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December 1995 • Volume 32 • Number 4

FINANCES Development



Financial Markets Anticipating Capital Flow Reversals

uri Dadush and Milan Brahmbhatt


Foreign Direct Investment in Developing Countries: Progress and Problems

Joel Bergsman and x/aofang Shen


Privatization and the Development of Financial Markets in Italy

Mahmood Pradhan


Progress Report on Commercial Bank Debt Restructuring

IMF staff

Saving and the Real Interest Rate in Developing Countries

Jonathan D. Ostryand Carmen M. Reinhart 16

Can Inflation Targets Help Make Monetary Policy Credible?

Timothy D. Lane, Mark Griffiths,



and Alessandro Prati

Corruption, Governmental Activities, and Markets

Vito Tanzi


Policies for Achieving Sustainable Growth in the Industrial Countries

IMF staff


Commercializing Africa's Roads

Rupert Pennant-Rea and Ian G. Heggie


Can Eastern Europe's Old-Age Crisis Be Fixed?

Louise FOX


Quantifying the Outcome of the Uruguay Round

Glenn Harrison, Thomas Rutherford,


and David Tarr

Setting Investment Priorities in Education

Nicholas Burnett, Kan Marble,


Why Macroeconomists and Environmentalists Need Each Other

Ronald McMorran and Laura Wallace


and Harry Anthony Patrinos

Comments by Stanley Fischer


Books How Russia Became a Market Economy by Anders Aslund Winds of Change: Economic Transition in Central and Eastern Europe by Daniel Gros and Alfred Steinherr Privatization & Economic Performance edited by Matthew Bishop, John Kay, and Colin Mayer The Confidence Game: How Unelected Central Bankers Are Governing the Changed Global Economy by Steven Solomon International Monetary Arrangements for the 21st Century by Barry Eichengreen Techno-Nationalism and Techno-Globalism: Conflict and Cooperation by Sylvia Ostry and Richard R. Nelson The OECD Jobs Study: Facts, Analysis, Strategies by the Organization for Economic Cooperation and Development; Unemployment: Choices for Europe, Monitoring European Integration by the Center for Economic Policy Research; and Spanish Unemployment: Is There a Solution? by Olivier Blanchard et al.

William Easterly Michael Deppler Andrew Ewing Daniel Hardy

50 50 51 52

Tamim Bayoumi Robert R. Miller Jeffrey R. Franks

53 53 54

ss_ 57

Letters Index 1995

© 1995 by the International Monetary Fund and the International Bank for Reconstruction and Development/THE WORLD BANK. All rights reserved. Requests for permission to reproduce articles should be sent to the Editor. Finance & Development will normally give permission promptly, and without asking a fee, when the intended reproduction is for noncommercial purposes.

©International Monetary Fund. Not for Redistribution

Letter from the Editor


JLhe past year has been an eventful one in the international financial markets. The dominant event was the sudden reversal of capital flows to Mexico at the end of 1994, which put Mexico's economy at risk, aroused fears of a "contagion effect" in other developing countries, and necessitated substantial financial support from the international community. Although Mexico took center stage, uncertainty about the direction of interest rates also created turbulence in securities markets in both industrial and developing economies, and huge derivative-related losses in some industrial countries triggered concern about the stability of the global banking system. How developing countries can avoid an economic crisis like Mexico's, precipitated by large capital outflows, is the subject of an article by Uri Dadush and Milan Brahmbhatt. Countries that have stable macroeconomic policies, high domestic savings, strong investment in the traded goods sector, and high export growth—and that do not rely excessively on short-term capital flows—are less likely to suffer abrupt economic downturns. Foreign portfolio capital flows to developing countries have surged over the past decade, but remain volatile and risky; stock markets are so shallow in some countries that even a small retreat by investors can have a very large impact. By contrast, foreign direct investment tends to be longer-term and less speculative—and may bring additional resources to host countries, such as technologies, managerial expertise, and access to new markets. But, as Joel Bergsman and Xiaofang Shen show in their article, to attract such investment, many developing countries need to pursue economic reforms far more aggressively. Mahmood Pradhan's article on the effect of privatization on financial market reform in Italy underscores the importance of deep and efficient financial markets for all economies, industrial as well as developing. Corporate governance in Italy has suffered because of the country's fragmented banking system and small equity market; the size of the latter has also limited share ownership in companies and hampered the Government's privatization program. The commercial bank debt problems of developing countries remain an important issue for international financial markets. Considerable progress was made in 1994 and the first half of 1995 in resolving these problems. By end-June 1995, 21 countries had completed deals that restructured commercial bank debts with a face value of $170 billion. But this progress has been uneven among developing countries. The Progress Report on Commercial Bank Debt Restructuring indicates that, even though secondary market prices for debt have declined over the past year, prices for the debt of many low-income developing countries have remained significantly above their levels of mid-1993, and are potentially out of line with the ability of these countries to service debt over the medium term. The Report suggests that, as a result, commercial bank creditors will need to show considerable flexibility in reaching agreements to resolve the debts of these low-income countries. The liberalization and integration of international financial markets has created challenges and opportunities for industrial and developing countries alike. As the events of the past year show, to reap the benefit of changes in the international financial environment without succumbing to the dangers, countries need to pursue sound macroeconomic policies and establish healthy domestic financial markets.

FINANCE Development is published quarterly in English, Arabic, Chinese, French, German, Portuguese, and Spanish by the International Monetary Fund and the International Bank for Reconstruction and Development, Washington, DC 20431, USA. Opinions expressed in articles and other materials are those of the authors; they do not necessarily reflect IMF or World Bank policy. Second-class postage is paid at Washington, DC and at additional mailing offices. The English edition is printed at Lancaster Press, Lancaster, PA. Postmaster: please send change of address to: Finance & Development 700 19th Street NW, Washington, DC 20431 Telephone: (202) 623-8300 Fax Number: (202) 623-4738 English edition ISSN 0015-1947

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Asimina Caminis



Luisa Watson ART EDITOR


June Lavin


Jessie Hamilton

CIRCULATION ASSISTANT ADVISORS TO THE EDITOR Masood Ahmed Adrienne Cheasty William Easterly Richard Hemming Naheed Kirmani Anthony Lanyi Anne McGuirk Gobind Nankani Lant Pritchett Orlando Roncesvalles Marcelo Selowsky Christine Wallich For advertising information contact Sylvia Chatfield Advertising Representative: Telephone: (203) 323-9282 • Fax: (203) 323-9284


Finance & Development / December 1995

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Anticipating Capital Flow Reversals URI DADUSH AND MILAN BRAHMBHATT


HAT early warning signals should policymakers heed to avoid a repeat of a Mexicotype reversal of private capital flows? Experience suggests that a combination of indicators can provide powerful hints of approaching problems. A review of the experience of developing countries that received major private capital inflows in the first half of the 1990s suggests that some of them were better able to manage these flows than others. Countries that have largely avoided sudden reversals of inflows have a number of common characteristics: stable macroeconomic policies; avoidance of protracted real exchange rate appreciation; high domestic savings; significant investment in industries in the traded goods sector; rela-

tively restrained current account deficits; high export growth; and relatively little reliance on short-term capital inflows. In contrast, countries that have proven to be more vulnerable to shifts in market sentiment have tended to exhibit these characteristics to a far lesser degree. A number of lessons emerge from the experiences of both sets of countries that can help policymakers avoid sudden reversals of capital flows.

Lessons of experience Large real exchange rate appreciation. Some of the countries that experienced significant private capital flow reversals in 1995—such as Argentina, Hungary, and Mexico—had also undergone large and protracted real exchange rate appreciation in the first half of the 1990s (see chart). A surge in capital inflows attracted by high returns in the wake of a comprehensive economic reform may contribute to some appreciation of the real exchange rate. But prolonged appreciation of the real exchange rate that threatens external competitiveness and puts the external sector under pressure may create the con-

Uri Dadush, a French national, is Chief of the International Economic Analysis and Prospects Division of the World Bank's International Economics Department.

ditions for a subsequent loss of confidence by foreign investors. The experience of a number of countries shows that this pattern need not always prevail. For one thing, some key reform measures, such as fiscal consolidation and trade liberalization, are apt to lead to real depreciation rather than appreciation. Indeed, many of the most successful reformers and recipients of capital inflows, particularly those in Asia, have seen only modest real appreciation or even significant real depreciation of their currencies (see table). Increases in private savings in these countries have tended to offset the excess demand and inflationary pressures generated by large capital inflows, pressures that would otherwise result in real appreciation. For example, Malaysia, which was among the countries receiving the highest volume of private capital inflows relative to GDP, experienced a small depreciation of its real exchange rate. In general, the correlation between private capital inflows and real appreciation was not significant for the 16 major private capital recipients shown in the table. In contrast, significant real appreciation is often the undesirable side effect of using the

Milan Brahmbhatt, a UK national, is an Economist in the International Economic Analysis and Prospects Division of the World Bank's International Economics Department.

