general

price level - wages, imports, exports and utilities. Let us consider them

in turn to see if they provide some handles that we may grip for prediction.

Real Wage Changes

42. Wage determination has become quite institutionalized in countries

with long inflations; the bargaining system itself now provides one of the

strongest pressures for the continuation of inflation. Wages are increased

at more or less regular intervals in acc.ordance with some index of inflation,

usually -the rise in thp cost-of-living i,r1' during the preceding year. Trade

unions are strong and active, and the c-mr.-ment participates in wage negotia-

tions in important cases. It would be a reasonable working assumption in

such,cases to say that real wage, i.e., the wage cost in constant money terms,

increases over the long run at the same rate as productivity; in other words,,

labor's share of the increasing national product remains stable. In the

short run, -s argued above (paragraph 15), the level of real wages will fluctuate

cyclicaJly around the long-run trend, the arnlitude and duration of the cycles

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being determined primarily by the rate of inflation and the bargainingpowe& of unions. For instance, if inflation suddenly accelerates overthree to four years, real wages will fall continuously if they are adjustedfor the rise in prices during the previous year; similarly, if inflationdecelerates, real wages will rise. It would not be too difficult, given anintimate knowledge of the institutional arrangements and barring any majorohange in the economic situation, to predict roughly the future course ofreal wages if the future course of inflation were known.

43. In some cases governments intervene in the wage-determinationprocess as part of anti-inflationary policy. Such intervention usuallytakes the foxm of a ceiling imaposed on wage increases, depressi;ig real wagesbelow what they would otherwise be. With strong support and great determina-tion, the government can persuade or coerce unions to follow its line -provided that economic circumstances turn out in the goverm nent's favor, i.e.,that the rate of inflation is considerably reduced, and the usual inflationgenerating forces (notably large public sector deficits) are strictly controlled.tn recent experience, wage restraint could not be maintained for long becausethe primary inflationary factors had not been controlled. For the purpose ofprediction,, therefore, government assurances on the future of wages have littlevalue beyond one, or possibly two, years. Any longer-range forecast becomesinextricably involved with a prediction of the course of inflation itself.

Trade Price Changes

44. 'e prediction of domestic import and export prices, i.e., of theexchange rate, tariff and subsidy policies, requires that one predLct both-the rate of inflation and government policy. If the exchange rate is de-valued continuously to maintain a realistic relationship between the externaland internal values of the country's cuxTency, the domestic price of importsand exports will remain constant in real terms. If, on the other hand,devaluation is periodic, the price of imports will fall relative to otherprices in the interim periods and rise suddenly whenever the exchange rateis adjusted, and the price of exports will behave in the same manner.

45. The actual domestic pxice of imports and exports may not exhibitthis sharp cyclical fluctuation if tariffs and subsidies are used to maintainbalance in external payments; the ultimate effect then depends on the combina-tion of exchange rate and fiscal policies by the authorities. Some importswill be hean.vly taxed, others let in without tariff, and others completelyexcluded; similarly, some exports will be subsidized, others left to flounder.The effects of inflation per se will be felt more by the relative untaxedimports, such as vital raw matexrials and some capital goods, and by unsubsi-dized exports. These will suffer the cycles in price engendered by inflationand a lagging exchange rate. Prediction of their prices will be very difficult,as with money wages.

Utility Price_Changs

46. Public utility prices are in many cases out of line with thegeneral price level in inflation, as described above in paragraph 11. Thereal price of public utilities is aLlowed to tfall for a considerable period

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before adjustment is made. Clearly the lags depend on the rate at whichinflation is proceeding and on the extent to hiich the government isprepared to subsidize utility operations.

47. In all these cases, therefore, where price depends on adr6Uaistra-tive decision or institutional bargaining rather than on free market forces,the future course of prices depends on the rate of inflation and. on govern-ment policy. Government policy is itself to some extent influenced by thecourse of inflation, which in turn is largely dependent on the ability ofthe government to reduce deficit financing. If we can forecast c2h?.ngses inthe general price level for the required period., then we can, bearing in mindthe simplifications introduced in paragraphs 38 and 41, assess the &irectionand speed of change of other paces in real terms. If, for instance, theinflation is expected to accelerate, the variables that react with a lag(real wages and public utilities) can be expected to suffer a fall in theirreal price while others (real profits, agricultural goods) can be expectedto enjoy a rise. The rate of acceleration will also be of great importance,because on it will depend a multitude of induced reactions (wage negotiations,exchange rate policy, and so on).

