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Finance &Development

©International Monetary Fund. Not for Redistribution

December 1983/Volume 20/Number 4

_ Finance tDevelopmentA quarterly publication of the International Monetary Fund and the World Bank

Mohsin S. Khan and 2 Sources of payments problems in LDCsMalcolm Knight External and domestic causes of deficits, 1973-81

Carl Dahiman and 6 The transfer of technologyLarry Westphal Factors in the acquisition of technology

Vito Janzi 10 The underground economyCauses and consequences of this global phenomenon

Kyung Mo Huh 14 Countertrade: trade without cash?

Shahid Javed Burki 16 UNCTAD VI: for better or for worse?International negotiations in a multipolar setting

Russell Kincaid 20 Korea's major adjustment effortEffective policymakmg in difficult circumstances

Yves Rovani 24 Energy transition in developing countriesLarger investments and more efficient use needed

Harinder Kohii and 28 Industrial energy conservation in developing countriesEdilberto Segura Substantial savings possible

32 World economy in transitionInterest rates in five major countries

Padma Gotur 33 Interest rates and the developing worldHow rates in developed countries affect LDCs

Alexandre Kafka 37 John Maynard KeynesTo mark the centenary of the birth of a great economist

Henry Owen 39 Changing public attitudes toward aidGuest article

Jacob Meerman 41 Minimizing the burden of recurrent costsWorld Bank experience in sub-Saharan Africa

Gerard Rice, James Corr, and 44 Maintaining financing for adjustment and developmentSusan Fennel/ The 1983 Joint Annual Meetings of the Bank and the Fund

48 BooksBooks on rational expectations, structuralist macroeconomics, the psychology oftaxation, development strategies, and successful management reviewed byHomi Kharas, Kyle Peters, Alan Tail, Phiroze Medhora, and Dale Weigel

52 Letters

53 Index for Volume 20 (1983)

The Editor welcomes views and comments from readers on the contents of the journal.The contents of Finance & Development may be quoted or reproduced without further permission. Due acknowledgement is requested.


Sources ofpayments problemsinLDCs

The role of external anddomestic factors during1973-81

Mohsin S. Khan andMalcolm Knight

The past ten years have proved to be a per-iod of considerable stress for the non-oildeveloping countries. Throughout most ofthe 1970s, a combination of events causedthe international economic environment tobecome less conducive to their stability andgrowth and to aggravate their problems ofeconomic management in general—andbalance of payments adjustment in particu-lar. External developments, including sub-stantial fluctuations in the world marketprices of primary commodities, sharp in-creases in the price of energy products, theslowdown of economic activity in the in-dustrial countries, and, toward the end of

the period, sharp increases in real interestrates in the international capital markets,were all major contributors to a seriousdeterioration in the current account posi-tions of most non-oil developing countries.At the same time, domestic developmentsin a number of economies also played asignificant role in exacerbating paymentsdisequilibrium, as inflationary demand-management policies—combined withrigid exchange rate policies and restrictionson trade and payments—created domesticdemand pressures and led to a cumulativeloss of international competitiveness and tocurrent account and overall balance of pay-ments difficulties.

Of course, some non-oil developingcountries were much more severely af-fected by these adverse factors than others,but for the group as a whole the combinedcurrent account deficit expressed as a pro-portion of their exports of goods and ser-vices, rose sharply between the period1967-73 and 1974-81 (see table). During thelatter period there were also considerableannual fluctuations in this ratio. In the im-

mediate aftermath of the first oil price in-crease in 1973-74, there was a sizable wors-ening of the current account positions ofthe non-oil developing countries. Favorablemovements in the prices of primary com-modities led to a marked improvement in1976-77, but from 1977 onward the ratio oftheir combined deficit to exports of goodsand services continued to rise steadily. Thesecond round of oil price increases in1979-80 appears to have had a muchsmaller impact than the earlier increase;indeed for the non-oil developing countriesas a group there was no important differ-ence between the deterioration observed inthe two years preceding the oil price in-creases (1977-78) and the two years thatfollowed it (1980-81).

The factors that are typically identified asthe major determinants of these current ac-count developments are (1) the deterio-ration in the terms of trade; (2) the slow-down of economic activity in the industrialcountries; (3) the sharp increase in the levelof real interest rates in international creditmarkets, particularly toward the end of the

Non-oil developing countries: current account balances and selected variables, 1967-81(In percent)

Current account balance1

Terms of trade change2

Foreign real interest rate3

1967-72(Average)

-17.2-0.4

5.4

1973

-10.66.7

-17.9

1974

-24.8-5.1

-20.1

1975

-30.9-10.0

8.1

1976

- 18.1

5.6- 1.4

1977

-12.96.9

-7.1

1978

-15.2-5.4

3.3

1979

- 17.70.8

-4.7

1980

-20.4-6.4-4.6

1981

-22.4-8.117.4

Sources: IMF, World Economic Outlook, 1982, and International Financial Statistics.1As a percent of total exports of goods and services.Percentage change.Eurodollar deposit rate adjusted for changes in an index of export prices of non-oil developing countries (expressed in U.S. dollars).

Finance & Development I December 19832


1970s; and (4) inadequate or insufficient do-mestic adjustment, signaled by rising fiscaldeficits and an appreciation of real effectiveexchange rates. This list is certainly not ex-haustive (for example, it omits the effects ofdomestic supply shocks and rising protec-tionism in export markets), but it doescover most of the more important causes.For descriptive purposes, it is useful toview the first three of these factors as "ex-ternal," in the sense that the typical devel-oping country was powerless to offsetthem. Analogously, changes in fiscal defi-cits and movements in real effective ex-change rates are "domestic" factors to theextent that a country's economic policiesinfluence both its nominal exchange rateand domestic input and output prices.

It is, of course, unwise to try to push thedistinction between domestic and interna-tional factors too far. After all, their respec-tive influences on current account positionsare so closely interrelated that it is oftenimpossible to disentangle them. Neverthe-less, in order to formulate successful poli-cies for external adjustment in the non-oildeveloping countries it is important to ex-amine each major factor separately so as togain a better appreciation of the role that ithas played in the past and might play in thefuture.

Terms of trade

The deterioration in the overall terms oftrade of non-oil developing countries be-tween 1973 and 1981 represented a distinctchange from the previous improving trend.A considerable part of the deterioration canbe attributed to the rise in import pricesthat resulted from the fourfold jump in theworld price of energy products in 1973-74and the further substantial increase in1979-80. The declines in the terms of tradethat were associated with each price in-crease were broadly similar. In both cases,price increases for primary commoditiescoincided with the oil price rise and helpedto mitigate the adverse effect for a numberof non-oil developing countries. The over-all price index of non-oil primary com-modities rose by 28 percent in 1974, andduring 1979-80 it registered an average in-crease of about 12 percent a year. Whilecommodity prices fell in 1975, 1978, and1981, the average annual rate of increasewas nearly 12 percent for 1973-81. Further-more, it is likely that the increase wouldhave been even larger had growth rates inindustrial countries not decelerated mark-edly toward the end of the 1970s and putdownward pressure on primary commod-ity prices.

The predicament of the non-oil develop-ing countries in the face of deterioratingterms of trade was not unique. On average,

the terms of trade of the industrial coun-tries actually deteriorated by a greateramount during this period, a fact that isperhaps not surprising, given the relativelylarge share of petroleum products in theirtotal imports. For a variety of reasons, how-ever, industrial countries were in a betterposition than the developing countries toadjust to the deterioration, so that the im-pact on the latter group was more severe.The only gainers in the 1970s were, as onewould expect, the oil exporting countries,which, as a group, experienced an averageimprovement of about 25 percent per an-num in their terms of trade.

Broadly speaking, the evidence in thetable seems to suggest that movements incurrent account ratios and the terms oftrade of the non-oil developing countriescoincided during the period under consid-eration. Using the aggregated figures in thetable to check this association, the annualchange in the combined current accountposition of the non-oil developing coun-tries can be correlated with the yearly per-centage change in their terms of trade. Al-though the results of this simple statisticaltest can only be taken as suggestive, owingto the small number of observations, theyconfirm the strong negative impact of achange in the developing countries' exter-nal terms of trade on their current accountpositions.

Industrial country growth

Growth in the industrial countries alsohas a direct impact on the current accountsof the developing countries through its in-fluence on both the prices and volumes oftheir exports. There was a pronounced de-cline in the average growth rate of the realgross national product of industrial coun-tries between 1963-72 (5 percent) and1973-81 (3 percent); for 1979-81 the averageannual growth rate was very low—only 2percent. Growth in the volume of exportsof non-oil developing countries also fell,but modestly, from 6.7 percent in 1963-72to 5.9 percent in 1973-81. In contrast towhat might have been expected, the rela-tively sharp fall in the average growth rateof imports of industrial countries betweenthe two periods, resulting from the fall intheir overall growth rates, was apparentlynot reflected in a proportionate declinein export growth for non-oil developingcountries.

It has been argued that two main factorshelped to minimize the consequences ofthis slower growth of industrial countries'imports on the exports of non-oil develop-ing countries during 1973-81. First, non-oildeveloping countries, particularly thosewith a relatively higher proportion of man-ufactures in their total exports, were able to

capture a larger share of the industrialcountries' slow-growing import volume.The process was assisted at the beginningof the period by tariff preferences, but wasto some extent reversed later, as protec-tionist pressures rose in the industrialworld. Second, non-oil developing coun-tries were able to increase their total ex-ports (in volume terms) faster than theirexports to industrial countries by directinga larger share to oil exporting countries, asthese became increasingly important mar-kets for exports of primary products andmanufactures.

Foreign real interest rates

The third major external factor affectingdeveloping countries' current account posi-tions, particularly during the late 1970s,was the sharp increase in the cost and avail-ability of financing from the internationalcredit markets. Service payments on exter-nal debt had not been a very serious prob-lem for many non-oil developing countriesduring most of the period prior to 1975 be-cause conditions in the international creditmarkets were generally favorable and alarge proportion of outstanding debt, par-ticularly for the low-income countries, hadbeen made available by foreign officialinstitutions during the 1960s at fixed con-cessionary rates. As a result, the effectiveinterest rates on external debt, when ad-justed by the increase in their export prices,yielded real interest rates that were low ornegative for many non-oil developingcountries.

In 1978 this picture changed quite dras-tically. Owing to adverse terms of tradeshocks and slow export market growth, thenon-oil developing countries' stock of ex-ternal debt, particularly short-term debt,rose sharply. In addition, interest rates ininternational capital markets were climbingto postwar highs at a time when devel-oping countries' export prices began toweaken, so that average real interest rateson external debt became positive (seetable). Their strongest impact was on thedebt-service burdens of those countrieswhose stocks of external debt were rela-tively large because they had already ex-perienced substantial current account defi-cits in earlier years and had resorted toforeign financing. From this point of viewthe recent rise in debt-service burdens canalso be seen at least partly as the laggedeffect on current accounts of the other fac-tors that are being discussed in the presentarticle.

Domestic factors

While factors beyond the control of thedeveloping countries played a large role inthe deterioration of their current account

finance & Development I December 1983 3


positions during the 1970s, domestic de-mand pressures were also an importantfactor in their external payments problems.A wide spectrum of developments can giverise to excess demand, but in non-oil devel-oping countries, as elsewhere, an increasein aggregate demand can often be traced toexpansionary government policies that re-sult in fiscal deficits. A rise in governmentspending, as evidenced by an increased fis-cal deficit, acts directly to expand domesticdemand, and if it is financed by domesticmonetary creation the expansionary effectsare intensified. Other things being equal,such increases in demand have a strongnegative impact on the current account.Adding to this problem is the fact that ex-cess domestic demand is normally reflectedin domestic inflation, and if the authoritiesare not able or willing to alter the nominalexchange rate to keep pace with the differ-ential between the domestic and foreigninflation rates the real exchange rate willappreciate. (The real effective exchangerate can be defined here as the home coun-try's consumer price index relative to animport-weighted average of consumerprice indices in partner countries, adjustedfor the nominal exchange rate.)

The combination of fiscal deficits and realexchange rate appreciations had seriousconsequences for the non-oil developingcountries' current account balances overthe 1970s. On average, the fiscal positionsof non-oil developing countries, measuredas a proportion of GDP, were consistentlyin deficit throughout the period 1973-81.The weighted average deficit rose fromabout 2 percent in 1973 to a little over 3percent in the period 1975-76. (These aver-ages are based on the sample of 100 non-oildeveloping countries presented in theWorld Economic Outlook, 1982.) After a slightimprovement in 1978, there was a signifi-cant worsening, and the ratio of the fiscaldeficit averaged about 3 J/2 percent during1979-81.

Partly owing to the direct and indirecteffects of rising fiscal deficits, inflation wasalso endemic in most non-oil developingcountries during 1973-81, averaging about29 percent a year, compared to about 12percent for 1963-72. More important, how-ever, from the point of view of the currentaccount, there was a tendency for exchangerate changes not to keep pace with the dif-ferences between domestic and foreign in-flation, resulting in an appreciation of thereal effective exchange rate. In this way,fiscal deficits, domestic demand pressures,inflation, and the real effective exchangerate were closely interlinked, and tended torise together. Such a link has been docu-mented for a number of countries. Thebehavior of the real exchange rate, essen-

tially being the outcome of changes in thenominal exchange rate and domestic infla-tion, reflects the way in which exchangerate policy and demand-management poli-cies are coordinated.

An increase in the real effective exchangerate is clearly a fundamental determinant ofa deteriorating current account since, otherthings equal, it tends to raise domestic de-mand for imports and to reduce foreign de-mand for exports. Further, if the homecountry has little influence on the prices ofits exports because they are fixed in worldmarkets, and if domestic nominal wagesrise in line with domestic prices, an appre-ciation of the real exchange rate induces acost squeeze on the exporting sector thatreduces the supply of exportables.

On the basis of these effects, it seemslegitimate to view movements in the fiscalposition and the real effective exchangerate as useful indicators of the domestic fac-tors that would typically be expected to in-fluence the current account. At the sametime, it should also be kept in mind thatexternal factors, such as changes in theterms of trade, may also exert a systematiceffect on the real effective exchange rate, sothat the latter is not always a reflection ofdomestic developments alone. For exam-ple, a worsening of the terms of trade re-sulting from an increase in import priceswould raise the domestic price level. If do-mestic policies (including exchange ratepolicy) were not changed, the real effectiveexchange rate, as defined here, would tendto appreciate. This is one reason for thepractical difficulties mentioned earlier ofmaking a clear-cut distinction between so-called external and internal factors.

Empirical evidence

It is widely acknowledged that each ofthe factors described so far played a signifi-cant role in the substantial deterioration ofcurrent account positions for the group ofnon-oil developing countries between 1973and 1981. Nevertheless, there is a differ-ence of views about the relative contribu-tions of each of these factors, both for indi-vidual countries and for the group as awhole. This is a question of considerableimportance. The particular combination ofadverse developments that the group of de-veloping countries had to face in the 1970swill, it is hoped, not be repeated during the1980s. But policymakers must still addressthe question of how a different combina-tion of domestic and external develop-ments would be likely to affect the currentaccount positions of the non-oil developingcountries.

One possible approach is to assess thecontribution of each of the factors on thebasis of empirical tests for all those coun-

tries for which the necessary publisheddata are available. In the research describedin this article, a simple model was used thatmade the current account position, ex-pressed as a proportion of total exports,dependent on the external and domesticfactors discussed. Estimates of the influ-ence of these factors were obtained using asample of the 32 countries for which thenecessary data were available for the period1973-80. These data were then "pooled" toproduce a single sample covering 8 annualobservations for each of the 32 countries.

The exercise yielded statistically signifi-cant results suggesting that the variablesrepresenting the terms of trade, fiscal defi-cits, real effective exchange rates, and thelevel of international interest rates in realterms had definite effects in the expecteddirection on the current account ratios ofnon-oil developing countries during theperiod under review. The fifth factor,changes in growth rates in industrial coun-tries, also appeared to induce changes inthe current account ratio, but the effect wasnot as significant, empirically, as in thecase of the other variables. This probablyreflected the fact that non-oil developingcountries were partially successful in off-setting the direct effects of the slowdown inindustrial countries by curtailing importsand, to a lesser degree, by increasing theirexports to other regions.

While each non-oil developing countrywas obviously affected by its own particular combination of factors, these resultshelp to explain the determinants of the cur-rent account ratio for the "average" coun-try in the sample. For example, the esti-mates suggested that a 1 percentage pointincrease in the ratio of the average coun-try's fiscal deficit to its GDP would cause itscurrent account, as a proportion of its ex-ports, to deteriorate by about half a per-centage point. A 1 percentage point fall inindustrial country growth rates was esti-mated to reduce the current account ratioby a little less than half a percentage point,while a similar rise in the real foreign inter-est rate would induce a fall of less than ahalf percentage point. By the same token, a1 percent deterioration in the externalterms of trade or a 1 percent appreciation inthe real effective exchange rate would lead,on average, to a decline of about half a per-centage point in the current account ratio.Finally, trend factors that are not separatelyidentified appear to have exerted a smallnegative effect on the average country'scurrent account position.

In order to judge the relative contribu-tions of the various external factors to thecurrent account positions of the non-oil de-veloping countries in 1973-81, it is impor-tant to consider both the quantitative im-



pact of a given change in each factor andthe actual changes in the factor that oc-curred during the period. On this basis, theempirical work suggested that the most im-portant single influence on current accountdisequilibrium in the non-oil developingcountries was, indeed, the deterioration intheir terms of trade. Next in importancewere fiscal deficits and movements in thereal effective exchange rate, which wereof roughly equal significance. Finally,smaller, though still significant, influenceswere exerted by movements in real foreigninterest rates, trend factors, and growth inindustrial countries.

These results certainly suggest a majorrole for the terms of trade deterioration inthe current payments experience of a broadgroup of non-oil developing countries dur-ing the 1970s. Nevertheless, they also sug-gest that, on average, the individual coun-try could have offset some part of the effectof adverse exogenous shocks on its currentaccount position by using an appropriatecombination of demand-management andexchange rate policies.

For instance, depreciation of the real ef-fective exchange rate, together with fiscalrestraint, could have been applied in orderto keep the current account ratio fromworsening markedly in the face of deterio-ration in the terms of trade. This assumes,of course, that the authorities were in aposition to alter the real exchange rate bychanging the nominal rate, an issue onwhich there is considerable dispute on boththe theoretical and empirical levels. It couldbe that, owing to widespread indexation,domestic factor prices would tend to snapback following a devaluation, leaving thereal exchange rate unchanged. Despitesuch obvious problems, it seems reason-able to assume that at least some portion ofthe current account effects of adverse inter-national developments could have beencounterbalanced by a combination of amore flexible exchange rate policy andtighter demand-management policies de-signed to keep domestic inflation in check.

While such real sector adjustments arecertainly very painful for a low-incomecountry, they would seem preferable to thealternative of failing to adjust or, worsestill, allowing the real effective exchangerate to appreciate and being forced to un-dergo highly deflationary and disruptiveadjustment at a later stage.

It should be stressed, of course, that theeffects of these policies would be severelyreduced if a large group of non-oil devel-oping countries tried to undertake policiesof exchange rate depreciation and domesticrestraint simultaneously, since their termsof trade would tend to deteriorate and tooffset the positive effects of the exchange

rate action. Since total world demand formany primary commodities is not very re-sponsive to price reductions, this raises apolicy issue that has become all too familiarduring the past year: an exchange ratechange will tend to be more effective for anindividual developing country if its com-petitors refrain from similar action; obvi-ously the beneficial effects of such a policywould be severely limited, or even elimi-nated entirely, if it were undertaken simul-taneously by a large group of developingcountries.

Financing and adjustment

The empirical tests support the hypothe-sis that both external factors (representedby the longer-run decline that has occurredin the terms of trade, the slowdown of eco-nomic growth in industrial countries, andthe increase in foreign real interest rates) aswell as domestic factors (captured bychanges in the fiscal position and move-ments in real effective exchange rates) arerelevant in explaining the deterioration ofcurrent accounts of non-oil developingcountries during the past decade. Theseresults also suggest the importance of cir-cumspection in attributing the current ac-count imbalances experienced by non-oildeveloping countries during the 1970s toany single cause.

It has sometimes been asserted that thenature of a balance of payments stabiliza-tion program depends on the origin, orproximate cause, of disequilibrium. Thisview holds that if a payments deficit isthe result of excessively expansionary

Mohsin S. Khanfrom Pakistan, is Advisor inthe Research Department.He was educated atColumbia University and theLondon School of Economicsand joined the Fund in1972. He has publishedarticles on monetary andinternational economics.

Malcolm Knighta Canadian, is Chief of theExternal AdjustmentDivision in the ResearchDepartment. Prior to joiningthe fund, in '1975, hetaught at the London Schoolof Economics. He haspublished work ininternational finance.

demand-management policies, the appro-priate cure involves domestic demand re-straint, whereas if the problem is caused byexogenous factors, such as a fall in theterms of trade, no adjustment is necessaryand foreign financing should be provided.Since our results indicate that both types offactors were at work during the 1970s andsince, as has already been mentioned, it isexceedingly difficult to separate the relativecontributions of domestic and external fac-tors to current account instability in adeveloping country, it would seem to makemore practical sense to adopt an alternativeview that has often been implicit in thework of the Fund. This view suggests thatthe question of whether a deficit oughtprincipally to involve adjustment or finan-cing should depend, among other con-siderations, on whether the imbalance isviewed as permanent or temporary, irre-spective of its origin. If developments thatgive rise to balance of payments difficultiesare expected to be short-lived and self-reversing, they may involve a need for tem-porary financing; permanent changes, onthe other hand, necessarily require adjust-ment of the basic supply-demand balancein the economy.

While one can argue that the slowdownin growth in industrial countries and thehigh level of foreign real interest rates aretemporary phenomena and are likely to bereversed in the not so distant future, thedeterioration in the non-oil developingcountries' terms of trade since 1974 appearsto have been more of a long-term change.The terms of trade fell in five of the eightyears 1974-81, and a further sharp declineof close to 12 percent is estimated to havetaken place in 1982. Some financing of thedeficits created by terms of trade changesdid occur, but the situation also called for asubstantial adjustment effort. In terms ofthe framework of this article, evidence ofinsufficient adjustment in a number of de-veloping countries is seen in the way theirreal effective exchange rates appreciatedand fiscal deficits expanded during thisperiod. For individual countries, suitableadjustment would have meant pursuing amore flexible exchange rate policy, supple-mented by the application of a broad rangeof demand-management policies. Somecountries, notably those among the groupthat are classified as major exporters ofmanufactures or "newly industrializedcountries," did adopt such a strategy withconsiderable success. However, the begin-ning of the 1980s also found a large numberof non-oil developing countries experi-encing increased current account deficitsresulting not only from adverse interna-tional factors but also from domestic devel-opments during the decade. HD

Finance & Development / December 7983 5


Issues in the acquisition of technological capability by developing countries

Carl Dahlman andLarry Westphal

Throughout history, the assimilation oftechnologies invented elsewhere has beencentral in raising living standards. Themodern era differs from previous epochs inthat although there are greater disparitiesnow in technological levels among coun-tries, there is also greater ease of commu-nication and transportation. These differ-ences have enhanced both the perceivedand the real gains from acquiring foreigntechnologies—hence the increasing promi-nence of technology transfer in discussionsof development.

Market failures in the creation and thediffusion of technology are at the heart ofthe international debate about technologytransfer. Technology has characteristics of apublic good in that, once produced, it is notdepleted through further use by others. Itis usually presumed that the cost of trans-ferring technology is zero and that addi-tional uses of the technology do not detractfrom its value. On those grounds, achiev-ing optimal welfare requires that tech-nology be available to all potential userswithout charge. This argument is the basisfor claims that developing countries shouldhave free (or cheap) access to developedcountries' technology. But free diffusionpreempts markets that the creator mighthave served, and may thus remove theincentive to innovate. The patent systempermits the diffusion of technology whileattempting to protect the proprietary rightsof the innovator. In exercising these rights,technology suppliers seek to restrict use ofthe technology so as to maximize their re-turns. Control over the supply, plus thebuyer's ignorance regarding the true valueof technology, can lead to excessively highprices.

High prices for technology and re-strictions on its use are the basis for manydeveloping countries' call for an inter-national code of conduct on the transfer oftechnology and a revision of the inter-national patent system. But no satisfactoryagreement has been reached on either.

Why? Because of the inherent conflict ofinterests between the suppliers and thedemanders, which mirrors society's funda-mental dilemma between the need tostimulate the creation and the need to en-courage the diffusion of technology.

Many governments in the developingworld have adopted "defensive" mea-sures—that is, measures that control con-tractual technology transfers—in order toredress the bargaining asymmetry and pro-tect the development of local technologicalcapabilities. Although such regulationshave helped reduce the price and improvethe terms of the contractual inflow, theymay also have affected the character of theforeign technology that can be imported.Foreign technology suppliers are unwillingto sell when they consider the returns toolow. Moreover, direct foreign investment isoften the only means of obtaining access toclosely guarded technological assets. It isalso not clear that regulating formal inflowshas stimulated the development of local ca-pabilities. Such development requires tech-nological effort on the part of local firms,which is not ensured by regulation of orprotection from technology imports.

What is technology?

Technology is a method for doing some-thing. Using a method requires three ele-ments: information about the method, themeans of carrying it out, and some under-standing of it. Much of the confusion aboutwhat technology transfer is arises from try-ing to identify one or two of the elements astechnology. Information and means can betransferred, but understanding can be ac-quired only by study and experience. In-formation embodied in blueprints, opera-tional manuals, and technical books istransferable, as are physical means, such ascapital goods. But both physical means andinformation are worthless unless the re-cipient knows how to use them, whichinvolves the knowledge of a technology'spotential and—most important—some ex-perience in its use.

The transfer of information or means isnot the same as the acquisition of techno-logical capability. The ability to use tech-nology effectively comes from a person's

(or organization's) understanding, and thedegree of understanding required is relatedto the objective sought in employing thetechnology. For example, full comprehen-sion of the potential of photography maycall for some knowledge of optics andchemistry, but this knowledge is not neces-sary to take standard snapshots. Moreover,all technologies are elements of larger sys-tems, and the presence or absence of othertechnologies has a major impact on whathas to be acquired to accomplish the objec-tive sought. For example, developing andprinting capabilities are not needed to takesnapshots, but they may be required wherethese services are not locally available.

Technological capability is not an end initself. Objectives can be achieved in variousways and the selection of the best wa}requires a strategy. Optimum strategiesfor choosing and acquiring particular elements of technologies vary across countries, sectors, firms, and individuals, according to their needs and characteristicsThese obvious considerations are too oftenneglected in discussions of technology anddevelopment.

Choosing a technology

For most activities in most industries, nosingle technology is best for all circum-stances. Local requirements and factor en-dowments vary widely—both among de-veloping economies and between them andthe developed economies. As well as differ-ing in their relative use of capital and labor,alternative technologies also use differentintermediate inputs and produce outputsthat are not strictly identical in all respects.These characteristics affect a technology'ssuitability for individual situations. Al-though definitions of appropriate technol-ogy vary, a core characteristic is that itmakes optimum use of available resources.The conventionally prescribed method forchoosing among alternative technologies isto evaluate their associated benefits andcosts, using prices that properly reflect rel-ative scarcities. The best or most appropri-ate technique is that which has the highestnet benefit.

Lack of local capability to identify needsand to search for and assess different tech-

finance & Development I December 19836

The transfer of technology


nologies is often responsible for the selec-tion of inappropriate techniques. In turn,government policies—such as those lead-ing to distortions in factor prices—can in-duce producers to search for technologiesthat are, in fact, inappropriate. Monopo-listic market structures and excessive pro-tection from imports can, by unduly raisingprices, destroy rational incentives to searchfor the most cost-effective technology. Inaddition, producers may anyway fail to re-spond to market signals, and base theirchoices on criteria that are independent ofeconomic forces, such as seeking the new-est or most sophisticated technology re-gardless of cost.

The implementation of an appropriatechoice often requires complementary in-vestments in local skills to make the opti-mum use of available resources. To the ex-tent that these skills can be augmented,they need not impose absolute constraintson the selection of what would otherwisebe appropriate technologies. Labor andmanagement abilities can be upgradedthrough investments in human capital for-mation, for example, or local machineryrepair and production facilities for spareparts can be developed.

But concern with appropriate technologyextends beyond choices among existing al-ternatives to address the possibilities forcreating new technologies. Technologicalchange in the developed economies has re-sulted in modern technologies that areurban-based, large-scale, capital-intensive,and whose requirements for capital andintermediate inputs are often import-intensive. Likewise, the characteristics ofthe outputs produced by these technol-ogies are sometimes ill-suited for devel-oping economies. Nonetheless, because oftheir high productivity, modern technolo-gies are frequently most appropriate. Butmodern and older technologies alike can beadapted to conditions in developing econo-mies. Whether changes are warranted de-pends on their costs relative to the expectedbenefits.

Acquiring technology

Less developed countries typically obtainmany elements of technology from moredeveloped countries. But there are variouscombinations of foreign and local contri-butions. Information, means, and under-standing can be (1) provided by foreignerswho retain ownership; (2) purchased fromforeigners; or (3) acquired through indige-nous efforts to translate foreign technolog-ical knowledge into specific methods. Andtechnology can be transferred with varyingdegrees of human capital accumulation andinstitutional development.

At one extreme, a package consisting of

all the elements is transferred, with indige-nous involvement limited to an unskilledlabor force—as with direct foreign invest-ment, or to operating the technology—aswith "turnkey" projects. (In the latter case,a foreigner contracts to provide all the ele-ments needed to design and establish aproduction facility in the local environ-ment, but ownership is local.) At the otherextreme the underlying knowledge is as-similated and then used to create the nec-essary elements. The knowledge can beacquired through education, experience,experimentation, research, or purchase.

The modes of technology transfer thatare most often discussed are those whereforeigners play an active role and provideinformation in an immediately operationalform—direct foreign investment, turnkeyprojects, licensing, know-how agreements,and technical service contracts. But modesin which foreigners play a passive role, andwhere locals acquire the knowledge andlater translate it into technology, are veryimportant channels of technology transfer.These channels include sending nationalsfor foreign education, training, and workexperience; consulting foreign technical lit-erature; and copying foreign processes andproducts.

In discussing what is acquired throughtechnology transfer, it is useful to dis-tinguish three broad types of capability:production capability—that required tooperate a technology; investment capabil-ity—that required to expand existingproductive capacity or to establish newcapacity; and innovation capability—thatrequired to develop new methods of doingthings. There is often an implicit notionthat technology transfer gives the recipientthe first two if not all three types of capabil-ity. That is rarely the case. The capability tooperate a technology is different from theability to develop the means of imple-menting it. Similarly, having the capabilityto implement a technology is different fromhaving the capability to create a new one.

Production capability is not achieved bypassively importing technology. It requireslocal participation and considerable indige-nous effort to master the technology's use.Research shows that in most cases wherethe technological elements are imported asa "black box," the recipients are not able totake full advantage of it because they do notunderstand how or why the black box oper-ates as it does. This hampers their ability toimprove productivity or to adapt to chang-ing circumstances—such as shifts in inputprices or demand patterns—that affect howit is best used.

The understanding that underlies pro-duction capability is also an important as-pect of the capabilities to invest and to in-

novate. Thus the accumulation of localproduction experience can provide the un-derstanding necessary to carry out some,but not all, of the tasks involved in in-vestment and innovation. For example,plant engineers may acquire some capabil-ity in plant design, spare parts production,and adaptation of existing technology fromexperience in breaking bottlenecks, main-taining equipment, and solving productionproblems. But it is unlikely that they willacquire a capability in basic plant design,capital goods manufacture, or the creationof radically new technologies. The back-ground and experience necessary to carryout many of these tasks is different, and therelevant capabilities tend to be developedin specialized entities, such as process en-gineering firms, capital goods producers,and technological research institutes.

Part of the increase in local capabilitiesacquired through transfers spills into re-lated activities. For example, the capabili-ties gained from establishing one industrycan enable greater indigenous participationin subsequent transfers of related technolo-gies, increasing their effective assimilation.The accumulation of such experiences canalso lead to the creation of specialized firmswhich, in turn, permits greater local partici-pation in future transfers. More generally,the increased capability contributes to aneconomy's capacity to undertake indepen-dent technological efforts, including repli-cation or adaptation of foreign technologiesas well as creation of new technologies.

But unless carried out with the explicitobjective of doing so, some modes of,tech-nology transfer do not provide the experi-ence that is critical to the development ofindigenous technological capability. Tasksinvolving project design and the manufac-ture of capital goods, for example, whichcould be performed locally, may be carriedout by foreigners. This precludes locallearning through experience—experiencethat may be directly relevant to the indus-try's subsequent development. Moreover,project costs may be higher: cheaper localservices may not be used; and intimateknowledge of local conditions, required tooptimize project design and to take advan-tage of available raw materials, may beignored.

Imported or domestic technology?