Finance & Development / December 1995

©International Monetary Fund. Not for Redistribution


export markets. If the country exchange rate as a nominal Exchange rate appreciation/depreciation among anchor in stabilization programs is rated a high risk, investors major private capital recipients 1 will expect commensurately in high-inflation countries. In (percent change, 1990-94) high returns, and rapid export a number of countries, high real growth becomes even more imappreciation of the exchange rate portant to sustained capital inin the 1990s was associaflows. As would be expected, ted with the use of nominal export growth in the early 1990s exchange rate anchors to curb showed a fairly close inverse the momentum of high inflation relationship with real exchange built up in earlier years. Of the 16 rate appreciation, averaging 7 countries shown in the chart, the percent (in nominal dollar terms) 8 countries with the largest real in the high appreciation half of appreciation had a median inflacountries but 12 percent in the tion rate of 53 percent in the low appreciation half. 1980s while the countries with Unsustainable current acthe smallest real appreciation Source: IMF Research Department. 1 Real effective exchange rate. count deficits. There is no hard (mostly in Asia) had a median and fast rule as to what inflation rate of only 9 percent. constitutes a sustainable deficit, Stabilization programs based on a nominal exchange rate anchor were in effect trast, it fell by about 1 percent in the four though a rule of thumb can be derived from at one time or another during the early 1990s countries in the table with the least real appre- setting a prudent target on foreign borrowing. in several of the countries showing high real ciation. Given that fiscal deficits improved by If, for example, the target is the commonly appreciation, such as Argentina, Hungary, 2-3 percent of GDP, on average, in both high cited prudent upper bound on the foreign liaMexico, and Poland. Persisting in this policy and low real appreciation countries, private bilities/export ratio of 2, then the sustainable much beyond the initial phase of such pro- savings rates must have fallen significantly in current account deficit in the long term, grams, instead of switching to greater reliance high appreciation countries. expressed as a proportion of exports, is equal Inadequate investment in the tradon tight fiscal and monetary policies, risks to twice the export growth rate. Computations ables sector. Insofar as capital flows are of sustainable current account deficits using undermining external competitiveness. Declining private saving rates. Some attracted by increased efficiency, one would this rough rule of thumb show that they vary decline in private saving rates could, in princi- expect to see significant foreign and domestic greatly by country. The median level for large ple, result from a perceived increase in perma- investment directed to the traded goods sector, recipients of private capital in Europe and nent income in the wake of successful reforms, reflecting improved international competitive- Central Asia is 2.5 percent of GDP, in Latin or from an anticipation of lower taxes follow- ness. If, however, capital flows finance a con- America 2.2 percent, and in Asia 8.9 percent. ing cuts in government spending. The evi- sumption boom and/or are driven by "herd Among high appreciation countries, actual dence suggests, however, that the most instincts," one might expect the inflows to find current account deficits in 1994 averaged successful reformers, such as the East Asian their way mostly to the nontradables sector, about 2 percent of GDP greater than sustaineconomies and Chile, have seen increased where relative prices and profitability have able levels. But 1994 deficits in low appreciaprivate saving rates even when these been bid up by high domestic demand (some tion countries were more than 6 percent of were very high at the outset (Corbo and of it induced by the capital flows themselves). GDP below sustainable levels—a further Although comparable data on tradables and degree of prudence no doubt reflecting the Hernandez, 1994). A number of analysts (for example, Kiguel nontradables investment are not available, it possibility that external conditions could lead and Liviatan, 1992; Calvo and Vegh, 1994) is notable that the services sector, which is to lower export growth than the rapid pace have argued that a strong initial boom in con- most closely associated with nontradables, achieved by these countries in the early 1990s. The rule of thumb applied here gives only a sumption is a typical result of nominal- expanded relative to GDP in the high appreciexchange-rate-based stabilization programs, ation countries but not in the low appreciation first indication. A fuller computation of susreflecting a fall in interest rates that is often ones. Real growth of the service sector in tainable deficits would account for other facan initial effect of such programs, as well 1990-93 in the high real appreciation half of tors such as the level of foreign aid, which as anticipation on the part of the public that countries shown in the chart exceeded overall would increase the sustainable deficit; the the program may not be sustainable. If GDP growth by 1.4 percent a year but only by maturity and initial level of foreign liabilities; the consumption boom persists—implying 0.3 percent a year in the low appreciation half. the volatility of export earnings; and the rapidly declining private savings—it can High real appreciation countries also experi- import content of exports. Increases in all have important consequences for the sustain- enced poorer overall investment growth than of these variables would tend to reduce the prudent liability/export ratio and the sustainability of the balance of payments position low appreciation ones (see table). Low export growth. This is a critical sig- able deficit. and the credibility of the exchange rate Growing reliance on short-term, anchor itself. For example, the ratio of private nal that a country's ability to service mounting consumption to GDP in Mexico increased by 5 foreign obligations could be called into ques- flows. Short-term borrowing is appropriate percentage points in 1990-93, compared with tion by investors. In theory, perfect capital for short-term needs such as trade, inventory, 1985-89 (see table). In four other countries markets could supply virtually unlimited and working capital finance, but it is inapprowith high real appreciation (Argentina, credit to a country expecting a future boom in priate for long-term projects, where it places Hungary, Peru, and Poland), the increase in exports but, in practice, creditworthiness indi- borrowers in the precarious position of having the consumption share between these two cators are based on the evolving track record to continuously refinance the investment. periods averaged 9 percentage points. In con- of export growth and the country's share in Growing reliance on short-term capital 4

Finance & Development / December 1995

©International Monetary Fund. Not for Redistribution

Key indicators for major recipients of private capital percent Average real exchange rate change 1

Long-term private capital flows 2

Inflation 3

Change in private consumptionGDP ratio 4

Change in investmentGDP ratio 5

Average annual export growth 6

Current account to GDP ratio 7

Deviation from sustainable current account ratio



































3.6 7.1

1.2 5.3

23.5 9.0

2.2 8.9

-1.2 -5.9

11.1 1.8

-2.0 -9.9

2.4 -8.8

China Colombia Hungary





























Malaysia Mexico

-1.0 4.8

9.4 4.3

3.7 69.1

0.1 5.1

7.6 2.2

18.7 9.4

-3.2 -8.2

27.3 -4.8














































Sources: International Economics Department, World Bank; and IMF for real effective exchange rates. Consumption and investment ratios and goods and nonfactor service export growth are measured in nominal dollar terms, 1 1990-94. 2 As percent of GDP, 1990-93. 3 Consumer price index, 1980-89. 4 1990-93 versus 1985-89. 5 1990-93 versus 1985-89. 6 1990-94. 7 1994.

inflows (especially to finance current account deficits) may be a sign of strain. Although the borrower prefers long-term financing, lenders or direct investors are reluctant to comply because of perceived risk. Large currency exposures. Stabilization programs that use the exchange rate as a nominal anchor create a strong incentive for domestic firms to borrow at low interest rates in foreign currency, and for foreign investors and domestic financial intermediaries to lend at high interest rates in domestic currency, while carrying the currency risk. At the same time, the maturity structure of loans tends to become shorter as both lenders and borrowers try to minimize currency risk. The absence of forward markets aggravates the problem, since investors find it difficult to cover currency exposures. This behavior creates powerful impediments to devaluation, even when it is clearly needed. Large currency exposure is not so much an early signal of crisis as it is an indication of the disruption that might ensue. Monetary tightening in industrial countries. Capital flows to developing countries may be adversely affected by monetary tightening in industrial countries. A consequent sharp rise in interest rates would reduce the relative attractiveness of developing country assets and would also be accompanied

eventually by falling aggregate demand in industrial countries and slower export growth in developing countries. Heavily indebted countries would see a large deterioration in creditworthiness indicators. This scenario helped precipitate the debt crisis of the 1980s. However, the rise in interest rates in 1994 does not wholly conform to this pattern. Rate increases were moderate in comparison with those of the early 1980s, and their effect on creditworthiness was offset by global recovery and a surge in world trade. The overall picture. This list of early warning signals is not exhaustive. Attention also needs to be paid to controlling quasifiscal as well as fiscal deficits, the appropriateness of monetary policy, and political stability. Other warning signals, such as high real interest rates to defend the currency, or slow economic growth resulting from currency overvaluation and high interest rates, may be late rather than early indicators of fundamental imbalance. Nevertheless, events since the start of the Mexican crisis have tended to confirm the value of the indicators discussed here. After a sharp pullback from most emerging markets in the immediate wake of the crisis, private capital flows to developing countries have recovered more quickly and substantially than seemed likely at the start of 1995. But the recovery has been most pronounced

for countries with the best early warning indicators, such as the East Asian countries, and Chile and Colombia.

Suggestions for further reading: Guillermo Calvo and Carlos Vegh, "Inflation Stabilization and Nominal Anchors," Contemporary Economic Policy, Vol. 12 (April 1994) pp. 35-45. V. Corbo andL. Hernandez, "Macroeconomic Adjustment to Capital Flows: Latin American Style versus East Asian Style," Policy Research Working Paper No. 1377 (Washington, World Bank, 1994). Uri Dadush, Ashok Dhareshwar, and Ron Johannes, "Are Private Capital Flows to Developing Countries Sustainable?" Policy Research Working Paper No. 1397 (Washington, World Bank, December 1994). Rudiger Dornbusch and Alejandro Werner, "Mexico: Stabilization, Reform, and No Growth," Brookings Papers on Economic Activity: 1 (Brookings Institution, Washington, 1994), pp. 253-315. Miguel Kiguel and Nissan Liviatan, "The Business Cycle Associated with Exchange Rate Based Stabilizations," World Bank Economic Review, Vol. 6 (May 1992), pp. 279-305.