The Unpredictable Pace of Inflation

48. But how can one foretell the pace of inflation? Even under relativelysteady inflationary conditions, prices vary from month to month and year toyear, in reaction to a complex mixture of political,, social and economicforces. A simple indicator like the supply of money, which seems to moveclosely in line with prices, may be misleading for the purposes of predictionbecause it may at times be the causative and at other times the permissivefactor. There are, as mentioned before, some factors which steadily generateinflation - public utility deficits, for instance, or deficit financing ofbudgetary expenditures. There are other factors which are accidental andunpredictable, like a sudden deterioration in the terms of trade or a harvestfailure, and which may cause a substantial expansion in money supply =-expectedly. Fahrthrnrmore, these unpredictable factors may also force theauthorities to abandon anti-inflationary policies and relinquish their targetsfor containing price increases..:

49. As a consequence, the prediction of inflation is an almst hopelesstask beyond the short period of about one year. A longer prediction wouldbe feasible only if the government committed itself to controlling inflationregardless of consequenqes; but no government can ever disregard consecuences,especially not where the affeeted intemests are powerful and numerous. Anyuntoward circumstance may cause a collapse? of the most determined polidywhen the co4sequence of the policy turns t to be severe depression andunemployment,. This is not to suggest that imflation cannot be controlled;it can and has been (e.g., in Mexico). But the process of control is diffi-cult and requires the support not only of the people but of various other groupswith economic power; the pacrifice that stabilizaiion requires may be toomnuch for the country to bear if the economic circumstances are not just right.Experience in tlfae high-inflation Latin American countries shows that govern-ment predictions about inflation rarely match subsequent eventsi an outsideobserver's guess can turn out to be as good as the government's.

50. In sum, the prediction of prices and profitability over the lifeof the pxoject or even over the first few years seems pretty hopeless.Accurate forecasts cannot be made for periods longer than a year or two,if that long. Anything beyond two years is pure guesswork. Where does thisleave us? If the financial analysis of a project that has been ahown to beeconomically justified is not possible, in the sense that long-term projec-tions of market pricet are expected to be wildly inaccurate, it does notnecessarily mean that the project should not be undertaken. An appropriateapplication of taxes and subsidies can ensure the financial viability of theproject: if the project runs into financial difficulties it shiould be sub-sidized by the govenment, and if it makes excessive profits it should betaxed. This should provide a sufficient st.feg-uard to the problems createdby inflation.

51. It must be admitted, however, that the provision of subsidy opensthe door to its abuse. 1. project may be economically justified in itsconception, yet may turn out to be unprofitable because it is badly operatedrather than because of inflationary price distortions. In such cases whatis needed is not subsidy but perhaps a change of management or strictercontrol of production. It is impossible to generalize on this point, but onthe whole the dangers do not seem to outweigh the advantages. In =7y case,inflation would tend to conceal inefficiency rather than penalize it ascompared to a stable situation, and in most cases there would be no need forsubsidization (with the obvious exception of price-controlled utilities).

The &;e of Regulated Prices

52. In projects where the price of output can be directly controlledby the producer, there is no need to forecast costs and prices with greataccuracy. All that needs to be done is to stipulate that prices will bevaried in such a way as to maintain a given financial rate of return on netassets over a certain period. This is in fact ihat is done for publicutility projects in the Bank. It is a perfectly reasonable and practicalmethod of ensuring financial adequacy of the borrower.l/

1/ That is, as long as the borrower abides by the covenant. Some doubthas been cast upon whether this is so, but we do not possess sufficientinfonaation to decide whether actual infringements have taken place.