Any project entails much iterative prob-lem solving and experimentation as theoriginal concept is refined and given prac-tical expression. Important elements of thetechnology appropriate to the project aredeveloped through applying existing tech-nological knowledge and engineering prin-ciples to specific local circumstances. Theremay even be some minor innovations or

Finance b Development I December 2983 7


adaptations in the technology being imple-mented. Whether the elements of technol-ogy should be obtained locally or fromabroad ought to depend on the relativecosts and benefits involved. Few wouldargue that foreign technical knowledgeshould be eschewed, so the issue ulti-mately concerns the division of labor be-tween foreigners and locals in transposingtechnological knowledge into concreteform.

An economy's capacity to provide thenecessary elements depends on the stageof development of the relevant sector andthose closely related to it. Firms engaged inwell-established activities may often ac-quire technology locally—either throughtheir own efforts or through the diffusionof expertise from other domestic firms. Hir-ing personnel with expertise from previouswork experience plays an extremely im-portant part in the diffusion of knowledgeamong firms, as does the interchange ofinformation among suppliers and users ofindividual products, especially for inter-mediate products and capital goods.

Firms in new or relatively new industriescan rarely take advantage of previous localexperience or the diffusion of expertise orinformation from other domestic firms.Such firms are likely to find it more cost-effective to rely initially on foreign tech-nological "packages" in the form of directforeign investment and turnkey contracts.As a country develops its technological ca-pability, it can disaggregate these packagesto import more cheaply or efficiently onlythose elements that it cannot obtain locally.

The relative merits of different ways ofacquiring various elements of foreign tech-nology depend on several factors. First, thecosts and terms at which elements can beobtained from abroad may be affected bythe competition among alternative sourcesof supply and the negotiating power of therecipient, including the degree of govern-ment support. The second factor is thetechnological capability of the recipient andstage of development of local technologicalinfrastructure. The third is the size of themarket for which the technology is to beapplied.

There are trade-offs—involving risks,short- and long-term considerations, andprivate versus social costs and benefits—between attempting to supply some of theelements locally and importing them. A ra-tional firm is unlikely to use inexperiencedlocal engineering services or untested capi-tal goods, for example, unless their usebrings long-run developmental benefitsthat more than compensate for the greatershort-run risks and higher costs of usingsuch local inputs. The social benefits fromincreasing technological capability gener-

ally exceed the private gains that an indi-vidual firm can expect to capture. There aremany avenues along which technologicalcapability can move to other firms, and notall of these are controlled by the firm thatfinances the initial acquisition. This dis-crepancy between private and social valueoften leads to underinvestment. Moreover,firms may value the private benefits thatthey do capture at less than their true socialworth, or consider that the cost of securingthem exceeds the true social cost.

Furthermore, firms may opt for more ex-pensive monopolistic sources of foreigntechnology, such as those that confer awell-known brand name, because suchsources confer monopoly power. There isthen a convergence of interests betweenthe domestic firm and the foreign suppliersince the domestic firm can offset thepromise of domestic monopoly profitsagainst the excessive price paid. Thus, themotives that give rise to technology im-ports can sometimes conflict with social ob-jectives. In turn, where imports are consis-tent with social objectives, domestic firmsmay prefer importing technology withoutconsidering ways of increasing domestictechnological capability. Even the simplestform of participation—intelligent observa-tion of activities carried out by foreigners—entails a cost to firms.

Strategy over time

The central issue of strategy is how tobuild upon what can be obtained fromabroad to stimulate the development of lo-

Carl Dahlmana Colombian citizen, spenttwo years in Brazil studyingtechnological change in thesteel industry for his PhD ineconomics from YaleUniversity before joining theBank in 1979.

Larry Westphala U.S. citizen, taught atNorthwestern and PrincetonUniversities and worked asan economic advisor inKorea before joining theBank in 1974.

Messrs. Dahlman and Westphal manage a researchproject on the acquisition of technological capabilityin developing countries in the Productivity Dh'isionof the Bank's Development Research Department.

cal capability in selected areas. For manyreasons, riming is of critical importance.Since all capabilities cannot be developedsimultaneously, and since the accumula-tion of any one capability takes time andexperience, the sequence in which variouscapabilities are developed is crucial. Andthe required capabilities change as a firm orcountry matures, because of changes in ex-isting capabilities, and because of changesin market conditions.

If the market is small and growingslowly, so that investments in new plantsare infrequent, the best strategy may be toacquire only production capability—say,by importing a turnkey plant, with thetraining required to adjust the operation asnecessary. But if the market is large orgrowing rapidly, it may be economic to ac-quire some investment capability. Further-more, if technology is changing rapidly, itmay be desirable to insure the capability toassimilate new advances quickly or even toinnovate new products or processes. Or adecision may be made to rely on direct for-eign investment in dynamic areas where itwould be too costly to keep up with rapidworld technological developments.

In this context, the strategy of Japanesefirms is instructive. During the 1950s and1960s, when they were technologically farbehind firms in the then developed nationsin almost all areas of industrial technology,they actively and unabashedly importedforeign technology. The means to accom-plish this included commercial contracts,such as licensing and know-how agree-ments and turnkey plants, as well as copy-ing products, getting training overseas,making visits to foreign plants, and study-ing foreign technical literature. In areas inwhich they wanted to excel, they soughtto understand the underlying principlesrather than simply to import technological"black boxes." Thus, Japanese firms allo-cated specific local research and develop-ment efforts to acquire this understanding.Further, they used the import of technol-ogy as a starting point and focused the bulkof their efforts on understanding, adapt-ing, and improving the technology. In par-ticular, they focused on increasing thequality of products and on reducing pro-duction costs. In the 1970s, and even morenow in the 1980s, Japanese firms have de-voted more attention to basic research andinnovation. Their strategy has changed astheir capabilities have evolved.

There are various situations in which itmay be cost-effective to develop basic prod-uct and process knowledge as an elementof local innovation capability. These in-clude instances when foreign technology isnot appropriate or does not exist for theneeds at hand, when it can be obtained



only at excessively high costs or is un-available because of monopoly supply re-strictions, or when the size of its potentialmarket is large enough to justify the cost ofdeveloping it locally because of the gainsfrom successive applications. Efforts to ac-quire substantial innovation capability maypay off by reducing future costs and pro-viding greater flexibility to adapt to chang-ing circumstances. The difficulty of assess-ing these returns, together with differencesin sensitivity to technological considera-tions, may explain why firms in the sameindustry exhibit vastly different levels oftechnological effort.

Because of market failures and exter-nalities in the creation, diffusion, andchoice of technology, there is an importantrole for government incentives and otherinterventions in fostering the effective useof technology. The objectives of such poli-cies include inducing the choice of thesocially most appropriate foreign tech-niques; importing technology on the bestpossible terms; ensuring adequate localparticipation designed to increase domestictechnological capability; and promoting,where appropriate, the use of local ratherthan foreign sources. Some of these aimscan be achieved through defensive mea-

sures, but others can only be attainedby positive steps, such as building uplocal physical and human technicalinfrastructure.

It is not always clear how to design andimplement policy measures most effec-tively. While defensive steps are notenough, positive measures are not alwayssuccessful. For example, many researchinstitutes have been poorly integrated withproduction needs. In addition, measures tosupport and encourage local technologicaleffort have frequently worked at cross pur-poses with other elements of industrial andtrade policies. As a result, firms, even thoseowned by the state, have often notresponded to technologically oriented poli-cies. Another difficulty is how to foster thedevelopment of technological capability indifferent domestic sectors, while min-imizing the costs to the users—often otherindustries—of temporarily shutting outmore efficient foreign sources or makingaccess to them more costly. And perhapsmore important than specific policy mea-sures is the establishment of an environ-ment that sensitizes firms to technologicalconsiderations and stimulates them todevelop greater technological capability toimprove their overall performance.

Technology is multidimensional. Manydifferent capabilities are required to assess,select, assimilate, use, adapt, and create it.Elements of different technologies alreadyexist in the developing world. Sometimes acompletely new technology is not needed,but rather an improvement on existingtechnological elements or a complement ofnew elements imported from abroad andadapted to local conditions. Countries mayfollow different paths toward the acquisi-tion of the technology they need, paths thatinvolve varying degrees of openness toforeign technology and of reliance on for-eigners rather than locals to transform tech-nical knowledge into concrete form. Notmuch is known about the relative merits ofthe different paths, because little attentionhas been focused on economic per-formance along these paths. There is muchto learn about the best strategies. Theperformance along the path matters. So dothe targets. There is an inherent difficultyin that the targets are constantly shifting asthe future unfolds and new technologiesare developed. The only recipe for successis pragmatism based on constant mon-itoring of performance and of the possi-bilities opened up by new technologicaldevelopments. HD

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Finance & Development I December 1983 9


The underground economyThe causes and consequences of this worldwide phenomenon

Vito Tanzi

In recent years, a growing number of ob-servers of the economic scene have calledattention to a phenomenon described by avariety of terms, of which the most com-mon is "underground economy." A rangeof names are used to describe this phenom-enon, including "parallel," "unofficial,"and "black." Regardless of the appellation,the phenomenon relates to activities rang-ing from relatively legal to totally criminalthat somehow escape official attention andmay distort official statistics and lead to er-roneous policies.

The underground economy—as itsplethora of names suggests—can be de-fined in various ways. If the relevantagency to which activities are not reportedis the tax or customs authority, the defini-tion is tax-related. If the relevant agency isthe national accounts authority, then weget a definition that relates to the nationalaccounts. More specifically, the under-ground economy can be defined either asthe total of incomes earned, but not re-ported to the tax authorities, or as the totalof incomes not included in the national ac-counts. There may be no close connection

between these two definitions; an activitymay not be reported to the tax authoritiesbut may still be assessed by the nationalaccounts offices if, for instance, national ac-counts data are compiled independentlyfrom tax data. Vice versa, there could becases where some activities come to the at-tention of the tax authorities but not of thenational accounts authorities. In this con-nection it should be realized that, depend-ing on the country, the national accountsmay be based more or less on tax informa-tion. For example, in the United States it isreported that only 6 percent of national in-come is based on information provided bythe tax authorities.

The causesIn a well-working market economy,

without a public sector, there would be nounderground activities. Incentives for thegrowth of these activities increase withgreater regulation of the economy, largerpublic sectors, and higher levels of taxa-tion. The factors that stimulate under-ground activities can be classified underfour different headings: taxes, regulations,

prohibitions, and bureaucratic corruption,although in several cases, undergroundeconomic activities may have been broughtinto existence by more than one factor.

Taxes. The tax factor has been empha-sized in most studies of the undergroundeconomy, and particularly in those dealingwith the United States, the United King-dom, and the Scandinavian countries. Inrecent years, the share of total taxes in thegross national product of many countrieshas increased substantially, reaching insome cases 50 percent. Further, the mar-ginal tax rates associated with these taxeshave been even higher. As tax rates in-crease, so does the incentive to evadethem. When tax rates are high, the cost ofhonesty also becomes high, and many tax-payers who, under lower tax burdens,would have been honest, make the transi-tion to tax evasion, even though in somecases only for parts of their incomes.

It is not just the level of the tax rates thatis important, but also the general mood ofcompliance that prevails in a country. Thismood may itself be affected by perceptionsabout the public sector—if these are thatpublic expenditure is wasteful or that thetax burden is inequitably distributed, theremay be a tendency not to participate in"above-ground" activities. Further, whentax administration is good and the penal-ties for evasion significant, high marginaltax rates may not lead to a high level ofunderground economic activity. Thus,when the attitude vis-a-vis the governmentand its tax and expenditure policies is nega-tive, when the tax rates are high, and whentax administration is poor, undergroundeconomic activity is likely to flourish.

Different taxes may stimulate these activ-ities more in one country than in another.In the United States, the major cause of theunderground economy has generally beenassumed to be high income tax rates. As aconsequence, the studies dealing with thiscountry have emphasized that aspect. Inother countries, and perhaps to a more lim-ited extent even in the United States, socialsecurity taxes have also been important. Infact, it is likely that these taxes, which insome countries have achieved a very highlevel, may have been more important thanthe income taxes. Both of these taxes may

Much of the material in this article is based onthe author's book, The Underground Econ-omy in the United States and Abroad (Lex-ington books, 1982), which covers the UnitedStates, the United Kingdom, Italy, Norway,Sweden, the U.S.S.R., Canada, Colombia, Aus-tralia, and Israel. The estimates in the chart forthese countries come from the book and fromother published articles.

10 Finance & Development I December 1983


bring about a kind of black market for labor;if workers can be hired without the pay-ment of income taxes or social security con-tributions, they can be paid lower wages.The worker may gain, as the wage he re-ceives will be free of income tax and of theemployee's contribution to social security,and the employer will gain by the lowerwage bill and by not paying his share of thesocial security tax.

Sales taxes also contribute to under-ground economic activities. The value-added tax, for example, is reported to havebrought about a proliferation of small anddifficult-to-control enterprises that produceservices or goods sold net of taxes. Forsome countries (for example, Italy andArgentina) there are estimates assessingthe value-added tax evasion at 50 percent.It is, thus, a fair question to ask whetherthe evading activity is being properly mea-sured in the national accounts.

For developing countries, other types oftaxes are also important factors. Countriesthat impose high import duties, which insome cases exceed 100 percent, providestrong incentives to smugglers to bringthose goods into the country without goingthrough the customs offices. The higherthe import duty, and the smaller, more eas-ily transportable, and more valuable theproduct, the greater is the incentive tosmuggle it into the country. As a conse-quence, smugglers make considerablegains from this activity and these gains aredifficult to measure. Estimates for somecountries indicate that they can be enor-mous. Export duties are another majorcause of these activities. The coffee pro-ducers who smuggle coffee out of the coun-try; the cattle raisers who simply cross thefrontier with their cattle to sell themabroad; and the diamond or emerald min-ers who take their finds abroad are allavoiding export taxes and making profitsthat are not likely to be properly measured.Even capital gains and capital transfer taxesmay induce those engaging in the transferor sale of property to underassess for taxpurposes the value of their property. In allof these cases, activities may have beenbrought into existence, or channels of dis-tribution may have been created, or eco-nomic relationships may have beenchanged because of the taxes. The end re-sult is higher incomes for some, lower taxrevenue for governments, and highly dis-torted statistics.

Regulations. By and large, the more reg-ulated an economy, the greater will be thepressures within it to try to get around theregulations. In the process, various activ-ities that cannot be controlled will comeinto existence; these will, to some extent,invalidate the objectives of the regulations

and will be associated with the phenom-enon of the underground economy. Theregulations may relate to labor markets,goods markets, domestic financial markets,and foreign exchange markets.

The regulation of the labor market mayinclude laws pertaining to minimumwages, overtime, and the work of minors,aliens, retirees, and working women.Many of these are circumvented or ig-nored. In the process, output is produced,incomes generated, and labor utilized inways not desired, or even contemplated,by the government. In many cases a blackmarket for labor develops.

Goods markets regulations include pricecontrols, rationing, forced sales of com-modities to the government or to marketingboards, import quotas, and export bans.All of these may generate a black market forgoods as both producers and consumerstry to escape the effects of these regulationsby developing parallel or hidden markets.Again, the end result is the creation of un-reported incomes, the distortion of mea-sured levels of activity, and a loss of taxrevenue. In the United States, the regula-tion of goods markets during the prohi-bition era and during World War II broughtabout widespread attempts at circum-venting them. Available estimates indicatethat underground economic activities werelarger during World War II than in any sub-sequent period. Black markets for goodshave reached epidemic proportions insome highly regulated African countries,and the same is reported to be occurring insome centrally planned economies ofEurope.

Regulations of domestic financial mar-kets are often associated with constraintson interest rates and with credit controls.When these regulations of domestic fi-nancial markets exist, a black market formoney, sometimes called a curb market,develops. In this case, interest received bylenders is for the most part unreported tothe tax authorities and the extent to whichit is properly reflected in the national ac-counts is an open question.

Examples of regulations of foreign ex-change markets abound. These are con-nected with the exchange rates, which maybe widely out of line from the equilibriumlevel, or with capital controls. Distorted ex-change rates, together with capital con-trols, are generally accompanied by at-tempts at getting around them. Obviousexamples of this type are the overinvoicingof imports, which allows an importer to getsome exchange at official rates and to leavesome of this money abroad, or to sell it inthe black market. Another example is theunderinvoicing of exports. The exporter'sobjective is to end up with unreported for-

eign exchange that can be kept abroad orcan be sold in the black market domes-tically. In all these cases, a black market forcurrency exists in parallel with the officialmarket. The exchange rates in the two mar-kets can be significantly different, some-times by as much as a ratio of ten to one.Again, untaxed incomes are created andeconomic statistics distorted as the relevantauthorities are unable to tax those incomesand do not have the full range of informa-tion necessary to put out accurate statistics.

Prohibition. In all countries some activ-ities are forbidden by law. To the extentthat individuals wish to engage in them,these will inevitably go underground.There are many such activities, includingtraffic in illegal drugs, illegal gambling,lending at extortionate rates, and so on. Aslong as individuals engage voluntarily inthese activities, they can be deemed to gen-erate incomes to some people and servicesto others. For example, illegal drugs im-ported into a country and sold in the streetcan generate phenomenal incomes, as thestreet value is likely to be far higher thanthe value at which they are bought at theplace of origin.

It is an open question, and a source ofconsiderable controversy, whether the in-comes generated by these activities shouldbe measured in the gross national productof a country. Traditionally, incomes mea-sured by the national accounts have notincluded those generated by criminal activ-ities. In addition, if these activities werediscovered and taxed, they would largelydisappear, so that it is also controversialwhether even the tax definition of under-ground economy should include incomesgenerated in these activities. On the otherhand, one can take the position that theyshould be included, on the grounds that aslong as people purchase these servicesfreely, they are in some sense better offbecause of them. Moreover, the sellers ofthese services are earning incomes and us-ing scarce resources, which, if used else-where, could increase the official gross na-tional product. Only if the resources usedin these activities would otherwise be com-pletely unutilized would they have had noopportunity cost associated with them.

In the United States, for which some esti-mates have been made, these illegal activi-ties are reported to range somewhere be-tween one third and one half the size of theunderground economy associated with le-gal activities. But, of course, in view of thedifficulty of finding any accurate informa-tion in this area, these are very unreliableestimates. The value of these activities de-pends to a large extent on the fact that theyare prohibited. For example, legalizing nar-cotics would almost immediately sharply



reduce their value; therefore, the incomesthat the sellers of these drugs receivewould also fall sharply.

Bureaucratic corruption. In all countries,some public employees find themselves incontrol of powers that can be used to gener-ate private gains. This private use of publicpower is obviously improper and fre-quently illegal, but it is a fact of life in somecountries, and examples abound in the lit-erature and in newspapers. In particularcountries, for example, it has been reportedthat government jobs are sometimes liter-ally sold by individuals with the power todispose of them. In other countries, gov-ernment contracts are awarded to individ-uals who are willing to make an under-the-table contribution to strategically locatedpublic employees. In still others, whereeconomic activities may require specific li-censes, acquiring a license, or, at times, ac-quiring a license without excessive delay,may be achieved in exchange for under-the-table payments. Licenses for invest-ments, imports, construction, and waiversfrom particular regulations, or even ob-taining public services which, because ofsupply bottlenecks, are not readily avail-able (such as telephones), can often be ob-tained by literally purchasing the license,the waiver, or the service from the rightperson.

The argument has been made that insome countries this payment to a certainextent compensates the public employeesfor low wages and oils the bureaucraticmechanism by introducing some spurioussort of efficiency. The common denomi-nator of these activities is that they all gen-erate incomes for some people and theseincomes are not reported to the authorities.They are not likely to be taken fully intoaccount by those who generate nationalstatistics.

Consequences

The existence of a sizable and possiblygrowing underground economy has obvi-ous consequences that may or may not beserious, and it raises issues of equity, eco-

Vito Tanzia U.S. citizen, holds a PhDin economics from HarvardUniversity. Director of theFiscal Affairs Department ofthe Fund, he has authoredmany books and articles onpublic finance, monetaryeconomics, andmacroeconomics.

nomic policy, and efficiency. This articlecannot engage in a full discussion of theseissues, but will make a brief reference tothem.

Equity. The issue of equity is particularlysignificant in the distribution of the tax bur-den and incomes. The fact that some peo-ple receive incomes that are not taxableimplies that to raise a given level of taxrevenues, the tax rate on officially recog-nized activities will have to be higher. Fur-ther, even when the economy expands be-cause of underground economic activities,the need for additional public services willgo up. For example, those who live on un-derground incomes still use roads and stillsend children to school. The reduction intax revenues and the increase in the needfor additional public expenditure as a resultof these activities is an aggravation of fiscaldifficulties. Equity considerations arise alsoin connection with income distribution, as

very large incomes may be made in connec-tion with underground activities, whichmay distort the distribution of income thatthe government wants to achieve.

Policymaking. The implications of un-derground economic activities for eco-nomic policy are perhaps more serious. Alarge underground economy will inevitablybe associated with greater difficulty inproperly assessing the size of variables thatare important for policymaking. For exam-ple, if the underground economy is grow-ing faster than the official economy, and isnot properly measured by the nationalaccounts authorities, the rate of growth ofthe country will be underestimated. Thiscould lead to policies that, on the basis ofwhat is officially known about the econ-omy, seem appropriate but are actuallyoverly expansionary.

The official unemployment rate may alsobe distorted. If people working in the un-

Measuring the underground economyEconomists have been very resourceful in devising different methods for esti-mating the size of the underground economy. One method is based on attemptsto measure directly the various activities that make up this phenomenon, and,through a process of aggregation, the calculation of the total. This method hasbeen used mainly in the United States. Its main weakness is that many under-ground economic activities are not observable.

A second method, which has given interesting results for Norway and Swe-den, includes the use of questionnaires to elicit answers from persons inter-viewed as to whether they have participated in these activities either as buyersor as sellers. In the case of noncriminal activities, selling the service may implyviolation of some law; buying the service does not. Therefore, if the answersreceived from the buyers give more or less the same magnitude for undergroundeconomic activities as the answers received from the sellers, one can have someconfidence in them.

A third method, which has been applied in Italy, is based essentially on thedifference between the population that, on the basis of demographic data, couldbe assumed to be part of the labor force and those who officially report to be partof it. These estimates need to be accompanied by some assumptions aboutproductivity in the underground sector. A fourth method, used in the UnitedStates and in the United Kingdom, has attempted to estimate the size of theunderground economy by comparing the official estimates of the gross nationalproduct made from the consumption side with those made from the incomesside. The assumption is that underground economic activities would affect onlythe income estimations of national product. There are difficulties with thismethod, as the underground economy is likely to affect both consumption aswell as incomes. Thus, some studies of the United Kingdom have attempted toestimate the underground economy by analyzing household budget studies forunusual levels of consumption corresponding to given reported income.

Many studies for a large number of countries have also attempted to measurethe activities in question by analyzing monetary statistics, on the assumptionthat certain monetary aggregates—for example, currency or currency in largebills—may be directly influenced by the size of the underground economy. Stillother methods have related electricity use to official output for a region or a town.If the electricity used is much higher than one would expect from the officialproduction level, one can assume that unofficial production is taking place.



derground economy are listed as unem-ployed, the unemployment rate will appearhigher than it actually is. This again mayinduce the government to pursue expan-sionary policies when, in fact, the real rateof unemployment may be much closer tothe full-employment rate than the officialrate would indicate. For the United Statessome have argued that the actual unem-ployment rate may be more than 2 percentlower than the official rate.

The rate of inflation may also be distortedif the underground economy is growingfaster than the above-ground one in coun-tries where the services of the former arerendered at lower prices. In this case, themeasured rate of inflation may be higherthan the real rate. In addition, if the under-ground economy is connected with blackmarkets for goods, then the reverse mayoccur, as scarcity of goods in the officialeconomy brought about by price control or

rationing may bring about much higherprices in the black market economy. In thiscase, the official price index is likely to bemuch lower than the real price index.

The balance of payments statistics, too,are likely to be distorted in the presence ofan underground economy, as many capitaland commodity flows will not be properlymeasured. Once again, economic policiesbased on the official statistics may not bethe right ones. The tax burden of a country,as well as the share of public expenditure ingross national product, will be distorted, astotal taxes or total public expenditure willbe divided by only the officially measuredand thus lower gross national product.Therefore, that ratio will appear higherthan it actually is. Official statistics on in-come distribution, as already stated, willalso be distorted as those actively engagedin the underground economy may appearpoorer than they actually are.

Whatever method is used to estimate the magnitude of the undergroundeconomy, it is evident that it is considerable. The accompanying chart providessome available estimates from studies of the underground economy for 19 coun-tries from various parts of the world and with different social systems. Many ofthese studies indicate that the underground economy is not only sizable but isalso growing faster than the official economy. The figures shown in the chartshould be accepted with considerable caution as they are the result of applyingdifferent methodologies and, in some cases, even of different concepts. There-fore, it would not be prudent to make precise cross-country comparisons withoutfirst consulting the studies themselves. As research techniques and factual infor-mation improve, it will probably become easier to generate estimates that war-rant a greater degree of confidence.

Estimated size of underground economy

Percent ol GNP'These data sho*v the ranges of estimates made tor each count ry ai different times: they are suggestive anrt

should noi be taken 10 be precise

Monetary policy may be distorted if thegrowth of money is related only to thegrowth of the official gross national in-come. If incomes in the underground econ-omy are growing faster than this, then therate of monetary expansion, determined inrelation to the official economy, may be toolow for the needs of the total economy.This discussion should be sufficient to em-phasize the importance of studying thisphenomenon, since economic policy inmost countries is strongly influenced bythe behavior of the officially measuredmacroeconomic variables.

Efficiency. The issue of efficiency can beapproached from different angles. This is,however, a complex issue that would re-quire far more time for a satisfactory treat-ment. In general, if the underground econ-omy is caused by taxation alone, one willfind that, ceteris paribus, resources (bothcapital and labor) will progressively moveout of the taxed or official sector into theuntaxed or underground sector. This ex-odus would continue until, at the margin,the rate of return net of taxes in the officialeconomy becomes identical to the untaxedrate of return in the underground econ-omy. Obviously, this movement of re-sources is likely to imply a substantial mis-allocation of resources.

However, the issue of efficiency involvessomewhat more complex considerationsthan that of misallocation. As has been em-phasized, in some studies related to theItalian situation, the existence of under-ground economic activities, often carriedout within the house by housewives, giveto the economy an efficiency that it wouldnot have otherwise. For example, a womanwho has children in school and who wouldfind it impossible to hold a regular job, willbe able to allocate to this (underground)domestic work those hours when the chil-dren are away and consequently do notneed her attention. In addition, to the ex-tent that this woman works in her ownhouse, she needs less investment in struc-tures, and there would be less need forroads because no transportation back andforth from work is required. Furthermore,as this person can fully and directly benefitfrom the additional output associated withany improvement in her human capital orin her equipment, there would be a greaterincentive to carry out these improvements.For developing countries, where excessiveregulation of the economy has at timesbrought about excessive rigidities, the un-derground economy, which in this casemight be more properly called the "paral-lel" economy, has often made a differencebetween a relatively viable economy and astagnating one. HQ

Finance & Development/ December 1983 13

AustraliaAustriaBelgiumCanadaDenmarkFinlandFranceGermanyIreland

ItalyJapan

NorwaySpainSwedenSwitzerlandUnited KingdomUnited StatesU.S.S.R.


Countertrade:trade without cash?

The cornerstone of postwar world eco-nomic relations has been a liberal and mul-tilateral system of international trade andpayments. This system, established underthe auspices of the Fund and the GeneralAgreement on Tariffs and Trade, fosteredan unprecedented growth of internationaltrade: the volume of trade increased almostsixfold between 1950 and 1980. While thefar greater proportion of world trade con-tinues to be conducted within the frame-work of the above-mentioned system, inrecent years there has been a growingtendency in some countries to resort to tra-ding practices that constitute a retreat frommultilateralism. These practices are collec-tively known as "countertrade."

Countertrade may take a variety offorms, but basically it is a barter or a quasi-barter arrangement that more or less explic-itly links import and export transactions. Itinvolves trading arrangements betweenprivate firms and/or government entities,such as foreign trade organizations, bywhich the seller is obligated to accept, as apartial or total settlement for his exports ofgoods (or in some instances services, suchas technology or industrial licenses), speci-fied goods or services, from the buyer.

On the basis of the types of goodstraded, the financial arrangements in-volved, and the length of time it takes tocomplete the transactions, four types ofcountertrade may be distinguished. Theseare barter, compensation, buy-back, andcounterpurchase.

(1) Under a barter arrangement, the ex-porter sells specified goods to the importerin exchange for specified goods. This typeof transaction, involving a limited numberof products and without the participationof a third party, is a one-time operation,and the transaction is completed in a rela-tively short time. Pure barter is relativelyrare because of the difficulties of finding abuyer for the product, which may not beeasily marketable, and of negotiating a mu-tually acceptable price.

(2) Under a compensation arrangement,the exporter agrees to take full or a partialpayment in kind for the goods sold, but theexporter transfers the purchasing commit-ment to a third party who may be an end-user of products or a trading house. Com-pensation arrangements are also not verycommon because it takes time to find a suit-able third party to whom the exporter cantransfer the purchasing commitment.

(3) The third type of countertrade,which is perhaps the most prevalent andinvolves a relatively large volume of trade,is the buy-back arrangement. Under thisthe exporter (usually an industrial firm)provides plant, equipment, or technologyto an importer (also an industrial firm) andagrees to accept, as a partial or full pay-ment, goods to be produced by theimporter with the exporter's equipment ortechnology. A variant of this arrangementis trade-related performance requirements,under which foreign investors are requiredto export a fixed proportion of the goodsproduced or to use a specified value oflocally produced inputs in production. Incontrast to barter, compensation, andcounterpurchase arrangements (discussedbelow), where the value of purchases bythe exporter is almost always less than (orat most equal to) the value of exports, thevalue of buy-back commitment may exceedthat of the original export transaction.Moreover, the contract period of buy-backarrangements is, by necessity, consider-ably longer than that of counterpurchasearrangements.

(4) The counterpurchase arrangement isalso common and complicated. Under thisarrangement, the exporter sells goods,technology, or services to an importer, andagrees to purchase from the latter, within aspecified period, a specific total value ofgoods selected from a list that excludesthose produced by the technology beingexported. Unlike barter and compensationarrangements, exporters entering into buy-back and counterpurchase arrangements

must use a trading firm to market the goodsthey purchase. The exporters do not usethese goods themselves, although undercertain buy-back arrangements they mayagree to purchase raw materials or partsthat could be used in their productionprocesses.

Although conclusive data are difficult toobtain, it is generally accepted that coun-tertrade has become an increasingly im-portant form of trade between WestEuropean and East European countriessince the mid-1970s. To a lesser extent, theUnited States also appears to have relied oncountertrade arrangements to expand itstrade with East European countries. Coun-tertrade has, too, become a feature oftrade between developed and developingcountries.

Factors in countertrade growth

Several factors have contributed to thegrowth of countertrade. In the case of thecentrally planned East European countries,domestic production can be planned, butexports are not as amenable to central plan-ning, largely because of the difficulty offorecasting foreign demand. Countertradeis therefore considered a way of over-coming uncertainty of domestic productionplans and, at the same time, of achievingbilateral balancing of trade—an importantobjective of foreign trade policy in thesecountries. Shortages of convertible foreignexchange and the desire to stimulateforeign technology inflows have alsomotivated East European countries to enterinto countertrade arrangements.

In many developing countries, certainindustrial and foreign trade activities arenationalized and some of the institutionalcharacteristics that apply to countertradein East European countries are also presentin these countries. In addition, developingcountries, particularly those maintainingovervalued exchange rates, have resortedto countertrade for the following reasons:(1) balance of payments difficulties arising

14 Finance & Development / December 1983


from sluggish export growth and a risingexternal debt-service burden haveprompted some to seek new ways of econ-omizing on scarce foreign exchange re-sources; (2) emphasis on the growth ofmanufacturing sectors, originally aimed atpromoting import-substitution, has createdovercapacity and has produced pressuresto find markets for surplus goods; (3) giventhe difficulties of gaining access to the mar-kets of the industrial countries for certainprimary and manufactured products,countertrade arrangements that commitindustrial country exporters to purchasinga given quantity of products over a speci-fied period are seen as a means of pene-trating existing markets or establishingnew ones; (4) countertrade in the form ofbuy-back arrangements is seen—by bothindustrial and the more developed devel-oping countries—as a means of securingreliable sources of essential raw materialswhile exporting equipment and technologythat have become outdated at home; and(5) for exporters (including some in indus-trial countries) countertrade may have be-come the only way to overcome the protec-tive trade policies of some countries.