Finance & Development / December 1995

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Foreign Direct Investment in Developing Countries: Progress and Problems JOEL BERGSMAN AND XIAOFANG SHEN

I ANY developing countries have made notable efforts to \ attract foreign direct investment in the past decade. Although total Hows to the developing world have exploded, they are unevenly distributed. Countries that have aggressively reformed policies have been far more successful than countries whose reforms have been half-hearted.


Foreign direct investment (FDI) is playing a growing role in economic development. FDI flows to the developing world quadrupled from an annual average of $12.6 billion in 1980-85 to $51.8 billion in 1992-93, and roseto $70 billion in 1994. Developing countries received 32 percent of total world FDI during 1992-94, up from 20 percent in the first half

of the 1980s. The share of FDI in the gross capital formation of developing countries more than doubled between 1986 and 1992, surpassing 6 percent in 1993. While FDI is surging, other forms of capital flows to developing countries are diminishing (see table). Aid has continuously declined as a share of capital inflows since the 1960s, when it was the most important source of external finance for developing countries; it now accounts for only one fourth of their capital inflows. Commercial loans, a major source of capital flows in the 1970s, have virtually disappeared since the debt crisis of the 1980s. Portfolio investment, which boomed when stock markets in developing countries caught the attention of investors in the 1980s, is important but is also volatile and risky—as demonstrated by outflows from Mexico in December 1994. Unlike other forms of capital inflows, FDI almost always brings additional resources—technology, management knowhow, and access to export markets—that are desperately needed in developing countries. Investors are exacting, however, when it comes to deciding which countries are the most desirable sites for investment, and the lion's share of FDI has been going to a handful of countries, mostly in East Asia and Latin America

(see chart). In 1994, 11 countries accounted for about 76 percent of total FDI flows to the developing world. Nevertheless, some small countries (including many island countries) have received amounts of FDI that are large in proportion to the size of their economies. But FDI flows to many other countries, particularly in sub-Saharan Africa, have stagnated.

Why East Asia and Latin America? More and more developing countries have reduced barriers to FDI and improved their business climates. At the same time, multinational corporations are responding to increased competition by considering a broader range of locations for their facilities. These mutually reinforcing trends have combined with technological changes in communication, transportation, and production to make "the global marketplace" a reality for investment decisions. The days of producing shoddy, high-cost products for sale in local markets are passing; most foreign investors are interested only in sites where they can produce to international standards of quality and price. This globalization means that the old distinction between export-oriented production and production destined for the local market is weakening and even disappearing. Countries

Joel Bergsman,

Xiaofang Shen,

a US national, is a Manager in the Foreign Investment Advisory Service.

a Chinese national, is an Investment Policy Officer in the Foreign Investment Advisory Service.


Finance & Development /December 1995

©International Monetary Fund. Not for Redistribution

that want to develop must What about other Selected capital flows to developing countries (million 1993 dollars) offer good business conditions countries? both for exporters and for proMany other developing 1960s 1970s 1980s 1991 1992 1993 duction for local markets. The countries have also embarked emphasis may differ, dependon reforms, addressing the 3,024 304 Net foreign direct investment 12,988 34,475 44,868 63,999 423 13 Portfolio investment 3,353 17,505 24,250 86,569 ing mainly on the size of the same issues—fiscal and mon9,839 384 1,892 14,541 11,791 Net commercial bank lending 5,482 local market, but providing etary imbalances, price dis9,854 34,366 59,301 47,383 52,336 Grants and official debt flows 1,466 the combination is increastortions, bloated public en2,167 23,140 62,498 113,173 131,042 208,386 Total ingly important. Countries in terprises, and unnecessary East Asia and Latin America regulations, among others. Sources: IMF, Balance of Payments Statistics Yearbook, various years; and World Bank, World Debt Tables, various years. have received the most FDI Many have made significant Note: Figures for the 1960s, 1970s, and 1980s represent the annual averages for those decades. because they have adjusted progress, winning deserved their strategies to keep up with praise from economists, globalization. banks, and international inSome of these countries initially based their upstream or downstream in a production stitutions, including the World Bank and the development on exporting labor-intensive chain, and cooperate closely with each other IMF. But FDI has either not appeared or, if it manufactured goods to the industrial coun- through networking and long-term buyer-sup- has, still falls short of the amount desired. tries. Recently, many have recognized that plier relationships. This type of system helps What is wrong? technological advances and intensified compe- integrate foreign investment into host One basic problem is that some countries tition have increased the capital and skill economies and allows the latter to derive more possess few attractions for foreign investors. intensity of production in many industries. benefit from FDI through induced economic One traditional attraction of developing counThis means that countries can no longer count activities, the transfer of technology and man- tries—cheap labor—is becoming less imporon low labor costs alone but also need high- agement skills, and better access to export tant in investment decisions. Economies at an quality, productive labor to sustain their com- markets. But companies need great flexibility early stage of industrialization do not offer the parative advantages. Those that have and highly developed skills to ensure "just-in- sophisticated providers of inputs—both goods succeeded in attracting FDI have focused on time" delivery of quality intermediate goods and business services—that most foreign improving general education, industrial skill and services, without defects. Countries that investors need to be competitive. Another factraining, and labor and managerial discipline. have the conditions that facilitate these kinds tor that deters investment is poor economic Facilitating companies' efforts to upgrade of operations have become much more com- performance—FDI tends to follow growth, technology has also been crucial in maintain- petitive in the eyes of foreign investors. not to lead it. None of the countries that have attracted ing their competitive edge. A closer look at the less successful counThe development of other successful coun- significant FDI inflows could have done tries, however, reveals that many that are tries was initially based on import-substitut- so without sustained trade reform enabling potentially attractive to FDI simply have not ing industrialization. This strategy produced them to keep up with the pressure of interna- carried their reforms far enough. Foreign valuable skills, institutions, and physical tional competition. All have carried out investors do not come just because some infrastructure, but was inherently limited substantial domestic economic reforms to en- progress has been made; to attract FDI, counbecause of small domestic markets and the courage private sector development. Many tries must have made enough progress to meet inefficiencies caused by continuing protection. have essentially succeeded in stabilizing the worldwide best-practice standards. These countries were either forced by eco- macroeconomic environment, reducing price Obstacles to entry. Many countries have nomic crises or inspired by countries that suc- distortions, deregulating investment proce- liberalized entry policies over the past few ceeded through more outward-looking policies dures, and increasing general economic effi- years. They have relaxed restrictions on forto reduce protection, privatize state enter- ciency—getting the "fundamentals" right for eign ownership and entry in certain sectors, prises, and make their productive apparatus all private investment, domestic and foreign. and they have also introduced "negative lists" competitive internationally. Whatever route they took, the rapid, sustained economic growth of the successful FDI flows to developing countries are concentrated in two regions countries of East Asia and Latin America has (1990-94) earned them the name "emerging markets." They are even beginning to rival the indusEast Asia and the Pacific trial countries as export markets because of strong, consistent increases in the demand for Eastern Europe and Central Asia consumer goods and services. All this has made them extremely attractive to internaLatin America tional investors. Middle East and North Africa Companies interested in establishing facilities in emerging markets need access to qualSouth Asia ity supplies of parts, components, and Sub-Saharan Africa supporting services. For manufacturing industries, especially, a major force driving success is a "flexible" system of intercorporate relations under which companies specialSources: IMF, Balance of Payments Statistics Yearbook, various years; and World Bank, World Debt Tables, various years. ize in different stages of production, either Finance & Development / December 1995