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PART III. PROBLEIPS CREATED BY INFILATION IN LENDIMTHROUGH INTERM4DIARITES

53. A substantial part of the Bank group's operations consists of

credit projects, i.e., loans to national financial intermdiaries for re-

lending to some selected sector of the economry.l/ The financial inter-

mediaries here concerned are those institutions that provide mediuum and

long-term credit to industry, such as development finance coqoanies, and

to agriculture, such as agricultural, or livestock, credit banks. These

institutions provide important services on the side of both savings and

investment. On the savings side, they act as repositories of the long-term

savings of people who do not have direct access to, or are not interested in,

equity investment, and who are not ideally served by commercial banks with

their low interest rates and essentially short-texm facilities. They tend

to deal with people who would otherwise find it inconvenient, even impossible,

to accumulate savings in monetary form, for instance, agricultural savers

and small urban savers. On the side of investment, they provide an. invaluable

addition to the flow of long-term monetary capital by tapping savings which

would otherwise be unused; and they help channel capital to relatively neglected

or needy sectors of the economy such as livestock farming, agriculture in general,

and risky industrial enterprises.

A. The Damagn Effects

54. Inflation damages the conditions required for the success of

finaansial intermediaries in various ways:

(1) by rendering money and assets designated in terms of money

unattractive as a form of saving, it both reduces the total

amount of personal (though perhaps not coxporate) saving and

directs much of what is saved into non-productive forms like

real estate, gold and foreign currencies;

(2) by offering an unwarranted transfer of real purchasing power

fr9nm lender to bQrrower it reduces the attractiveness of lending;

(3) by lowering or nllifying the real interest charged on loans

it destroys the ?ssential allocat^'ve function of the rate of

interest, and permits credit to be used for unproductive but not

unprofitable speculative activity;

(4) by introducing a large elerment of uncertainty about the future

value of money it shor'ens the -Vme horizon of both lenders

and borrowerr;, inducing them to commit themselves, if at all,

for shorter periods than under stable conditions;

(5) by eroding the real value of the intermediaries' finar+cia

assets it endangers their very existence;

1/ The appraisal of the specific projects ultimately fixauiced. by these

loans faces, of course, the same problems as discussqd in Part II.

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(65 by cwusing he government in many cases to impose price controlson selected sectors, particularly agriculture, it throttleseconomic activity in those sectors ,nd thus harms the inter-mediaries dealingin them.

From the Bank's point of view the damages to bfficient allocation of fundsand to the stability of the intermediary are of special and immediate concern,though in the long run all the above effects are relevant to the success ofintermediary institutions.

55. Where inflation has to be accepted as a fact of life for someyea±s to come, it becomes necessary to counter in some way its undesirableeffects in order to ensure the effectiveness and success of financial inter-mediaries. The best technique would be one which reproduced the conditionsof price stability, in other words, one which fostered accumulation of long-term savings at constant real value at an appropriate real rate of interest,lending for long periods at constant value and a suitable real rate ofinterest, and the preservation of earing power in the sectors in which theintermediaries deal. Clearly it would be difficult to do away with all thedeleterious effects of inflation with one technique of conpensation; twoor more could be used in conjunction to achieve the best result.

B. Four Possible Remedies

56. Various met-hods h'ave been suggested to counteract inflation. Westart wit-h the least satisfactory and work up to what we consider the besttechniques.

Subsidy, Protection

57. This is a ra-ter special case which applies to financial institu-tions whose borrowing is in a foreign currency but whose lending is in termsof local currencyg without p:rovisions for the maintenance of value of repay-ment in real tenrs. In such a case, a devaluation would automatically increasethe debt burden in terms of the domestic currency of the financial institutionwithout correspondingly increasing its loan receipts. For instance, a live-stock credit bank in Argentina receives an interest free loan (from abroador from the government) of pesos 350 million, to remain equivalent to $1 million,w.hich it lends out for a year. Sometime during the year the peso is devaluedby 20 percent, so that the banks obligations in pesos go up to pesos 4j20 millionwhile its receipts stay 4t pesos 350 million plus an interest charge of, say,7 percent, totalling pesos 375 million by the end of the year. Thus the bankultimately suffers a loss of pesos 45 million. Such an arrangement canobviously be very dangerQus to the institution, and some provision should bemade to protect it.

58. Usually, the national government undertakes thef burden of maintain-ing the value of the intermediary's debts. In Colombia, for example, thegovernment requires its agricultural bank (INCORA) to repay only the amountborrowed; the government meets any difference due to a change in the exchangerates. This method applies, however, to the special case of irntermediaries

with foreign liabilities and contributes noth'z- to the solution of thetwo maajor problems created by inflation, of attcctg deposits and allocat-ing funds, It only perpetuates previous problems and even accentuates thedistortion by drawing from government funds to su7t-c r'^ze borrowers and anypossible resource misallocation they may m.eke. It may, however, be usedin conjunction with some other technique whbich solves the domestic distor-tions faced by the intermediary, and may prove a desirable safegrgLz to -l-'growth of new institutions.