As already mentioned, the magnitude oftrade conducted under countertradearrangements is difficult to estimate. Thereare several reasons for this. Where govern-ments engage in such arrangements, stra-tegic goods may be involved, so thatdetailed trade data are not likely to be pub-lished. When trade returns are compiled ona commodity basis, they do not usually dif-ferentiate between trade conducted undernormal trading arrangements and counter-

trade. Countertrade in the form of buy-back arrangements often extends overseveral years, making it diff icul t to estimatethe annual volume of trade. One frequently-mentioned estimate by the OECD is that upto 15 to 20 percent of the trade betweenEast European and West European coun-tries is conducted under some form ofcountertrade arrangement. On the basis ofthis estimate, in 1980 when total East-Westtrade was $80 billion, countertrade wouldhave amounted to about 512-16 bil l ion. In arecent study by the U.S. Internat ionalTrade Commission, U.S. imports undercountertrade were estimated to have been$279 million in 1980—$170 million of whichwere estimated to have been from centrallyplanned economies. Assuming that theannual values of imports and exports con-ducted under countertrade arrangementsare equal, and applying the U.S. propor-tion of countertrade with the centrallyplanned economies of 61 percent to theestimate of countertrade in total East-Westtrade of $12-16 billion mentioned above,global countertrade in 1980 may be roughlyestimated to have amounted to $23 billion,or about 1 percent of world trade that year.A number of figures have recently ap-peared in the press that are much higherthan this—as high as 25 percent of worldtrade—but estimates based on these tiguresimply implausibly rapid growth of counter-trade since 1980.

Drawbacks

Although the magnitude of trade con-ducted under countertrade arrangementsis small in relation to world trade, the

Some examples of countertrade• Under Indonesia's counterpurchase policy, all foreign companies awarded

government contracts for construction projects and major procurements mustundertake to export specified Indonesian products, other than oil or natural gas,equivalent to the total foreign currency value of the equipment and materials theyimport into Indonesia. The export of Indonesian products purchased under thesearrangements to a third country is permitted only if the third country is a new marketfor such products. (Guidelines issued by the Indonesian Government, December 2,1982.)

• In 1983 Greece plans to purchase 30,000 barrels of crude oil a day from theU.S.S.R. at the price of $28 per barrel and to pay for them partially with goodsproduced in Greece (The Wall Street Journal, April 22, 1983).

• The Malaysian-owned rubber trading company, Sime Darby, is said to haveworked out a barter deal with Mexican tire manufacturers under which the Mexicanfirms paid Sime Darby's New York-based agency for Malaysian rubber with cocoabeans. Sime Darby, New York, in turn, resold the cocoa beans to confectionerymanufacturers in the United States (Far Eastern Economic Review, January 27,1983).

• The United States aerospace company McDonnell Douglas is reported to havesold aircraft to Romania in return for canned ham "which the firm's staff is expectedto munch its way through at the company's canteen for years to come" (Far EasternEconomic Review, January 27, 1983).

proliferation of such practices tends toundermine the operation of the multilateralsystem of trade and payments. Counter-trade practices entail many of theundesirable restrictive and discriminatorypractices traditionally associated with bilat-eralism. While, as already mentioned,countertrade practices may, in the shortrun, be viewed as having some advantages,in the longer run they may have seriousshortcomings. Manufacturing firms have toset up subsidiaries to handle countertradearrangements or employ the services oltrading companies specializing in suchactivities. Export sales linked to counter-trade arrangements require careful plan-ning to ensure that the imported productswill be of good quality, easily marketable,delivered on schedule, and reasonablypriced to take account of the additionalmarketing costs that may be involved. Asalready mentioned, one of the moreimportant motives for engaging in counter-trade is the promotion of exports. There-fore, when a manufacturing firm entersinto a countertrade arrangement, it isessentially performing a market ing func-tion for those producers and may feel com-pelled to add the cost of marketing to theprice of products or to seek a discount onthe price of products it purchases.

Countertrade arrangements are there-fore time-consuming to conclude and tendto increase the cost of trade because addi-tional risks not usually present in normalbank-financed foreign trade must be cov-ered. Risks increase as countertradearrangements extend over several years.Uncertainty about the availability and qual-ity of products to be purchased in futureyears is an especially serious disadvantage.Where a large sale of plant, equipment, ortechnology is involved, a potential changein the political and national security consid-erations adds to the uncertainty.

Because they are complex and time-consuming, countertrade arrangements, insome instances, may actually reduce theamount of trade. In the longer run, trans-actions based on conventional financialarrangements provide a much greaterflexibility for importers as well as forexporters and promote growth and thediversification of the country's exports.Countertrade has been characterized as"trade without cash," but this is mis-leading, because in most countertradetransactions there is a need to translate thevalue of traded goods into cash equiv-alents. Under complicated arrangementsinvolving more than one transaction overseveral years, an "escrow account" is usu-ally established at a commercial bank, andeach trade transaction is settled throughthe account, thus involving an imitation of

finance fr Dnvlopment I December 198.3 15


payments mechanisms. When counterpur-chase or buy-back arrangements are con-cluded, exporters may have to obtainbridging finance for themselves or provideit for foreign buyers. This increases the fi-nancial costs of countertrade transactions.From the standpoint of the developingcountries, the dumping of their exports inthird markets by importers in the de-veloped countries may be harmful, as itmay undercut the normal trade relationsthat developing countries have with thesemarkets.

At present, there are no internationallaws or agreements that deal directly withcountertrade practices, although some docover certain aspects. The existing interna-tional trade law, the GAIT, has no provi-sion dealing specifically with countertradepractices. A number of its important pro-visions, such as those on national treat-ment, on internal taxation and regulation,antidumping and countervailing duties,quantitative restrictions, subsidies, statetrading enterprises, and emergency actionon imports of particular products, may beinterpreted to cover certain aspects ofcountertrade practices. Their applicabilityhas not been examined closely, and someGATT members have proposed a thoroughexamination of trade-related investmentperformance requirements.

Countertrade practices may entail manyof the restrictive and discriminatory fea-tures that are considered undesirableunder Fund policies that aim more broadlyto reduce bilateralism and exchange re-strictions. One such practice, which hasbecome prevalent, is the importation ofgoods and services in developing countrieswith the stipulation that payments bemade in domestic currencies. This is usu-ally done in order to tie those funds topurchases of domestically produced goodsin accordance with government regula-tions. This practice may be inconsistentwith the Fund's policy on exchange restric-tions and bilateralism because it restrictsthe importer's freedom to settle importpayments and limits the transfer of pay-ments that exporters have received. TheFund's policy on countertrade practices isto encourage its members to rely on appro-priate fiscal, monetary, and exchange ratepolicies rather than on restrictive practicesto achieve balance of payments adjust-ment. (A report on the Executive Board'srecent review of countertrade practiceswithin the context of the Fund's continuingexamination of bilateralism is contained inthe 1983 Annual Report on Exchange Arrange-ments and Exchange Restrictions, pp. 44-46.)

Kyung Mo Huh

UNCTADVI:

A more integrated andmultipolar world economyrequires a different approach toglobal negotiations from thatbased on the static North-Southconcept. UNCTAD VI may havebeen a stepping stone in thatdirection

Shahid Javed BurkiUNCTAD VI convened in Belgrade onJune 6, 1983, against the background of themost severe international economic crisissince the Great Depression. There was avirtual stagnation in global economicgrowth; many developing countries had ex-perienced sharp reductions in their percapita incomes. Unemployment was highand foreign trade stagnated. A number ofoil exporting developing countries were hithard by falling oil prices and sharply re-duced volumes of exports, while many oilimporters had to face the task of servicinglarge accumulated debts. This crisis fol-lowed in the wake of the upheavals of the1970s, which had seen profound modifica-tions in the pattern of international trade.

The New Delhi Conference of the Non-Aligned Nations and the Buenos Aires"platform" of the Group of 77, which pre-ceded UNCTAD VI, had signaled a morepragmatic approach by the developingcountries toward global economic prob-lems. In a special message from BuenosAires, the Group of 77 called for dialogueand consensus and invited the developedcountries to bring to UNCTAD VI the samespirit of understanding and cooperation.The industrial countries (called Group Bwithin UNCTAD) had also made extensivepreparations for the Conference, and theannual ministerial meeting of the OECDand the Williamsburg Summit had gener-ated an air of expectation that progress

could be made. When the Conference wasover and little of substance was achieved, anumber of commentators were quick topass the verdict of failure.

But UNCTAD VI should not be seen asan isolated event to be judged on its own.It is part of a process toward a recognitionof the existence of a more interdependentand multipolar world economy and has tobe considered in this light.

Interdependence

The growing interdependence of theworld economy is a reality, evident in therecent dramatic growth in global trade andfinancial flows. Trade represented 10 per-cent of the combined world GNP in 1960,and had nearly doubled by 1980. Over thepast decade, the volume of world exportsrose by 69 percent, and real world GNP by49 percent. While industrial countries'trade with non-oil developing countriesdeclined slightly as a share of exports be-tween 1960 and 1981, the share to oil ex-porting countries rose. Imports from devel-oped countries represent an even highershare for developing countries, in the re-gion of 58 percent of their total imports in1981. Over the last two decades, trade hasexpanded much faster than growth inworld output. Trade growth has also re-mained unexpectedly resilient in the face ofthe various "shocks" of the 1970s, in partic-ular the oil price increases and the rapidand substantial exchange rate changes thatcame with floating rates.

Financial flows also expanded rapidly inthe 1970s; net capital flows to developingcountries expanded at an average annualrate of 20 percent (in current dollars), fall-ing to 2.2 percent in 1980^82. Total flowsfrom all official and private sources to de-veloping countries rose from $51 billion in1970 to $96 billion in 1982 (in constant 1981prices). This decade also saw a substantialchange in the nature of financial flows, asprivate loans and investment and official



for nfetter or for worse?

nonconcessional loans became more im-portant than official development assis-tance for all but the low-income countries.Official development assistance repre-sented about 60 percent of total flows in the1960s, but only 28 percent in 1982. The fi-nancial solvency of a great number ofdeveloping and some developed countriesbecame a major preoccupation of the com-mercial banks and other developed countryinvestors toward the late 1970s. There areseveral other indications of interdepen-dence: the presence in the industrial worldof workers and skilled personnel from de-veloping countries; the transfer of tech-nology from industrial to developing coun-tries; and the flow of private investmentfrom industrial countries to the developingworld.

The extent of this growing interdepen-dence is only now beginning to be appre-ciated. A recent International MonetaryFund study suggested that each 1 percentincrease in industrial country real GDP isassociated with about a 0.2 percent to 0.3percent increase in non-oil developingcountry real GDP, with the elasticity rang-ing from about 0.7 for major exporters ofmanufacturers to practically zero for low-income countries. There are also indica-tions that this relationship became firmer inthe 1970s compared with the 1960s. Theevolution and causal links of this re-lationship can, of course, largely, but notexclusively, be attributed to growing inter-dependence through trade. Even morestriking are the conclusions of another re-cent study (by Morgan Guaranty Trust) re-garding the impact of changes in devel-oping country output on that of industrialcountries. According to this study, a 3 per-cent cutback in developing country GNPwould decrease the United States' GNP by0.5 percent, that of Japan by 1.1 percent,and that of Europe by 0.8 percent. Whilethe conclusions of these studies are highlytentative in view of the complex relation-

ships between a considerable number ofvariables, they nevertheless point in thesame direction. Does this type of associ-ation reinforce the concept of a worlddivided into an industrial North and a de-veloping South?

Beyond "North-South"

The concept of a North-South dichotomydescribes a situation where a small part ofthe world's population, largely in thenorthern hemisphere, has reached a highstandard of living, whereas a great major-ity, generally in the south, is still a longway behind in terms of per capita income.The developing countries have persistentlyargued their case for changing the structureof a global economic order on the groundsthat at present they are unequal partnerswith the industrial nations. While this con-cept may be politically attractive, it is in-creasingly inaccurate as a framework foranalysis of the dynamics of current worldeconomic development, where many de-veloping countries have grown at ratesmuch higher than those of the industrialcountries. One product of this view of theworld is the developing countries' attitudetoward trade policy, where the constant,overwhelming emphasis has been on ob-taining preferential treatment. With hind-sight, however, it is clear that the worldtrading system has not been static, enjoy-ing unprecedented growth rates through-out the 1960s and much of the 1970s. Thistrade was to the benefit of the North andSouth alike, and without much impetusfrom preferential rules and schemes. In-deed, since 1963, the share of manufacturesin OECD nonfuel imports from developingcountries rose from 13 percent to 51 per-cent. Without belittling the contributions ofpreferential schemes (such as the Gener-alized System of Preferences) to developingcountry exports, the question is whether itwould not have been to the advantage ofdeveloping countries if they had engaged

more fully in the multilateral give-and-takeof the Kennedy and Tokyo Rounds of tradenegotiations. The same paradox may be im-plicit in the developing countries' suspicionof multinational corporations—on balancethe Third World's gains from these can beand have been enormous—and for theiremphasis on concessional flows. While agreat many developing countries needed,and continue to need, large and expandinglevels of aid, private lending to andinvestment in a large number of themhave grown significantly without officialprompting from developed country gov-ernments. Indeed without this increase incommercial finance, the developing coun-tries could not have achieved their robustrates of growth of the 1960s and 1970s.

Growing LDC disparities

The static, quasi-Manichaean descriptionof North-South relations has proved itselfwrong. Developing countries as a group, infact, do not seem to suffer from any com-mon malady other than a relatively lowstandard of living. And even this is lesscommon than one might suppose; there isa greater difference between per capita in-come in the more advanced developingcountries and the least advanced than thereis between the former and many "devel-oped" countries. This should not implythat there are no longer differences be-tween the North and the South nor thatmany developing countries no longer needconsiderable assistance. It does imply,however, that many developing countriesare now highly integrated into the worldeconomy, and that the differences amongthem are as sharp as (or sharper than) thosebetween the North and the South.

Developing countries have coped differ-ently with the cumulative effects of suchexternal factors as successive oil price in-creases and deteriorating export prices.Some succeeded in mobilizing domestic

i;finance fr Dnvlopmcnt I December 1983


(and sometimes external) resources andemploying them efficiently and were ableto achieve impressive growth records,while integrating their economies into theglobal system. Others were less well man-aged. The 1983 World Development Report ofthe World Bank suggests that pervasive dis-tortions in domestic economic policies cancost—indeed may have cost—as much as 2percentage points every year in their GDPgrowth.

The middle-income oil importing coun-tries, a category that contains some of theworld's most dynamic economies, had anaverage GDP per capita in 1981 of about$1,670—compared with $1,250 for middle-income oil exporters, $270 for low-incomeeconomies, and $11,000 for industrial mar-ket economies. The annual per capitagrowth rates of middle-income oil impor-ters over 1960-81 were virtually the same asthat of middle-income oil exporters. Anumber of newly industrialized economiesshowed extremely high growth rates be-tween 1960 and 1981. In 1981, the differ-ence between income per capita in theupper-income developing countries com-pared to low-income economies was nearlyten to one; the ratio between these coun-tries and developed countries was aboutone to four. The comparison between re-spective purchasing power parities lowersthe spread but does not invalidate the argu-ment. In terms of export performance,middle-income oil importers showed an-nual volume increases of 7.0 percent in1960-70 and 4.3 percent in 1970-81, com-pared with 4.9 percent and -0.7 percent inlow-income countries, respectively. Fi-nally, while the middle-income developingcountries succeeded in saving about 24 per-cent of GDP in 1970-80, the saving rate ofsub-Saharan Africa was much smaller, ofthe order of 9 percent. The saving rate ofthe middle-income developing countriescompares very favorably with developedcountries that, despite considerably higherper capita income, only managed to save 21percent of their GDP.

The countries with the most impressivegrowth records have, in most cases,adopted outward looking economic poli-cies and relied on rapidly rising exports,especially to developed countries, andgrowing inflows of public and private capi-tal to finance the imports needed for highlevels of capital investment. Many (thoughnot all of them)—especially those with thepolitical will and capacity to make rapidadjustments—have managed to weatherthe successive "oil shocks" and economicdownturns in developed countries. Notonly are some of these countries rapidlyapproaching the per capita income levels oflow- to middle-income developed countries

but their potential for growth in the me-dium and long term seems to be as good, ifnot better.

It is clear that not all developing coun-tries need preferential trade treatment tocompete successfully in developed countrymarkets; in fact, the more advanced amongthem can provide markets for the goodsand commodities of those farther down thedevelopment scale. Nor do all poor coun-tries need external flows on highly conces-sional terms; because of the sound manage-ment of their economies many of them canobtain returns on investment significantlyhigher than the interest currently chargedby commercial lenders. The rate of returnon investment in the poor countries ofSouth Asia was measured at 19 percent bythe 1983 World Development Report.

Meanwhile, developed countries havebeen beset by problems of stagflation,structural rigidities, and endemic unem-ployment (although here, once again, onewould be overgeneralizing in describingthis as the situation in all developed coun-tries). Many need to make the same radicaladjustments that have traditionally beenurged on developing countries, whether tomanage their domestic economies better orto resist protectionist pressures that de-crease the overall efficiency of their econo-mies and slow down the emergence of asustained recovery. Developing countriesas a group now absorb nearly 30 percent ofall exports from developed countries (40percent of exports from the United States).Hence, whatever is done to aid developingcountries—whether by improving their ac-cess to markets in the developed world orby increasing concessional or nonconces-sional capital flows—is an important mac-roeconomic precondition for sustained de-veloped country growth.

New directions

Faced with increased demands forgreater international economic cooperationone may be tempted to deplore the slowprogress of the individual discussions inthe various international forums on theseissues. But if these are viewed as a part of

Shahid Javed Burkia Pakistani, is the Directorof the InternationalRelations Department of theWorld Bank. A graduate ofPunjab University(Pakistan), Oxford andHarvard Universities, hejoined the Bank as a senioreconomist in 1974.

a process, one may discern progress inmany vital areas—in particular toward abetter understanding of the dynamics ofthe global economy. Thus, when the GATTmet at the ministerial level in late 1982, theemphasis was on resisting protectionism,on rolling it back, and on moving forwardon various fronts where progress had beenlacking in the past. On issues such as barri-ers to trade in agriculture, the divisionswere more among developed countriesthan between North and South. New is-sues, such as trade in services, were, how-ever cautiously, introduced as new subjectsfor GATT examination, and the developingcountries were willing to participate morefully in these deliberations than they haddone in the past. At subsequent meetings,there also seems to have been a growingrealization among developing countriesthat they have to be more active in the mul-tilateral system. At the New Delhi meetingof the nonaligned nations in February 1983the developing countries appeared to moveaway from the objective of negotiating anew international economic order in onego. They showed willingness to deal sepa-rately with the issues of trade, commodityprice stabilization, and financial flows. Atthe same time, they were prepared to rec-ognize that there had emerged a consid-erable potential for economic cooperationamong themselves that could be tackled onthe basis of what has come to be calledECDC—economic cooperation among de-veloping countries.

This evolution of developing countrythinking was central to the adoption of theBuenos Aires "platform" for UNCTAD VIin which the Group of 77 indicated that,while global negotiations were still impor-tant to them, they would focus first on im-mediate measures to revive the global econ-omy and their own development. At thesame time, some progress was also made atthe Williamsburg Summit of the industrialnations toward a better understanding ofthe dynamics of North-South relations, inparticular the recognition that economic re-covery must be treated in the context of theeconomic interdependence between devel-oped and developing country economies.The Williamsburg participants also under-lined the importance of not limiting theirefforts to rolling back protectionism as therecovery proceeded, but to look towardachieving further trade liberalizationbetween developed and developing coun-tries and between developing countriesthemselves.

UNCTAD VI—in retrospect

UNCTAD VI was held against this back-ground. The Conference addressed a con-siderable number of major issues, many of



which were new. UNCTAD has tradi-tionally been a forum for addressing a vastarray of North-South issues. Significantly,its three major tangible achievements havebeen directed to sharing and stabilizing theglobal pie. This was true for the Gener-alized System of Preferences, which wasjustified by the perceived need of devel-oping countries to obtain a competitiveedge over their developed country com-petitors. This is true for the Code of Con-duct for Liner Conferences, the essentialresult of which is to share liner cargo ship-ping between developed and developingcountries. It is also true for the CommonFund—the linchpin of a series of com-modity agreements, whose objective is tointroduce greater stability in commoditymarkets and help commodity producers indeveloping countries move into more prof-itable lines of economic activity through theactivities of the so-called second window.

At UNCTAD VI, however, the devel-oping countries attached major emphasisto global recovery and to protectionism.Consequently, the conference devoted con-siderable effort to preparing a commonanalysis of the world economic situationand an agreed overall strategy for economic

recovery and development. In the end,UNCTAD VI adopted resolutions (mostlyby consensus) on most aspects of interna-tional cooperation for development, in-cluding agreement on the next steps to betaken and evolutionary improvements inmany areas. Trade proved to be the mostdifficult area of negotiation. The Groupof 77 long resisted any language thatsuggested that developing countries, too,might improve their trade policies, but theyeventually accepted a statement con-demning protectionism in general. Certainindustrial countries, on the other hand, ini-tially insisted that a rollback of protec-tionism should be conditional on the long-awaited economic recovery. In the end,developed countries as a group agreed to"halt protectionism by fully implementingand strictly adhering to the standstill pro-visions they have accepted, in particularconcerning imports from developing coun-tries" and to "work systematically towardreducing and eliminating quantitativerestrictions and measures having a similareffect."

On financial issues, previous UNCTADsessions had been preoccupied with the is-sue of whether UNCTAD was an appropri-

ate forum to discuss World Bank and Fundmatters. The conference finally adopted, byconsensus, and without reservations or in-terpretations, a resolution on multilateraldevelopment institutions. This stated es-sentially that these institutions must be ad-equately funded for "continuing significantgrowth in their lending in active pursuanceof their increasingly important develop-ment role." The essence of this and otherreferences to the multilateral developmentinstitutions was to underline a significantconsensus on the important role of theseinstitutions, in general and in respect ofparticular groups of developing countries,and to emphasize the generally shared con-cern that developing countries' liquidityproblems and capital requirements aresuch that they call for continuing re-sponsiveness of developed countries to thefunding needs of the Fund, the WorldBank, and other international financialinstitutions.

Although these developments canhardly be described as a great advance,they are part of a gradual process that, it ishoped, will lead to a more constructive ap-proach to international deliberations on

rneconomic cooperation. IsU

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finance & Development / December 1983 19


Korea'smajoradjustmenteffortA resolute program to meetdomestic and externalproblems, and its costs

G. Russell KincaidNon-oil developing countries (NODCs)were confronted with serious economicproblems in the early 1980s stemming fromthe oil price increases in 1979-80, the un-precedentedly high interest rates in inter-national financial markets, and the pro-longed recession in industrial countries.Coping with the resulting strain on the bal-ance of payments and with the adverse im-pact on incomes and growth became amajor task of economic policy in NODCs.

Although the deterioration in global eco-nomic conditions affected each country dif-ferently, Korea's experience is particularlypertinent for several reasons. First, theKorean economy was particularly hard hitby these external developments because ofits total dependence on imported petro-leum, its high level of external debt subjectto variable interest rates, and its pursuit ofexport-led growth. Second, the develop-

ments mentioned above were compoundedby difficulties of domestic origin that to-gether brought to an end a long period ofremarkable development, the so-calledKorean "economic miracle." Third, Koreawas highly successful in its adjustment ef-forts: in 1979 its economic performance wasclose to the average for NODCs; however,by 1982, a vigorously implemented adjust-ment program had brought the current ac-count deficit and inflation rate well belowthe mean for NODCs, while real GNPgrowth was substantially above the average(Table 1). Notwithstanding Korea's posi-tion as the fourth largest debtor amongNODCs, its external debt indicators wereclose to, or below, those of other NODCs.

"Economic miracle": 1960-79

In a span of two decades, Korea pro-gressed from being one of the world'spoorer countries, with a per capita incomeof $90 in 1960, to belong to the ranks of themiddle-income countries, with a per capitaincome of $1,600 in 1979. A more thanthreefold increase in real per capita incomewas associated with a broad-based im-provement in living standards. Substantialand efficient investment in the manu-

facturing sector transformed a predom-inantly agricultural economy dependent onforeign aid into a semi-industrial econ-omy with a dynamic export sector, whichrecorded average annual increases inexport volume of 30 percent during thisperiod.

Agriculture's share in GNP declinedfrom 45 percent in 1960 to 20 percent in1979, while that of the manufacturing sec-tor rose from 10 percent to 25 percent dur-ing the same period. The principal reasonfor this decline was the rapid growth in themanufacturing sector, based on an expan-sion of labor-intensive export goods, whichaveraged 19 percent per annum—morethan double the growth rate for real GNPand five times that for the agricultural sec-tor. Reflecting this development, the pro-portion of the labor force engaged in agri-culture declined from about 60 per cent to30 percent, while that of the manufacturingsector rose from less than 10 percent to over20 percent. The rapid growth in labor-intensive manufacturing goods absorbedlarge increases in the urban labor force,while real wages rose by about 7 percentper annum.

Korea's rapid transformation was madepossible by socioeconomic factors, as wellas by the implementation of appropriateeconomic policies. Korea underwent a suc-cessful land reform during the 1950s,which facilitated the introduction of newagricultural technology and encouragedinvestment. Widespread education, dili-gence, and thrift facilitated the transition ofrural workers to factory jobs, contributed tohigher labor productivity, and supplied thenecessary savings for capital formation.

The most important factor, however,was the decision to pursue an export-ledgrowth strategy. With a poor natural re-source endowment and little capital, Koreaadopted a strategy for growth based on itsonly abundant resource—labor. Light man-ufactured products, using labor-intensivetechniques, became the key to sustaineddevelopment. Economic policies encour-aged capital accumulation in sectors whereKorea had a comparative advantage. Thereal trade-weighted exchange rate wasmaintained, except during the late 1970s, ata level that made the export sector com-petitive. Exporters had virtually free accessto imported inputs at international prices.Fiscal incentives that promoted investmentin exports included generous depreciationallowances and exemption from indirecttaxes on intermediate inputs. The Govern-ment also extended export incentives to do-mestic producers of intermediate inputsused in exports; however, because of therelatively free trade in these inputs, onlyefficient domestic producers flourished.



Table 1Selected economic indicators for Korea and non-oil developing countries, 1979-82

1979

Korea NODCs1980

Korea NODCs1981

Korea NODCs1982

Korea NODCs

As a percent of goods and services

Current accountdeficit

External debtDebt service1

-21.3105.015.2

-17.9119.219.0

-23.6121.218.4

-20.5112.917.6

-17.0119.120.7

-23.2124.920.4

-9.0131.320.9

-19.3143.323.9

!n percent

GrowthInflation

6.418.3

5.024.6

-6.228.7

4.831.0

6.421.3

2.532.8

5.47.3

1.434.0

Sources: Data provided by Korean authorities; IMF, World Economic Outlook, 1983'Includes interest payments on short-term debt.

historical trend to only 14 percent in 1978and fell by 1 percent in 1979. While slowergrowth in foreign demand and rising pro-tectionism contributed to the stagnation ofexports, the strong export performance ofother East Asian countries suggests thatthe primary cause was the decline in Ko-rea's external competitiveness. The currentaccount position deteriorated from a virtualbalance in 1976-77 to a deficit of almost 7percent of GNP in 1979. Domestic factorswere the principal reason for this deterio-ration (Table 2).

By the end of 1979, the immediate out-look for the Korean economy was bleak.The domestic economy was severely over-heated and faced major structural problemswith supply bottlenecks, overinvestment in

(On the other hand, producers for thedomestic market were protected from for-eign competition by a system of importcontrols.)

The public sector deficit remained rela-tively small throughout this period partlybecause the Government relied on selectivecredit policies to achieve its objectives. Aliberal credit policy provided financial re-sources for working capital and fixed in-vestment within a tightly controlled fi-nancial system. The Government owned allfive nationwide commercial banks and nu-merous nonbank financial institutions,through which it set all nominal interestrates and allocated loanable funds to im-portant sectors (mainly exports) at sub-sidized interest rates. As a consequence ofthese controls, an unorganized moneymarket emerged. Official interest rates,both for loans and deposits, were main-tained at positive real levels in order to en-courage domestic savings and discouragecapital-intensive investments.

Emerging problems: late 1970s

Toward the end of the 1970s, the Koreaneconomy began to show signs of strainfrom sustained excess domestic demandpressures. A major investment boom, asso-ciated with the Government's ambitiousdevelopment plan (Fourth Five-Year Plan,1977-81) raised the investment/GNP ratiofrom 25 percent in 1976 to 35 percent in1979. Unlike previous development plans,investment in heavy industry (i.e., ma-chinery, steel, shipbuilding, and petro-chemicals) and housing was emphasized.Generally, these investments were morecapital-intensive than past investments andsubject to a longer gestation period; con-sequently, the incremental capital/outputratio nearly doubled. The substantial in-crease in investment did not immediatelyproduce a commensurate expansion in ca-

Table 2Korea: external adjustment, 1979-82

(In percent of GNP)

197911980 1981 1982

Exogenously induced change in thecurrent account deficit2

Oil price adjustmentChange in non-oil terms of tradeChange in foreign interest ratesOther changes in invisibles accounts,

excluding overseas construction3

Extraordinary rice importsAdjustment effort2

Change in volume of oil imports4

Change in volume of non-oil imports4

Change in export volumeChange in net receipts from

overseas constructionActual change in the current account

deficit2

-1.3-1.9

2.1-0.7

-0.8—

-5.6-0.4-8.8

2.4

1.2

-6.9

-9.4-4.4

2.8- 1.1

-1.1—

7.30.14.13.0

0.1

-2.1

-3.21.80.4

-1.1

0.3-1.06

4.3—

-1.36

4.9

0.7

1.1

2.20.31.20.8

-0.1—

1.00.1

-1.51.8

0.6

3.2

Source: IMF staff calculations.— Indicates zero.'Change from 1977.2A negative sign indicates an increase in the current account deficit; a positive sign indicates a decrease.3Mainly increased interest payments due to greater external debt.4Positive number indicates a decline in the import volume or an increase in export volume.5Made necessary by the crop failure in late 1980.6Excludes extraordinary rice imports.

pacity and a large domestic resource gapemerged, exerting pressure on the balanceof payments. Rapid credit creation to fi-nance the investment boom further fueledexcess demand, and domestic inflationclimbed well above the level of Korea's tra-ding partners. An overheated economyand a diversion of workers for overseasconstruction projects led to a tight labormarket and to increases in real wages thatgreatly outstripped productivity growth.

The combination of relatively high do-mestic inflation, sharply rising unit laborcosts, and the adoption of a rigid exchangerate policy resulted in a progressive deteri-oration of export competitiveness. As a re-sult, export volume growth slowed from its

heavy industries, and a relatively energy-intensive production pattern. The alreadydifficult situation was greatly compoundedby the triple shocks of a doubling in petro-leum prices, higher interest rates in inter-national financial markets, and a recessionin Korea's trading partners.

As a result, Korea's oil import bill in-creased by $2.7 billion during 1980 to $6.2billion (28 percent of total imports). Over 60percent of Korea's external debt was con-tracted at variable Eurodollar interest ratesthat rose to 14.5 percent by the end of 1979,about a 6 percentage point increase overthe previous 12 months, and remained atthat level throughout 1980. These higherinterest rates were a primary cause of inter-



est payments on Korea's external debtdoubling to $2.6 billion in 1980. Foreign de-mand for exports weakened abruptly in1980; economic activity in Korea's exportmarkets fell by 1.7 percent compared withan increase of 5.2 percent in 1979. More-over, protectionist pressures in these mar-kets intensified and Korea's non-oil termsof trade deteriorated by 10 percent in 1980.

At the outset of 1980, there was no doubtthat Korea faced a major adjustment prob-lem: in the absence of corrective policies,the current account deficit would have in-creased to over 16 percent of GNP duringthe year. The severe economic problemswere compounded by an equally difficultpolitical and social crisis. The President wasassassinated in October 1979; considerablepolitical uncertainty and the worst socialunrest in 20 years ensued. The situation didnot stabilize until September 1980.

Adjustment program begun: 1980

Early in 1980, the Korean authoritiesstarted implementing a wide-ranging ad-justment program in response to the deteri-oration in the country's economic condi-tions and outlook. The prospective currentaccount deficits were clearly unsustainable.Because of the magnitude of the imbal-ances, which were partially rooted in theeconomic structure, it was recognized thatthe adjustment process would take con-certed efforts over several years but thatsignificant progress was required in thefirst year. The authorities believed that aviable external position was a prerequisitefor sustained growth, even though adjust-ment policies would entail some initial re-duction in growth. As the external positionimproved, economic policies were directedmore toward containing inflation andmaintaining acceptable growth. These sta-bilization efforts were supported by a seriesof stand-by arrangements with the Fund;the most recent arrangement was approvedin July 1983 and extends through March1985.