©International Monetary Fund. Not for Redistribution


to limit the types of investments that require screening and approval. In many countries, however, entry is still needlessly restricted and/or arbitrarily regulated—often because of pressure from domestic interest groups or from regulatory authorities with vested interests in screening. Inadequate legal protection. Most governments have recognized the need for investment protection, and many have guaranteed equal treatment for foreign and national investments. An increasing number of countries have enacted laws forbidding expropriation or guaranteeing prompt and adequate compensation in the event of expropriation. In more and more countries, foreign investors have recourse to international arbitration for settling investment disputes. Legal reforms are still far from adequate in most countries, however. In many cases, laws still implicitly allow expropriation of investors' property for arbitrary reasons. The very poor functioning of judicial systems in many countries calls into question the "prompt and adequate compensation" promised by law. Finally, investors are often required to exhaust domestic means for settling disputes before resorting to international arbitration. In the context of a weak domestic court system, this dramatically weakens investors' confidence. Overvaluation and restricted access to hard currencies. Since the late 1980s, a growing number of developing countries have taken steps to liberalize their foreign exchange systems. Many have devalued their currencies, and some have allowed market determination of the exchange rate. In spite of considerable adjustments, however, many currencies are still overvalued, and extensive controls on exchange transactions are still seen as necessary. Moreover, foreign exchange liberalization in many countries has been accomplished by decree but not followed up by appropriate legislative steps, creating an atmosphere of uncertainty for investors. Trade barriers. In the past, many developing countries that had adopted an importsubstitution strategy attracted FDI by offering investors a protected domestic market. Recognizing the importance of competing in global markets, most have now reduced protection and taken steps to promote exports. In too many instances, however, trade reforms have still not gone far enough. Some countries have reduced protection significantly, but still have too much to foster real competition at home or to provide an exchange rate that is conducive to exports. There is also a widespread problem in the developing world with customs services. Better trade policies may be negated by bureaucratic customs pro8

cedures and the obstructionist attitude of customs agents. Thus, imported capital equipment and other inputs do not arrive at production sites on time; drawback payments due to exporters are delayed for months or even years; and going through the multilayered clearance process is very costly. Tax distortions. To attract foreign investment, some countries use special investment incentives, including tax holidays, tax credits and exemptions, and reduction of duties. However, experience shows that such strategies have had little, if any, impact on most long-term investors. Tax holidays create distortions of tax regimes; they favor new investors and discriminate against existing ones—in some countries, they discriminate against domestic investors. The expiration of tax holidays causes sudden increases in tax burdens on companies. Moreover, these incentives are often granted through complex and bureaucratic administrative procedures that encourage corruption. A stable, automatic tax system with reasonable rates and without discretionary incentives is better both for investors and for the host country. Many countries have a long way to go to reach that goal. Getting the word out. Investment promotion—persuading investors to come—has become widespread in recent years. More countries, however, need to have a carefully planned program of making the improvements achieved at home known to the world—not so much through expensive advertising supplements but rather through sophisticated, long-term public relations campaigns. Providing effective assistance to interested investors and businesslike follow-up, and helping existing investors to solve administrative problems are important parts of promotion that are too often neglected.

Role of governments For many countries that have not achieved the expected results, the problem is that reforms have been inadequate. Governments need to persevere with reforms already under way. Intensified global competition has put companies under greater pressure, and they are responding by investing only in the most favorable places. Countries should take this as a challenge rather than a threat if they want to win the battle for FDI. Furthermore, policy liberalization alone may not increase competitiveness sufficiently. Economic opening is the necessary "stick" to force competition and shift resources to their most productive uses. Experience in many countries suggests that "carrots"—public support of efforts to make firms more efficient—are also urgently needed. For example, now that international investors have

begun to be more interested in high productivity than in low labor costs, government assistance is needed to upgrade technology and labor skills. Access to information and technical services, general education, and specialized industrial and managerial training are more important than ever. "Public support" does not mean, however, that governments should do, or even pay, for it all. To the contrary, many of the support services required by industries are best delivered by private institutions. Foreign investors themselves can provide assistance, motivated by their own business interests. Private companies not only benefit from such a supporting system but also can play a crucial role in the design and operation of it, and they must bear at least part of the cost. The role of governments is thus becoming more complex. Governments can no longer act simply as monopolies providing certain services or goods, or even simply as regulators; their functions must include those of organizer, coordinator, assistant, and partner. To succeed, governments will need to change their orientation and acquire new skills. Commitment, creativity, and willingness to learn from mistakes are crucial assets that can lead to success.

The Foreign Investment Advisory Service This article is based, in part, on the experience of the Foreign Investment Advisory Service (FIAS). Created ten years ago by the International Finance Corporation (IFC), FIAS is now jointly operated by IFC and the World Bank. Its mission is to help governments of developing countries to attract foreign direct investment through improved policies, sensible deregulation, and more effective institutions. Governments that request FIAS's help get frank and confidential analysis of the problems that concern them. FIAS's advice reflects the experience of other countries but also takes into account the political and administrative realities of the client. FIAS works informally and closely with client countries to build relationships of trust and understanding with them. By now, FIAS's clients number about 90, including developing countries all over the world, as well as transition countries in Eastern Europe and the former Soviet Union. Clients pay part of the costs of FIAS's advisory work. The rest of FIAS's expenses are underwritten by IFC and the World Bank, and by donations from the United Nations Development Program and individual industrial countries.

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Privatization and the Development of Financial Markets in Italy MAHMOOD PRADHAN

TALY's financial markets have been extensively liberalized in recent years. \ The Government's largescale privatization program and the European Union's singlemarket initiative have provided, and continue to provide, strong incentives for eliminating market distortions.


Italy's relatively underdeveloped capital markets and fragmented banking industry, compared with those of other large industrial countries, as well as its structure of corporate ownership and pattern of corporate finance, have limited the role of financial markets in corporate activity. These features of the economy have posed considerable difficulties for the large-scale privatization program initiated in 1992 to reduce the state's share of economic-

activity. Several public banks, insurance companies, industrial firms, and major public utilities were earmarked for privatization. Most of the early privatizations were carried out through private placements, primarily because of the small size of Italy's equity market (although in some cases the specific characteristics of the firm being privatized may have made this appropriate). Although recent privatizations carried out through public offerings—mainly those of state-owned banks—have generated considerable interest among small shareholders, structural weaknesses in financial markets, including a lack of transparency of corporate ownership and control, have continued to hinder the broadening of share ownership. Since June 1993, total proceeds from privatization have amounted to over 15 trillion lire (about $9.4 billion), of which the stock market has effectively financed about Lit 11 trillion, representing about 5 percent of stock market capitalization. Forthcoming privatizations will involve significantly larger amounts than have been raised in recent years. The Government's 1996-98 fiscal program contains projections for privatization proceeds of roughly Lit 10 trillion per year. By

contrast, since 1988, new capital raised on the Milan Stock Exchange—the largest of the ten Italian stock exchanges, accounting for more than 90 percent of all equity trading—has averaged about Lit 6 trillion a year. The Government's need to sell large volumes of shares generated by the privatization program is having the beneficial effect of providing an impetus for reforms to enhance the efficiency of financial markets. For instance, reforms of takeover legislation and new regulations concerning representation of minority stockholders in privatized companies have been designed to improve the system of corporate governance and to encourage wider share ownership. There have also been important changes in other areas, such as improvements in the liquidity and transparency of equity markets and a move toward establishing a universal banking system.

Financial markets Bond market. Italy's bond market is one of the largest in the world and the second largest in Europe; its government bond market is the largest in Europe and the third largest in the world. Large public sector deficits have led to dramatic growth in the

Mahmood Pradhan, a UK national, is an Economist in the World Economic Studies Division of the IMF's Research Department.

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European stock markets: indicators of size and turnover in 1994 (million dollars)

United Kingdom

Market capitalization

Market capitalization as percentage of GDP


118.1 23.0 34.0 108.9 85.9 17.7 32.1 66.6 36.9

















Average company size 2

585 1,128 983 1,199 894 808 409

1,149 543

Turnover ratio (percent) 3

78.1 97.8 133.9 80.1 73.5 72.3 44.1 70.5 15.6

Sources: International Finance Corporation, Emerging Stock Markets Factbook, 1995; and IMF, World Economic Outlook data base. 1 Total market value of all listed domestic companies at the end of 1994. 2 The ratio, as of end-1994, of market capitalization to the number of listed domestic companies, in millions of dollars. 3 The total value of shares traded during the period divided by the average market capitalization for the period.

bond market, and government debt now accounts for over 85 percent of the total value of debt instruments traded. The market's size and the broad range of debt instruments traded there, particularly the relatively large floating-rate market, have attracted significant interest from foreign investors. The introduction of an active secondary market, improvements in the settlement process, and withholding tax reforms have also increased the international attractiveness of Italian bonds. A particularly striking feature of the Italian bond market is the small amount of corporate debt issued and traded there. In 1993, new debt issues by nonfinancial corporations accounted for less than 2 percent of the market. In the past, regulatory constraints limited the growth of this market, and the absence of rating agencies hindered the development of an active secondary market. The new Banking Law that came into effect in early 1994 virtually eliminated stamp duty on corporate debt transactions, and firms that could provide a good record of profitability and a bank guarantee were permitted to issue short-term commercial paper and investment certificates. These reforms did not result in an immediate flourishing of private bond markets, however, since they coincided with a period of relatively high interest rates that limited new issues by private sector borrowers. Equity market. In contrast to the bond market, the equity market in Italy is relatively underdeveloped, with a market capitalization, measured as a percentage of GDP, that is among the smallest in Europe (see table). Although recent privatization issues have attracted a large number of small shareholders, household sector savings have traditionally been channeled mainly through banks. 10

and the total amount of equities held by the domestic household sector remains relatively low. Institutional investors are also underrepresented, compared with other European countries. This partly reflects the absence, until recently, of a legal framework encouraging the emergence of several key types of institutional investor. New investment funds have been permitted only since 1992, and closed-end funds and private pension funds since 1993. Banks have only recently been allowed to own equity stakes in nonfinancial enterprises. Most important, however, the limited involvement of institutional investors reflects the structure of corporate ownership, which consists of a small number of large business groups with extensive cross-holdings (accounting for roughly 80 percent of the market capitalization on the Milan Stock Exchange) and a large number of small and medium-sized firms that are mainly family-owned. Transactions costs in the Italian equity market, as in other European equity markets, have fallen significantly over the past decade, largely because of dramatic technological advances in information dissemination and trading systems but also, to a lesser extent, because of extensive regulatory reforms. The latter have included liberalization of access to membership of stock exchanges, reductions in transaction taxes, and liberalization of brokerage commissions. Underlying these reforms has mainly been the recognition by many countries of the increased competition between national stock markets resulting from the liberalization of capital flows in Europe. Reforms in Italy were implemented beginning in the early 1990s, which was relatively late compared with those in France, Germany,