Higher Interest Rates

59. The natural reaction of a borrowing andl lending inst.tution toinflation would be to raise rtes paid and charged on its tran ;.Rctions, ithis were legally permitted. hiss may not, however, be a good vay of com-pensating for inflation, for the following reasons:

(1) The actual rates charged for loans have to be fixed beforethe loan is given, and will thus be based on anticipationsof price rises over the life of the loan. Clearly the inrterestrates would not correspond exactly to the actual inflationand the compensation would be haphaza-rd. The tendency forprivate institutions would be to over-compensate, that is, tocharge higher interest rates than expected rates of inflation, inorder to have a margin of safety. This would unduly tcx theborrowers, and might depress investment.l/ Official institu-tions may deliberately wish to undertake the risk of not chargingan extra margin above the expected rate of infl~tion; the govern-ment would then have to insure them against the possibility ofunplanned losses in real repayments.

(2) The raising of interest rates by itself would not prevent theshortening of lending periods normally occurring in inflations.Both the lender and the borrower would tend to shorten the lifeof the loan because both prefer to adjust the tp-rm of lendingand borrowing to the changing conditions. Inflation hasextremely damaging effects on long-term monetary contractseven if intewest rates are free to rise, because it introducesa random element of uncertainty. Consequently, long-term in-investment suffers in favor of shorter-term; the fonmer becomesmore difficult to finance by borrowing and re-borrowing whilethe latter becomes more convenient to both parties. In shortinflationary spurts, in particular, this tendency is exaggeratedand much institutional lending is specifically directed to self-liquidating (speculative) short-4-rm activity. In more protractedinflations, the natural relati.;n etween short-and long-term

1/ This happened in Brazil in 1965, when the cost of living rose by 45percent and interest charges in the non-bank credit market rose toover 100 percent per annum for about six months aind then fell to about60-70 percent. This market is supposed to provide a fair indicationof the true cost of borrowing in Brazil. See Economic Growth of Brazil,IBRD, October 23, 1967, Vol. I, para. 16,

- 19 -

investment more or less re-establishes itself, but long-terminvestment is still rarely financed but of borrowing in afree credit market.l/

65. For these reasons the raising of intere6t rates is not by itselfa satisfactory solution. Beasides this, in many countries the governrentor central bank imposes limits on rates chargeable on loans, so that hiddencharges have to be introduced., further comqlicating matters, introducinglegal problems, and increasing uncertainties. And though rates can be raisedto extremely high levels for short periods,2/ it is probably impractical tomaintain them for extended periods without destroying the fabric of thecredit system.

Shorter Lending Periods

61. As the foregoing argument shows., this is a natural consequenceof inflation. In some cases institutions have adopted it as a deliberatepolicy when prevented from revising interest rates freely, in order to lessenthe inflationary imnpact. This policy has all the disadvantages mentionedabove, plus I

(1) It does not provide a way to attract deposits or compensatesavers. If interest rates are fixed at negative real levels,all non-commercial bank financial institutions suffer a lossof deposits, for obvious reasons.

(2) It does.not make f6r a more rational aliocation of creditbecause no provision is made for charging a realistic price fqrcredit. It continues to subsidize the borrower, but shorterloan periods of, say, three months or even less, cancel out partof the subsidy because of the additional trouble and cost ofre-negotiating the loan.

In general, therefore, such a policy must be regarded as a lighly undesirablemeans of coiribatting inflation.

Adjustmnt of Terms to Inflation

62. Theoretically and practically the most satisfactory solution toadjusting either the loan principal and/or interest by some index of inflation;such an adjustment meets the problem directly and provides an adequate answer.

/ Brazil is again a good case in point. "It appears that during the lasteight years virtually the whole value of additions to real fixed assetsin private industry was financed by (a) funds generated within the firmsinvolved (62 percent including reinvested profits of foreign firms), and((b) new foreign investments and net foreign loans to private industry ...Equally striking are the insignificant amounts of medium- and long-termcredit that were available to the private industrial sector ... Indeed,since 1964 Bank credit to private industry seems to have financed lessthaan one-half of the tota:l additions to inventories, leaving nothing atall for the growth - which undoubtedly took place - in accounts receivable."Ibid.,, Vol. I, paras. 95-96.