Economic policies in 1980 reflected theGovernment's determination to face thechallenges with bold and resolute actions.The won was depreciated by 17 percent inJanuary 1980 to restore external competi-tiveness and declined further during theyear under a flexible exchange rate policy;for the year as a whole, the won depreciatedby about 30 percent on a trade-weightedbasis. To alleviate demand pressures, the1980 budget (formulated in late 1979) wasrevised and its deficit reduced as a per-centage of GNP by cuts in real currentexpenditures—largely wages—and by de-ferring investment projects. Fiscal policy,on a cyclically adjusted basis, was contrac-tionary. Credit policy was also tightened;

real domestic credit growth slowed to 5percent in 1980, compared to an annualaverage increase of 15 percent during1977-79. Interest rates were raised by 6 per-centage points; real interest rates, however,turned substantially negative as inflationaccelerated. More moderate wage increaseswere promoted through a massive cam-paign to educate the public about Korea'seconomic problems.

Demand-management policies were sup-plemented by measures designed to correctstructural supply weaknesses in the econ-omy. Reorganization of certain key heavyindustries was begun to alleviate past over-investment and to promote efficiency. In-vestment strategy shifted from capital-intensive industries toward high skilledlabor-intensive products, such as semicon-ductors, electronics, and telecommunica-tions equipment, in a continuing effort tocompensate tor Korea's diminishing com-parative advantage in low wage, labor-intensive products. The main thrust forenhancing productivity was to come fromincreased competition in domestic indus-tries, resulting from reduced import bar-riers, greater foreign investment, and di-minished government intervention.

A major financial sector reform was ini-tiated to improve financial intermediationby relying more on market signals to allo-cate financial resources. The first stepswere taken to denationalize the bankingsystem, to liberalize financial markets, andto eliminate the difference between prefer-ential and general interest rates. To reducedependence on imported oil, the Govern-ment launched a long-term energy plancentered on the development of nuclearpower and incentives for energy conserva-

tion. In order to encourage conservation,prices of petroleum products were raisedabove the level of international prices byincreasing domestic prices by 170 percentbetween January 1979 and February 1980.

Implementation of these stabilizationand structural policies resulted in substan-tial external adjustment in 1980 that limitedthe increase in the current account deficit toonly about one quarter of the rise inducedby the deterioration in the external envi-ronment (Table 2). Nearly all the adjust-ment took place in the non-oil trade ac-count. Export volume rose by 11 percent, asincreased export competitiveness offset theeffects of recession in Korea's export mar-kets. Non-oil imports contracted by 16 per-cent, reflecting the effects of the depreci-ation of the teem and stagnant aggregatedemand. Adjustment efforts of this mag-nitude were not without costs; real GNPdeclined by 6.2 percent—the first decline inover 20 years—and inflation soared to itshighest level in over a decade. Financialpolicies were only partially responsible forthese outcomes. A disastrous rice harvestin late 1980, caused by adverse weather, ledto a 22 percent drop in agricultural produc-tion; nonagricultural production rose byabout 1 percent. Energy price increases, thedepreciation of the won, and the crop fail-ure accounted for about three quarters ofthe rise in prices and masked the mod-eration in the underlying inflation.

Efforts continued: 1981-83

During 1981, the authorities continued topursue their objectives to reduce the exter-nal imbalance and lower inflation but re-laxed policies somewhat in order to counterthe domestic recession. Fiscal stimulus was


Korea—selected economic indicators

Source: Korean authorites


provided by increasing public spending,particularly capital expenditures, and cut-ting tax rates. Investment projects wereconcentrated on rural infrastructure—withthe aim of alleviating some of the sharp fallin agricultural incomes—and on low-income housing—with the goal of raisingincomes of urban workers. As a result, thepublic sector deficit rose to 5 percent ofGNP from 3.5 percent, and, on a cyclicallyadjusted basis, the impulse of fiscal policybecame expansionary.

There was also a marked easing of mon-etary conditions; real domestic credit roseby 16 percent to accommodate the largerfiscal deficit and to provide sufficient creditto the private sector. Nevertheless, real in-terest rates rose throughout 1981 and, inthe fourth quarter, turned positive. Thewon depreciated by 6 percent against theU.S. dollar, but with the strengthening ofthe U.S. dollar against major currencies,the nominal effective exchange rate re-mained constant. Consequently, the realeffective exchange rate appreciated byabout 5 percent as domestic inflation re-mained higher than foreign inflation.

Structural reforms initiated in 1980 werecontinued: the reorganization of heavy in-dustries was completed; a second commer-cial bank was denationalized; and interestrate ceilings on certain short-term commer-cial paper were eased. Import liberalizationalso continued as the proportion of importson unrestricted categories rose to 75 per-cent in 1981 from 69 percent in 1980.

Korea's external adjustment effort—equivalent to about 4 percent of GNP—re-mained substantial in 1981. The significantimprovement in external competitivenessachieved in 1980 contributed to a 20 percentgrowth in export volume. The volume of oilimports was unchanged in spite of the re-turn to high growth rates, due in part tosuccessful conservation efforts, includingthe large domestic price adjustments, whilenon-oil imports, excluding rice, rose byonly 5 percent in real terms. Most of thisadjustment effort was offset by sizable riceimports necessitated by the poor harvest in1980, a further deterioration in the terms oftrade, and still higher foreign interest rates.Nevertheless, the current account deficitdeclined. The objectives for growth and in-flation were also largely met; real GNP roseby 6.4 percent and inflation fell to 13percent.

Adjustment efforts were moderated in1982 and 1983 with the emergence of a sus-tainable current account deficit. Economicpolicies during this period have aimed atachieving price stability with acceptablegrowth and some improvement in the cur-rent account position. Budgetary policy hasbeen the principal tool of the Government's

adjustment strategy as fiscal policy, on acyclically adjusted basis, once again turnedcontractionary. The high nominal incomeelasticity of the tax system was the mainreason for the further reduction in the fiscaldeficit. Monetary policy's support of theobjectives for 1982 and 1983 was con-strained by a crisis in May 1982 in the unor-ganized money market, which disruptedthe flow of funds to firms. To avoid a gener-alized financial crisis, bank credit was in-creased at an annual rate of 50 percentduring the third quarter of 1982. With nor-malization of financial conditions in thefourth quarter of 1982, the authoritiesturned to a tighter monetary policy; bymid-1983, nominal credit expansion haddeclined to its lowest level in over a decade.Real interest rates remained positivethroughout 1982 and 1983 and averagedabout 4 percent. The won's depreciationagainst the U.S. dollar has continued atabout 6 percent per annum during 1982-83.The nominal effective rate also depreciated,while Korea's better relative price perfor-mance led to a depreciation of the real ef-fective exchange rate that reversed the ap-preciation in 1981.

The pace of structural reform was quick-ened in 1982-83. Within the financial sec-tor, the Government denationalized all na-tionwide commercial banks, eliminatedpreferential interest rates, replaced directcredit control through credit ceilings on in-dividual banks by indirect control throughreserve money management, and autho-rized two new commercial banks and nu-merous nonbank financial insti tutions. Tostimulate foreign direct investment, thenumber of industries in which foreignerscan invest was increased substantially, ap-proval procedures were simplified, and re-strictions on repatriation of capital anddividends were removed. High-technologyindustries have been encouraged by theformation of a venture capital system,greater expenditures on research and de-velopment, and new manpower trainingprograms. Korea has also continued to lib-eralize imports.

The current account deficit in 1982 wasalmost half its level in 1981; two thirds of

G. Russell Kincaidrt U.S. citizen, until degreesfrom the University of

California at l.,os Angela;and Columbia University,joined the Fund in 1976.Mr. Knieaid /s currently aSenior Economist in theAsian Department workingon Korea.

this reduction stemmed from an improve-ment in the terms of trade and lower for-eign interest rates, while adjustment poli-cies accounted for the remainder. Non-oilimport volume increased by 6 percent,partly due to reduced rice imports, whilereal oil imports declined. In spite of weakexternal demand and the rise in protec-tionist pressures abroad, export volumerose by 6 percent or in line with the exportperformance of Korea's competitors in EastAsia.

Output growth slowed to 5.4 percent un-der the influence of the weaker export per-formance, contractionary fiscal policy, andthe return of agricultural expansion to itstrend growth rate after the sizable expan-sion of the previous year. Inflation fell to 5percent as import prices, in domestic cur-rency terms, were unchanged and domes-tic inflation was moderated by the Govern-ment's anti-inflationary policies.

Data for 1983 are as yet incomplete.Nevertheless, there are clear signs thatprice stability has been achieved along withdynamic output growth and a sustainablecurrent account deficit. Prices rose by only3 percent over the 12-month period endedJuly 1983, while real GNP expanded by anestimated 8 percent in the first half of 1983.During the first seven months of 1983, thecurrent account deficit was $1.2 billion orabout 3.5 percent of estimated GNP.

Korea's adjustment path since 1979 hasneither been smooth nor easy, but it has ledto considerable success. In response to thedeterioration in external conditions andpent up excess demand pressures, and not-withstanding considerable domestic tur-moil, Korea adopted strong adjustmentpolicies in early 1980. The magnitude of theadjustment effort was unprecedented forKorea—amounting to almost 13 percent ofGNP over 1980-82. Over half of this adjust-ment effort was undertaken in 1980 at thecost of a slowdown in real growth. Never-theless, when viewed from a longer-termperspective, the costs associated with theKorean adjustment program were substan-tially less; its average annual growth of realGNP was about 3 percent during 1980--82 orequal to the mean for all non-oil developingcountries. During 1982, Korea's current ac-count deficit, as a percentage of exports ofgoods and services, was less than half theaverage for NODGs; the level of Korea'sinflation was only about one fif th the aver-age for NODCs; and Korea's real growthwas 4 percentage points above the averagefor NODCs. Consistent application of ad-justment policies by Korea during the 1980shas succeeded in establishing a viable ex-ternal position and in providing the basisfor sustained growth with low inflation.

EDFinance f-r Development! December 1983 23


Issues in adjusting to higher prices and exploiting potential energy resources

Yves Rovani

Since the dramatic change in energy pricesin 1973, the world economy has been vol-atile and uncertain. After the initial shock,many felt that the problem would be ashort-term financial one—manageable be-cause the international money market wasflexible, commodity prices were booming,and interest rates lagging behind inflation.Since the late 1970s, however, the problemhas become more complex: inflation andthe measures taken to combat it have con-tributed to a slowdown and eventual re-cession in the rich countries; world tradehas stagnated, commodity prices haveslumped; and protectionist pressures haveintensified. Developing countries have ex-perienced lower export earnings, vastly in-creased indebtedness, a reduced flow of ex-ternal capital, and lower economic growth.

One of the most difficult tasks facing themajority of these countries (but one that isunavoidable if they are to resume healthygrowth) is to adjust their economies tothe higher costs of energy. For many, ex-

panded investments to increase energyproduction and to raise the efficiency oftheir energy use will be central to the pro-cess of economic growth. These invest-ments require:

• The mobilization of funds on an un-precedented scale, both externally andfrom domestic sources, particularlythrough operating surpluses in energy en-terprises; and

• The upgrading of human resources toensure that investments in energy devel-opment form part of a rational strategy,and that energy programs and projects aredesigned and executed in a cost-effectivemanner.

Moreover, these extra investments haveto be made at a time when the aggregate oilimport bill of the oil importing developingworld has risen to $62 billion per annum(absorbing almost a quarter of total exportearnings and over 50 percent for somecountries). Further, borrowing for energyinvestments is double the level it was fiveyears ago, and the creditworthiness ofmany of these countries has been eroded.

Two recent developments—the slow-down in world energy consumption and

the significant softening in international oilprices—give the developing countries atemporary respite from the rising financialburden of importing energy. They do not,however, lessen the need for adjustment tohigher prices.

Since 1980, global energy consumptionhas risen hardly at all and oil demand hasfallen significantly. This is due partly toenergy conservation and oil substitutionmeasures, particularly in the industrialcountries, and partly to the slowdown ineconomic activity. But though it is difficultto establish the relative importance of thesetwo factors, it is widely agreed that evenwith continued conservation, the revival ofglobal economic activity will result in ahigher rate of energy consumption. AsChart 1 shows, the World Bank estimatesthat between 1980 and 1995 the developingcountries' commercial energy consumptionwill almost double. This is an annualgrowth of about 4.5 percent on average, orabout the same rate as their projectedgrowth in GDP over this period (of 4.8percent).

As in the rest of the world, the devel-oping countries' oil consumption will grow

24 Finance & Development I December T983

Energy transtionin developing countries


much more slowly than total commercialenergy consumption (at about 2.7 percentper annum, which is less than half the com-parable rate for the 1970s). Nevertheless,this will still entail a 50 percent increase intheir oil consumption in absolute terms by1995. Moreover, despite this slowing downin the growth for oil demand and notwith-standing the major efforts that are plannedto increase indigenous oil production, theoil importing developing countries will stillneed to increase their oil imports by over30 percent between 1980 and 1995. Thesetrends will make the developing countries amajor global oil consumer. In incrementalterms, these countries will account for thewhole of the projected global increase in oildemand, offsetting declines in oil use byother country groups. Their share of globaloil consumption will also rise from 20 per-cent in 1980 to 27 percent by 1995.

This expected revival in oil demand inthe developing world is one important fac-tor why the long-run trend of internationaloil prices is forecast to be rising. Obviously,short-term fluctuations in oil prices cannotbe ruled out, but low prices, say in therange of $20-25 per barrel, are not expectedto be sustainable in the longer run. Suchprices would cause the growth in total en-ergy demand to accelerate again and thedemand for oil to increase even moresharply, since the price of oil would belower than those of other fuels. On the sup-ply side, much of this additional demandfor oil could eventually only be met outsideOPEC sources by developing petroleum re-sources costing, at the margin, more than

Chart 1Commercial primaryenergy consumptionin developingcountries,1970-95

Oil

Coal

Naturalgas

Primaryelectricity

Sources: United Nations J Series and World Bankestimates

'Tons of oil equivalent.

$20-25 a barrel. Moreover, it is now gen-erally agreed that giant oil fields that couldbe developed at lower costs than this arehighly unlikely to be discovered. Recent ex-perience has also shown that synthetic sub-stitutes for oil are likely to be much moreexpensive than was init ial ly envisaged.

Managing demand

Developing countries have already madeprogress in adjusting to higher energyprices. It is crucial for their future develop-ment that this adjustment be not only sus-tained but given additional momentum.The key elements of an adjustment strategyconsist of: increasing the efficiency of en-ergy use through rational pricing and de-mand management measures; undertakingan expanded and diversified program ofinvestments to expand the supply of in-digenous energy; raising resources to meetthese new investment needs; and, finally,in order to carry out these tasks effectively,strengthening the management and insti-tutional capacity in the energy sector.

Developing countries can improve theefficiency of energy use in virtually all sec-tors. There are many ways of achievingthis, ranging from appropriate pricing pol-icy to the provision of technical assistanceand information to the main users. Experi-ence has shown clearly that appropriateenergy pricing is the single most effectiveway of managing demand. In many oil im-porting developing countries, changes inoil costs have been quickly reflected in theprices paid by final users; between 1975and 1981, the growth in their real domesticprices kept pace with international prices.In contrast, in many oil exporting developing countries, retail petroleum productprices are still well below internationalprices. Moreover, in both groups of coun-tries there are still distortions in the relativeretail prices of different petroleum prod-ucts. In the sector as a whole, more effortsneed to be made in most countries to bringthe price of domestically produced "fuels"(principally electricity but also coal and gas)more in line with the opportunity costs ofsupply.

Appropriate pricing usually needs to besupplemented by demand managementprograms. There are several reasons forthis. First, energy users may be unaware ofthe potential for using energy more effi-ciently, or of the technical options availablefor doing so. Second, institutional or policyfactors may reduce interest in savingenergy—this is particularly true in state en-terprises that are protected from competi-tion and have their input and output pricesregulated. Third, shortages of finance, orimperfections in the systems allocating fi-nance, may make it d i f f i cu l t to finance eco-

nomically attractive projects that improvethe efficiency of energy use but do not ex-pand production capacity. For the largerenergy users--such as industrial plants,large public and private transport enter-prises, and electric power utilities- directgovernment assistance and support may benecessary to identify and realize savingsthrough such low-cost improvements asbetter energy management and mainte-nance, as well as through large investmentsin retrofitting and process change. Forsmaller users, the priority will be to de-velop policies conducive to efficient utili-zation as well as suitable institutions toprovide firms and households with the in-formation, incentives, and know-how toimprove their own energy efficiency.

In the broader economic sense, a wholerange of strategic and policy choices affectthe future pattern and growth of energydemand in each country. The increasedcost of energy requires a more critical re-view than is customary of the expansionplans of energy-intensive industries, thepolicies affecting the choice of transportmodes, the design of commercial and insti-tutional buildings, the urbanization pat-terns, the sources of primary energy forelectric power, and the design and opera-tion of petroleum refining facilities.

Increasing supply

Since 1973, developing countries haverecognized that higher international oilprices make it worthwhile to exploit anddevelop indigenous energy resources thathad previously been uneconomic, andmost of them have strengthened programsto increase domestic energy supply. Anal-ysis of the supply potential and market re-quirements of the developing countries in-dicates that their production of commercialenergy could rise to almost double the 1980levels, reaching 3.1 billion tons of oil equiv-alent, in 1995. About a third of this increasewould be in the production of oil, 27 per-cent in coal, 22 percent in natural gas, and19 percent in primary electricity drawnmainly from hydro and nuclear power(Chart 2). In the aggregate, this projectedincrease amounts to half of the projectedglobal incremental commercial energy production over 1980-95 and it will result inthe developing countries supplying over athird of the world's commercial energysupply by 1995, as compared with onefourth in the 1970s. These projected in-creases in supply are based on an in-depthcountry-by-country evaluation of energyresources and production potential andtake into account the limitations imposedby the growth of energy demand and thepace of fuel substitution programs in thedeveloping countries. They reflect the fact

Finn nee <.V Development / December I.4.SJ 25


that only a fraction of the enormous po-tential for exploiting indigenous energysources in the developing world has beenrealized to date.

Financing energy investment

Realizing the necessary investments willpose an enormous financing problem andwill require far-reaching changes in theway energy operations are managed. Sev-eral developing countries have substan-tially increased their investments in en-ergy. In Turkey, investments (in 1980dollars) rose from $780 million in 1973 to$2.2 billion in 1980; in India, investments inthe oil and gas sector grew at an averageannual rate of about 25 percent, while over-all energy investment during the same pe-riod grew about 19 percent per annum. InPakistan, the share of energy in nationalinvestment increased from 15 percent in1975 to 21 percent in 1981.

However, the investments of the pastfew years are dwarfed by the requirementsfor the future. Countries will need to de-vote a much larger share of their total re-sources to energy development than in thepast. As a rough guide, energy invest-ments may claim 4 percent of GDP in the1980s compared with 2-3 percent in the late1970s. The World Bank estimates that de-

Chart 2Commercial primaryenergy productionin developingcountries,1970-951

Commercial energy investment requirements in developing countries, 1982-92(In billions of U.S. dollars)

Oil3

Coal

Naturalgas

Primaryelectricity4

Sources: United Nations J series and World Bank estimates.'Total excludes alcohol, oil shale, tar sands, and other non-

conventional primary energy sources that may add a smallamount (up to 10 million toe, or less than 0.5 percent) todeveloping country energy production by 1995, but whoseprospects are too uncertain to quantify.

2Tons of oil equivalent.Includes natural gas liquids and oil production from sec-

ondary recovery techniques."includes hydropower, nuclear, and geothermal electricity.

Middle-income countries

Low-incomecountries

Oilimporters

Oilexporters

All developingcountries

Annualaverage1982-92

Electric powerHydroNuclearGeothermalThermalTransmission and distribution

OilExplorationDevelopmentOther1

Refineries2

Natural gasExploration, development, trans-

mission and maintenanceDomestic distribution3

Exports

74.46.30.1

43.249.9

173.9

21.243.2

2.566.9

30.8

Coal

17.54.30.0

21.8

55.2348.6

132.240.8

4.375.8

101.8354.9

48.932.4

6.087.3

52.8

16.84.73.0

24.5

27.2546.7

31.86.12.1

39.749.9

129.6

99.1195.9

16.7311.7

39.7

30.27.46.2

43.8

6.3531.1

238.453.2

6.5158.7201.6658.4

169.2271.5

25.2465.9

123.3

64.516.49.2

90.1

88.71,426.4

21.74.80.6

14.418.359.8

15.424.7

2.342.4

11.2

5.91.50.88.2

8.1129.7

Source: World Bank estimates.Note: These estimates are for the investments required during 1982-92 to achieve the energy production levels set out

in Chart 2. Some additional investments amounting to $13 billion per annum will be required in 1993-95 to complete theprojects for 1995 production. Expenditures shown in this table do not include investments for fuel storage and retaildistribution (except for pipeline investments for domestic distribution of natural gas) and for infrastructure associated withenergy imports.

'Includes maintenance of old fields, enhanced and secondary oil recovery, pipelines, and infrastructure.2Estimates include investments in refinery modifications necessary to achieve a balance between petroleum product

supply and demand within developing countries, as well as investments in refinery rehabilitation and replacement of old plantand in energy conservation measures. These estimates could vary by as much as 20 percent, depending on assumptionsconcerning the refinery mix in China, and on the extent to which product imbalances in the developing countries are metthrough direct trade in refined products. Estimates exclude investments in infrastructure! development, which amount toabout $10 billion.

•Distribution of gas from major transmission pipelines to residential and commercial users.

veloping countries will need to invest $30billion a year in energy production (in 1982dollars) during 1982-92 (see table). About$60 billion of this required investment is inelectric power, which is becoming morecapital-intensive because of an increasingreliance on hydro resources and coal-firedthermal generation. Investments in oil arealso likely to rise dramatically from histori-cal levels and amount to about $40 billion ayear, while gas and coal account for theremainder.

Two general points need to be empha-sized about these estimates of investmentcosts. One is that energy investments arebecoming more and more expensive. Forexample, to generate a kilowatt of hydro-electricity can require three to four times asmuch investment as to generate a kilowattby burning oil. Second, costly as they are,the investments projected are not only nec-essary and technically feasible—they willalso remain economically attractive under awide range of oil prices. Most of themwould still be profitable even if the world

oil price settled at a much lower level, thatis, at $25 a barrel in 1983 dollars.

Just over half of the total sum required bydeveloping countries, or $66 billion a year,is needed in domestic currencies. Espe-cially in power and coal, where 60-75 per-cent of the financing needed is for localcosts, expansion programs will stand or fallon the ability to raise domestic resources.This calls for strong action, first, to reformpricing policies, so that consumers pay theeconomic costs of supply, allowing enter-prises to finance expansion; and, second,to modernize management, so that enter-prises are more efficiently run.

The other part of the resource require-ment—$64 billion a year—is for foreign ex-change. At present, the foreign exchangeflows to developing countries for these pur-poses amount to only $25 billion a year.The size of the difference speaks for itself.

But there is an additional difficulty,which concerns the distribution of invest-ment flows among countries and among"fuels." The middle-income countries will,

26 Finance b Development I December 1983


by and large, be creditworthy enough toborrow from commercial banks and to ob-tain export-related credits on commercialterms. As a group, they currently obtain 50percent of their external energy financingfrom these two sources. Most of those ex-porting oil can also obtain equity financingfrom international oil companies.

Low-income countries, by contrast, re-ceive very little direct private investmentand obtain 80 percent of their external en-ergy borrowing from multilateral and con-cessional bilateral sources. For many ofthem, the viability of future energy devel-opment programs will depend on the ex-pansion of financing from these sources. In1975-80, official sources provided about S4billion a year (in 1982 dollars) for energy indeveloping countries at all income levels.The low-income countries need about $8.6billion annually in foreign exchange, but ifpresent external financing patterns for en-ergy continue, they can expect a total ofless than half this amount from all sources.

Perhaps the most vulnerable part of theprojected investment program—thoughfrequently the most promising from thepoint of view of national development—isthat for oil and gas in oil importing coun-tries. The estimated foreign exchange re-quirement of $9 billion a year for oil and gasprojects in these countries is about equal tothe current publicly guaranteed financingflows for the whole energy sector in thesecountries.

Improving energy management

Throughout the developing world, mak-ing the best use of the resources availablefor energy investments will be a complextask for governments. The sheer increase inthe number of potential energy projectsand the size of energy investment pro-grams poses a major management chal-lenge. Added to this, there are severalreasons why energy investments, at thenational and enterprise levels, can be pecu-liarly difficult to plan and manage:

• The resource base is uncertain;• The technologies to be used are often

new, rapidly changing, and risky;• Investments are lumpy, often large in

relation to GDP, and mistakes are ex-pensive;

• The investments need a long planninghorizon. Over 10-20 years, there is a widerange of possible patterns of growth anddemand for energy. It is risky, but oftenworthwhile, to keep some strategic optionsopen as long as possible;

• Last, energy is an input or an output inalmost all productive activity. Not only doenergy investments compete with those inother sectors—decisions on them cannot betaken without considering their relation-

ships with trends and policies in the rest ofthe economy.

Energy investments thus need to be con-ceived as part of a national energy devel-opment strategy that clearly defines supplyand demand objectives, the measures thatwill be used to achieve them, and the re-spective roles of the various public and pri-vate agencies involved. Planning and im-plementing such a strategy, and ensuringthat investments are designed and imple-mented in a cost-effective manner, requiresa supportive policy environment and, ex-tremely important, people with trainingand experience.

The World Bank's role

The principal objective of the Bank's en-ergy program is to assist developing coun-tries to define and implement an appropri-ate development strategy for the energysector. The urgency and the magnitude ofthe necessary structural adjustments de-mand greater attention to policy and man-agement issues, preinvestment studies toformulate better strategies for energy sup-ply and utilization, and the mobilization offinancing. The Bank functions as a catalystin promoting strategy formulation, policyreform, and institutional improvements;and in mobilizing external sources of tech-nology and finance to implement effec-tively the changed investment priorities indeveloping countries. It has expanded anddiversified its energy lending and isputting greater emphasis on assisting bor-rowers in the choice and use of new tech-nologies, strengthening institutions, andimproving the policy framework in the en-ergy sector.

The Bank's dialogue with national pol-icymakers covers a wide range of issues;these may include demand managementand pricing, interfuel substitution, invest-ment planning, resource mobilization, andthe respective roles of public and privateagencies in the development of the sector.This work has made an important contri-bution in helping to define "energy" as anintegrated sector in many developing coun-tries. Because of the unfamiliar issues

Yves Rovania French national, has beenDirector of the Energi/Department since itsestablishment in 1972. A

graduate of the University ofParis in law, businessadministration, andeconomics, he was in privatebanking before joining the'Bank in 1956.

posed by a sudden change in relative costsof different forms of energy, there was aclear need for assistance to developingcountries in evaluating their main energyissues and options. To meet this need, theBank collaborated with the United NationsDevelopment Program in launching the En-ergy Sector Assessment Program, which isdesigned also to serve as a framework forfurther multilateral and bilateral assistancein the sector. Studies of 21 countries havebeen completed under this program andanother 14 are in an advanced stage of pro-cessing. This program is being followed byan Energy Sector Management Programdesigned to provide a rapid and flexibleresponse to governments who requesttechnical or management assistance in im-plementing the strategy proposed in theenergy assessments and in carrying outprefeasibility studies to identify priority en-ergy projects.

The Bank's advice is backed by a signifi-cant amount of lending for energy projects,making it the single most important officialsource of external capital for energy devel-opment in the developing countries. Its en-ergy lending has risen from $1.5 billion infiscal year 1979 to about $3 billion in fiscalyear 1983 (including $343.8 million in con-cessional IDA credits). Further, the Bankhas made a special effort to mobilize addi-tional external financing and promote op-portunities for direct private investment.During fiscal year 1979-83, the $12.9 billionof Bank lending for energy was associatedwith another $12 billion of cofinancingfrom other external sources. A key featureof the Bank's energy lending in recent yearshas been the increase in lending for oil andgas exploration and development, from$112 million in 4 projects in fiscal year 1979to $1 billion in 17 projects in fiscal year1983. In this period, the Bank has sup-ported petroleum projects in 36 countries.Energy lending has also been diversified tosupport the development of coal and otherprimary energy sources.

While the need and the scope for in-creasing the scale of Bank involvement inthe energy sector is clearly considerable,the Bank's financial contribution will be alimited one: energy cannot claim more than25 percent of its total lending without com-promising programs in other sectors. De-spite the scarcity of IBRD and IDA re-sources, continuation of Bank involvementat this level is justified by the priority thatthe energy sector has in the overall adjust-ment process for many developing coun-tries, by the complex and substantial ad-justment that is urgently required withinthe energy sector in member countries, andby the very large volume of financing nec-essary to carry out such adjustment. HD



Industrial energy conservationIntegrated conservation effortscould reduce industrial energyconsumption by an estimated20-25 percent.

Harinder Kohli andEdilberto Segura

The recent drop in international petroleumprices is unlikely to diminish the funda-mental challenge that both developed anddeveloping countries face in adjusting tothe high cost of energy. For oil importingdeveloping countries, the challenge is allthe more acute since even a modest growthof their economies will generate increaseddemand for energy.

In most developing countries, initial ef-forts to reduce the cost of imported energyhave centered on increasing the domesticsupply of energy. While most have in-creased the average level of energy pricesand some have rationed energy supplies,other institutional and policy measuresnecessary to reduce energy demand havenot yet received adequate attention. Yet formost developing countries, more efficientutilization offers substantial opportunitiesto improve their energy situation. Increas-ing domestic energy supplies normallytakes several years to yield significant re-sults, while many energy conservation anddemand measures can produce more im-mediate results. The objective of energyconservation measures, however, is notmerely to minimize the cost of energy rela-tive to GDP but also to maximize the rate ofGDP growth for given energy prices,subject to environmental and other con-straints. For most purposes, though, min-imizing the cost of energy relative to outputis consistent with maximizing GDP.

While in most industrial countries the in-dustrial, transportation, and householdsectors are all major consumers of com-mercial energy, in many developing coun-tries—due to their frequently mild climatesand less intensive urban transportationneeds—the main energy consuming sectoris industry, accounting for an average ofabout 40 percent of total commercial energyconsumption. Preliminary studies pre-pared in the World Bank indicate that asmuch as 20 to 25 percent of industrial en-ergy consumption could be saved withadequate conservation measures. Throughsuch measures, the additional energy sup-plies required for economic growth couldalso be reduced, thus alleviating, to someextent, the financing constraints in devel-oping country economies.

The energy intensity of a country's in-dustrial sector is affected by a number offactors, including the type of industry andthe process used. Some industries, such asammonia or aluminum production, con-sume large amounts of energy. The oper-ation of petroleum refineries may, in itself,require 5 to 9 percent of the total crudeprocessed. By contrast, other manufac-tures, such as electrical and mechanicalequipment, have considerably lower en-ergy intensity. Likewise, modern and effi-cient ammonia plants based on steam re-forming of natural gas may require only 60percent of the fuel that older processes hadneeded. Other factors affecting energy in-tensity are the type of energy used (for ex-ample, processes using coal normally re-quire larger quantities, though at a lowerunit cost, than oil and gas); the age of theplants (efficiency declines with age); the cli-matic conditions (more energy is usedwhere space heating is required), and thegeneral operating practices and skills of theplant operators (maintenance and lossesdue to inoperational plants).

With the exception of a few countriessuch as China and India that rely substan-

tially on coal, most developing countriesmeet their industrial energy requirementsprimarily with petroleum products. Non-commercial fuels, such as bagasse andwood, also play an important role in someindustries. In most countries, most plantdesign and equipment were developedprior to the energy price increases of themid- and late 1970s and were designed tominimize capital investments and to takeadvantage of low energy costs. This hasresulted in higher energy consumption andlower investment costs than today's costsand technological developments wouldjustify. Many processes also involve mas-sive conversion of petroleum raw materialswith significant losses of energy during thetransformation process. While some ofthese losses are unavoidable, much usefulenergy is wasted. With increasing energyprices, it is becoming economically attrac-tive to recover much of this wasted energythrough the installation of additionalequipment.

Conservation potential and costs

There is, thus, considerable economicscope for additional investments in existingplants to improve the efficiency of energyutilization. Such investments would reducetotal energy consumption and improveproduction capacity utilization.