Spain, and the United Kingdom. However, after the January 1991 law that set up singlecapacity stock exchange firms, Societa di Intermediazione Mobiliare (SIMs); the introduction of block trading in November 1991; and, more recently, the New Banking Law (September 1993), which relaxed constraints on banks' ownership of stock exchange member firms, the Italian stock market has largely caught up with competing markets in Europe. To improve the transparency of trading volumes and the information content of transactions prices, the 1991 SIM law made it mandatory for all trades to be conducted on the stock exchange. Before the November 1991 reforms, Italian banks had for some time acted effectively as market makers by offering to match block trades. An important incentive for banks to offer this service was the fixed commissions that existed up to that time. Such off-exchange trading had often provided scope for insider trading, especially for large traders who could artificially affect prices on the exchange prior to their own offexchange trades. Competition from other European stock markets has also led to the development of markets in derivative securities. In September 1992, a futures contract on ten-year government bonds was introduced on the Milan Stock Exchange. More recently, there has been increasing interest in derivative instruments in equities, particularly since the introduction of trading in futures contracts based on the equity price index, Indice della Borsa di Milano (MIB30), on the Italian Futures Market (MIF) in November 1994.

Corporate control and finance Systems of corporate control differ considerably among industrial countries. In stockmarket-based systems, such as the United Kingdom and the United States, control is exercised by institutional investors via large and active equity markets. By contrast, in many countries in continental Europe, control and finance are institution-based; banks and other financial institutions are major shareholders in nonfinancial corporations and perform an active role in supervising and managing them. In stock-market-based systems, investor protection—that is, taking steps to ensure adequate performance and an equitable distribution of corporate profits—is provided largely through potential and actual takeovers. Typically, there are few takeovers in institution-based systems, and investors are protected largely by the active involvement of equity-holding financial institutions. Corporate control. In Italy, neither of these systems of corporate control has been effective: control is concentrated in the hands

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of a few large business groups; there are few hostile takeovers; and, until recently, banks were impeded by regulations from taking an active role in corporate governance. Although the greater concentration of ownership in Italy does not necessarily imply weaker performance of its corporate sector—since majority stockholders have greater incentives than minority stockholders to actively monitor performance of corporations—the absence of both external monitoring and the threat of hostile takeovers has resulted in less effective protection of minority shareholders. The corporate sector in Italy consists of a small number of large business groups with widespread intergroup shareholdings and a large number of small and medium-sized firms that are either family-owned or have one majority owner. Shareholdings of the nonfinancial corporate sector account for almost 80 percent of the capitalization of firms listed on stock markets, with most of the remainder being held by financial institutions. Furthermore, companies where a single entity owns a majority stake account for 60 percent of stock market capitalization. By comparison, in the United Kingdom, less than 4 percent of market capitalization is held by the nonfinancial corporate sector, and of the largest 200 companies, more than two thirds have no single shareholder with more than 10 percent of the equity. Ownership is more concentrated in Germany, where 90 percent of the largest 200 companies have at least one shareholder with more than 25 percent of the equity. In both Germany and the United Kingdom, however, minority shareholdings are more significant than in Italy. These differences have important implications for the Italian Government's privatization program. The efficiency of privatized industries will depend largely on effective monitoring and supervision of corporate performance, especially in sectors where existing public enterprises may be transformed, at least in part, into private monopolies. Reducing the concentration of ownership will require particular attention to the rights of minority shareholders, especially where privatization is intended to lead to wider share ownership. Large business groups in Italy are typicallycharacterized by extensive cross-holdings of equity stakes, both within and outside the group. The hierarchical nature of business groups distinguishes the Italian system of cross-holdings from those of other countries where cross-holdings are also extensive, such as France, Germany, and Japan. In Italy, "parent" companies—those at the top of a pyramidal structure—have stakes in smaller firms lower down the hierarchy, but these sub-

sidiaries rarely hold equity in parent firms. Such business group interests are extensive in the manufacturing sector, where they account for 75 percent of total employment. For parent firms, control of firms lower down the hierarchy can often be exercised with a minority holding. The controlling group can gain at the expense of other shareholders through transactions among subsidiaries that are designed to transfer profits to subsidiaries in which the controlling group has a larger share. This makes the protection of minority investors a particularly important issue in Italy: without adequate protection, there is little incentive for investors to hold noncontrolling stakes. Corporate finance. In comparison with other major industrial countries, debt finance in Italy differs significantly in terms of maturity and source; most such debt consists of short-term bank loans. Equity finance is both small and restricted mainly to large firms: for example, the five largest business groups account for 70 percent of the market capitalization of the Milan Stock Exchange. This pattern of corporate finance is attributable primarily to relatively high corporate income tax rates, favorable tax treatment of interest payments on debt, and regulatory constraints on the amount of long-term lending by banks. Few Italian banks have well-established procedures for analyzing the risk exposures entailed in longer-term lending. The market in wholesale corporate banking is dominated by Mediobanca, which is owned mainly by large industrial groups. It is the only institution active in mergers and acquisitions and has a dominant position in managing equity issues for large industrial enterprises and has, therefore, been extensively involved in the Government's privatization program. The regulation of Italy's banking industryhas recently been relaxed, however, and banks will consequently be able to play a greater role in both corporate finance and the Government's privatization program. The banking system is moving toward the universal bank model, although some restrictions on banks' activities have been retained: they are still not permitted to operate directly in insurance, mutual funds, or stockbroking. Under the European Union directive on financial services, however, banks will be allowed to offer stockbroking services by 1996. The Italian equity market is widely perceived to favor insiders. Small stockholders who do not have controlling interests, especially those who hold nonvoting shares, are often placed at a disadvantage, because they do not benefit from the transfer of firm ownership. Legislation approved in 1974 enabled Italian companies to issue savings shares (azioni di rispannio) that do not have

voting rights; holders of these nonvoting shares are entitled to the same dividend paid on voting shares plus an additional 2 percent in years when dividends are paid to other shareholders, with a minimum dividend of 5 percent of the par value in years when no dividends are paid to holders of voting shares. Although the number of companies issuing both voting and nonvoting shares in Italy—about 50 percent—is not unusually high, nonvoting shares accounted for 57 percent of the market capitalization of the Milan Stock Exchange in 1990. Further, the premium on voting shares is significantly higher in Italy than in most other countries. Between 1987 and 1990, the average premium on voting shares, compared with nonvoting shares, was over 80 percent. In contrast, in the United Kingdom, voting shares traded at a premium of just over 10 percent; in Canada, of just over 20 percent; and in Sweden, where voting and nonvoting shares are extensively issued, the premium was only about 6 percent. For companies with a majority holder, the premium was significantly lower than for companies that had a number of large holders but no majority holder—suggesting that the premium reflects the private benefits of control, even though these benefits cannot be observed directly.

Reforms of takeover legislation The primary aim of recent takeover legislation in Italy has been to ensure that when one party, or a group of shareholders acting in concert, acquires a controlling interest in a firm, the effective takeover is transparent and that minority stockholders are offered the same terms for their holdings as those who sell out to the bidder. In 1992, the new law relating to takeover bids (offerte pubbliche d'acquisto (OPA)) made it compulsory for those intending to acquire control of a listed company to make a public tender offer, which must cover enough capital (a minimum of 10 percent) to enable them to achieve control. It is, however, intrinsically difficult to detect informal agreements or voting trusts among investors. Moreover, although the regulatory authority, in principle, has to be notified of any such trusts, it is not in general obliged to make public any information it obtains on formal or informal voting trusts. The widespread existence of informal agreements among investors has raised some concerns in the context of the privatization program, particularly with regard to the potential for core groups to acquire control without the knowledge of minority holders. In response to such concerns, the OPA law of 1992 was revised and strengthened by the March 1994 law, which requires public Finance & Development / December 1995

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notification of agreements among investors bidding for firms being privatized. The new law, however, applies only to takeover bids for such companies; the more general problem of defining and identifying informal agreements remains. These recent reforms of takeover legislation may, in the long run, act to reduce concentration in corporate ownership to the extent that acquiring control of enterprises will be more costly. Takeover activity should also, in principle, become more efficient, in that transfers of ownership will be more transparent.