2/ During the hyperinflation in Germany loans were even made at 20 percentper da.y.

- 2o

63. The adjustment of lending terms by an index of inflation is notby any means a new technique. Marshall aIvocated purchasing poer gu.aranteesfor loans in 1886, Jevons even earlier in 187' and Keyxnes in 1927; in recentyears various economists in different coUntries have advocated this techniquefor inflationary conditions.1/ Many countnies have used and are still usingthis device in various forms Finland,, Israel., France, the United States,Austria, and some Latin Amexican countries. Kn7lan, in particular, has hadan extremly successful experience, and. since l965 the use of the devicethere has spread to many financial institutions though Finland does not suffera high rate of inflation (about 48 percent in 10 years).

Ajections to Value-Lin

64. Conservative financia.il circles have, however, resisted the useof value-linked financial paper. If money is the accepted medium of exchange,most people naturally expect it to be also a good store of value; bankers,in particular, are reluctant to introduce a standard of value for deferredpayments which is completely divorced from the currency. This reluctanceis understandable since a proliferation of different standards may be compli-cated and difficult, but it is not fully justified,,because inflation doeshave a definite redistributive effect in fiich lenders lose to borrowers.65. It is also sometime.s argued, that the introduction of value-linkingby the authorities would be taken by the population as an indication thatinflation was acceptable to the government and the central bank and would notbe overcome in the near future; this may give rise to destabilizing expecta-tions and exacerbate the inflationary situation. Clearly there is so6re pointin this., and the timing and method of the introduction of a new device con-taining value-linking can be extremely important. But in a country whereinflation has become the normal way of economic life, the danger of a suddenloss of faith in the currency is slight. If the government were to publicizethe fact that the fight against inflation would continue and that value-linkedinstruments were only tq safeguard some portion of the population, the resistancecould easily be overcome. Experience in different countries shows, moreover,that value-linking has become acceptable with little destabilizing side effects.2/In the countries we are concenied with, value-linking of some sort is alreadyin use, and the psychological barrier does noot exist.

1/ For a good survey of the history end practice of this method, seeDavid Finch, "Purchasing Power Guarantees for Deferred PVments, t IMStaff Papers, February 1956 (pp. 1-22).

2/ Stanley Please, in Value-Link of DDo.e_tic. Bond Issues, unpmblisheddraft, IBRD, January 2,Y969, saysieitft refe'renle to Finlad #nd Israel,"But there seemed to be virtually no support for the view ..... that thedevice itself is inflationary because it reinforces peoples t expectationsthat prices will rise in the future" (page 62).

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Choice o& Index

66. The chief problem with value-linking is not its accentabilityin principle, but the acceptability bf the index to be used. The idealindex would reflect the purchasing pawer of money in the wide3t possiblecontext,.would be suitable to all sectors and areas of the economy, andequally relevant to both borrower and lender.

67. Unfortunately, in both theory and practice, this sort of indexdoes not exist. In theory, an index carn be ideal for all value-linking inan economy only if it accurately reflects, without bias or distortion, thedeclining value of money for all the people engaged in financial transactionsin all sectors land ardas in that economy. This requires that the economy issmall or unified enough that the rate and composition of price changes aremore or less similar in every inst,ance. Otherwise the use of a single averageindex will benefit borrowers and damage lenders in areas where- the purchasingTower of money declines faster than the average, and damage borrowers andbenefit lenders where it declines slower. In large underdeveloped countrieslike Brazil, wide disparities do in fact exist between the rate and composi-tion of price changes among different regions and . Btween towns and villages,partly because prices in general change erraticaJ.xy at different rates andpartly because the structure of relative prices changes differently.

68. In practice, there is an even knottier problem. General priceindices of the type that may seirve as the ideal index are very difficult tocompute for whole countries. The paucity and poor quality of data,, thecomplicatio;ns of weighting, the problems introduced by price controls, allassume immense dimensions when index coverage is enlarged to include wholecouintries rather than particular areas.l/ In inflationary countries generalindices are compiled only for the largest cities (the cost-of-living index)or for the organized sector (the wholesale price index). They are hardlyindicative of price changes in, say, smaller towns or villages, which may bethe areas where special financial institutions are particularly needed.