The range of specific energy consump-tion measures can roughly be divided intotwo groups: short-term measures, whichrequire small investments and consistmostly of better maintenance and processcontrol, including, for example, insulationand steam system efficiency improve-ments; and medium-term measures, whichrequire larger investments in retrofitting ofexisting plants and additions to facilities,including waste heat recovery, combinedheat and power generation, increased useof waste fuels, improved process controls,and replacement of inefficient equipment.



in developing countries

Potential energy savings and investment in developing countries

Industry

Iron and steelElectrometallurgy

PetroleumChemicalsCementPulp and paperFoodTextileGlassBricks

Process orproduct

SteelAluminum (from

alumina)RefiningAmmoniaDry and wetAll gradesCane sugarFinishingAll gradesAll grades

Other industries (estimated)Total (estimated)

Range of energy savings(In millions of tons of oil equivalent a year)

Short-term Medium-term Total

3.30.3

3.80.45.71.62.80.51.50.9

-7.6-0.5

-6.5-0.9-7.0-2.2-3.2-0.6- 1.7-1.3

17.0-34.037.8-65.5

16.31.3

8.13.89.11.82.60.62.21.3

34.0

-21.8- 2.0

- 13.5- 4.1-14.3- 2.3- 5.2- 0.7- 2.9- 1.8-51.0

81.1-119.6

19.61.6

11.94.2

14.83.45.41.13.72.2

51.0

-29.4- 2.5

-20.0- 5.0-21.3- 4.5- 8.4- 1.3- 4.6- 3.1-85.0

118.9-185.1

Range of investment required(In billions of 1982 U.S. dollars)

Short-term Medium-term Total

0.8-2.70.1 -0.2

0.7- 1.50.1 -0.21.3-1.90.5-0.80.5-0.70.1 -0.20.4-0.50.2-0.43.4-10.28.1-19.3

13.9-20.80.6-1.1

3.2-6.11.9-2.56.4-11.41.0-1.41.6-3.60.3-0.41.0-2.00.6-1.2

17.0-35.747.5-86.2

14.70.7

3.92.07.71.52.10.41.40.8

20.4

-23.5- 1.3

- 7.6- 2.7-13.3- 2.2- 4.3- 0.6- 2.5- 1.6-45.9

55.6-105.5

Source: World Bank, Potential and Prospects for Industrial Energy Conservation in Developing Countries, forthcoming.Note: Details may not add up to total because of rounding.

Estimating potential industrial energysavings for all developing countries is acomplex task. Using industry-specific data,a recent World Bank study has estimatedthat developing countries, as a group,could save 5 to 10 percent of total industrialenergy consumption through short-termmeasures and 10 to 20 percent by medium-term measures (see table). The largest in-dustrial energy conservation potential liesin steel, petroleum refining, cement, andchemical industries (including fertilizers).

While the potential for saving energy inindustry is substantial, the investment re-quired to achieve it is proportionatelymodest. For short-term measures, the aver-age investment cost per ton of oil equiv-alent saved per annum is estimated to bebetween $175 and $350. For the medium-term measures, the average investmentcosts range from $400 to $550 in petroleumrefining and chemicals and from $850 to$950 in the iron and steel industry.

At today's crude oil price of about $200per ton, most short-term measures wouldrecover their investments in 12 to 18months. In many process industries wherenaphtha is used as a raw material, or inapplications where gas oil is used as fuel,the capital costs would be recovered in lessthan 8 to 12 months. For the majority of themedium-term investments, this period isnormally between two to five years whenenergy saved has the less expensive fueloil equivalent value, and between ninemonths to three years when it is equivalentto the more expensive naptha/gas oil value.The economic rates of return range be-tween 50-125 percent and 20-50 percent forthe short- and medium-term measures, re-spectively. Total investment requirementsof developing countries to achieve thesepotential savings are estimated at $8-$19billion for short-term measures and an ad-ditional $47-$86 billion for medium-termmeasures, averaging less than three years

in terms of payback period. Because ofmanagerial, financial, and other con-straints these measures cannot be imple-mented all at once. If developing countriespursue active energy conservation pro-grams, the implementation of all possibleshort-term measures would require be-tween three to seven years, and medium-term measures may take seven to ten years.

These investment estimates include onlypotential measures for energy conservationin existing plants and facilities. Interfuelsubstitution and the installation of new,more efficient plants require substantial ad-ditional investment. The experience of theWorld Bank in about a dozen industrial en-ergy conservation projects in ten countriesindicates that interfuel substitution mea-sures are often as economical as purelyenergy-saving measures. Such interfuelsubstitution measures involve switchingfrom more expensive, often imported,forms of energy (such as naphtha, gas oil,

finance & Development t December T983 29


or fuel oil) to less expensive and domesticenergy supplies (coal, natural gas, or re-finery gases). For example, in Turkey a fer-tilizer plant is being retrofitted to switchfrom naphtha to natural gas and refinerygases for ammonia production, and a num-ber of cement plants in Portugal and Hun-gary are being converted from fuel oil tocoal. Such interfuel substitution measuresare important components of practically allof the Bank's energy efficiency projects inthe fertilizer, cement, and petrochemicalsectors. In many instances, the major en-ergy conservation measures are imple-mented along with interfuel substitutioninvestments.

Implementation

In a free market economy, the adjust-ment of energy prices to long-term oppor-tunity cost levels should, in theory, providesufficient incentive for consumers to adjusttheir energy consumption. Experience indeveloping countries, however, has indi-cated that industrial and other consumersare slow to invest in energy conservationmeasures, even where the potential eco-nomic and financial benefits of such in-vestments are visible and excellent. This isdue to four factors: (1) the lag, perhaps dueto inertia, in responding to changes in in-put prices, particularly when existing facili-ties have operated well in the past andwhen energy represents a relatively lowportion of operating costs; (2) the complex-ity of energy conservation investments,caution over the innovative nature of manyof the proposed devices, and the risks in-volved in interrupting production flows; (3)the low visibility of these investments,which normally consist of a large numberof separate items and facilities; and (4) thecurrent economic climate, which has madeit difficult to generate the substantial re-sources needed for new investments.

Technical, financial, and economic barri-ers may also intervene. At the plant level,lack of information about the appropriatetechnical options and the absence ofexpertise in energy management oftenhamper conservation, as does the non-availability of specialized energy auditingcapabilities and the lack of suitable equip-ment and instrumentation. Financial stum-bling blocks include scarcity of capital, highinterest rates, and lack of simple, accessi-ble forms of medium-term financing forenergy-saving equipment. Common eco-nomic obstacles are energy prices belowopportunity costs, distortions in relativeprices of different energy products, andcost-plus product pricing systems that re-duce incentives for energy efficient use.

Many of these constraints are more seri-ous in developing countries than in indus-

trial countries. For example, in developingcountries, the technical skills needed arenot as readily available; sophisticated tech-niques to alert industrialists about eco-nomics of energy-saving investments arenot common; and distortions in relativepricing are also generally more serious. Tosurmount these barriers, integrated energysavings programs must often be designedand implemented at the national level. Keyelements in such programs include (1) ap-propriate energy and product pricing; (2)energy management and audit programs;(3) technical and financial assistance; and(4) institutional and regulatory measures.

Pricing; management and audit

Appropriate industrial energy pricingpolicies must take into account both the ab-solute and relative price levels of the vari-ous energy sources and, where relevant,the rate structure that will provide ade-quate incentives to improve energy effi-ciency through both conservation and fuelconversion. Although the pricing strategywill depend on individual country condi-tions, domestic energy prices for industrialenergy normally need to reflect economicopportunity costs. Rate structures forpower or gas are also important in that re-spect. Declining blockrate structures thatunduly lower unit costs with increased en-ergy consumption may, for example, re-duce incentives for energy conservation.Some countries used quota systems for keyenergy products so that consumptionabove the quota carries a substantiallyhigher price. Further, it is of utmost im-portance that the government's intention

Harinder Kohlian Indian national, is actingAssistant Director, Policy,in the Industry Departmentof the Bank. He holdsdegrees from PunjabUniversity and HarvardUniversity. He has writtenwidely on energy andindustry matters.

Edilberto SeguraPeruvian, is a DivisionChief in the IndustryDepartment. He holds anMBA from Stanford and aPhD from ColumbiaUniversity. Prior to joiningthe Bank in 1972, he wasvice president of a U.S.investment bank.

to rationalize energy pricing policy be an-nounced in clear terms.

Experience suggests, however, that ade-quate energy pricing is a necessary, butgenerally not sufficient, condition for aneffective conservation program. The overallproduct pricing policy for industry is alsocrucial. In countries where prices are ad-ministered and manufactured products arepriced on a cost-plus basis to guarantee re-turns to the producers, there is often noreal incentive to save energy.

A policy of high or increasing energyprices will have its full effect only to theextent that enterprises are adequately in-formed about the various energy savingsmeasures that are technically and eco-nomically feasible; this is a particularly im-portant problem in developing countries.Energy costs, of course, account for vary-ing shares of total production costs de-pending on the industry concerned. Whereenergy costs are proportionally modest, en-terprises might give higher priority to in-vestments that improve their productivityor competitiveness through other means.Because of the complexity and variety ofpossible solutions, it is important to designan integrated energy conservation programthat also includes an array of nonpricingmeasures and programs.

Energy audits of large- and medium-sized energy-intensive facilities constitutethe core of any national program for indus-trial energy savings. Energy audits are nec-essary to estimate the potential for energysavings, to identify the individual mea-sures implied and their cost, and the eco-nomic viability of the investments. Thetype of audit needed depends on processenergy consumption intensity, the com-plexity of the in-plant energy distributionand utilization systems, and the objectivespursued.

In-depth audits require a detailed analysisof energy flows and balances for each majorenergy-using piece of equipment and mayinvolve up to 30-50 man-months of tech-nical input. They are recommended forlarge steel, chemical, fertilizer, cement, re-finery, and paper plants. General energyaudits, while also requiring the preparationof a plant's energy balance, involve lesstechnical analysis of the individual facilitiesand may take up to 8-12 man-weeks oftechnical services. They are more appro-priate for facilities with a simpler energyuse pattern and are sufficient for mostmedium-sized facilities in food, textile,bricks, and similar industries. Brief auditscollect essential data through basic energyaccounting; that includes, for example, to-tal fuel and electricity consumption by typefor a given period (generally the previousyear). They normally involve three-five



days of consulting services. Such briefaudits indicate relative performance inenergy consumption and are usually ade-quate for most small-sized plants. Theyalso furnish the basic data for national esti-mates of potential savings and benefits.

Energy audits may be either voluntary ormandatory, though in many countries theyare generally mandatory for establishmentsexceeding a certain energy consumptionthreshold (for example, 1,000 tons per an-num of fuel oil equivalent). Some countriesalso provide subsidies for energy audits orprovide free brief audits or plant surveys.Crucial to the effective performance of anoverall energy audit program is the devel-opment, through training, of domestic en-ergy auditing capabilities, particularly withrespect to general and brief audits. Thetraining and appointment of energy coordi-nators or energy management teams in themajor energy-consuming enterprises canassure follow-up on the audits and intro-duce better management practices.

Technical, financial assistance

Promotion and information campaigns,both at the national and plant levels, havebeen useful in creating an awarenessamong industrial managers, employees,and the public at large of the benefits ofenergy savings. Brochures, pamphlets,general or subsector seminars, and energysavings contests have proven effective edu-cational devices. Training programs in con-servation or auditing can be addressed toenergy auditors, energy managers of enter-prises, boiler operators, and maintenanceengineers with significant results. For morecomplex needs, technical assistance can beprovided in the form of free audits or auditassistance, technical advisory services, orreferral services.

Most countries that have formulated na-tional industrial energy savings programshave provided, at least initially, some fi-nancial assistance and incentives for con-servation investments. In general, grantsinitially used for energy savings projects inindustrial countries have been phased outand replaced over time by preferential in-terest rates, accelerated depreciation, andother tax-related incentives. Subsidies forenergy audits have, however, been main-tained in many countries. When energyprices are low, some form of financial assis-tance for capital investments might beneeded during the transition period, pro-vided its amount is reduced as energyprices are gradually increased to their op-portunity cost. The desirability of such asubsidy should, however, be weighedagainst the merits and feasibility of a policyof faster energy price increases. Also im-portant is the need to provide simplified

access to medium-term financing for in-vestments in energy savings, particularlyfor small- or medium-size enterprises thatembark on relatively small energy conser-vation projects.

Finally, in most developing countries,technological possibilities for alternativeenergy sources and uses remain largely un-exploited. It may be appropriate in the de-veloping countries with more advancedtechnological infrastructure to undertakeformal and institutionalized industrial re-search into alternative energy sources anduses.

Institutional, regulatory aspects

Institutional and regulatory mechanismsare often necessary to complement marketsignals and synchronize the various ele-ments of integrated industrial energy con-servation programs. Since 1973-74, mostindustrial countries have established en-ergy conservation centers that coordinateinformation, training, and technical assis-tance on conservation matters, often in col-laboration with training or technical assis-tance for other purposes, and sometimeswith private sector participation (as inJapan and France). Only a few developingcountries have established such centers.Some, however, are in the process of beingset up, with Bank assistance, in Bangla-desh, Hungary, Pakistan, Peru, Portugal,Thailand, and Turkey.

To have maximum impact, the energyconservation centers should be organizedand staffed on the basis of an in-depth re-view of the industrial sector, the potentialfor energy savings, and the capabilities ofthe domestic technical specialists. All exist-ing centers render information and pro-motion services, and most carry out energyaudits and sponsor training programs—thetraining of plant energy managers and localenergy auditors being of special impor-tance. Only rarely are these centers directlyinvolved in financial assistance (particu-larly in view of the trend away from grantsfor energy conservation to credit and taxincentives).

While the regulatory framework varies,most developed countries have enacted ba-sic energy conservation laws of a very tech-nical nature. These generally set energyconsumption standards for boilers, fur-naces and other combustion units, andsometimes for industrial lighting, spaceheating, and other items. Energy consump-tion standards by product are significantlymore difficult to establish and administer.The usefulness of and the compliance withsuch standards varies considerably fromcountry to country. Most such regulationsalso require the mandatory appointment ofenergy managers and the mandatory per-

formance of energy audits in industrialestablishments that exceed minimal energyconsumption standards, and these are par-ticularly applicable to most developingcountries.

To be successful, energy conservationregulations need to be complemented withappropriate measures for promotion, in-centives, and free technical assistance. Theexact blend in this "carrot and stick" ap-proach must, however, be determined byindividual country circumstances and in-dustry response.

World Bank role

During the last few years, the WorldBank has assisted some 20 countries in de-veloping programs primarily aimed at im-proving energy conservation in the in-dustrial sector. Our experience shows thatindustry and governments in developingcountries are increasingly aware of thelarge potential for energy savings in the in-dustrial sector and the significant impactthat this could have in reducing costs andimproving balance of payments situations.The realization of this potential, however,could be a long and slow process unlessgovernments carry out vigorous and com-prehensive measures and campaigns to in-duce industries to initiate and implementrequired investments. International finan-cial institutions such as the World Bank canplay a catalytic and increasingly importantrole in assisting member countries in de-signing and implementing comprehensiveenergy conservation programs. HD

Recent Bank publicationson energy

Potential and Prospects for IndustrialEnergy Conservation in DevelopingCountries, forthcoming.

The Energy Transition in DevelopingCountries, $5 (paper),

Prospects for Energy Efficiency and FuelSubstitution in the Cement Industry,Technical Paper, $5.

Prospects for Energy Efficiency and FuelSubstitution in the fertilizer Indus-try, Technical Paper, $5.

Copies are available from the Bank's Publi-cations Unit. Please see page 19 for order-ing information.



WORLD ECONOMY IN TRANSITION

Merest ratesin five majorcountries

United States

United Kingdom

- FranceGermany

Japan

Sources: IMF, International Financial Statistics and (he IMF Data Fund.Notes:Discount rates are the official interest rates at which the monetary authority lends to financial institutions; the data are

reported for the end of the period,Money market rates are the annual average rates that represent the cost of short-term borrowing between financial

institutions.Government bond yiettts represent annual average yields to maturity of long-term government bonds."Real" interest rates represent the yields of government bonds deflated by domestic prices. The indicator for domestic price

changes is derived from the implicit deflator of national accounts data on private domestic demand (sum of private consumptionand gross fixed investment).

32 Pittance & Development t December 1983

Chart 1 Discount rates(End of year)

Chart 2 Money market rates(Annual averages)

Chart 3 Government bond yields(Annual averages)

Real interest rates(An nua [âverages)

Chart 4

Interest rates reflect the cost of borrowingfor different types of borrowers. The dis-count rate (Chart 1) reflect the cost atwhich monetary authorities provide fundsto the monetary system and indicate themonetary policies being pursued. Themoney market or call money rates (Chart 2}reflect the cost at which financial institu-tions may obtain liquid funds in the mar-ket, while the government bond yield(Chart 3) is indicative for the cost of long-term loans.

Changes in interest rates are closelyretotecl t© the general price variations,although'the latter are generally more pro-

- |»0HMiCe4. A real interest rate is calculatedf^ftl^fisweituaent bond yields deflated by

' thegpcke iMex of private domestic demand•jilS jttt.BBoSt representative indicator of"swaraUL-price changes (Chart 4). In periods.pfilp^ptices were rising faster than nom-

t IrtOTjrrterest rates, "real" interest rates, Jm&4 negatis*. This was notably the case in!|jperid9&oMMtematkuial price shocks, suchpif iSS^^perietKed in 1951-52 (following^fep^ttk'hostiities) and 1974-75 and, 9S9y|&fhi*ring the oil price increases). A~aRftt|Siiifey. feature is the historically high,j3tet|i |eslifi.terest rates in most countries£<|fe,iJ|ii|Sf^wWch reflects the increasedIfeiltpirftBg' requirements mainly to finance

' ^nilr^^Twrfget and balance of payments'- >:.^J- _ „*•


Interest rates andthe developing world

Interest rates in the developedworld have pervasive andimportant effects on debt,growth, and commodity exportsin developing countries

Padma Gotur

In combination with the rise in oil pricesand the international recession, the highinterest rates of the past several years havehad a marked impact on the economies ofthe non-oil developing countries. The oilprice increases of 1979 led to an initial dete-rioration in these countries' current ac-counts; this was then aggravated by theslowdown of economic activity in the de-veloped countries and the shrinkage ofworld trade that, in turn, reduced devel-oping country exports and caused a sharpdecline in the prices of some of their majorexports.

Meanwhile, the external liabilities ofthese countries had risen markedly, from$130 billion in 1973 to almost $400 billion bythe end of the decade. This escalation re-flected the resort to additional borrowingrather than adjustment in response to thelarge current account deficits of the mid-1970s—borrowing that had been facilitatedby the ready availability of loans during theperiod, frequently at negative real rates ofinterest. Since 1978, however, real interestrates have turned sharply positive, reflect-ing tight monetary policies pursued by in-dustrial countries to control inflationarypressures and expectations. As a result, thedebt-servicing costs of developing coun-

tries increased sharply and commodityprices worsened, leading to a further dete-rioration of their terms of trade and forcingmany countries to expand their externalborrowing and increase their debt-serviceburden yet more. The effects of these in-creased payments, combined with the im-pact on their current accounts of the worldrecession, resulted in a sharp curtailmentof growth of these countries' output.

The surveys of international financial de-velopments in the Fund's World EconomicOutlook and other studies indicate the rela-tive importance of the different factors ac-counting for this deterioration in the devel-oping countries' balance of payments andillustrate the diversity of their experience.Of an increase of $66 billion in the aggre-gate current account deficit of non-oil de-veloping countries between 1978 and 1981,the oil trade balance accounted for $18 bil-lion; net interest payments accounted for$24 billion; and the cyclical element in theterms of trade accounted for $21 billion.The relative impact of these factors also dif-fered across groups of developing coun-tries. While all the non-oil exporting coun-tries were severely affected by the rise in oilprices, the middle-income countries, par-ticularly those of the Western Hemisphere,were seriously hurt by the increase in inter-est rates, because of their significant de-pendence on borrowing from the interna-tional banking system. For the low-incomecountries, on the other hand, the interestpayments were generally less important asthey relied to a larger extent on officialsources of financing on concessionaryterms. These countries, however, wereseriously handicapped by the steep declinein the prices of commodities, which oftenconstituted their only exports.

Further, some countries had a net assetposition vis-a-vis the international bankingsystem. The higher interest rates earned onsuch assets helped to compensate partly forthe higher interest payments on their over-all net debtor position, since it was withrespect to banking obligations that interestrates rose to particularly high levels. Coun-tries in this position in June 1982 wereChina, Egypt, Ethiopia, Ghana, India,Kenya, and Pakistan. However, in general,the non-oil developing countries had a netliability position and were thereforeadversely affected by the rising real ratessince the late 1970s.

Interest rates and debt

International interest rates have beenhighly volatile since the early 1970s andhave reached postwar peaks over the pastseveral years. As measured by Eurodollarinterest rates—which, except for a countryrisk premium, are representative of theterms at which developing countries bor-row from private international sources—nominal rates tripled from 1976 to 1981.Real rates of interest, defined here as nom-inal rates adjusted for concurrent increasesin prices, have fluctuated even more.Adjusted for increases in the GNP deflatorsfor the industrial countries, real rates ofinterest as perceived by lenders were nega-tive during the mid-1970s and turnedsharply positive toward the turn of thedecade to average almost 6 percent for1979-82—markedly above historical norms.Real rates of interest, as perceived by devel-oping country borrowers—that is, adjustedfor changes in these countries' export unitvalues—have been even more volatile and

Finance tV Development I December J9S3 33


Non-oil developing countries: long- and short-term debt and debt service, 1973-82'(Values in billions of U.S. dollars; ratios in percent)

Total outstanding debtShort-term debtLong-term debtRatio of external debt to

exports of goods and services2

Ratio of external debt to GDP2

Value of debt-service paymentsInterest paymentsAmortization3

Debt-service ratio4

Interest payments ratioAmortization ratio3

1973

130.118.4

111.8

115.422.417.96.9

11.115.96.19.8

1974

160.822.7

138.1

104.621.822.1

9.312.814.46.18.3

1975

190.827.3

163.5

122.423.825.110.514.616.16.79.4

1976

228.033.2

194.9

125.525.727.810.916.815.36.09.3

1977

278.542.5

235.9

126.427.434.713.621.115.46.09.4

1978

336.349.7

286.6

130.228.550.319.430.919.07.3

11.7

1979

396.958.8

338.1

119.227.565.028.036.919.08.2

10.8

1980

474.085.5

388.5

112.927.676.240.435.817.69.38.3

1981

555.0102.2452.8

124.931.094.755.139.720.411.98.6

1982

612.4112.7499.6

143.334.7

107.159.247.923.913.210.7

Source: World Economic Outlook, 1983.1For classification of countries in groups shown here, see the introduction to Appendix B of World Economic Outlook, 1983. Excludes the People's Republic of China for the

years prior to 1977.2Ratio of year-end debt to exports or GDP for year indicated.3On long-term debt only. Estimates for the period up to 1981 reflect actual amortization payments. The estimates for 1982 reflect scheduled payments, but are modified to take

into account the rescheduling agreements of 1982."Payments (interest, amortization, or both) as percentages of exports of goods and services.

reached extremely high levels (15-20 per-cent) in 1981-82 (Chart 1).

The average interest costs paid by thedeveloping countries have not risen assteeply as international interest rateswould suggest. For instance, whereas mar-ket rates roughly tripled from 1976 to 1981,average interest rates paid on the develop-ing countries' medium- and long-term debtrose from 5 to 9 percent (Chart 2). Thesemarkedly lower average rates reflect twoprincipal factors. First, a significant part ofthe total debt (some 50 percent in 1981) con-sists of long-term fixed interest rate loansthat, unlike the rates on new bank lendingshown in Chart 1, reflect the much lowerloan rates prevailing before the mid-1970s.Second, a fairly sizable fraction of the debt(about 31 percent in 1981) is from officialcreditors (including the multilateral institu-tions), who have generally continued tocharge low concessional interest rates, de-spite small increases.

Nevertheless, interest rates paid bydeveloping countries have risen steeplyover the past several years, reflecting inpart changes in the sources and structure ofthe debt. Between 1973 and 1981, there wasan increase from about 36 percent to about44 percent in the proportion of commercialbank lending to the total debt of non-oildeveloping countries—such lending is typ-ically linked to a variable interest rate basesuch as the LIBOR (London interbank of-fered rate), modified for an allowance tocompensate for bank exposure and countrycreditworthiness. As it is this part of thetotal debt that carried the highest rates, thisrise is significant, particularly when ac-count is taken of the fact that the nominalvalue of total debt rose almost fourfold over

the period. Meanwhile, the proportion ofconcessional loans in the total long-termdebt declined from 43 percent in 1974 to 28percent in 1981, while the proportion ofvariable interest rate loans increased fromabout 16 percent to about 37 percent duringthe same period. Besides raising averageinterest costs, these shifts also had the ef-fect of reducing average maturities andgrace periods, since maturities and graceperiods on loans from private creditors aretypically shorter than those from officialcreditors.

As a result of these changes in the struc-ture of their external indebtedness, devel-oping countries were exposed to the sharprise in interest rates of 1979-82. Themiddle-income countries were especiallyaffected because they borrowed propor-tionately more from private sources. Forthese countries, the increase in interestpayments raised the debt-service burden,which in turn added to the risk premiumon new loans and thereby led to a furtherrise in their interest payments. Countrieswith large floating rate obligations alsofaced complicated debt management prob-lems, arising not only from the increase inthe real cost of such obligations but alsofrom the extreme volatility of interest ratesas well as of exchange rates. (For a dis-cussion of the impact of floating rates, see"Floating interest rates and developingcountries" by Paolo Neuhaus in Finance &Development, December 1982.)

The rise in interest rates, the rapidgrowth in external indebtedness, and thechanges in the composition of that debt ledto a significant increase in the non-oil de-veloping countries' debt-service payments(Table 1). Interest payments accounted for

the bulk of the rise. Taking account of theforeign exchange holdings of developingcountries and on the basis of total net bank-ing liabilities of over $200 billion, each per-centage point increase in Eurodollar inter-est rates represents a rise of over $2 billiona year in their interest payments. For coun-tries in the Western Hemisphere, debt-service payments amounted to over 50 per-cent of export earnings in 1982.

The implications of such increases indebt-service payments very much dependon parallel developments elsewhere in theeconomy. These are discussed later, butthe key role of the inflation rate and of itsrelationship to interest rates deserves men-tion here. If interest rates are lower thaninflation rates, as was the case in the mid-1970s, increases in interest payments, infact, mask a net real transfer of resources tothe debtor countries. The size of the trans-fer depends on the rate of inflation, thematurity of the loan, and the marginbetween the interest rate and the inflationrate. However, for any given relationshipbetween interest and inflation rates, anacceleration of inflation, such as occurredin the late 1970s, entails, in effect, a fasteramortization of the real loan. The short-ening of the underlying average maturitydepends on the original maturity of theloan and the pace of the rise in inflation(see G. Russell Kincaid, "Inflation and theexternal debt of developing countries" inFinance & Development, December 1981).Finally, if interest rates rise more than infla-tion, as has clearly been the case since 1978,the real debt-service burden rises commen-surately. In such circumstances, borrowersare under pressure to refinance their pay-ments and can be severely handicapped by



Chart 1The three-month Eurodollar

interest fata, 1972-82(In petcem per ann-urn)

Chart 2Interest rates on medium and

long-term debt of non oil LOCs, 1374-02

Chan 3Nominal and real commodity prices*

1970-82Real oo«s Nominal pnce mden

SOU'Ces IMF. inlertijttQttft frwn&aS 5t9tHi>CS. anflFund SlflH eitimaiei

'Delved as nominal <a<e less in? ê.ghTert aêi-ay*.- o1Ihe GDP deHalor ol 4! I indusTri#l taunt-1.**

'Derived as ncnTnnai rale lass, Ihe U 5 dollar basedexport unM value index lor nor>-oii developing countries

Chart 4Changes in interest rates and commodity

prices, 1976-62(In percent)

Sources World Bank. Wttrttt Debt Fjotes. 1932-83.and fund scan1 eslimar.es

fluctuations in export receipts or any dis-location in capital markets.

Effects on commodities

Aside from their effect on debt service,the high real interest rates of the past sev-eral years have significantly lowered theprices of non-fuel primary commoditiesexported by the developing countries.These commodities accounted for abouthalf of their export earnings on trade otherthan oil in 1980. Although the increasingimportance of manufactured exports haspartly mitigated the effects of unstablecommodity export earnings for somemiddle-income countries, the primary sec-tor continues to play a major role in thedetermination of GNP and the generationof foreign exchange resources in manydeveloping countries, particularly in thosewith low per capita incomes.

Theoretical and empirical analyses ofcommodity markets have shown that shiftsin demand for commodity exports havebeen caused primarily by the business cycleand the changing pace of price inflationin the industrial countries. Since 1977,however, other factors have also been im-portant—namely, changes in interest rates,in exchange rates, and in internationalliquidity.

Interest rate changes have a direct impacton the transactions, inventory, and specu-lative demands for primary commodities.The transactions demand for a commoditypertains to its use as a raw material in theproduction processes of intermediate andfinal goods in the consuming countries, orfor other direct consumption purposes. An

Sources IHf. Research Deparimoni. Commodities Dn*rsion. and Uni1 Ed Nations. UVMcvMhrVArittfriaf&lfrllfcl

'fifilers In non-oil primary cnmmtrimflt comprising load.hfil teverages. agricultural raw rnawiiils. and metal) Av-erages of percentage changes ol (oniponent commoditypr.ces are weighted by [he U S dollar varue of frnpons oleicn commodity From primary producing cOuniriej in1966-70

JRo*l prices are me nominal index deflated by the U HBMpfjri MINI uiilui1 index for the manufactures ol the devt'loped countries-

increase in the cost of inputs, resulting, forinstance, from an increase in the real inter-est rate, raises the cost of production of thefinished product. The consequent decreasein the quantity produced reduces thederived demand for all inputs used in theproduction process, including commodityinputs, unless the producer can fully passon the higher cost to the consumer.

The inventory and speculative demandsboth depend on expected changes in theprice of the commodity relative to the nom-inal interest rate, but the inventory de-mand is also affected by the expectations ofprice changes in the finished product. Thisdemand stems from the role of raw materialstocks as a buffer against uncertaintiesabout their supply or fluctuations in salesof intermediate and finished products.Higher real interest rates reduce inventorydemand by raising the opportunity cost ofholding inventories and thus discouraginginventory replenishment and commoditypurchases. Such interest rate-induced fluc-tuations in inventories tend to reinforce theeffect of the business cycle on inventoriesheld by firms.

The speculative demand for commodi-ties arises from the expectation of capitalgains or losses from changes in the marketvalue of the commodity net of holdingcosts. Since the difference between thenominal interest rate and the expected rateof increase in the price of the commoditygives the expected real cost of holding thecommodity, an increase in interest ratesreduces the speculative as well as the in-ventory demand for the commodity.

Interest rates also have other, less directeffects on commodity prices. For instance,the unusually high real interest rates of the

Sources IMF. Rfritfarch Derailment. Commodities DIVIsipn. and IntrrntttQnat fmfitHJSrevfna. and united Nalions. UN Monthly Sttittttin ol SltltltKS

'F.rst difference mine real imftreai rait, wtlich is derivedas the three-month Eurvdollrji rale less Ihe percentage-change in the weighted average GNPdeflatoi tor all ittdustrial countries

Âdjusted prices are residuals obtained from repressingthe percentage change in real commodity prices on thepercentage change in me weighted average industrial prodvchon for all industrial countries. Since demand lectorsnave the maior impact on prices, removing their erfectisolates the comoonent lor residual] aHected bv changes iriinterest rate* Ol any other noncvclical yarrable This relationship is not clearly evident in the pre-1976 period,perhaps partly because of the much smaller fluctuations pfinterest rales in the early and mid 1970s

past several years are likely to have exacer-bated the declines in industrial productionand output in developed countries andhence reduced their demand for imports ofindustrial raw materials. Another channelof influence has been via exchange rates.The high level of international interest rateshas largely reflected developments in U.S.interest rates, developments that have fos-tered large capital inflows into the UnitedStates and a marked appreciation of theU.S. dollar, which, in turn, tend to reducethe demand for dollar-priced primary com-modities. Various analyses have suggestedthat, other things being equal, a 1 percent-age point appreciation of the U.S. dollarvis-a-vis the currencies of other industrialcountries typically leads to a 1A percent de-cline in the dollar price of non-fuel primarycommodities. Given the more than 30 per-cent effective appreciation of the U.S. dol-lar from 1980 to late 1982, a sizable declinein commodity prices is thus implied.

In sum, higher real interest rates havedepressed commodity prices as a result oftheir demand-reducing effects. Admit-tedly, these interest rates have also raisedthe costs confronted by primary productexporters, but these supply-reducing ef-fects have been swamped by the demandeffects and the competitive nature of themarkets in question. Empirical analyseshave concluded that increases in interestrates have a statistically significant negativeeffect on real commodity prices, with theeffect being strong for agricultural raw ma-terials and metals. Further, it appears thatinterest rate movements have a stronger in-fluence on commodity prices during peri-ods of increased interest rate instabilitythan in periods when rates are moving

I'inance & Development I December 1983 35


within a small band. However, even with-out the use of sophisticated estimationtechniques it is clear that increases in nom-inal and real interest rates have depressedcommodity prices in 1981-82 over andabove the commodity price reduction attri-butable to the stagnation of industrial de-mand in consumer countries (Charts 3 and4). The effects of lower commodity pricesand the accompanying deterioration in theterms of trade on those developing coun-tries that export commodities are seriousfor middle-income countries, but are partic-ularly severe for the low-income group thatis proportionately more dependent on pri-mary commodities for export earnings.