Promoting equity finance The authorities have sought to strengthen the protection of minority shareholders by establishing the relevant legal and supervisory structures. A law prohibiting insider trading and other related insider activity was passed in October 1991. Other measures to protect the rights of "outsiders" include rules for the selection of outside directors and rules mandating postal voting in privatized companies. In the recent privatization of the state-owned insurance company Istituto Nazionale delle Assicurazioni (INA), for example, three seats on the management board were reserved for directors nominated by minority shareholders. Also, effective

February 1995, privatized companies have been obliged to introduce postal voting at shareholder assemblies. The Government has also introduced a number of measures designed to encourage small investors. In June 1994, it issued a decree that would harmonize the withholding tax on shares at 12.5 percent, the same rate applied to withholding tax on bond interest payments, and shareholdings of up to Lit 100 million were exempted from inheritance tax.

Conclusion In embarking on a large-scale privatization program, the Italian Government has needed to address many distortions in domestic capital markets. For a long time, the relative lack of transparency of corporate ownership and control in Italy have acted to discourage share ownership. Many of the recent reforms of takeover legislation and regulations relating to minority representation on corporate boards should, over time, lead to improved confidence in the system of corporate governance. To the extent that legislation was required, many of the necessary reforms are in place. There is, however, a different kind of problem that may not be resolved by legislation. The practice of exercising control via informal coalitions (voting trusts) among

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This paper is based on a more detailed study of privatization and the financial markets that is included in "Italy: Background Economic Developments and Issues," Staff Country Report No. 95/36 (Washington, IMF, 1995). Suggestions for further reading: Colin Mayer, "Financial Systems, Corporate Finance and Economic Development," in G. Hubbard (editor.), Asymmetric Information, Corporate Finance and Investment (Cambridge, Massachusetts: National Bureau of Economic Research, 1990); C. Robinson and A. White, "The Value of a Vote in the Market for Corporate Control," (unpublished, York University, Toronto, Ontario, 1990); and Luigi Zingaks, "T\ie Value of the Voting Right: A Study of the Milan Stock Exchange Experience," Review of Financial Studies, Vol. 7 (Spring 1994), pp. 125-48.

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PROGRESS REPORT ON COMMERCIAL BANK DEBT RESTRUCTURING IONSIDERABLE additional proIgress was made in 1994 and the 1 first half of 1995 in resolving the I commercial bank debt problems of I developing countries. Debt- and 1 debt-service reduction operations were concluded by Bulgaria, the Dominican


Republic, Ecuador, and Poland. Panama announced in May 1995 that it had reached an agreement in principle with its banks. Among low-income developing countries, comprehensive buybacks using resources from the Debt Reduction Facility for International Development Agency (IDA)-

Table 1

Commercial bank debt- and debt-service reduction operations 1 (million dollars)


Debt restructured under DDSR operation 2 (1)

Debt- and debt-service reduction (DDSR) (2)

Total debt- and debt-service reduction as a percentage of debt restructured Cost of (3) = (2)/(1) reductions

Concluded agreements 385 9,386 612 442

Albania (1995) Argentina (1992) Bolivia (1987) (1993) Brazil (1992) Bulgaria (1993) Chile (1988) Costa Rica (1989) 4 Dominican Republic (1993) Ecuador (1994) Guyana (1992) Jordan (1993) Mexico 4

385 19,397 643 473 170 40,600 6,186 439 1,456 776 4,522 69 736 51,902

(1989) Mozambique (1991) Niger (1991) Nigeria (1991 ) 4 Philippines (1989) (1992) Poland (1994) Sao Tome and Principe (1994) Sierra Leone (1995) 5 Uganda (1993) Uruguay (1991) Venezuela (1990) Zambia (1994)

48,231 124 111 5,811 5,812 1,339 4,473 9,989 10 148 152 1,608 19,700 200

20,544 124







13,198 3,527 439 1,128 511 2,602 69 312 22,214




3,701 1,339

2,362 6,332


148 152 888 6,043 200

100.0 48.4 95.2 93.5 100.0

100 3,059 61 35 26

32.5 57.0



10 118 7,677 555

100.0 77.5 65.8 57.5 42.5 42.8 45.5 42.6


100.0 75.6 63.7

100.0 52.8 63.4

100.0 100.0 100.0 55.2 30.7 100.0 44.6

652 248 196 149 583

7,122 12 23


1,795 670 1,125 1,933


22 18 463 2,585 22 25,212

Pending agreements Memorandum Panama (1995)





Source: IMF staff estimates. Debt- and debt-service reductions are estimated by comparing the present value of the old debt with the present value of the new claim, and adjusting for prepayments made by the debtor. The amounts of debt reduction contained in this table exclude debt extinguished through debt conversions. Years in parentheses refer to the date of the agreement in principle. 2 Excludes past-due interest and includes debt restructured under new money options for Mexico (1989), Uruguay (1991), Venezuela (1989), the Philippines (1992), Poland (1994), and Panama (1995); the Philippines' (1989) new-money option was not tied to a specific value of existing debt. 3 Cost at the time of operation's closing. Includes principal and interest guarantees, buyback costs, and, for Venezuela, resources used to provide comparable collateral for bonds issued prior to 1990. Excludes cash down-payments related to past-due interest. 4 Includes estimated value-recovery clauses. 5 Corresponds to the first phase of the buyback.


Only Countries and from donor countries were completed for Albania, Sao Tome and Principe, Sierra Leone, and Zambia. As regards debt reschedulings, Russia and its commercial bank creditors agreed in October 1994 on a legal framework for dealing with the country's bank debt, and payments with respect to interest arrears have been made by Russia into an escrow account at the Bank of England. Algeria reached agreement in principle on a rescheduling arrangement for its commercial bank debt in May 1995. Slovenia, after a complex series of negotiations, reached agreement with the commercial bank creditors of the former Socialist Federal Republic of Yugoslavia on Slovenia's share of the unallocated debt of the former Yugoslavia, marking an important first step in resolving this difficult debt problem. Altogether, by end-June 1995, 21 countries had completed deals that restructured commercial bank debts with a face value of $170 billion, obtaining roughly $76 billion in debt reduction in present-value terms at a cost of $25 billion (see Table 1). Allocations to the options in the various debt packages have differed, reflecting in some cases explicit limits imposed by debtor countries and the views of the holders of the debt regarding the expected future values of the debt instruments issued in exchange for the old bank claims (see Table 2). On the whole, cost efficiency has been achieved in each debtand debt-service reduction operation concluded thus far, with the cost per unit of debt reduction achieved (the buyback equivalent price) being in line with the secondary market price of the bank claims at the time of the agreement in principle (see Table 3).

Prospects The sharp run-up in secondary market prices of bank claims during the second half of 1993 and into early 1994 raised concerns that future bank debt negotiations might be complicated by market speculation that a country would conclude a debt- and debtservice reduction operation. As a result, secondary market prices in several instances were not seen to be reflective of the countries' medium-term capacity to service their debts. In addition, the up-front costs of debt operations (especially straight debt buybacks) were bid up substantially. Subsequent developments (most notably, the rise in world interest rates during 1994 and the Mexican crisis at

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end-1994) have contributed to large declines in the secondary market prices of developing country bank claims from their early 1994 peaks. With the adjustment in prices, there is less concern in some cases that high levels of secondary market prices will make it more difficult for countries to reach agreements with their creditors. Nonetheless, despite the general fall in secondary market prices, prices for the debt of many low-income developing countries have remained significantly above their levels in mid-1993 and potentially out of line with the ability of these countries to service debt over the medium term. Speculation prior to the conclusion of a debt- and debt-service reduction deal also remains a potential concern, as evidenced by the run-up in the price of Cote d'lvoire's debt in advance of discussions between the country and its bank advisory committee in May 1995. Creditors will need to show considerable flexibility in reaching agreements to resolve the debts of these low-income countries, possibly entailing even steeper discounts on debt buybacks than those that creditors have accepted at times in the past. Even at very steep discounts, the total amount of assistance that a few low-income countries would require to buy back their commercial bank debt far exceeds available resources. In these cases, Brady-type debtand debt-service reduction operations may have to be considered. Key considerations in structuring such operations will be assessments of the country's medium-term debt-servicing capacity and the resources available to fund the up-front costs of the operation. The menu of options in such deals may entail, in addition to steep discounts on debt buybacks, sizable discounts on discount bonds, par bonds with interest rates substantially below market levels, the write-off of past-due interest, and the provision of less than full collateralization of principal on bonds issued as part of the package. To meet the financing requirements for such operations, there will be a continuing need for substantial concessional resources from multilateral institutions and bilateral donors.

This article was derived from Private Market Financing for Developing Countries, prepared by a Staff Team in the IMF's Policy Development and Review Department, and published in the World Economic and Financial Surveys series. International Monetary Fund, Washington, November 7.9.95.