69. For these reasons, therefore, it would be unrealistic and fruitlessto search for an ideal index for value-linking. Though an arbitrary averageindex could be imposed by the government throughout an economy, the resultwould probably be that in areas obviously out of line with the average index,people would stop using value-linking and rely on some other method ofcompensating for inflation, or would regress to the point of not enteringinto financial contracts at all. To introduce value-linking on any scalewould consequently require the u.se of indices appropriate and equitable tothe parties concemed in different types of loans in different sectors.

70. But this, too, raises problems. The application of many differentindices for value-linking, with different types of borrowers and lenders

1/ There may also be problems of trustworthiness and acceptability ofindices, which are discussed below (pages 22-26).

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using different scales of value adjustment introduces confusion and.possible distortions into the finance market.l/ It may even lead. to mis-allocation of resources of the economy and hinder the development of anefficient credit market, perpetuating the divisions between different sectorsand preventing an easy interflow of resources. It is difficult to see howthese problems can be avoided.

71. Clearly, index-linking, if it is to be used as a tool of economicpolicy at all, must be used as widely as possible; otherwise the intermediaxythat uses linking by itself will drive borrowers to other sources of creditwhile attracting large numbers of lenders. If value-linking is widely usedon the basis of different indices, it will create some new distortions,Supporters of value-linking can plausibly argue that the benefits of value-linking will far outweigh its defects, and that the most we can do is tominimize the new distor4ions.

72. In order to do this, we can set down a sixple ruile-of-thunib thatthe index used for value-linking must be the most general available andacceptable in any given set of conditicns facing a financial intenmediary.If the inflationary economy is so constituted that in spite of all effortsa workable index-linking system conpris3es numerous indices, the governmentshould ensure that particular intermediaries or areas of funds are notdeprived while others benefit, and that healthy development of the capitalmarket remains possible. This may require selective subsidization,effortsto improve the compilation and coverage of indices., and flexibility in theuse of index-linking will certainly produce fewer distortions than iteliminates, and its benefits will be immense.

73. The following indices are commonly proposed or used for value-linking.

Gold or Foreign Exchange Index

74. This index has been used in some Latin Anmrican countries andIsrael, with mixed succVss.2/ It possesses the great advantages of simplicityand freedom of index com'putation pmblems, and, if left free to adjust tomarket forces, provides a reasonable approximation to the fall in the purchas-ing power of the domestic qurrpncy. Problems arise when it is subjected togovernment control and to specilative pressures. If devaluations are periodicand the increments large, the foreign excha-nge rate can be a very misleadingindex of value, particularly if it is subjected to large fluctuations because

1/ See David Finch, loc. cit., page 21, who specifically recomnends theuse of a standarrdized index for loan 74,§ustment. He does not, however,consider the problems arising from the inapplicability oir lack of ageneral index.

2/ Israeli experience has been particularly unhappy, and after the largfledevalluation in 1962 this index was dropppd for value-linking purposes.See PLease, and Morag, oc. cit. Israeli problems arose more from thelarge jumrp in the exchange rate than anything else; a steady depreciationmight have worked quite well.

K E S: e R N 4S t S- r,. ;; S4- .:L i*- .i! -^t ASs, ,ov=tv,IV.r*W .;:o:W....#G-,*.,'\[/'si.:<st4:.-.l- .-..................... kt sY-u-J.L/ ...... #:6 s .IS. X ; '....,...,-.i.C*},..

23 -

of "hot money" movements. In countries which have adopted the system ofmore or less constant depreciation in line with infllation, iti may serveas a useful index as long as speculation is kept well in hanad.. It may alsoprove more acceptable than other indices, particularly in cities, becausepeople have become used to holding part or all of their savings in foreigncurrencyA For the same reason it may appear rather remote to rural saversand borrowers, though in actual fact the exchange rate may be more sensitiveto agricIltural price dhanges than industrial ones if the country's exportsare pred6minantly agricultural.