Instability in commodity prices, rooted inpart in fluctuating interest rates, also cre-ates a problem because of its effects on thecost of borrowing. Changes in real interestrates, based on adjustment of nominalrates by movements in export unit valueindices, make it difficult to forecast the realcost of borrowing. Real rates determinedon this basis became highly volatile in the1970s as export prices were subject toconsiderable variation, especially in thosecountries that exported only one or two pri-mary commodities. This difficulty in pre-dicting real borrowing costs, even on fixedrate debt, compounded the debt man-agement problems faced by developingcountries.

Effects on growth

During the mid-1970s, the relatively easyavailability of private international bankcredit at negative real interest rates encour-aged a rapid growth of investment spend-ing in developing countries. This growthwas generally associated with significantlyincreased productivity, incomes, and ex-port capacity in the developing world dur-ing the 1970s. The middle-income countries(the largest developing country borrowers)accelerated their real investment spendingto about 8 percent per annum—half a per-cent above the average rate of the 1960s—at a time when the growth of investment inthe mature industrial economies fell fromabout 6 to under 2 percent per annum. AFund study of the experience of a sample of20 of the higher-income developing coun-tries suggested that the increases in ex-ternal borrowing of the period generallyhelped finance investment outlays ratherthan spending for consumption. Neverthe-less, the relatively easy availability of creditat negative real interest rates may haveencouraged some countries to maintainultimately unsustainable levels of importsand to avoid the reductions in consumptionand investment—and therefore growth—rates that would otherwise have beencalled for. Moreover, the negative real in-

terest rates of those years may have led todistortions in the allocation of foreign aswell as domestic resources.

However, if the low real interest rates ofthe mid-1970s may have resulted in possi-bly undue rates of investment spending,the subsequent rise in real interest rates hashad the opposite effect. It has contributedto the slowing of growth in the developingworld and threatens these countries'medium-term growth prospects as well.The steep rise in the real costs of borrowinghas narrowed the range of economicallyattractive investment opportunities, as ithas reduced the real rate of return (afterallowance for the increased cost of borrow-ing) on all investments. Though this mayforce decisionmakers to be more selectivein screening investment projects, it is a de-velopment that, if sustained, is likely todampen investment, and hence overallgrowth, over the medium term. The impactis especially severe on past investmentsfinanced through floating rate debt. Theeconomic viability of these investments hasbeen undermined by the higher real inter-nal rates of return required to match theincrease in real interest costs. Further,regardless of whether they were financedusing fixed- or floating-rate debt, rates ofreturn on past investments depend onactual and projected revenues that in turndepend on the path of output in thedeveloped world and on the prices of thedeveloping world's exports. But these ele-ments have, in general, been adverselyaffected by the international recession, tothe further detriment of the profitability ofinvestment in the developing countries.

In the short term, this deterioration inprofitability together with the sharplylowered levels of export earnings has sig-nificantly slowed spending and the processof income generation in these countries.The rise in interest payments to foreigncreditors induced by increased rates hasalso amounted to an increase in the leak-ages from the spending stream, thus fur-ther weakening aggregate demand andoutput.

Further, following a host of develop-

Padma Goturan Indian, is an Economistin the Fund's EuropeanDepartment. She has a PhDfrom George WashingtonUniversity and was anAssistant Professor thereand at Trinity College,Washington, DC, beforejoining the Fund in 1982.

ments related to the increase in real interestrates—the decline in the perceived profit-ability of both past and future investments,the sharply higher debt-servicing costs,and the worsened outlook for export earn-ings—there was a reassessment by finan-cial markets of developing countries' capac-ity to service external debt. As a result,commercial lending to these countries hasbeen severely curtailed since 1982, forcingmany of them to reduce imports and cutback growth. For the non-oil developingcountries as a group, growth slowed con-tinuously from some 5.5 percent in 1977-79to about 1 percent in 1982. While much ofthis slowdown cannot be traced directly tothe rise in interest rates, there is little doubtthat the steep rise in those rates was a ma-jor contributory factor.

The debt-service problem differs in in-tensity among the different groups of de-veloping countries according to the size,source, and terms of their indebtedness.The problem is particularly serious forseveral countries of the Western Hemi-sphere that have become heavily indebtedto private creditors at relatively high realrates of interest. Several of these countrieshave had to substantially reduce their im-ports and to negotiate substantial resched-ulings of their existing debt-service obliga-tions. For these countries, outright declinesin output were common in 1982.

Outlook

The outlook for economic recovery andresumption of growth in the developingworld is dependent, principally, on thestrength of the revival of economic activityin the industrial countries and the associ-ated resumption of growth in internationaltrade. Such a resurgence in industrial coun-try demand for imports from developingcountries should improve their prices,which would, in turn, help reduce the realcost of foreign borrowing for the exporters.Further, an increase in these exports wouldimprove the current account positions ofthe developing countries, augment theirforeign exchange reserves, and enablethem to meet debt-service obligations bet-ter and to finance productive domesticinvestment. Nevertheless, the pace anddurability of the economic recovery and theassociated improvement in relative com-modity prices depend critically upon thelowering of real interest rates, which re-main very high. This is particularly impor-tant in the present recovery, which is beingled by interest-sensitive components ofdemand—stock rebuilding, consumer du-rables, and residential construction—thatwill, it is hoped, be followed by an increasein fixed business investment in the indus-trial world. HI



To mark the centenary of the birth of Keynes, the Editor invited Alexandre Kafkaof Brazil to reflect on Keynes the man, and Keynes the economist.Mr. Kafka has been an Executive Director of the Fund since 1966.

lohn Maynard Keynes Alexandre Kafka*

The year 1983 marks the centenary or multicentenary of the birthof significant heretics, the most important one, of course, beingMartin Luther. Two economic heretics were born in 1883. JosephSchumpeter (who had propounded an unorthodox theory of in-terest) and John Maynard Keynes.

Keynes was, in the first place, a civilized human being withwide-ranging interests. He was a gifted essayist; one of the mostsensitive accounts of the human effects on a patriot of a lost waris his "Dr. Melchior: A Defeated Enemy," in which he describesthe attitudes of the German economic negotiator at the armisticenegotiation after World War I. His first technical work, his fellow-ship dissertation, was in the field of probability. He came to eco-nomic theory through his practical work; his interest in theorywas always a reflection of the particular economic policy problemshe wanted to solve. In these he was involved all through his adultlife, sometimes as a formulator, sometimes as a critic of officialpolicy.

He was a bitter critic of the reparations provisions of the Treatyof Versailles of 1919: the payment of reparations was (nearly)impossible, because the transfer would occasion a violent terms oftrade loss for the paying country. Bertil Ohlin showed that thetransfer could come about not only through a change in relativeprices but also, in an extreme case, entirely through offsettingchanges in the volume of expenditure in paying and receivingcountries, effected via fiscal policies implemented in a good faitheffort to pay reparations. Nevertheless, Keynes had made an im-portant practical point: a sudden change in the payments patterncan be very costly due to terms of trade changes, quite apart fromthe political cost of reparations.

The avoidance of financial reparations after World War II (trans-fers in kind were exacted) reflects this lesson. Today's debt prob-lem poses dangers similar to the reparations problem—insofar asa sudden switch from a negative to a positive resource gap isrequired, even though debtor countries are not expected to switchall at once to the net borrowing level that may be appropriate inthe medium term, and creditor countries as well as banks arebeing exhorted with some success to continue to ease this transi-tion by increasing their loan exposure. Another lesson of thereparations controversy, still appropriate today, is the need forthe creditor countries to expand their overall expenditure andreduce their barriers to imports; it will be ignored at their peril andthat of the world.

For a brief time, Keynes—basically a free trader- flirted withprotectionism. He also, briefly, espoused a simple multiple ratesystem for the United Kingdom to shield the overvalued pound.Trade would proceed at the devalued rate (brought about by off-setting surcharges on imports and subsidies on exports), whilefinancial transactions would take place at par in order to protectthe investment income of the United Kingdom.

In "The Economic Consequences of Mr. Churchill," Keynesmade an important point on how not to calculate an equilibriumexchange rate; there are many recent examples of Churchill'smistake. The United Kingdom's return to the prewar parity of thepound was justified by comparing the wholesale price indices inthe United States and United Kingdom. But the relationship be-

tween worldwide wholesale prices and those in a country heavily-dependent on trade unavoidably stands close to the exchange rateof that currency vis-a-vis any major foreign currency. Wholesaleprice relationships cannot be used to determine purchasingpower parity (even if that was all we had to worry about).

General Theory

As an economist, Keynes is remembered mainly for the GeneralTheory of Employment, Interest and Money published in 1936. al-though his Treatise on Money is considered more important bysome theorists. The General Theory was heretical in several re-spects when it was written. It appears far less so today, partlybecause so much of it has been accepted into conventional wis-dom and partly because some overenthusiastic generalizations byKeynes himself, but mainly by his many naive followers (theywere often respected academics), have been reduced to theirproper proportions.

One of the heresies ascribed to Keynes was the thesis that evenin the absence of uncertainty generalized industrial unemploy-ment could be a state of competitive equilibrium, requiring expan-sionary policies as a cure. Critics of Keynes have argued that evenif falling nominal wages would be offset by falling prices, so thatreal wages would not fall (initially), the real money supply wouldrise in the process; thereupon demand would rise, which wouldeventually restore full employment (presumably, the rise in de-mand would raise prices relative to nominal wages, which wouldbe held down by unemployment). In fact, Keynes was aware oithis real balance effect, but he thought that it would operate veryslowly and would be bought at a horrendous cost. A differentinterpretation of Keynes' fear of persistent mass unemploymenthas become more prominent recently. That is, sustained unem-ployment may be explained not by the impossibility of reducingreal wages but rather by the high information costs that are en-gendered by disequilibrium, which makes nominal wages (evenin the absence of institutional wage floors) respond only slowly tochanges in prices.

The idea that expansionary policies could cure generalized in-dustrial unemployment as long as the real wage is flexible wasdiscovered or at least instinctively practiced by others beforeKeynes; inter alia, it seems to have been preached in (preFriedmanian) Chicago. As Roberto Campos has pointed out tome, there seems in any case to be a somewhat disconcertingcomplementarity between Friedman and Keynes: the practice ofnaive Friedmanian policies may be about to recreate the condi-tions in which the world may need a new dose of Keynesiamsm(and, perhaps, the opposite was also true).

Keynes was, of course, writing about unemployment in industrial countries and not about underemployment in developingcountries, which is due not to excessive real wages but to thepeculiarities of the income distribution system in noncommercialagriculture. Developing countries have learned at their cost thaiunderemployment cannot be cured by monetary expansion. And

*I am indebted for valuable suggestions to]. Boughton, Roberto Campos, Gottfriedllaberler, Bahrain Nmvzad, / . / . Polak, Robert Solomon and Alan Tail.

riiiiinee i-f Development / December /'V,! 37


industrial countries have also learned at their cost and, unfor-tunately and unfairly, at the cost of the rest of the world, thatexpansionary policies cannot cure their type of unemploymentwhere the real wage is not flexible.

Keynes both believed in the need for monetary expansion in adepression and doubted its efficacy when compared to fiscal pol-icies. Fiscal-monetary controversies are eternally modern. Today,industrial countries seem to be able to use only monetary policiesto combat inflation. Keynes' problem was the liquidity trap—interest rates could not fall enough in a cyclical or secular collapseof the marginal efficiency of capital to stimulate private invest-ment; monetary expansion would be ineffective; and fiscal policywould have to step in. Few would today defend the (secular)stagnationist hypothesis even in the wealthiest countries—andparticularly not since the two oil shocks of the 1970s havepresented the world with the need for a new productive structurealigned with new price relationships. In any case, Keynes' inven-tiveness was equal to the stagnationist thesis. He disinterred thewritings of the German-Argentine economist Silvio Gesell whohad proposed a negative real interest rate to be brought about bystamps that would have to be affixed to money periodically tomaintain its legal tender characteristics. As a means of maintain-ing investment in a depression, Gesell's prescription would havebeen a better way than to make interest rates negative throughinflation.

Keynes, the Fund, and the BankThe creation of an international Clearing Union was for Keynes

the cornerstone of postwar economic reconstruction. He insistedfrom the outset that to avoid the economic disorganization of theinterwar period, there was also a need for other internationaleconomic institutions (though the Clearing Union deserved pre-cedence because it could finance these institutions and becausedebit and credit balances held by the Union could serve as indi-cators to guide them). Among them he specified bodies chargedwith the promotion of postwar relief, rehabilitation, and recon-struction; commodity control; international investment; the main-tenance of price stability and control of the trade cycle; and inter-national trade. He also mentioned the possibility of financing apeacekeeping body via the Union. The genius of Keynes and theothers who started the reconstruction process was to realize thatthe institutional infrastructure had to be in place before the warended if it was to be established at all. Coordination and theacceptance even of enlightened leadership would become moredifficult after the war. It is unfortunate that those who establishedthe infrastructure vastly underestimated the size of the task.

Keynes' original idea of a Clearing Union was different not onlyin scope but in structure from the American-inspired Fund thatwas to emerge. The main difference in the latter respect was thatKeynes' Union would have created whatever internationally ac-ceptable assets it needed to finance its operations simply byrecording overdrafts in its books. All members would have beenobliged to accept the corresponding liabilities of the Union insettlement of international claims. The Fund requires a collectionof currencies and other international assets (owned or borrowed)to finance its operations and not all of them are usable at all times.More important and embarrassing, the degree of usability of theseassets, and therefore the possible scale of operations of the Fundat any time, is unforeseeable. It is interesting to remember that inaddition to the British and American proposals, there was also aCanadian one, which, on the whole, followed more closely theAmerican than the British design. It had an extremely interestingfeature that, in case of need, required countries to lend theircurrencies to the Fund up to 50 per cent of their quota. The ideaof a lending obligation (as distinct from voluntary agreements,

even long-term ones, to lend) to reinforce quota resources is onethat might have made the recent life of the Fund easier, althoughit can always be claimed that quotas would have been correspond-ingly scaled down. Like the Fund in its initial incarnation, Keynes'Clearing Union laid great stress on the need for preventing spec-ulative capital flows.

Keynes' Union would have given members more automaticaccess to its resources than the Fund has done. But conditionalityof access was definitely part of the Keynesian concept for persis-tent debtors. There might have been parallel fines for excessivedebtors and creditors (and, from the outset, greater freedom tochange exchange rates).

Would an enlarged access policy, which has been so helpful tothe international community recently, have been possible in aClearing Union? Keynes regarded each member's quota as thelimit of its indebtedness to the Union. There is, however, notechnical reason why the Union's articles of agreement could nothave permitted the waiver of this limit, just as the Articles ofAgreement of the Fund allow it to waive its access limits. Enlargedaccess could not have failed for lack of financing under the Union:Keynes was insistent that there must be no limit on members'credit balances held with the Union. However, J.J. Polak hassuggested to me that this unlimited financing obligation underthe Clearing Union might well have made potential creditor coun-tries even more reluctant to agree to enlarged access than theyhave been.

Although the name of Keynes is generally linked to the deliber-ations at Bretton Woods concerning international monetaryarrangements, it is important to recognize that he took a keeninterest and played an important role in the establishment of theInternational Bank for Reconstruction and Development (an insti-tution whose creation was the initiative of the U.S. Treasury).Keynes was the Chairman of Commission II at Bretton Woodswhich concerned itself with the Bank. He had mentioned the needfor an investment institution both for cyclical and for develop-mental purposes in his memorandum on the Clearing Union,though at first he was skeptical on the Treasury proposals. Heforesaw not only the immediate functions but also the sub-sequent, broader role of the Bank. In his own words, "It is likely,in my judgment, that the field of reconstruction from the con-sequences of war will mainly occupy the proposed Bank in itsearly days. But as soon as possible, and with increasing emphasisas time goes on, there is a second primary duty laid upon it,namely to develop the resources and productive capacity of theworld, with special reference to the less developed countries."

It would be hard to improve on the summary of Keynes' signifi-cance in the editorial preface to his celebrated posthumous article,"The Balance of Payments of the United States," published in theJune 1946 Economic Journal: "The world has lost one of the veryfew with the imagination, courage and leadership needed to re-store civilisation and build a firm economic base for peace andhappiness. Britain has lost the chief architect of the economicpolicy which made victory possible, her chief advocate in eco-nomic negotiations, the brain which more than any other wasshaping her economic future. His friends have lost one who em-bodied for them not only all that was finest in liberal civilisationand learning, but also all that was firmest in moral strength,human affection and intimacy. Economics has lost the inspirationof one who for a generation has been the centre of every contro-versy, the fountain of new ideas, the iconoclast who destroyed tobuild better, the thinker who more than any other in the historyof our science has helped to make man master of his fate." HQ



Guest Article As previous articles in Finance & Development have noted, the current state of the world economypoints to the need for a vigorous role for the multilateral financial institutions. The World Bank, as theworld's leading development assistance institution, is at the center of efforts to promote economicgrowth in developing countries. To carry out its functions, however, it needs the support of ail itsmembers. This article assesses the climate of support for development aid within the United States.

Changing public attitudestoward aid

The need for a constituency in the United States

Henry OwenConsultants International Group, Inc., Senior Fellow,Brookings Institution, and Ambassador at Large for

Economic Summit Negotiations, 1977-81

Attitudes toward foreign aid in the United States seem to havemoved full circle in the last 40 years. Foreign aid first surfaced asan issue before the U.S. public when the Bretton Woods agree-ment was concluded in 1945, creating the World Bank and theInternational Monetary Fund. The intended role of the Bank wasnot then described in terms of providing "foreign aid," but that iswhat it amounted to: a transfer of resources to nations thatneeded help to recover from the effects of World War II. Theunderlying notion was that the health of the world economyrequired systematic assistance from nations in a position to pro-vide it to others that could put it to good use. It was thought thatthe burden of this aid should be fairly shared among donors, thatit should be divorced from short-term foreign policy considera-tions, and that tough economic conditions should be imposedupon aid recipients. A multilateral institution with a strong inde-pendent management seemed best suited to accomplishing thesepurposes.

Since 1945, U.S. attitudes toward foreign aid have passedthrough several phases. First came the Marshall Plan: U.S. aid tomeet recovery needs in Western Europe that exceeded the re-sources of the World Bank and other then-existing institutions.The Marshall Plan succeeded, and went out of business as in-tended. It left a legacy; the U.S. public came to expect its aid toproduce large and evident effects very quickly, and then to termi-nate. This view, irrelevant to conditions in developing countries,was to plague later planners of U.S. aid.

The next phase of aid came in 1949, when President HarryTruman announced his Point IV program of U.S. technical assis-tance to developing countries for development and humanitarianpurposes. Public and congressional support were quickly forth-coming.

Then came the Korean War: U.S. security assistance wasprovided to help nations threatened by external aggression

strengthen their armed forces and their economies. The term"Mutual Security Program," used to describe this aid, reflected itsintent, which increasingly overshadowed the original human-itarian aims of the Point IV program.

With the passage of time, this dichotomy was resolved: theinformed U.S. public concluded that both development and secu-rity aid were needed and that, since the purposes of the two typeswere very different, they should be separated from each other inboth the appropriation process and their administration. Thisseparation was effected in 1957, when a separate instrument forU.S. bilateral development aid, the Development Loan Fund, wascreated. Public U.S. attitudes came to focus increasingly on "newdirections" in U.S. bilateral aid as the main means of helping poorpeople in poor nations. Western European countries and Japanalso mounted increasingly large programs of bilateral develop-ment aid.

In the United States, this trend toward rising bilateral devel-opment aid peaked in the 1970s. In the latter part of that decade,it became increasingly clear that the U.S. Congress intended tohold U.S. bilateral development aid to a nominal level at or below$2 billion (not counting PL 480 concessional sales of surplus U.S.agricultural commodities). A very large scale U.S. bilateral pro-gram to transfer capital for development purposes was evidentlynot in the cards.

Since 1980, Peter McPherson, the Director of the Agency forInternational Development in the Reagan administration, hasmoved U.S. bilateral development aid increasingly toward sup-port of technological cooperation. In carving out this special nichefor bilateral aid, McPherson is taking account of its limited sizeand is building on U.S. public attitudes that have favored tech-nical cooperation and assistance ever since the Point IV programwas announced in 1949.

I'tnance & Development I December 1983 39


The multilateral role

This view of U.S. bilateral development aid leaves infrastruc-ture building more and more to the multilateral developmentbanks. President Jimmy Carter took the lead at successive annualeconomic summit meetings in urging other industrial nations tosupport the expansion of these institutions—particularly theWorld Bank. He focused congressional and public attention in-creasingly on the Bank as the spearhead of U.S. developmentassistance. The share of total U.S. aid going to multilateral devel-opment banks increased steadily during his administration. Therewere objections from those in the administration who wanted tosee more emphasis placed on bilateral aid, because of its sup-posed short-term foreign policy benefits. President Carter, how-ever, continued to give top priority to the multilateral banks'long-term development purposes, whose fulfillment he consid-ered essential to a healthy world economy.

As a result, the multilateral development banks became in-creasingly the main battleground for conflicting U.S. attitudestoward development aid. Opponents of foreign aid focused theirattention on multilateral aid because, as Willie Sutton said inexplaining why he robbed banks, "that's where the money is."Opponents' attitudes were enhanced by concern over lack of U.S."control" over the Bank's operations. They objected to enlargedactivity not only by the World Bank but also by its concessionalloan window, the International Development Association.

IDA had been founded partly because of a U.S. initiative in thelate 1950s, when Senator A.S. Mike Monroney and Undersecre-tary of State Douglas Dillon joined forces to this end. At first, itelicited strong support in the United States, where concern wasthen focusing on the need for more aid to the poorest countries.In recent years that support has weakened, not only for the rea-sons cited above but also because IDA's concessional terms makeit especially vulnerable to attack and reduction in the U.S. appro-priation process.

Now, as at the rime of Bretton Woods, the World Bank is seenby interested Americans as the key element in the continuingtransfer of public resources to developing nations; it is viewed bycritics and proponents of aid alike as the only institution capableof mobilizing development resources on the scale that is needed.This makes it the focus of congressional debate for and againstdevelopment assistance. For reasons already discussed, the bal-ance of this debate has tended to go against multilateral aid in thelast few years. The question is whether that balance can be re-dressed in the years ahead.

The constituency; the battles

The business and banking communities in the United States areaware of the importance of the World Bank. At a time when mostlarge U.S. businesses derive a substantial part of their earningsfrom operations abroad, it is easy to perceive how effective multi-lateral aid contributes to these earnings. Some U.S. labor leadersmust share this perception. While reflecting their members' con-cerns about building up competitive industries abroad, they can-not escape the fact that employment in U.S. exporting industriesdepends, to a considerable extent, on growth in the developingcountries that buy these exports.

Church and humanitarian groups in the United States have notyet focused their attention on multilateral aid, despite the centralrole that this aid has played in the war on hunger and poverty.The achievement of virtual food self-sufficiency in India, Pakistan,and Bangladesh has been the greatest victory in that war to date;it could not have been achieved without World Bank aid. Overtime, U.S. church and humanitarian groups will increasingly con-clude that the best way of eradicating human misery is to have an

expanding world economy, and that the multilateral institutionsare essential to this end.

What do these changing U.S. public attitudes portend for thefuture of the Bank? Under its present and past leadership, theinstitution has maintained the high professionalism of its staffand the independence of its management. The continuing qualityof the institution's work is thus not in question; the quantitativelevel of its efforts is. Two areas are particularly worrisome:

• World Bank lending at market rates should grow as the needsand absorptive capacity of such middle-income development na-tions as Brazil and Mexico increase. Given the limitations on com-mercial lending, these nations will have to attract public loans, aswell as private lending and investment, if they are to make astrong contribution to the global economy. Since the World Banklends money at market rates and has never had a default, it cansecure these increased resources from the private market. Butgovernments must first give their approval. The attitude of theUnited States on this point has yet to be fixed. But the health ofthe U.S. economy and of the economies of other industrial coun-tries is at stake; they cannot prosper if their trading partners in thedeveloping world stagnate.

• By contrast, IDA requires appropriated funds, since it pro-vides concessional loans to poor countries that cannot service allthe loans they need on hard terms. The Bank's management hasadvocated $16 billion as a realistic target for the Seventh Replen-ishment of IDA. Taking account of inflation, this is not a largeincrease over the $12 billion pledged for IDA VI. But the U.S.Congress has become increasingly restive at appropriating grow-ing sums for an institution it cannot control. The outcome hingeson the willingness of other donor nations to make increased con-tributions to IDA, perhaps through a supplemental fund, even ifthe United States does not fully match their contributions.Whether other donors do this will probably depend partly onwhether they believe that this is a temporary problem or an indi-cation that the United States is permanently committed to a lessgenerous posture toward the Bank and IDA.

These two battles—over increasing the lending of the WorldBank and over replenishing IDA— cannot be won without stron-ger support for the Bank from the U.S. public. Leaders in the U.S.private sector will have to be more vigorous in sharing their viewsabout the need for multilateral aid with the executive branch andthe Congress. Businessmen, bankers, the churches, labor, andother U.S. groups—all will have to play a key role to this end.

Almost every facet of U.S. governmental activity has a constitu-ency to which the U.S. agencies charged with that activity canturn for counsel and support. There is no major constituency towhich the U.S. executive branch and the Congress can turn withrespect to the World Bank and the regional development banks.Such a constituency needs urgently to be created. Changing U.S.attitudes toward development aid make this feasible, as well asnecessary. More private citizens probably now recognize the needfor strong Bretton Woods institutions than at any time since 1945.These institutions were given unequivocal public support by Pres-ident Ronald Reagan at the Bank-Fund Annual Meetings in 1983.The future of the Bank depends on whether a powerful and activeU.S. constituency comes into being to translate this support intocongressional action.

The policies of other donor countries, as well as the UnitedStates, hinge on whether this is done. In the long run, it will bedifficult to expect other countries to increase their contributionswithout U.S. leadership. They may conceivably be willing tobridge a temporary gap, but they will have to be convinced thatit is temporary—that is, that a turn around in U.S. attitudes isunder way. This depends, in good part, on whether action in theU.S. private sector is mounted to this end. HD



Minimizing the burdenof recurrent costs

World Bank project experiencein sub-Saharan Africa indicatesa need for more cost recoveryand better planning

Jacob Meerman

There is universal recognition that invest-ment is a key element in expanding theproductive capacity of developing coun-tries. As a consequence, their governmentshave become increasingly active investors.But the accumulated capital and the associ-ated large public organizations that haveresulted have also brought an expandingbudgetary burden of recurrent expendi-ture, particularly as much recent invest-ment has taken place in the nonmarket sec-tors, such as education and health care.When a country is growing, as most devel-oping countries were during the 1970s, thisburden is more manageable because of theconcomitant growth of government reve-nues. But if growth stalls—the situation inmany countries today—recurrent costs fre-quently become excessive and the problemis manifested, among others, in ill-maintained highways, schools withouttextbooks, or equipment out of service forlack of spare parts. Yet, quite apart fromthese cyclical causes of the problem, manygovernments now have a burden of recur-rent expenditure that they would be unableto fund even in normal circumstances.

In sub-Saharan Africa, with its exceed-ingly low income per capita, the problemalso has another dimension. Insofar as ser-vices such as medical care, potable water,and sanitation are publicly produced, gov-ernments cannot provide them to morethan a minority because their domestic rev-enues and policies to direct resource allo-cation are so seriously constrained. This"structural shortage" of resources is an im-portant reason why, for instance, life ex-pectancy at birth is so low in the region,namely, 47 years as compared to a globalaverage of 63 years. Consequently, the re-current cost problem in sub-Saharan Africais not only manifest in an inability to keepexisting organizations running at capacity;

it is also evident in an inability to provideservices adequately to the population. In-deed, even if adequate services were de-veloped, say with the aid of some foreigndonor, maintaining them would be quitebeyond the fiscal capacity of the nationalgovernments. For this same reason, im-proving fiscal management is a far morepressing issue in Africa than in regionswith higher incomes and stronger govern-ment institutions.

The reasons for the inability of govern-ments to meet their recurrent obligationsfor existing facilities are various, but similarthroughout the world. In many countries,the excess demand for recurrent resourcesis partly a result of the institutional sepa-ration between government budgeting andplanning. The ministry of planning con-cerns itself with investment and its finance,frequently relying on extrabudgetary re-sources such as foreign loans, while theministry of finance may be quite unawareof the new recurrent costs that it will laterbe called upon to cover once the capital isinvested. In brief, recurrent budgetingtends to be incremental—the finance minis-try gives the others what they received theprevious year, plus a little more, and doesnot plan for longer-term developments.Occasionally, this tendency for capital toexceed recurrent funding is increased bydonor agreements to cover local costs forgovernments unable to do so during theproject period in the (often vain) hope thatthe authorities will be able to pay them af-ter the project is implemented.

In addition, many of the economic activ-ities undertaken by governments in thearea that could be fully self-financing arenot covering their costs and are, in one wayor another, dependent on government sub-sidies. Prices for the output of public en-terprises, utilities, or state farms may beeroded by inflation; cost recovery may beinefficient; costs of production may be ex-cessive because of overstaffing; or the prin-ciple of full cost recovery may lack politicalsupport. In sub-Saharan Africa, parapublicenterprises undertake most or at least alarge share of these activities, and typicallyinclude production in industry, transport,large-scale marketing, or housing. Ratherthan becoming rapidly expanding self-

financing organizations that generate a sur-plus for additional investment as well asdevelop skilled labor and enhance manage-rial capacity, most have become serious fis-cal burdens. Hence, national growth slowsbecause the parapublic sector stagnatesand does not provide the needed basic out-puts, but rather consumes much of anysurplus that might be invested.

Although increased taxation to raise rev-enues is feasible in many countries, it canbe greatly increased in but a few countriesin Africa. Most taxable African productionis already heavily burdened; there is sub-stantial evidence that in many countries ag-riculture, for instance, is stagnating in partbecause after taxes producers can onlybarely cover their costs. Higher growthrates, which would increase governmentrevenues to ease the shortage, are thusmade more difficult, and countries findthemselves in a vicious circle of deficit,excessive taxation, reduced growth, anddeficit.

Partial cost recovery

The Bank's approach is that the projectsto which it contributes and which are in themarket sectors (that is, those whose outputis normally sold at full cost) should gener-ate enough resources to cover at least recur-rent costs, if not part or all of capital costs(depreciation plus net return). In severalsectors, however—education, subsistencefood-production, and health care, forexample—the Bank finances projects inwhich typically neither recurrent costs nordebt service is covered by charges on out-puts generated by the project. Here, thecosts are expected to be borne by the gov-ernment budget.

But even in these sectors, partial cost re-covery to reduce the burden of the re-current funding on the government budgetis possible. Many governments in WestAfrica, for example, not only pay all of theeducational costs of secondary and highereducation but also provide students withfree room and board and a stipend. Yet inmany of these same countries, enrollmentrates for primary school are less than 50percent because governments are finan-cially unable to extend primary educationto most of the rural population, while the

Finance & Dnvlopment / December 1983 41


villagers themselves are too poor to be ableto cover the costs. Frequently the bene-ficiaries of the free higher education comefrom the better-off urban families whowould be able to pay for much of it directly.But even if they cannot, the value of theeducation they receive puts them in a favor-able position to obtain and repay studentloans, since their increased lifetime earn-ings from higher education are consider-able. The Bank has frequently emphasizedrecovering costs from the beneficiaries ofhigh schools and universities to releasemore funds for primary education. Never-theless, the policy of free education at thehigher levels is extremely popular and gov-ernments have been unable to move awayfrom it.

Partial cost recovery is also necessary ifexpansion in urban services is to keep pacewith urbanization, since in most countriesurban growth is more rapid than thegrowth of government resources to financeit. Following a history of lending for publicutilities, transportation, and industry, in1972 the Bank started lending to finance theprovision of low-cost city housing sites,municipal services, and slum upgrading(this involves improving streets, water sup-ply, and sanitation, and providing tech-nical assistance to city management andadministration). In 1980, the Bank carriedout an assessment of its experience in EastAfrica with cost recovery from urban proj-ects. Its findings seem generally applicableto cost recovery from urban projects else-where. Six problems emerged: political am-bivalence, inadequate legislation, delay ingranting land tenure, absence of sanctions,weak administration, and the unwilling-ness of beneficiaries to pay. Evidence sug-gested that the ability to pay was less aproblem than the willingness to do so. Var-ious studies showed that 15-25 percent ofthe income of average urban householdswas spent on shelter, and that the chargesfor the self-help shelter provided throughBank projects were less than this range forall except the poorest.

Political ambivalence, even outright re-sistance, was the most serious cause of de-lays in starting cost recovery, especially forupgrading. Countries with successful costrecovery from urban projects, such asKenya, had broad support among politicalleaders, civil servants, and project benefi-ciaries. In Botswana and Zambia, however,the principle was accepted only grudginglybecause some people, frequently fromhigher-income groups, had traditionally re-ceived similar or better services free.