Table 2

Bank menu choices in debt-restructuring packages

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^H ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^HJ^^^^^^M^^^n^3T^mH^l^^n^Rra^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^H ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^H


Debt reduction Discount Buyback exchange

Debt-service reduction Principal collateralized Other par par exchanges exchanges

Argentina Bolivia Brazil Bulgaria Costa Rica

46 13 63

34 35 3 5 60 -

66 19 3 2 -

Dominican Republic Ecuador Jordan Mexico Nigeria

35 62

65 58 33 43 --

42 67 47 38

Philippines (1989) 1 Philippines (1992) Poland Uruguay Venezuela

100 28 25 39 7

54 9


3 4

Total 2

New money

5 27 37




42 18 33 3 8

17 1 5

13 4 28 3 1

3 9


Other nondebt- and debt-service reduction options

2 2



Overall package

Secondary market price at time of agreement in principle

Sources: National authorities; and IMF staff estimates. The agreement included new money, but was not tied to a specific amount of eligible debt. Weighted average. --: Not applicable. 1


Table 3

Buyback equivalent prices in debt- and debt-service reduction operations 1 (percent of face value)


Debt reduction Discount Buyback exchange

Debt-service reduction Principal collateralized Other par par exchanges exchanges

Argentina Brazil Bulgaria Costa Rica 2 Dominican Republic

--25 16 25

25 26 18 -28

32 36 -

19 8 293 --

30 30 18 18 26

37 35 27 19 23

Ecuador Jordan Mexico 2 Nigeria2 Philippines (1989)

39 40 50

19 25 33 ---

29 41 39 36 --


24 35 36 39 50

23 39 44 40 50

Philippines (1992) Poland Uruguay 2 Venezuela 2

52 41 56 45

14 -35

45 22 45 38

28 --25

48 25 53 38

53 39 54 46

Total 4







Source: IMF staff estimates. 1 The buyback equivalent price for a debt exchange is the total value of enhancements as a proportion of the total reduction in claims payable to banks, including effective prepayments through collateralization, evaluated at prevailing interest rates at time of agreement in principle. This is the price at which the debt reduction achieved through a debt exchange is equivalent to the debt reduction under a buyback at this price. 2 The calculations include estimates of value-recovery clauses. 3 Weighted average of the buyback equivalent price of the series A par bond (33 cents), the series B par bond (0 cents), and the series A past-due interest bond (119 cents). 4 Weighted average. --: Not applicable.

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Saving and the Real Interest Rate in Developing Countries J O N A T H A N D. OSTRY AND C A R M E N M. R E I N H A R T


\AISING real interest rates has often been cited as a way to I increase private saving, and thus provide the resources for growth. But this may not be a viable approach in the poorest developing countries, in which most people live at the subsistence level. How does private saving respond to changes in real interest rates in developing countries? The answer will influence judgments about the effectiveness of a range of policies. For example, financial liberalizations, which generate higher real interest rates, will result in greater savings by households only if the latter decide to defer consumption; in other words, if the sensitivity of consumption and saving to higher interest rates is significant. Similarly, when fiscal policy shocks contribute to movements in domestic interest rates, their impact on the external current account will depend on how responsive private saving is to changes in real rates of return. In this article, we present some evidence to suggest that raising domestic interest rates

to stimulate saving is unlikely to be successful in the poorest developing countries, where consumption choices are heavily influenced by subsistence considerations. Indeed, the evidence suggests that the interest rate sensitivity of saving to real rates of return rises with a country's income level. Hence, the same policies undertaken in different countries could produce very different outcomes, depending on the country's level of development.

Is saving responsive? There is little consensus in the empirical literature on the interaction between saving and the real rate of interest in developing countries. Some studies have concluded that, for a large number of developing countries, there does not appear to be any systematic relationship between rates of return and consumption/saving behavior; others have suggested that there may be considerable regional variation in this elasticity. One reason may simply be the poor quality of the data in general and, more specifically, the fact that there is considerable variation in the economic significance and informational content of the data on real rates of return. Lack of sophistication and depth in domestic financial markets or direct regulation may result in interest rates that do not adequately reflect expectations about the underlying economic fundamentals. In many low-income developing countries, there are few banks, and there is little scope for true market determination of interest

Jonathan D. Ostry, a Canadian national, is a Senior Economist in the IMF's Southeast Asia and Pacific Department.


rates. This feature of credit markets in the least developed countries may itself make saving less responsive to interest rates. Another reason that might explain the failure of existing studies to detect significant effects of interest rates on household saving in developing countries relates to the fact that—particularly in the poorest countries—subsistence considerations are likely to be a significant factor determining consumption behavior. Given that, to be able to save, households must first achieve a subsistence consumption level, the interest rate sensitivity of private saving will be close to zero for countries where a large share of the population lives at or near subsistence consumption levels. Indeed, a subsistence model would predict a nonlinear relationship between saving behavior and the level of development, with the most significant changes occurring when countries move from low-income to low-middle-income status, and relatively minor changes between middleincome and high-income countries. Of course, the interest rate sensitivity of saving could be low even in middle-income countries if the income distribution were sufficiently skewed so that a large proportion of the population lived at or near subsistence levels. A frequently used proxy for the importance of subsistence in household budgets is the budget share going to food. It is indeed noteworthy that food consumption accounts for a markedly lower share of total expenditure in high-income than in low-income countries. As shown in Table 1, food consumption

Carmen M. Reinhart, a US national, is an Economist in the IMF's Western Hemisphere Department.

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Table 1

Food as a share of expenditure


(1990)' Country groupings Low-income Lower-middle-income Upper-middle-income High-income


55.6 32.1 30.5 13.0

Source: Judith Jones Putnam and Jane A. Allshouse, Food Consumption, Prices and Expenditures, United States Department of Agriculture, Statistical Bulletin No. 867. 1 Expenditure on food as a percent of total personal expenditure. For details of the countries included in each country grouping, see World Bank, World Development Report 1994: Infrastructure for Development, Washington, DC, 1994. 2 Data refer to averages for each country grouping.

accounts for an average of 13 percent of total expenditure in high-income countries and for only 8 percent of total consumption in the United States. For middle-income countries, such as Mexico and Thailand, the share is often 30-40 percent while, for the poorest countries, the share of food is over 50 percent; it is in the 60-70 percent range in some countries, such as Sierra Leone and Sudan. The very sharp differences in food expenditure across countries with different per capita income levels suggests that subsistence considerations may indeed be important in understanding saving behavior, particularly in low-income developing countries. There are, however, additional reasons why saving may be less responsive to changes in real interest rates in low-income than in middle-income countries. Some have argued that low-income countries are characterized by pervasive liquidity constraints, which implies that changes in consumption will be heavily influenced by changes in current income, rather than by changes in rates of return.

Savings and income Subsistence considerations offer two main predictions about saving behavior. First, saving rates should increase with the level of real income at the initial stages of development, with the largest increases in the saving rate occurring as a country moves from low- to middle-income levels. Second, saving should become more responsive to changes in real interest rates as countries become richer. The first prediction follows directly from the role of subsistence consumption in the low-

income developing countries, and the fact that tries than among the Latin American counthe share of subsistence in total con- tries in the sample, despite similar income levsumption—perhaps proxied by the food els. The more equitable income distribution share—declines as income increases. The sec- that characterizes the Asian countries may be ond prediction may also be related to subsis- a factor behind those differences. Institutional tence considerations, since incentives to save arrangements (such as pension funds), which over time should affect only that portion of the play a more prominent role in several Asian budget left over after subsistence has been countries, may also be conducive to fostering higher saving rates. achieved, that is, discretionary income. The role of real interest rates in saving Among countries in various income groups, the patterns of saving rates that emerge are behavior is more difficult to gauge. One probbroadly consistent with the predictions of the lem—which is particularly important in subsistence model. As Table 2 shows, private Africa—is that financial markets remain thin saving is, on average, considerably lower for and governments often set interest rates at the poorest developing countries, where the nonmarket levels. Nevertheless, there is some saving rate is about one half that of the high- evidence that financial saving increased as a income group. In fact, such differences also result of the increase in real interest rates appear within regions. World Bank data show associated with liberalization of financial marthat median gross domestic saving as a per- kets in developing countries, both in Africa centage of GDP (1987-91 average) was 5.6 per- and elsewhere. For example, increases in savcent for low-income African countries and 19 ing rates have been associated with higher percent for middle-income African countries. real interest rates in Indonesia and the Average gross domestic saving for both Republic of Korea and, more recently, in Argentina, Chile, and Pakistan. There is also groups was 7.7 percent of GDP. Furthermore, the relationship between the some evidence that reform programs in level of income and the saving rate appears to Africa—which caused real interest rates to be nonlinear, as the largest increases in saving move from sharply negative to mildly positive rates occur in the transition from low- to levels—were successful in mobilizing domeslower-middle-income levels, where the average tic savings. personal saving rate rises by 5.5 percentage points. The average for the upper-middle- Empirical findings When households are assumed to maximize income countries is still 2.8 percentage points above that of the lower-middle-income group, utility, or welfare, subject to a resource conbut there appears to be relatively little differ- straint, the interest-rate sensitivity of houseence between the average saving rates in the hold saving depends on how easily high-income and upper-middle-income coun- households can substitute future consumption for current consumption (technically known tries in the sample. It is noteworthy that liquidity constraints as the intertemporal elasticity of substitution and precautionary motives for saving could (IBS) in consumption). If a given change in produce the opposite pattern in saving rates. real interest rates induces large shifts in conIf poor consumers cannot borrow but face sumption, then the IBS—one of the paramean uncertain income stream, the demand ters describing household preferences—will for precautionary saving rises. Hence, the liquidity-conTable 2 straint/precautionary saving Income and personal saving rates hypothesis would predict that it GNP per adult Personal saving as is the poorest consumers, who in 1985 dollars a percentage of GDP have no access to credit marCountry groupings (1980-87 average) (1985-93 average) kets, who would save the most. Low-income 1,380 11.2 Still, there appear to be 16.7 Lower-middle-income 2,806 marked cross-country differ19.5 Upper-middle-income 4,896 ences in saving rates that can20.0 High-income 16,161 not be accounted for by a Sources: IMF, World Economic Outlook, October 1994, Washington; and subsistence explanation. For World Bank, Adjustment Policy Research Report, Oxford University Press, New York, 1994. example, saving rates tend to be higher among the Asian counFinance & Development / December 1995