Specific Price Index

75. Another simple and easily monitored index is the price of thespecific conmdity produced by the borrower. It has been used in France withsome success, and some Latin American cc,untries are also experiienting withit. Economically it is hard to justify the choice of this sort of index toequitably serve both parties to the transaction, unless, as is very unlikely,the particular price chosen accurately reflects the rise in the general pricelevel, i.e., coincides with the "average" price. However, in practice, itis likely to prove the most acceptable index to borrowers,l/ especially thosewhose selling prices tend either to fluctuate more widely than dthers or todecline consistently in real terms. There is some reason to argue thatborrowerp whose incomes are subject to unpredictable and large fluctuationsshould have their debts adjusted to match their incomes. In the long runneither borrower nor lender is likely to gain at the expense of the other, andthe borrower will certainly find it more convenient to meet his obligations.

76. When the borrower's se'lling price declines constantly in realterms, however, it is difficult to see why the burden of his debt should bereduced accordingly to the detriment of the lender. If the decline is dueto controls imposed by the governmexnt as is comaon with agricultural produc-tion, the saver is in effect forced to subsidize the ultimate purchaser ofthe product. This form of subsidy is harmful to investmnent and resourceallocation, and, what is more, does little to encourage the production ofthe commodity under price control. By cheapening agricultural credit, forexample, while imposing price controls on foodstuffs, the government willdiscourage agricultural production on the one hand, and encourage the in-efficient use of credit by farmers on the other. The correct policy wouldbe to let the farmers bear the full burden of their debts in real terms butc, remove price controls or subsidize their incomes directly.

77. If the price decline for thfe specific commodity is due not togovernmeent controls but to changes in market conditions, there is no reasonwhy the producer should get credit cheaper than under stable price conditions;

1/ If there is no other form of indexing available in the economy, it mayalso prove quite attractive to lenders, becaus'e any form of value adjust-ment to inflation will probably draw forth substantial savings in monetaryform. Whether or not it is the most effective index for increasing suchsavings is a different problem.

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he should be reducing or stopping the production of that commodity, andcredit should be switched to commodities in greater demand. This pointis worth remembering because the use of the individual porice index can ijnthese cases lead to very undesirable results, in spite of its other attrac-tions. The use of such ndices will also be inoractical on a large scale,because it would involve hundreds of different standards of value adjustment.

78. The use of the spiecific pri-e index may nevertheless be recommndedin those cases where nmre general indices are not available or reliable,and where such an index is not specifically used as a subsidy to the borrovr.Thus in rural areas it may be the only acceptable index for value-linking,at least initially; it could be easily checked by bQth parties and, assumingno government interference with prices, would not be liable to deliberatedistortion one way or the other.

79. Many variations on this them. are also possible. A conpositeindex of different kinds of agricultural prices could be used; a profit-sharing arrangment could be introduced so that the lender enjoyed some ofthe benefits of equity-type investment; t-he index could be periodicallyrevised and extended until a realistic general index of prices in rural areaswas built up, etc. As a practical technique it has much to recommend it.l/

Ejidex

80. A wage index is the counterpart to the specific price index on thesavers' pide. It adjusts the value of loans to the real incore of most smallsavers, and is likely to prove most acceptable to them as a value-linkingdevice. The wage index, especially in urban areas wiere unions are strongand wages are adjusted constantly to the rising cost of living, can generallybe a good indicator of the rate of inflation. It has two defects. First,the adjustment of money wages to inflation may be affected by political andfortuitous factors (rises in pro4uctivity, strength of union leaders, formof linkage to cost of living, etc.), and may at tiTms give a misleadin^indication of the value, of money. Second, wages may lag behind the rise inthe cost of living by up to a year. When inflation is accelerating, a wageindex favors borrowers against lenders; in periods when inflation is decelerat-ing, real wages lead prices, and the index favors lenders against borrowers.In practice, these are not very serious defects, and a savings-,nd-loan schemein Chile has been using this index among others wth great succvss.

81. The main limitation of the wage index is that it is not relevantoutside industrial and urban areas, or even withir. dustrial a s that donot have organized trade unions. Wages which are adjusted haphazardly toinflation cannot serve as guides to valcur- asjustment.

General, Cost-of-Living or Wholesale Price Index

82. For the purpose of index-linking, any of these i-ndices would beappropriate if they were accurate, unbiased and generally available. Theyare the closest approximations we carn get of the ideal index, Unfortunxately,

1/ A small practical advantage of the specific price index is that it isalways available, whiJe more general indices are published annually orsemi-annually after considerable lags.