Administering sanctions for nonpay-ment was also a serious problem in bothsite and services and upgrading projects.The repossession of serviced sites was fre-

quently obstructed by both inadequate leg-islation and political ambivalence. In thecase of upgrading costs, it was difficult toidentify an effective sanction for nonpay-ment. Repossession or eviction was not re-alistic. Neither was legal if the house wasprivately owned; where either was legal,families knew that governments would of-ten avoid evictions rather than take the riskof creating new squatter areas. Zambianauthorities attempted disconnecting waterand electricity, but where families did notsimply reconnect the services, those whoshared the services and had paid regularlystopped paying. In general, families initi-ally willing to pay for urban project servicesbecame confused and discouraged becauseof delays in promised improvements, de-lays in the delivery of tenure documents(often due to legislative problems), andpoor information on amounts due and howpayments were to be made.

Full cost recovery

The Bank believes that public utilities—providing power, water, sewage disposal,and telecommunications—should fully re-cover their recurrent expenses and theirdebt service and provide some self-financing for expansion. External benefitsand social considerations allow this prin-ciple to be relaxed for projects in the waterand sewage sectors, but revenues shouldalways cover operating expenses and debtservice. Covenants on rates of return andcash flow are used to ensure this result.This does not imply that each componentof an operation has to be entirely self-supporting. Progressive "block tariff"structures are often recommended by theBank for water supply and power invest-ments. These charge low rates for the initialblock of consumption, steadily increasingthem as consumption rises. In this way, theaverage cost per unit to the poor is less thanthat to the better off, who consume more,and services can be expanded to both with-out fiscal subsidy.

One of the obstacles to recovering costsin power projects in sub-Saharan Africa hasbeen the inadequate increases in chargeseroded by inflation. To restore the realvalue of revenues, the Bank's financial cov-enants for power projects in West Africanow typically include automatic tariff ad-justments as the price of fuel and othercosts rise with inflation. But many govern-ments have been reluctant to permit auto-matic increases. Frequent revaluation offixed assets because of inflation has alsobeen common, and useful insofar as tariffsare designed to ensure a minimum finan-cial rate of return to fixed assets. But cov-enants requiring such returns are falling

into disuse. This is partly because of thecomplexity of measuring an adequate rateof return given rapid inflation and partlybecause of the association of high rates ofreturn with colonial exploitation. Instead,covenants are increasingly defined to en-sure a cash flow that will cover depreciationplus debt service and finance a substantialshare of new investment. In some cases,the latter has been 40 percent of annualadded capacity.

In the 1960s, World Bank highway loansfor the region included covenants for ear-marking a portion of motor fuel taxes forroad funds, partly to assure adequate fund-ing for highway maintenance. In practice,only a small part of the funds was used formaintenance; most were used to constructnew roads and to improve existing ones. Ifthe earmarked funds from the user taxeshad been set against maintenance, mostcould have been financed until about theend of 1973. But maintenance was givenlow priority and worldwide inflation begin-ning in 1973 exacerbated the shortage offunds for maintenance, as the commonlyused fixed motor fuel taxes per liter or gal-lon were not increased to keep pace withprice rises.

In addition in many countries, includingmost of those in the Sahel, governmentshave become so short of funds that theyhave long since virtually ceased earmark-ing revenues for maintenance. At the sametime, they have been very reluctant tomove to the inflation-proof ad valorem tax,which sets the tax as a fixed percentage ofthe price of motor fuels. As a result, therehas been such a widespread deteriorationin road networks that in many countriesthe maintenance problem goes beyond rou-tine needs. Many highways have deterio-rated so badly that complete reconstructionis necessary. Almost every country that is amember of the World Bank in West Africa,for example, has at least one highwaymaintenance loan, typically for equipment,spare parts, and training.

Conclusions

The Bank's experience with cost recov-ery, which is not atypical of that of otherdonors, suggests some general conclu-sions. First, the institutional causes of re-current cost problems imply that countriesneed a plan not only for developmentexpenditures, which most have, but alsofor the recurrent outlays associated withthose development expenditures, includ-ing other future budget claims. Moreover,the typical independent approach of dif-ferent ministries toward undertaking in-vestments, with inadequate concern forbudgetary implications, needs to be coordi-

42 Finance &• Development / December 1983


nated. In particular, the estimation of gov-ernment financial contributions to projectsinvolving foreign aid should be centralizedin the budget office. During preparation ofdevelopment projects, no matter how theymay be funded, a realistic estimate needs tobe made, based on the entire budget and itsfuture evolution, of whether there will besufficient uncommitted resources to sup-port the new government activities. Donorsalso need to look hard at the fiscal impli-cations of their combined activities in thecontext of the ongoing budget situation ofthe recipient country.

A second conclusion of this examinationof the recurrent cost issue is that cost-benefit analysis might usefully be appliedto services involving direct investments inpeople. The World Bank, as do other do-nors, does not apply cost-benefit analysisas an input into an analysis of the economicdesirability of education projects, for in-stance. Although there may be technicalproblems in estimating the economic bene-fits from education, not to use such anal-ysis is paradoxical, since the scarcity of ed-ucated people is the most fundamentalconstraint on growth in sub-SaharanAfrica. Indicative use of cost-benefit anal-ysis—suitably hedged, because risks arehigh and quantitative estimates of benefits

are hazardous—might nevertheless makedonors willing to consider funding the re-current costs of education. This is a veryimportant consideration, since recurrentgovernment expenditure for education istypically one of the largest components inthe current expenditure budget. Such anal-ysis would also be useful in determiningthe best allocation of funds among the dif-ferent levels and kinds of education.

Perhaps of even more pressing impor-tance in many sub-Saharan African coun-tries is some measurement of the effective-ness of expenditure for ongoing education.The enormous and very impressive expan-sion in the numbers enrolled in schools hasbrought with it very low quality education

Jacob Meermana U.S. citizen, is a SeniorEconomist in the WesternAfrica Regional Office of theWorld Bank.

in many countries. There, the economicrate of return to improving certain existingeducational services may well be higherthan the returns to expanding the numbersof the educated.

A final conclusion is that those activitiesthat can clearly pay part or all of their ownway should be encouraged to do so. Tele-communications, public utilities, high-ways, and export agriculture can generatetheir own funds—capital and recurrent. Onthe one hand, they are well suited for con-cessionary financing of their capital expen-ditures; on the other, they usually producean output that can be sold or taxed in waysto permit substantial surpluses. Conse-quently, it is unwise to let them deteriorateso far that they can no longer produce thesesurpluses. In highway transport this mayrequire greater funding of the road mainte-nance organization. In several other sectorsit means tariffs indexed so as to offset infla-tion. In the subsidy sectors—certain urbanservices, education, health care—all ofthese could be more widely available if therecipients were to pay a greater part of theircosts. In general it means another approachin which the goal of providing basic goodsto all is coupled with the necessity of recip-ients, normally, to contribute to the costs oftheir production. ISO

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Finance & Development I December J98.5 43


Maintaining financingfor adjustment and development

The 1983 Annual Meetings ofthe Boards of Governors of theIBRD, IDA, IFC, and the Fundwere held in Washington, DC,September 27-30.

A report on the main themesemerging from the Meetings

The atmosphere at this year's Meetings wasmore positive than that surrounding the1982 Meetings in Toronto, which had beenmarked by a sense of crisis regarding thehealth of the global economy. Yet whileprogress had been made in major areas,there was widespread agreement amongGovernors that the transition to sustained,noninflationary growth had by no meansbeen fully achieved. First, economic recov-ery had been relatively strong in NorthAmerica in 1983, but it had not been signifi-cant in many other industrial countries,and had been negligible in most developingcountries. Even in North America, the out-look for a sustained recovery that includeda revival of business investment remaineduncertain.

Second, many developing countries hadundertaken courageous and difficult ad-justment measures and some had hadmarked success, but their prospective bal-ance of payments deficits, the outlook for

This article mis written by Gerard Rice, in theSecretary's Department of the World Bank, andfames Con and Susan Fennell, in the Secretary'sDepartment of the Fund.

financing, and the continuing uncertaintieswith regard to world trade and growth, leftthem no alternative but to persevere intheir efforts.

Third, the world's financial system hadweathered a series of severe strains in 1982and 1983 through prompt and vigorous ac-tion by the international community. Thisin itself was a major achievement; never-theless, the management of external debt,the high level of interest rates in real terms,and the ongoing volatility in exchange mar-kets all called for continued attention andfor an active financing and surveillance rolefor the Fund. At the same time, the stilldifficult international economic environ-ment required the Bank and its affiliates,the International Development Associationand the International Finance Corporation,to pursue vigorously their policy dialoguein support of an adjustment process lead-ing to sustainable medium-term economicgrowth.

Global economic prospects

"The central task of policy in present cir-cumstances is to consolidate the recoverythat is taking hold and to ensure that itis extended and sustained," Jacques deLarosiere, Managing Director of the Fund,stated in his opening remarks to Gover-nors. This theme was echoed by speakersfrom industrial and developing countriesalike, who acknowledged that a prerequi-site of success was to maintain the progressachieved in bringing down inflation. Whilesome believed that there was already moreroom for maneuver in those countries thathad brought inflation rates down to rela-tively low levels, it was generally recog-nized that a rekindling of inflationary ex-pectations through a premature relaxationof financial policies would only serve to en-danger the still fragile economic revival.

Sustained noninflationary growth wouldalso be threatened, many speakers pointedout, if real interest rates remained high. Inaddition, a number commented that highinterest rates added to the already severedebt-service burden of developing coun-tries. A reduction of 1 percentage point ininternational interest rates, it was noted,would result in an approximately $2 billionreduction in debt-service payments forthose countries. Large fiscal deficits, by ab-sorbing a high proportion of available sav-ings and by undermining confidence in theauthorities' commitment to financial disci-pline, helped to maintain interest rates atlevels that could impede the revival of thebusiness investment crucial to the mainte-nance of growth. It was, therefore, essen-tial that governments should act to reducefiscal deficits progressively over the me-dium term.

The much-sought recovery in investmentactivity would be aided by policies de-signed to increase both domestic and in-ternational competition; such measuresshould increase flexibility in wage-settingprocedures and remove subsidies andother price-distorting measures. It was con-sidered especially important to reduceprotectionism, which not only hinderedstructural adjustment in the developedcountries but also posed a major obstacle tothe expansion of the developing countries'exports and thus to their prospects forgrowth and for servicing their externaldebt. The persistence of protectionist pres-sures was regrettable and the major devel-oped countries, in particular, should takeaction to rescind measures of protection,many Governors stressed.

Indeed, it was agreed that the outlook forthe non-oil developing countries as a groupremained the most worrisome aspect of theinternational economy. As A.W. Clausen,



President of the Bank, noted: "Most [devel-oping] countries have experienced, in dif-fering degrees, deteriorating per capitaincome growth, stagnating governmentrevenues, and serious balance of paymentsand debt-servicing difficulties."

Governors from developing countries, inparticular, emphasized the heavy socialand economic costs that adjustment en-tailed. All acknowledged that a consid-erable measure of external adjustment hadalready taken place in many countries, of-ten in conjunction with Fund support.Nevertheless, it was agreed, those effortsneeded to be continued if viable externalpayments positions were to be achievedand if growth and development were to re-turn to reasonable levels.

A crucial element in support of adjust-ment was the provision of adequate fi-nancing. Many Governors singled out forpraise the active coordinating role that theFund had played in the past year in work-ing with official creditors, central banks,the Bank for International Settlements,other multilateral agencies, and the com-mercial banks to arrange a series of fi-nancial packages for countries faced withsevere debt management problems. Speak-ers also commended the World Bank forproviding complementary support to theadjustment process in the medium andlong term through its active dialogue withmember countries on policy improve-ments, institution-building, and other as-pects of structural reform. In addition,Governors called for increased lending byIDA, particularly in sub-Saharan Africa,and the expansion of the activities of IFCsupporting private sector development.

Given the reduction in flows of commer-cial credits to the developing world, speak-ers considered that the catalytic role of theFund would continue to be a major factor in

mobilizing the resources required to com-plement the adjustment effort of devel-oping countries. For the same reason, thosecountries should also seek to create theconditions that would make direct foreigninvestment more attractive. In addition,speakers suggested, it would be essential toincrease the flow of official developmentassistance, particularly to the low-incomecountries with little access to private capitalmarkets. Governors also emphasized thatneither the Fund nor the Bank and its affil-iates could play their parts effectively with-out sufficient resources.

Role of the Fund

The continued volatility of exchangerates and the related need for closer coordi-nation of economic policies among themajor industrial countries received consid-erable attention from Governors, who com-mented particularly on the Fund's surveil-lance role in that area. Several noted thatfluctuations in exchange rates not only con-tributed to uncertainties, which could ham-per both investment and trade flows, butthey were also a factor encouraging protec-tionist tendencies. Governors welcomed,therefore, recent efforts to develop moreeffective consultation procedures amongthe major countries, and they urged thatthe Fund's Article IV consultations withmembers should be strengthened to focusmore closely on the international impact ofdomestic policies.

The implementation of Fund-supportedadjustment programs had been instrumen-tal in maintaining commercial bank lendingto a number of debtor countries. As oneGovernor stated: "[the Fund's] effective,innovative response to the strains of thepast 12 months represents a landmark in itshistory." For the debtor countries to attainlasting creditworthiness, and for the Fund

to retain its credibility, it was essential thatadjustment programs should be sound andrealistic and that they should be success-fully implemented. Governors recognizedthat the conditionally applied to the use ofFund resources was needed for that pur-pose. "There is no single path of adjust-ment applicable to all countries," one Gov-ernor observed; therefore, the Fund shouldcontinue to tailor the programs it sup-ported to the specific needs and circum-stances of individual countries. Concernedthat the Fund appeared to be increasing itsconditionally, particularly with respect tothe use of resources under the special facil-ities (the compensatory financing and buf-fer stock financing facilities), some speak-ers urged that conditionally be appliedflexibly in light of the current difficultworld economic situation.

The continued availability of Fund fi-nancing to support adjustment was a majorconcern addressed by virtually all dele-gates. Since the 1982 Annual Meetings, ne-gotiations on the Eighth Review of Quotasand the expansion of the General Arrange-ments to Borrow had been concluded, and,in advance of the Annual Meetings, the In-terim Committee of the Board of Governorsof the Fund had agreed to continue theenlarged access policy in 1984. InterimCommittee members' views differed con-siderably on the level of access that wasappropriate under that policy. However, acompromise solution was reached, withannual limits of 102 or 125 percent of quota,three-year limits of 306 and 375 percent ofquota, and cumulative limits of 408 or 500percent of quota "depending on the seri-ousness of the balance of payments needsand the strength of the adjustment effort."As at present, it was also agreed that theExecutive Board should retain the flexibilityto approve stand-by or extended arrange-

rinanci' fr Development! December 1983 45


merits for amounts above the access limitsin exceptional circumstances. The enlargedaccess policy would be reviewed annuallyin light of all relevant factors, including themagnitude of members' payments prob-lems and developments in the Fund's liq-uidity position.

A number of speakers at the plenary ses-sions considered that, given the persis-tence of large balance of payments imbal-ances and the contraction in commercialcredit, the degree of access to Fund re-sources after the new quotas come into ef-fect should have been more liberal if thefinancial position of member countries wasto improve. They regretted the decisiontaken by the Interim Committee, arguingthat it was particularly unfortunate that, ata time when the Fund was asking lendersto increase their exposure in the developingcountries, it was reducing access to its ownresources. Such a development would givethe wrong signal to the international finan-cial community, they believed.

Other Governors, while supporting acontinuation of the enlarged access policyin light of the payments imbalances thatmany members continue to face, com-mented that the policy was always in-tended to be temporary and that thereforeaccess should, in due course, be graduallyscaled down to customary lending limits.The agreement reached by the InterimCommittee, they noted, constituted a com-promise solution that would not reduce po-tential access in absolute terms for anymember of the Fund. In addition, the Exec-utive Board would retain the flexibility toapprove, in exceptional circumstances,programs for amounts in excess of the re-vised limits. In the words of Willy DeClercq, Chairman of the Interim Commit-tee: ".. .there are no losers.. .the interna-tional community is the winner. ..." Somespeakers also stressed that the enlarged ac-cess policy had to take into account thelikely availability of resources to the Fund.

It was for this reason, among others, thatGovernors focused closely on the Fund'sliquidity position. In its communique theInterim Committee had reaffirmed thatquota subscriptions should be the primarysource of financing for the Fund, and allGovernors stressed the urgency for na-tional authorities to take the action neces-sary to bring the quota increases under theEighth Review into effect. However, someGovernors, particularly those from the de-veloping countries, considered that thequota increases were insufficient to meetthe demands on Fund resources and urgedthat the Ninth General Review of Quotasbe advanced. It was generally agreed that,given the severe liquidity constraints facedby the institution, Fund borrowing, prefer-

ably from official sources, would have toincrease, and Governors fully endorsed theManaging Director's efforts to secure addi-tional financing to bridge the growing gapbetween the Fund's commitments and theavailable lines of credit.

All Governors favored the maintenanceof the special facilities, but their views weredivided on specific access limits. Many,supporting the retention of present limits(100/125 percent of quota under the com-pensatory financing facility and 50 percentof quota under the buffer stock financingfacility), also stressed the need to ensurethat the quick-disbursing and low condi-tionality features of the facilities weremaintained. Some Governors consideredthat access to the special facilities should bereduced after the Eighth Review of Quotasbecame effective, since this would be inline with the revisions in enlarged accesspolicy. A few suggested that such accessshould be reduced by a proportionallygreater amount in order to shift the balanceof Fund financing to the conditional facili-ties. The Interim Committee called on theExecutive Board to consider the matter asearly as possible.

An allocation of SDRs in the current basicperiod was also discussed. Most Governorsconsidered that the arguments for an SDRallocation had been strengthened by recentdevelopments. Commercial bank lendinghad contracted, restricting the supply of re-serves, which had fallen to levels that couldplace a constraint on economic recovery,and inflationary pressures had weakenedin many parts of the world. Further, a newallocation would be consistent with the ob-jective of enhancing the role of the SDR asa major reserve asset. Some Governors, onthe other hand, held the view that the casefor a further allocation remained to bemade. They were not convinced that therewas a long-term global liquidity shortage,or that an SDR allocation would help toalleviate the debt problem or spur growth,as others had suggested. However, Gover-nors welcomed further consideration of theissue as a matter of priority.

Role of Bank, IDA, and IFC

Governors pointed out that the demandson the Bank, IDA, and the IFC for financialand nonfinancial assistance over the nextseveral years promised to be greater thanbefore. Given the prospect of economic re-covery, the developing countries wouldfeel it essential to compensate for the slip-page and delays in their investment pro-grams that had occurred during the lastthree years of recession. In this light, therewas serious concern that the Bank's pro-jected lending level would be virtually stag-nant over the next several years and that its

net transfers to borrowing countries wereprojected to decline after fiscal year 1985.Many Governors called for a real increasein Bank lending of at least 5 percent perannum. They recognized that in order toovercome the fundamental constraints onthe Bank's lending level an expansion ofthe Bank's capital base was required. Gov-ernors looked forward, therefore, to fruit-ful discussions beginning in the near futureon a General Capital Increase; it was hopedthat an agreement would be reached beforethe end of fiscal year 1986. As one group ofspeakers put it, "the long-term needs ofthe borrowing countries can only be ad-dressed in the context of a General CapitalIncrease."

In addition, a Selective Capital Increasewas required to realign member countries'voting rights following the Fund's EighthGeneral Review of Quotas. Several Gover-nors felt that a Selective Increase of $20 bil-lion was justifiable; but another view heldthat no more than $3 billion was required.At a meeting of the joint Bank/Fund Devel-opment Committee, the majority of mem-bers favored a compromise figure of $8billion; this would permit the needed re-alignment of member countries' votingrights as well as a modest increase in theBank's lending program. The DevelopmentCommittee instructed the Bank's ExecutiveDirectors to "work out the specifics" ofsuch a Selective Increase by the end of1983.

Governors noted that the recent declinein capital flows, both public and private,had severely impaired development mo-mentum. The cutback in concessional flowshad been particularly damaging to the low-income countries and, as one Governor re-marked, "massive increases" of official as-sistance in the future were unlikely. IDA'srole as the chief source of concessional as-sistance, institutional support, and policyguidance for the poorest countries was ac-knowledged as being of increasing impor-tance. Virtually all Governors expressedprofound concern, therefore, at the slowprogress of negotiations on IDA's SeventhReplenishment (IDA7).

Noting the difficult experience with theSixth Replenishment—the Association hadhad to cut back its planned commitmentsbecause of a shortfall in its resources (duemainly to a major donor's failure to honorits pledge on time) and emergency "bridg-ing" arrangements had had to be institutedfor fiscal year 1984—many Governors felt itessential that IDA7 should be implementedon an adequate and secure basis in fiscalyear 1985. Given the dire needs of IDA'sborrowers—which now include China—some Governors supported the IDA man-agement's proposal for a $16 billion Re-



plenishment; others considered an IDA7 of$12 billion an indispensable minimum, Theposition of the United States, however, im-plied that $9 billion was all that could berealistically achieved at this time. Gover-nors stressed that while major differencesremained among donor countries on thesize and burden-sharing arrangements forIDA7, a compromise had to be reached thatwould ensure that the minimum needs ofIDA's expanded recipient communitycould be met; include an objective and eq-uitable burden-sharing arrangement; andreflect the multilateral nature of the Associ-ation. Some Governors said that they re-garded the negotiation of 1DA7 as the "acidtest" of the international community'sspirit of cooperation.

While underlining the need to maintainofficial assistance flows, many Governorsalso highlighted the importance of privatecapital to the development process. Severalspeakers felt that the Bank should give in-creased attention to stimulating direct pri-vate investment. In this context, the IFC'srole in catalyzing the flow of capital, tech-nology, and modern management fromprivate sources for development purposesreceived broad endorsement. A number ofGovernors expressed strong support for aproposed $750 million increase in the IFC'scapital base. This would allow it to achievean investment growth rate of 12 percent ayear over 1985-89 and expand the breadthof its operations, particularly in its low-income member countries.

Governors recognized that an expandeduse of cofinancing was another importantway in which the Bank could catalyze theflow of financial resources to the devel-oping countries. It was noted that in Jan-uary 1983, the Bank had introduced newcofinancing instruments that permitted itto participate directly in commercial bankloans. Resources mobilized in this waywould complement the ongoing cofinan-cing activities with official sources and withexport credit institutions. While severalspeakers stressed that the purpose of Co-financing should always be to bring addi-tional resources to the developing coun-tries and that it should not become aprecondition of Bank lending, there wasgeneral encouragement for the Bank's ex-panded use of cofinancing arrangementswith public and private sources.

Looking ahead to the Bank's role in the1980s, one group of Governors felt thatmore attention should be given to formu-lating a specific medium- and long-termstrategy for the Bank that would equip it toaddress the problems facing its borrowingcountries. At the same time, several speak-ers stressed that sound and disciplined do-mestic economic policies were the most im-

portant contributions any country couldmake to its own development. The Bank'swork had its greatest impact, they said, inan environment in which efficiency, sav-ings, and investment were encouraged.

Among the challenges facing the Bank,the continuing plight of sub-Saharan Africawas given particular emphasis. A group ofGovernors stressed that the current foodsupply crisis in Africa was of "emergency"proportions and that the long-term solu-tion depended on achieving adequateproduction levels, which would require ad-equate levels of assistance. Another majorchallenge commented on by Governorswas the developing countries' investmentneeds in the energy sector. The Bank's 1983report, The Energy Transition in DevelopingCountries, estimated that the developingcountries would need to invest about $130billion a year in this area for the rest of thedecade. A number of Governors felt thatthe Bank's financial contribution in this sec-tor played an important role by attractingprivate sector investors to high priority,economically sound projects; they also en-dorsed the Bank's role in supplying policyadvice, institutional support, and tech-nology transfer. On the other hand, oneview held that it was inappropriate to lendscarce Bank and IDA resources for finan-cially attractive energy projects when alter-native sources of financing were clearlyavailable.

There was also some discussion of theexpanding role of the nonproject com-ponent of Bank lending. Several Governorsstressed that project financing was theBank's raison d'etre and that departuresfrom this should be approached cautiouslyand implemented carefully under clearlyenunciated guidelines. Other Governorsfelt that the Bank's nonproject loans—especially for structural and sectoral adjust-ment—were the most appropriate andeffective vehicles for responding to the bor-rowing countries' changing needs and cir-cumstances. Several speakers suggestedthat the Bank might increase this type oflending and also be more flexible regardingthe conditionality attached to these loans.

Many Governors applauded the flexibil-ity the Bank had shown in introducing theProgram of Special Assistance (approvedby the Executive Directors in February1983). By expanding its economic policy di-alogue; accelerating disbursements for themaintenance, rehabilitation, and comple-tion of high priority projects; expandingsectoral and structural adjustment support;increasing the share of Bank financing inprojects; and expanding export develop-ment funds, the Program was aimed athelping the Bank's borrowing countries torestore their development momentum

(since IDA already finances a high percent-age of its projects' costs, the Program re-lates primarily to Bank projects.) It was esti-mated that the Program would increaseBank disbursements over fiscal years 1983-85 by $2 billion and that net transfers wouldincrease by 25 percent. Several Governorsfelt that the Program should be supple-mented so that it could have more effect onthe lowest-income countries and that itshould be expanded beyond its projectedtwo-year time frame. However, given theresource constraints facing the Bank, Gov-ernors welcomed the Program as a "step inthe right direction" in an extraordinarilydifficult economic period.

New challenges

In the four decades since Bretton Woodsthe world economic and financial systemhad undergone profound transformations,many Governors observed. The growthand diversification of the world economyand the increased interdependence of theconstituent parts had presented a series ofchallenges to the Fund and the Bank thatthe institutions had met with remarkableadaptability and skill.

Some Governors, while praising the ef-forts of the Bretton Woods institutions insupport of the international trade and pay-ments system, suggested that "nothingshort of a fundamental review" was calledfor, in the words of one speaker. The timewas approaching, they believed, when aninternational conference should be held tore-examine the structure of the system.

Other Governors felt that it was wrong toassume that the world's economic and fi-nancial problems could not be resolvedwithout an overhaul of the system. Thecurrent difficulties facing the world econ-omy would be more readily overcomethrough sound domestic policies and thepromotion of coordinated economic per-formance. This did not rule out, of course,examination of specific ways in which theexisting international system could beimproved. Many Governors urged a rein-forcement of international cooperation, be-lieving that such mutually supportive ef-forts should be encouraged to improve theprocess of adjustment in the internationalsystem and advance the prospects for thesustained betterment of living standards inall member countries. There was resound-ing support for the roles of the Bank andthe Fund in this process and, as the Chair-man of this year's Meetings, Spain's Fi-nance Minister Miguel Boyer, commented,it was up to the member countries of bothinstitutions "to support their further evo-lution vigorously and to strengthen theirability to achieve the goals on which wehave all agreed." ED



Books

David K.H. Begg

The Rational ExpectationsRevolution in Macroeconomics:Theories and EvidenceJohns Hopkins, Baltimore, MD, USA, 1982, 304 pp.,$25 (cloth), $8.95 (paper).

Frank Hahn

Money and InflationMIT Press, Cambridge, MA, USA, 1983, xii + 116 pp.,$12.50.

Rational expectations theory was originallydeveloped by monetarist economists to but-tress their arguments that demand manage-ment policies could not be used to affect thereal economy. Both these books contributeto the intensified debate over the scope forpolicy intervention. Both are to be com-mended for their care in divorcing the dis-cussion over the appropriate modeling ofexpectations formation from the deeper de-bate over the characteristics of the macro-economic equilibrium within which these ex-pectations operate. Both are clearly written,using a level of mathematics appropriate forgraduate economics students.

Begg's emphasis is on how to model ex-pectations. He convincingly argues that ra-tional expectations are more compatible withthe basic postulates of competitive, opti-mizing agents and markets than are adap-tive or static expectations. He presentsresults of econometric tests on the parame-ter restrictions imposed on reduced formequations by the rational expectations hy-pothesis. These tests are, however, condi-tional on the underlying model.

Next, Begg surveys the debate on sta-bilization policy, concluding that only in thespecial case of market-clearing models doesthe theory imply that demand policies have

no effect on such real variables as un-employment or real output. Then, in perhapsthe most interesting chapter, he analyzesconsumption and investment functions, fo-cusing on the dynamic adjustment to un-anticipated events. The sudden jumps inasset prices, characteristic of equilibriumpaths under rational expectations, yield avery different pattern of demand activity inthe short run thanextrapolative expectationswould indicate.

While Begg's book is an excellent intro-duction for those who wish to add rationalexpectations to their economic toolkit, itdoes not, finally, shed much light on thedeeper questions of the appropriateness ofalternative model structures. ProfessorHahn, in inimitable style, does attack thenew wisdom of monetarism in three essays.He is concerned with the logic behind theuse of rational expectations in a monetaristmodel to derive propositions about policyneutrality.

In the first essay, Hahn argues that ratio-nal expectations may be a two-edged swordfor monetarists. For expectations are onlyimportant in economies that progress fromone equilibrium to the next, and this focusimplies that the key issues are in the dy-namic transition period. But by assumingcontinuous competitive, price-clearing mar-kets, the monetarists skirt the main issue.Hahn argues that to evaluate monetary pol-icy, the role of money must be properly un-derstood; that given rational expectations,the existence of money implies it has a rolenot performed by other interest-bearing as-sets; that this role may involve intertemporalsubstitution, liquidity, and self-insurance;and, thus, that any monetary theory thatdoes not incorporate these elements is un-likely to be robust. In essence, Hahn arguesthat monetarists find no role for monetarypolicy because they introduce money in anad hoc fashion into their models.

In the second essay Hahn asserts thatmonetary policy can affect real variables.

Arguing that rational expectations by them-selves do not yield a unique price path, andstressing the lack of a full price formationtheory, he claims that adjustments are likelyto reflect the historical pattern of investmentand future expectations. Agents would thenrespond to both real and monetary variablesin forming a conjectural equilibrium. Hahnstresses the complexity of labor supply deci-sions, where the social character of workdistinguishes labor from other commoditytransactions. Relative, as well as absolute,wage levels may be important determinantsof unemployment. Then, monetary policycould be effective in pushing the economytoward a Walrasian equilibrium.

The last essay tackles the monetarists'pet subject of inflation. Why is inflationviewed as such an evil if monetarist condi-tions hold—that is, if inflation does not affectreal magnitudes? Hahn dismisses the nor-mal explanation of inflationary costs—theloss in consumer surplus of holding lowermoney balances, the effect on liquidity, thevariability of prices, the resulting taxdistortions—and concludes that the currentoverriding concern with inflation implies thatit is not simply a monetary phenomenon butrather one characteristic of a "bootstrapeconomy" featuring declining output andemployment levels. Rather than attacking in-flation, policy should be geared to alleviatingthe latter phenomena, perhaps perversely(and in the Keynesian mode) by expan-sionary monetary policies.

This collection offers a valuable reminderof the major problems unaddressed by sim-ple monetarist models. Considering the in-fluence of these models on present policies,this is a sobering presentation. The practicalmessage is that the preoccupation with in-flation may be misplaced, diverting attentionfrom more fundamental distortions in taxsystems and labor markets that should bethe focus of macroeconomic management.

Homi Kharas

Lance Taylor

Structuralist Macroeconomics:Applicable Models for the Third World

Basic Books, Inc., New York, 1983, vii + 234 pp.,$18.95.

Professor Taylor has written an informativeand provocative book on development is-sues and policies for "countries at middleand low-levels of GDP per capita." His basicapproach, the major macrobalance equa-tions, relies heavily upon the two-gap mod-els of development economics: the internalbalance (investment equals national savingsplus foreign savings) and the external bal-

ance (foreign savings equals imports plusinterest minus exports plus workers' remit-tances). Both are ex post, and ProfessorTaylor studies the adjustment mechanismsthat bring them into balance in the real andthe financial sectors. In the short run, theseadjustments are examined in terms of theirimpact on economic growth and income dis-tribution; in the long run, they are analyzedwith regard to the transitions between con-stant growth paths and the economic sta-bility of the solutions.

Using increasingly complex models, thebook analyzes numerous topics in devel-opment economics. The ground is prepared

in the earlier chapters by one and two sectormodels of the real economy, which allowTaylor to trace the consequences of foodsubsidies, increases in nominal wages, andhigher agricultural exports. A model of a fi-nancial sector, comprised of a central bank,commercial banks, firms, and individuals, isthen introduced. With this, Taylor is able toshow that a policy of financial liberalization,which attracts funds into the banking systemthrough an increase in deposit rates, neednot be expansionary. Having underscoredthe uncertainties that hover around short-run monetary actions, he then adopts alonger-term perspective and indicates how a

48 Finance b Development I December 1983


monetary contraction would, under certaincircumstances, result in both a drop in out-put and wages and an increase in inflation.