25

the indices that actually exist are usually limited in coverage, sorpetimesinaccurate, and suspected of bias. The cost-oeP-living index, compiled onlyfor the largest cities, is hea.vily influenced by controlled prices on suchitems as rent, public utility tariffs and some foodstuffs and understatesthe true extent of inflation. The wholesale price index, which would reflectmore closely the prices affecting the borrower, does not give an acc uratepicture of the value of money to the saver. The general price index faceseven thornier weighting problems and is undeperndable in most highly inflation-ary countries.

?utti4g Index into Prac-tice

83. All general indices of prices are open to criticisms, true or false,of "Trigging"l bias, and inaccuracy, which nay reduce their acceptability. Oneof the biggest problernLs in the introduction of. index-linking is to get a widesection of the population concerned to accept its honesty and usefulness;these problems can be greater for general than for specific indices. Brazilfaces the pmblem of having a multiplicity of indices which give quite differentresults, none of which is entirely acceptable, but still those indices whichprove acceptable are used in the area of its coverage (chiefly Sao Paolo andRio). Chile has inicluded the cost-of-living inde2t as one of the value adjustersin its successful savings-and-loarL scheme, and Israel and Finland have alsohad happy results from this index.

84. In general, however, even the cost-of-living index cannot have a.wide application in inflationary underdeveloped countries. It may be usedin the ve-ry largest cities, but even there it is possible that people wouldprefer a foreign exchange index or a wage index. In the long run it would,of course, be best to use a general index, but that may have to wait until theidea of linking has become comaonly accepted and index compilation has inproved.In all non-urban areas, the only pr4'tcticable indices may be specific priceindices or the foreign exchange index.

85. No index is thus completely satisfactory, and all the qualificationsmentioned above must be borne in mind in applying them. It is clear that thegovernmeat will have to take the initiative in introducing value-linking, andtp do this on a sufficiently wide scale it may have to go to a great deal oftrouble and expense. A promotional campaign may be required to pave the way,and subsidies may be needed if different indices give differing results, orif savers and borrowers with an inteimediary have to be compensated by differentindices. In some cases borrowers may have to be charged less than full adjust-ment to overcome their initial misgivings or to compensate for the extra riski-ness involved in investing in commodities that have particularly erratic prices.

86. It is evident, however, that some form of index-linking is necessaryfor the success of financial intermaediaries under high inflation. No otherpolicy short of stopping inflation c:reates conditi7 ons under which they canbegin to operate. The potential benefits of index-linking on a broad scaleare immense, and are likely to far outweigh any distortions that the choice ofindices causes.

26 -

87. Is it plausible that investors,, particularly in the industrialsector which has been managing fo- a long time without financial intermedariespwill accept and use indexed loans?. Such loans will involve a real cost bothem much higher thian commercial bank loans or self-financing, the only domes-tic sources of finance. There are many mrasons why they should accept., evenwelcome., indexed loans from nowy-established financial intermediaries: itwill open up an entirely new source of long-term institutional finance whichdoes not exist in highly inflitionary economies; if the rate of interestcharged is reasonable, the funds can be used productively to yield high profitstthe real cost of borroing outside commercial banks is very high; capital r. o c.externally is perhaps mowre difficult to negotiate and in effect is equivalentto a loani tied to the foreign-exchange index, If the intermediary also under-takes promotional work such as the dissamination of new technique.,, research,project appraisal and the like, investors will gain immensely from theirassistance.

C. S&um!azY

88. In summary, a high and persistent inflation creates conditions andattitudes detrimental to the founding of financial intedrmdiaries like develop-ment banks, agricultural -redit banks, and building societies. These conditionscannot be adequately combbatted by raising interest rates or subsidizing inter-mediaries. The best solution seems to be the tying,of all debts to some indexof inflation to maintain their value in real terms. There is no single indexwhich can ideally serve the whole economy., and perhaps many different kindsof indices will have to be used, at the cost of some confusion and distortionin the credit market. However, the benefits of even this sort of imperfectsystem are immense in terms of increased monetary saving, better allocationof resources, and the fostering of long-tem financial contracts. The maininitiative would probably have to come from the government, since initiallya great deal of trouble and expense may be required. The limited experiencewithf index-linking in 4ghl,y inflationary ecpnomies does, however, indicatethat the results are worth the trouble.

Bibliography

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