At this stage the author unveils the fulltwo-gap model. In neoclassical models, thetwo-gap problem is resolved by free trade;however, the author points out that theseeconomies are not structurally similar to theneoclassical world—"few countries permitfree trade, full employment of resources israrely observed, and the law of one price ismore often than not in abeyance." There-fore, this model takes the two gaps as bind-ing, employing a disequilibrium approach.The output level and the distribution of in-come, instead of free trade, bear the brunt ofadjustment; and the implications of capitalflows for the balance of payments are exam-

ined. In this context one interesting findingthat emerges from an analysis of the crawl-ing peg is how a move to slow down thecrawl in order to restrain inflation could limitthe growth of the economy.

The major conclusions of this book con-cern the impact of standard stabilizationpolicies—monetary contraction, devalua-tion, abolition of government price controls,financial and trade liberalization, crawlingpegs, and wage freezes. Taylor is critical ofthe Bank and the Fund for recommendingthese policies, which he feels have beenbased on highly aggregated and simplisticeconomy-wide models, but his own book isnot above reproach in this regard. The ad-verse consequences of these stabilizationpolicies, according to the structuralist ap-

proach, seem counterintuitive; yet they flowlogically and mathematically from the au-thor's assumptions. The empirical relevanceof these assumptions, however, still needsto be ascertained, and debate continuesover whether these conclusions are a math-ematical curiosity or an accurate descriptionof economic relationships.

There is no question, though, of the im-portance of this book for practitioners ofdevelopment economics. Its most usefulmessage is that structuralist macroeconom-ics focuses on individual economies as sep-arate entities and as such each economy'sstructural characteristics need to be care-fully studied before any "canned" solutionscan be safely applied.

R. Kyle Peters

Alan Lewis

The Psychology of TaxationSt. Martin's Press, New York, 1982, x- f 257 pp.,$27.50.

Lionel Bobbins remarked that "The border-lands of Economics are the happy huntinggrounds of minds averse to the effort of ex-act thought" and included in these "ambigu-ous regions" the alleged "psychologicalassumptions of Economic Science." The de-clared aim of Lewis' study is to show thatpsychological attitudes can be observed andinvestigated and that these investigationscan improve "predictions and comprehen-sion of economic phenomena."

The book examines the main areas wherepsychological attitudes to taxation may beimportant, in the link between taxation andpublic expenditure, in tax evasion, and inwork motivation. An early conclusion is thatpeople usually support government ex-penditures but do not make the connectionwith the taxes needed to finance that ex-penditure. The difficulty for psychologistslies in framing questions that link the price ofpublic spending in terms of taxation and thebenefits of taxes in terms of public service. Iftaxes and expenditure are discussed in theeven more complicated context of macro-fiscal policy, then not only does "fiscal igno-rance" block taxpayer perceptions but "formost people fiscal policy is not an importantissue and respondents look for guidance tothe interviewers."

What emerges from this examination ofnumerous publications is that tax and fiscalconsciousness are affected, in part, by theinformation governments choose to impart,and a principal recommendation is that gov-ernments simplify and provide better expla-nations of their fiscal systems. Some gov-ernments have tried to do so, but it might bepreferable to emphasize the old economicassumptions of self-interest and allow tax-

payers to offset the cost of hiring profes-sional help to complete their tax returnsrather than emphasizing "government ser-vices" and "cheerfulness."

The interesting chapters (9 and 10) on taxevasion raise many issues; but does it helpour prediction capability much to know thattax evasion is considered by most people tobe a crime comparable in seriousness tostealing a bicycle? Of course, there is roomfor a "vast effort in civic education" to com-bat tax evasion, but such advice comes per-ilously close to common sense. Similarly, itmight be important to know whether highmarginal tax rates discourage work effort butthe chapter on work motivation and taxationdoes not help prove that they do. The mostcomprehensive study on the topic sufferedfrom "lack of attention to detail and inade-quate control"; other studies indicated it wastaxpayers' "perceptions, feeling and attitudetowards taxation that determined its effects."Quite so, but if there are as many reactionsas there are taxpayers, are we much furtherforward unless we go into the even moredifficult world of "group decision making"?

The problems of using psychological in-vestigations are perhaps more overwhelm-ing than ignoring them. Reliance on surveysraises doubts about the context of the inter-view, the attitude of the interviewer, thephrasing of questions, and, most imponder-able of all, whether the person interviewedwould or does act in the way he says hewould. Lewis agrees that such attitudes,opinions, and fiscal preferences are not"facts" and, as anyone who has helpedcreate national income accounts knows, theso-called "hard figures" become less un-yielding the closer you get to them. Eco-nomics uses suspect data the whole timebut in a data spectrum from hard to soft,Lewis is inviting economists to use somepretty squishy stuff.

In view of an impressive synthesis of avast number of sources (the bibliography is18 pages), it may seem churlish to questionthe author's omissions but some of the mostinteresting (and perhaps answerable) ques-tions about psychology and taxation relate toattitudes toward different taxes and differentexpenditures. Most of the text refers to tax-ation without discriminating between taxeson personal income, corporate income,wealth, land, excises, customs, value-addedtax, and so on. (The index does not referindividually to any of these categories.) Psy-chological attitudes to paying, say, personalincome taxes are likely to be very different topaying value-added tax or excises. Interviewtechniques might, for instance, yield usefuldata on individuals and their attitudes towarddifferent income taxes or their preferencesbetween income taxes and sales taxes. Fi-nally, developing countries are mentionedonly once—immigrants from developingcountries "less acclimatized to a relativelyhigh tax culture" were less likely to complyfully with the tax assessment process—yet itis likely that substantial differences in psy-chological perceptions of taxation exist be-tween industrialized and less industrializedcountries.

Psychological attitudes may be able to im-prove economic prediction and the compre-hension of economic phenomena but theircontribution, to date, has been small.Robbins argued that economists are inter-ested in economic consequences and doesit matter, as Lewis asks, what goes on in the"black box" between tax stimulus and taxreaction? The overall assessment of this in-teresting and provocative book seems to bethat, for the time being, it still seems tomatter more to the psychologist than to theeconomist.

Alan Tail

Finance & Development! December 1983 49


Manfred Bienefeld and Martin Godfrey (editors)

The Struggle for Development

John Wiley and Sons, Somerset, NJ, USA, 1982, vii +378 pp., $49.95.

The postwar growth of the development "in-dustry" has been phenomenal; it is no longeran esoteric subject for scholars; politicians,civil servants, and others have also taken akeen and publicized interest in it. This out-come is natural; people are not willing toaccept a dualistic world society with rich andpoor states, and, with the rapid accession ofmany countries to independence, the worldhas become a laboratory for testing devel-opment theories and models. The volumeunder review is interesting from two points ofview: it brings together the recent devel-opment experience of a number of countriesand compares this to that of two old-timers,the United Kingdom and Japan; it provides,moreover, eclectic and diverse analyses ofthese experiences.

The British experience is presented hereas being pioneering—one that was in manyrespects unique rather than archtypal, al-though the analysis by J.K.J. Thomson ap-pears to support the "domestic" basis for theUnited Kingdom's growth and recognizesthe role of overseas trade in fostering it. Mar-tin Bronfenbrenner emphasizes the role ofagricultural taxation (and the consequentdelay in the transfer of benefits of growth tothe rural sector) in financing Japan's eco-nomic growth. Both experiences bring outsome of the difficulties of current devel-opment efforts: the United Kingdom, by be-coming the world's workshop, benefitedfrom the later industrialization of other coun-tries, and few countries (except, perhaps,the U.S.S.R. in the 1930s and 1940s) cansponge on the rural sector the way Japan didto foster industrialization.

Through the articles of Gordon White,Terry Byres, and Regis de Castro Andrade,respectively, the book also covers the ex-perience of three large countries—China, In-dia, and Brazil—which have varying degreesof state participation in development. BothIndia and (pre-1949) China had large anddirect state intervention, while Brazil allowedprivate enterprise, both domestic and for-eign, a considerably free hand, with the statelending the required support. China faced adifficult political time during the interwar pe-riod, and its industrialization efforts did nottake off. India, after a brisk start, saw itsindustrial growth faltering after 1965; Brazil'svast land resources gave it the semblance ofa frontier economy, but here, too, devel-opment proceeded only fitfully.

Among the smaller countries discussed,the Republic of Korea and the DemocraticPeople's Republic of Korea provide twopoles. In the Republic of Korea, Tony Michellargues that U.S. military aid freed state re-sources for infrastructure development,while Japan provided the export market forits goods and the state directed this process.But while the Republic of Korea began withrelative equality, after 1970 inequality(though not necessarily absolute poverty)appears to have been accentuated. On theother hand, the Democratic People's Repub-lic of Korea has pursued a highly autarkicand highly nationalistic development ap-proach. Purely in terms of growth ratesachieved, Gordon White finds the resultshave been far less significant than the Re-public of Korea's.

Africa offers its own examples of varyingdegrees of state intervention and reliance onprivate enterprise. Bienefeld notes the ironicdependence of Tanzania's self-reliancestrategy on large foreign aid flows, whileGodfrey, in his fragmented analysis of the

Kenyan experience, cites the emergence ofa local bourgeoisie within an internationalsystem of production that offers fading pros-pects for future growth.

The two remaining papers, Ennio Rod-riguez' on Costa Rica and Anthony Cough-lan's on Ireland, both examine open anddemocratic systems. Coughlan calls Irelanda nonpoor underdeveloped country, with thestate playing an important role, both directand indirect, in fostering investment. CostaRica has developed on the basis of its agri-cultural resources without the exploitation oflabor that has prevailed in many othercountries.

Very few general lessons and conclusionscan be derived from these heterogeneousexperiences. Whatever the path taken, di-verse growth strategies, including the Re-public of Korea's, seem to have stalled forthe moment; and, whatever the strategyadopted, there is constant need for adapta-tion, a factor that gives the state an im-portant role in development. Questions stillremain: Japan, starting later than India anddepending upon state enterprise, has devel-oped faster than India, perhaps because In-dia's private enterprise operated under thehandicap of foreign rule and the benefits ofits railway system were not internalized butleaked to the colonial power. The progressof China and the Democratic People's Re-public of Korea, insulated from externalpressures, has not been notably fast. In thisfeast of analytical and empirical assessmentof country development strategies, the pa-pers of Thomson, White, Byres, Michell, andCoughlan, as also Bienefeld's overview, are,to this reviewer, outstanding, and make thebook a noteworthy contribution to the devel-opment debate.

Phiroze Medhora

Thomas J. Peters and Robert H. Waterman Jr.

In Search of ExcellenceHarper and Row, New York, 1982, xvii + 360 pp.,$19.95.

What distinguishes the best run and mostsuccessful companies from their less suc-cessful brethren? Thomas Peters andRobert Waterman have produced a stimu-lating answer. Based on research supportedby McKinsey and Company, the manage-ment consulting firm, the authors find thatthe "excellent" companies in the UnitedStates share eight principal characteristics:(1) they are driven by overriding nonquanti-tative values; (2) have a bias for action; (3)stay close to their customers; (4) foster au-tonomy and risk-taking among their staff; (5)generally look to the rank and file as the bestsource of quality and productivity gain; (6)focus their attention on a limited range ofactivities; (7) maintain lean staffs and simple

organizations even in the very largest com-panies; and (8) decentralize to the greatestextent possible while remaining highly cen-tralized for certain functions.

It is interesting to note that these conclu-sions with respect to organization structureare quite at variance with the advice thatMcKinsey and Company gave the WorldBank in the early 1970s. On the basis of aMcKinsey report, the Bank adopted a com-plex matrix organization that the authorsnow find is a type studiously avoided by thebest-run U.S. companies.

The conclusions of the study are provoca-tive and in many ways appeal to commonsense, yet the methodology may leave ques-tions in a reader's mind. The conclusions aresupported wholly by anecdotal evidence.While the total study encompassed 43 com-panies, the anecdotes are drawn from amuch smaller set. Clearly the authors were

greatly impressed by the approaches of afew companies, such as IBM and Hewlett-Packard.

The book also completely ignores the im-pact of the economic environment on thesuccess of the excellent companies. In fact,an implicit thesis of the book is that if certainmanagerial and organizational approachesare right, success can ensue, virtually irre-spective of the economic environment.

Despite these shortcomings, this is a stim-ulating book. The notion that companies canachieve excellence through identifiablemanagerial and organizational approachesraises the prospect that in development, theexcellent companies create the economicenvironment, rather than the other wayaround. Moreover, this thesis raises hope forstate-owned as well as private enterprises.

Dale Weigel



Books

Karel Jansen (editor)

Monetarism, Economic Crisis andthe Third WorldFrank Cass, London, 1983, xiii + 194 pp., $30.

Karel Jansen's survey article provides a usefulintroduction to this collection of lectures given atthe Institute of Social Studies in The Hague in1982. This analysis of monetarism on a worldscale and discussion of its implications for coun-tries at different stages of development and withdifferent systems of economic organization spansa variety of theoretical perspectives: monetarism,Keynesianism, structuralism, and Marxism. Theimportance of monetary policy is clearly broughtup in interesting articles by Robert Mundell, whotraces monetarism from ancient to present times,and Jacques Polak, who analyzes its global impli-cations for the international economy. The Key-nesian approach and the role of state interventionare explored by Francis Cripps and Lai Jay-awardena, and the socialist-Marxist viewpoint isrepresented by Ernest Mandel and MichaelEllman. Dudley Seers recalls the debate betweenstructuralism and monetarism that took place inLatin America some 25 years ago, and, finally,Brian Van Arkadie discusses structural adjust-ment in Tanzania. In sum, a somewhat disparatecollection of papers; but while there is not muchnew ground broken, individually the papers areinteresting and readable.

Kathleen J. Murphy

Macroproject Development in theThird World:An Analysis of Transnational Partnerships

Westview Press, Boulder, CO, 1983, xx + 196 pp., $20 (paper).

Using data from 1,600 large projects started orplanned between 1970 and 1979 in 90 developingcountries, Murphy summarizes the sectoral andcountry distribution and explains the special prob-lems of coordination and management that haveaccounted for average cost escalations of be-tween 100 and 149 percent on troubled projectsand for typical completion delays of one to twoyears. The characteristics of the main customersand multinational suppliers are presented, with ananalysis made of the strengths and weaknessesof different types of transnational partnerships inproject sponsorship and in contractual arrange-ments for technology transfer and project man-agement. The key to success proved to be theright balance of risks and rewards between hostsand their multinational guests, since relative pow-ers shifted during the project's lifetime andunanticipated problems occurred. Although thesummary tables are sometimes unclear and in-consistent, the book gives useful insights into thestructure of project partnerships and the criticallinkages that owners should consider in establish-ing effective control and accountability to stake-holders.

F. Gerard Adams and Lawrence H. Klein (editors)

Industrial Policies for Growth andCompetitivenessD.C. Heath and Company, Lexington, MA, USA, 1983, viii +434 pp., $33.95.

In view of the poor performance of the world econ-omy during the past three years, this book, whichreports on the first stage of a larger research ef-fort, is very timely. Explicit policies may be neededto supplement market forces in adapting econo-mies to the post-OPEC world. Industrial policyaims to increase an economy's supply potential byshifting production functions and the compositionof factor inputs; it emphasizes growth, pro-ductivity, and competitiveness. This study com-prises a descriptive overview of the issuessurrounding industrial policy: a definition of theconcept, the underlying economic rationale, andthe philosophy and experience of industrial anddeveloping countries in policy implementation. In-dustrial policies can be either general—seeking tostimulate supply through economy-wide fiscal ormonetary measures—or specific to particular sec-tors, industries, or firms. Examples of policies in-clude direct subsidies, government corporations,public sector purchases, loan guarantees, interestsubsidies, aid to research and development, andtax breaks. The book includes country studies ofthe major industrial economies and key devel-oping countries.

Roy Bahl and Barbara D. Miller

Local Government in the ThirdWorld:A Case Study of the Philippines

Praeger, New York, 1983, xvi + 260 pp., $29.95.

This book draws attention to an important issuebut raises two questions: are the analysis andrecommendations appropriate to the Philippinesand can they be generalized to other countries?Its recommendations—that local authorities relyless on ad hoc supplemental budgets and moreon longer-term planning; that central governmentgive more discretion over expenditure allocationsto local authorities; that real property taxes beimproved by better "tax mapping," up-to-date as-sessment, and effective application to "idlelands"; that business license taxes based on turn-over should be extended; and that goals for localgovernment public enterprises be defined andextended—are sensible but invite major imple-mentation difficulties. The Government of the Phil-ippines is, for example, already grappling with theproblems of a declining tax ratio and low tax elas-ticity; any central government's natural inclinationis to exercise more control over lower-level gov-ernment expenditure, reduce subsidies, and with-hold tax bases from local authorities. Although thestudy is limited in some ways (education andhealth expenditures are not discussed), the broadtitle is justified overall. The book does suggestways in which other countries might analyze theproblem of the revenues and expenditures of localauthorities, but, as is usual in this field, the recom-mendations and solutions will tend to be uniquefor every country.

John Williamson

The Open Economy and the WorldEconomyBasic Books, New York, 1983, xvi + 414 pp., $23.95 (cloth).

The world economy is changing rapidly; today'sconcerns and problems differ from those of, say,ten years ago. Textbooks, unless they deal solelywith pure theory, must be up-to-date to be useful.This book is up-to-date on most issues includingthe outbreak of worldwide inflation and the prob-lem of the "oil deficit"; it just misses the hugeexternal debt problems that emerged in late 1982.It is clearly written, and ample for the readershipintended, that is, advanced undergraduate stu-dents. It should have particular appeal to studentsin developing countries, since it drops the tradi-tional two-country approach in favor of one basedon a small country trading with the outside worldtreated as parametric.

Alicia Puyana de Palacios

Economic Integration AmongUnequal PartnersPergamon Press, Inc., Elmsford, NY, USA, 1982, xxvi +404 pp., $40 (cloth).

Based on the experience of the Andean Group,this book analyzes the problems of economic inte-gration among developing countries with small na-tional markets and uneven economic develop-ment. The study is divided into three parts: (1) thehistorical, political, and theoretical backgroundsthat led to integration proposals in Latin America;(2) the dynamic effects of economic integration,such as the expansion of trade in new and moresophisticated products and the promotion of newinvestment; and (3) the problems that arose withprograms attempting to harmonize the divergentnational economic policies. A useful book for botheconomists and political scientists.

Hermann Sautter

Regionalisierung und komparativeVorteile im internationalen HandelMohr, Tubingen, Federal Republic of Germany, 1983, xiii +353 pp., DM 86 (paper).

This study of regionalism and comparative advan-tage in international trade examines devel-opments in the direction and composition of tradeover the last 50 years. Its statistics confirm widelyheld notions about the important role of three "po-lar" regions (Japan, North America, and WesternEurope) but find no clear tendency toward an in-crease in regionalism. The direction and com-position of trade appear primarily determined byrelatively invariant geographic, cultural, and eco-nomic factors rather than by a deliberately region-ally oriented trade policy. The author doubts thatregional trade liberalization and "common mar-ket" schemes are suitable alternatives to world-wide liberalization or that such schemes facilitatemore closely coordinated structural adjustment ona global basis.



Letters

Hazards of import substitution

I was interested to read Anne O. Krueger'sarticle, "The effects of trade strategies ongrowth," in your June 1983 issue. As apracticing trade economist who hasworked on commercial policy issues in anumber of developing countries in Africaand Asia, I found myself in completeagreement with Professor Krueger's mainconclusions.

However, in my view, in conventionaleconomic analysis, insufficient attention ispaid to some important socioeconomic fac-tors which tend to exacerbate the problemsgenerated by import substitution policies.Such policies tend to be self-perpetuatingbecause of the power of the vested interestgroups they help to create. One such inter-est group will comprise all those having adirect financial stake in the protected do-mestic industries (and these may includeleading figures in the political and commer-cial life of the country). Another significantinterest group is composed of the bureau-cracy charged with the administration ofthe numerous regulations and controls as-sociated with an import substitution policy.Any move by the government toward tradeliberalization could lead not only to a loss ofjobs within the administration, but, no lesssignificant, to the loss of valuable incomearising from the "emoluments" receivedfrom the public for the approval of importlicenses or for speeding up the notoriouslyslow bureaucratic process.

Recommendations for policy changes inthe area of trade strategy which fail to takeinto account the above-mentioned factorsmay have little chance for acceptance andimplementation by the governmentsconcerned.

Ben BanianRaanana, Israel

Anne O. Krueger replies:Mr. Bardan's point is quite correct, although itis hardly accurate to say it is neglected in con-ventional analysis. It is widely recognized thatone of the major problems of liberalizing re-strictive trade regimes lies in the opposition thatcomes from those who gain from receiving im-port licenses and selling behind a wall of protec-tion and who would lose by liberalization.

Prosper the plough

The article, "Managing oil wealth" byJahangir Amuzegar (September 1983) is

very much to the point. Mr. Amuzegar ob-viously speaks from experience.

From observation in Iran, before the rev-olution, I would add only one suggestion:more attention to agriculture. New indus-tries, supported by petrodollars, drew peo-ple to the cities. Food became in short sup-ply and prices rose. To avoid unrest thegovernment imported food and imposedprice controls. At the same time inflationcut the real income of the peasant farmer.Without incentives, the farmers producedless and dependence on imports increased.Rice, a staple food in Iran, was imported, aswere apples, oranges, mutton, and whitecheese, although Iran produces all theseproducts.

Efforts to improve the lot of the peasant,although well meaning, were ill-managed.Land from the large states was redis-tributed to the farmers, but the cooper-atives, which were supposed to supply theservices such as fertilizer, seeds, and main-tenance of the underground irrigation ca-nals (qanats), formerly provided by thegreat landowners, were not adequatelysupported.

Too often aid to the farmer was confusedwith protection of government-owned in-fant industry. For example, a government-owned nitrogenous fertilizer plant forceddealers and cooperatives to take their fertil-izer in place of imports, but did not makedeliveries when fertilizer was needed and ayear later dealer and cooperative ware-houses were full of fertilizer hardened inthe bags and totally useless. The fertilizerfactory, which had no salesmen on theroad, could not understand the reluctanceof the peasants to use the fertilizer andcomplained that the factory was forcedto dump products in the export market.Concurrently, farm-to-market roads wereneglected and little effort was made to im-prove distribution beyond periodic cam-paigns against profiteering.

There were some exceptions to the ne-glect of agriculture. A large-scale sugar in-dustry, based upon both beets and cane,was established; poultry-raising was un-derway near the cities; and there was agood agricultural experiment program. Ingeneral these successes were in heavy in-dustry, such as sugar refining, which couldbe managed from offices in Tehran, or newenterprises, such as battery raising ofpoultry, which had little connection withtraditional agriculture and were run bybusinessmen. Educational limitations pre-vented the peasants from taking full advan-tage of the experiment stations.

Nothing gave the peasant farmer whathe most needed: easy access to suppliesand to markets.

George GibsonNew Jersey, USA

Jahangir Amuzegar respondsAgriculture has been the Achilles' heel of eco-nomic development in almost all developingcountries—oil or non-oil—and not exclusively apre-1979 Iranian problem. A new World Bankreport on Africa's farm problems and recentpress accounts of food shortages, increased foodimports, and rationing indicate that an ideal"managing of oil wealth" involves a lot morethan mere "more attention to agriculture."

What is aid?

I read your quarterly with great and sus-tained interest; its articles, graphs, and ta-bles are always well done in every area, andthey are easy to read—which is not alwaysthe case with other publications.

The complaint I should like to make inthis letter is not a direct one, for as youmention in an article, "ODA from devel-oped countries " (June 1983), you use thedata from each country.. .as you receivethem. In Table 2, p. 29, France, my country,appears—with the exception of the Nether-lands and Sweden—to be by far the mostgenerous. Fortunately, you do mention inthe text that the ODA percentage of GNPquoted for 1981 included the ODT (Over-seas Departments and Territories)!

For 20 years I have been urging in Franceand in Portugal that the following not beincluded as assistance to developing coun-tries: assistance to colonies (this is the re-sult of an historic process) and assistance tothe ODT, which are regarded as de-partements (and I am far from wanting thesecountries to separate from France). A dis-tinction should be made between grantsand loans. Although some progress hasbeen made in this respect, it is not enough.

I feel that an institution such as yoursshould have made an effort to include inthis table, not a little footnote which mostpeople will not read, but a separate head-ing for the figures, even if only approxi-mate, for: ODT (which accounted for 40percent of ODA in 1981) and assistance toforeign countries.

Naturally, every country tends to favorits former territories, or countries to whichit is close; this is normal but it should not berepresented as ODA.

A. NordonParis



Index for Volume 20 (1983)

ArticlesAdjustment and growth June page 13Agricultural growth and rural nonfarm

activities Hans P. Binswanger June page 38Arab concessional assistance, 1975-81

Zubair Iqbal June page 31Aspects of the safety net for international

banking G.G. Johnson September page 30Capital utilization in manufacturing

Helen Hughes March page 6The challenge of development today

Ernest Stern September page 2Changing public attitudes toward aid

Henry Owen December page 39Coffee and cocoa trends Takamasa Akiyama

and Ronald Duncan March page 30Cofinancing—new World Bank approaches

March page 40Countertrade: trade without cash?

Kyung Mo Huh December page 14Debt rescheduling: what does it mean?

September page 26Devaluation and adjustment in developing

countries Nicholas Kaldor June page 35Devaluation in developing countries: the difficult

choices Karim Nashashibi March page 14Economic impact of defense expenditures

Shuja Nawaz March page 34The effects of trade strategies on growth

Anne O. Krueger June page 6Energy transition in developing countries

Yves Rovani December page 24External debt—the continuing problem

March page 22Family planning and health: the Narangwal

experiment Rashid Faruqee June page 43Fiscal deficits and Fund-supported programs

Margaret Kelly September page 37Government employment and pay: some

international comparisons Peter He//erand Alan Tait September page 44

The importance of interest rates in developingeconomies Anthony Lanyi and RiJ$duSaracoglu June page 20

Improving the quality of education in developingcountries Stephen Heyneman

March page 18Industrial energy conservation in developing

countries Harinder Kohli and EdilbertoSegura December page 28

Interest rates and the developing worldPadma Gotur December page 33

International money, credit, and the SDRWm. C. Hood September page 6

Is there cause for export optimism?Oli Havrylyshyn and Irad] Alikhani

June page 9Issues in external debt management

Nicholas Hope and Thomas KleinSeptember page 23

John Maynard Keynes Alexandra KafkaDecember page 37

Korea's major adjustment effortG. Russell Kincaid December page 20

Main developments in the European MonetarySystem Horst Lingerer June page 16

Maintaining financing for adjustment anddevelopment Gerard Rice, James Corr,and Susan Fennell December page 43

Management: a limiting factor in developmentPierre Landell-Mills September page 11

Management and institutional developmentArturo Israel September page 15

Managing oil wealth Jahangir AmuzegarSeptember page 19

Measuring macroeconomic performanceDona/ Donovan June page 2

Minimizing the burden of recurrent costsJacob Meerman December page 41

ODA from developed countriesInes Garcia-Thoumi June page 28

Opportunities and constraints in internationallending David Williams March page 24

Private sector petroleum exploration in devel-oping countries Keith Palmer

March page 36Protectionism An/aria et al. March page 2Reducing poverty September page 10Sources of payments problems in LDCs

Mohsin S. Khan and Malcolm KnightDecember page 2

Taxes and growth Keith MarsdenSeptember page 40

Toward a more orderly exchange rate systemJacques Artus March page 10

The transfer of technology Carl Dahlman andLarry Westphal December page 6

UNCTAD VI: for better or for worse?Shah'/d Javed Burki December page 16

The underground economy Vito TanziDecember page 10

Unemployment in the major industrialcountries Uoyd Kenward June page 24

What are credit ceilings? G. Russell KincaidMarch page 28

What you think of Finance & DevelopmentJune page 52

Whither the Global Negotiations?Jagdish Bhagwati September page 34

The World Bank and the training and visitsystem Joslin Landell-Mills June page 41

World economy in transitionInflation and related variables

September page 48Interest rates in five major countries

December page 32International reserves, 1948-82

June page 34Trade shares and trends, 1950-81

March page 39

BooksArgy, Victor, Tne Posfwar International Money

Crisis, reviewed by Andrew Crockett, Septem-ber, p. 49

Begg, David K. H., The Rational ExpectationsRevolution in Macroeconomics, reviewed byHomi Kharas, December, p. 50

Bienefeld, Manfred and Martin Godfrey (editors),Tne Struggle for Development, reviewed byPhiroze Medhora, December, p. 50

Currie, Lauchlin, The Role of Economic Advisersun Developing Countries, reviewed by GuyPfeffermanu and Vinod Thomas, March, p. 42

Frame, J. Davidson, International Business andGlobal Technology, reviewed by Carl Dahlman,June, p. 49

Freeman, Christopher, The Economics of Indus-trial Innovation, reviewed by Carl Dahlman,June, p. 49

Gibney, Frank, Miracle by Design, reviewed byShahid Yusuf, September, p. 51

Hahn, Frank, Money and Inflation, reviewed byHomi Kharas, December, p. 48

Jones, Leroy P. (editor), PUD//C Enterprise inLess-Developed Countries, reviewed by MaryShirley, September, p. 50

Kindleberger, Charles P. and Jean-PierreLaffargue (editors), Financial Crises, reviewedby Andrew Crockett, September, p. 49

Lewis, Alan, fne Psychology of Taxation, re-viewed by Alan Tait, December, p. 48

Little, Ian M. D., Economic Development, re-viewed by Javad Khalilzadeh-Shirazi, June,p. 48

MacAvoy, Paul W., Crude Oil Prices, reviewed byAdrian Lambertini, June, p. 50

Maddison, Angus, Phases of Capitalist Develop-ment, reviewed by Subimal Mookerjee, Sep-tember, p. 50

Mascarenhas, R.C., Technology Transfer and De-velopment, reviewed by Carl Dahlman, June,p. 49

Nakamura, Takafusa, Economic Growth in Pre-War Japan, reviewed by Shahid Yusuf, Sep-tember, p. 51

Odell, John S., Japanese Manufacturing Tech-niques, reviewed by Shahid Yusuf, September,p. 51

Peters, Thomas J. and Robert H. Waterman Jr., InSearch of Excellence, reviewed by DaleWeigel, December, p. 48

Schonberger, Richard J., Japanese Manufactur-ing Techniques, reviewed by Shahid Yusuf,September, p. 51

Stewart, Frances and Arjun Sengupta, Interna-tional Financial Cooperation, reviewed by Clau-dio Loser, March, p. 42

Taylor, Lance, Structuralist Macroeconomics,reviewed by R. Kyle Peters, December, p. 48

Williamson, John (editor), IMF Conditionality,reviewed by Bahram Nowzad, September, p. 49


,. Finance §Development


International Monetary Fund

New Occasional Papers

The following Occasional Papers haverecently been published by the Fund:

No. 20. Alternatives to the Central Bank in theDeveloping World, by Charles Collyns.

Not all newly independent countries choose to setup full-fledged central banks, and many of the alter-native arrangements that have been adopted in thedeveloping world are described in this OccasionalPaper. The present institutional diversity is describedin terms of deliberate adaptation by countries totheir own socioeconomic conditions.

No. 21. World Economic Outlook: A Survey by theStaff of the International Monetary Fund.

This annual survey provides a statistical record ofpast and prospective developments in the worldeconomy; analyzes the significance of these devel-opments and the problems they present; and discus-ses the main issues of policy confronting membercountries and the international community. Thelatest study is particularly timely because of the inci-pient economic recovery from prolonged conditionsof high inflation and low growth.

No. 22. Interest Rate Policies in Developing Coun-tries, by the Staff of the Research Department of theInternational Monetary Fund.

The accumulated experience of developing coun-try members of the Fund with the issue of interestrate policies is analyzed in this paper. The impact ofthese policies is studied in terms both of their effectson savings and of their role in demand management.

No. 23. International Capital Markets: Devel-opments and Prospects, 1983, by Richard Williams,Peter Keller, lohn Lipsky, and Donald Mathieson.

This paper provides a description and analysis ofdevelopments in the international capital markets in1982 and the first part of 1983 and examines marketconditions and prospects for financing flows, in par-ticular for developing countries, over the near term.Attention is also given to trends in certain key mac-roeconomic variables that underlie market demandand supply relationships and determine the generaleconomic environment in which lending decisionsare made.

No. 24. Government Employment and Pay: SomeInternational Comparisons, by Peter S. Heller andAlan A. Jail

Data on public sector employment and pay for 64developing countries and 24 member countries ofthe Organization for Economic Cooperation and De-velopment are analyzed in this paper. The analysisfocuses on such topics as the size of governmentand public sector employment, the relative level ofpublic and private sector salaries, the degree of in-equality in a government's salary structure, and thedevelopment of intercountry indices to analyze thelevels of government wage rates and governmentemployment.

Prices: Occasional Paper No. 21, the World Eco-nomic Outlook, is available for US$8.00 (US$5.00for university libraries, faculty, and students) withdelivery by surface mail and for US$11.00 (US$8.00for university libraries, faculty, and students) withdelivery by air or first-class mail.

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