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be correspondingly large. In our work on this issue, macroeconomic data from a sample of countries were used to evaluate the magnitude of the IBS for households from developing countries with diverse income levels. The low-income countries in the sample were Egypt, Ghana, India, Pakistan, and Sri Lanka. The low-middleincome countries were Colombia, Costa Rica, Cote d'lvoire, Morocco, and the Philippines. Three upper-middle-income countries also were included in the analysis: Brazil, Korea, and Mexico. In addition to not requiring that the IBS be equal across countries with very different per capita incomes (consistent with the subsistence model), our methodology allowed relative prices (of imports and home goods) to enter into households' saving decisions. To take one example, a temporary reduction in import prices should reduce saving, other things being equal, because the price of imports is a factor whose changes over time (like the changes in interest rates) affect incentives to consume today or in the future. Estimation of the IBS for countries with different per capita incomes is, however, an intermediate step. Ultimately, the aim of our analysis is to quantify the responsiveness of saving to policies that alter domestic interest rates, that is, the elasticity of saving with respect to the interest rate. It is possible to simulate how saving responds to changes in real interest rates using our empirical estimates of the IBS. By estimating how the IBS varies with income level within our sample of 12 countries, we can infer values of the IBS outside the sample (using information on the per capita income levels for other countries) and thereby simulate the interest rate elasticity of saving for a broad range of countries. Our results (see Table 3) suggest that a 1 per-centage point rise in the real rate of interest should elicit a rise in the saving rate of only about two tenths of 1 percentage point for the 10 poorest countries in the sample. For the wealthiest countries, by contrast, the rise in the saving rate in response to a similar change in the real interest rate is about two thirds of a percentage point. As Table 3 shows, the results are not very sensitive to the initial level of the real interest rate. In general, the cross-country variation in the responsiveness of saving to a change in the real interest rate is wide, consistent with the predictions of the subsistence consumption model and the wide variation in income levels in the sample of countries included in our study. As with saving rates, the relationship between a country's income level and the interest elasticity of saving varies as one 18

Table 3

Interest sensitivity of saying1 under alternative scenarios Initial real interest rate Country groupings

3 percent 4 percent 5 percent

Low-income Average for group Average for 10 poorest Lower-middle-income Upper-middle-income High-income

0.312 0.177 0.532 0.560 0.584

0.306 0.174 0.522 0.549 0.573

0.300 0.171 0.512 0.539 0.562

Source: M. Ogaki, J.D. Ostry, and C.M. Reinhart, "Saving Behavior in Low- and Middle-Income Developing Countries: A Comparison," IMF Staff Papers (forthcoming). 1 The data refer to the change (in percentage points) in the saving rate owing to a 1 percentage point increase in the real interest rate. For example, in high-income countries with a real interest rate of 3 percent, a 1 percentage point rise in the real interest rate would raise the saving rate by nearly two thirds of a percentage point (0.584 of a percentage point). At higher baseline levels of the real interest rate, the saving response diminishes slightly.

moves up the income scale. Specifically, in low-income countries, the IBS (and hence the interest rate elasticity of private saving) is close to zero. In low-middle-income countries, there is a marked rise in the IBS. The IBS is found to increase again in the upper-middleincome countries, though there is little difference between this group and the high-income countries.

Implications The main conclusion that emerges from our analysis is that much of the considerable variation among countries in both the level of saving and the responsiveness of saving to the real interest rate can be systematically explained by the country's income level. Specifically, the hypothesis that the saving rate and its sensitivity to interest rate changes are rising functions of income finds considerable empirical support. In particular, our results may help to explain why the rising real interest rates that typically accompany financial liberalization have failed to elicit an appreciable rise in private saving in many countries. Though financial liberalization policies—and the resulting increases in interest rates—may have a number of positive effects (including increasing both the efficiency of investment and economic growth), the results suggest that the direct impact of such policies on household saving behavior is likely to be relatively small in low-income countries. Other policy questions—for example, the relationship between government deficits and the current account of the balance of payments—will also depend on the responsiveness of private saving to real interest rates, to the extent that changes in public saving (increases or decreases in the budget deficit or surplus) alter domestic rates of return. Hence, our find-

ings may shed some light on the wide variation among countries in the response of the current account to fiscal policy changes that alter interest rates. The failure of saving to respond to changes in real interest rates in many low-income countries is particularly problematic, since these are also the countries that have the least access to international capital markets and foreign savings. But even for developing countries that can obtain foreign financing, achieving or maintaining adequate domestic savings is essential for sustained growth. As the turbulence at the end of 1994 in Mexican and other emerging financial markets highlighted, foreign financing can be volatile and reversals can be quite abrupt. Increasing national saving in lowerincome countries may therefore require an alternative strategy. A recent World Bank study of high-performing Asian economies highlights the role of lower public sector deficits (achieved through expenditure cuts rather than tax increases) as an important means of achieving higher national saving. Reducing the level and volatility of inflation, and promoting macroeconomic stability more generally were also seen as useful ways of promoting saving. Mandatory saving programs may also have been effective in boosting saving in some Asian countries. In contrast, in upper-middle-income developing countries, the household saving rate is likely to increase significantly as interest rates move up, and the response is unlikely to be very different from what would typically be observed in industrial countries.

References: J.D. Ostry and C.M. Reinhart, "Private Saving and Terms of Trade Shocks," IMF Staff Papers, Vol. 39, September 1992, pp. 495-517; M. Ogaki, J.D. Ostry, and C.M. Reinhart, "Saving Behavior in Low- and Middle-Income Developing Countries: A Comparison, "forthcoming in IMF Staff Papers; G.L. Kaminsky and A. Pereira, "The Debt Crisis: Lessons of the 1980s for tin 1990s," forthcoming in the Journal of Development Economics; World Bank, Adjustment in Africa: Reforms, Results, and the Road Ahead, World Bank Policy Research Report (New York: Oxford University Press, 1994); and World Bank, World Development Report 1994, and World Development Indicators (New York: Oxford University Press, 1994).

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New Occasional Papers from the International Monetary Find Uganda: Adjustment with Growth, 1987-94, by Robert L. Sharer, Hema R. De Zoysa, and Calvin A. McDonald. No. 121. 1995. vii + 43 pp. This paper explores not only Uganda's recent adjustment efforts but also the country's prospects in the medium term. It provides an overview of recent economic performance with respect to growth, saving, and investment, and provides an analysis of Uganda's external adjustment efforts. The paper surveys fiscal adjustment and the prospects for a sustainable fiscal position, public enterprise reform, and army demobilization. Available in English, (paper) ISBN 1-55775-461-6 Stock #S121EA Capital Flows in the APEC Region, edited by Mohsin S. Khan and Carmen M. Reinhart. No. 122. 1995. viii + 76pp. The developing economies of the Asia Pacific Economic Cooperation Council (APEC) have been the recipients of a considerable volume of capital inflows in the 1990s. Given the increased integration of capital markets, it is not surprising that monetary control became more difficult for many developing APEC economies. Formulating an appropriate policy response has naturally been important. Each of the three papers that make up this Occasional Paper examine different aspects of these issues. Available in English, (paper) ISBN 1-55775-466-7 Stock #S122EA Comprehensive Tax Reform: Hie Colombian Experience, edited by Parthasarathi Shome. No. 123. 1995. viii + 67pp. This paper analyzes particular areas of tax policy that have concerned the Colombian authorities during the 1990s, albeit comprising a comprehensive approach to tax reform over time. It is intended to allow the reader to view in technical detail the type of analysis conducted in a representative tax reform study carried out by the IMF. Available in English, (paper) ISBN 1-55775-464-0 Stock #S123EA Saving Behavior and the Asset Price "Bubble" in Japan: Analytical Studies, edited by Ulrich Baumgartner and Guy Meredith. No. 124. 1995. vii + 79 pp. This volume brings together various analytical studies the IMF staff has undertaken on the Japanese economy, focusing on two areas of particular interest for both longer-term economic performance and recent cyclical developments. The first is Japan's saving behavior; the second is the remarkable swing in asset prices that occurred in the late 1980s and early 1990s. Available in English, (paper) ISBN 1-55775-462-4 Stock #S124EA I'nited Germany: The First Five Years: Performance and Policy Issues, by Robert Corker, Robert A. Feldman, Karl Habermeiei; Huri Vittas, and Tessa van der Willigen. No. 125. 1995. vii + 74 pp. This paper reviews economic and financial developments in Germany since its reunification nearly five years ago and analyzes some critical issues that have featured prominently in the policy debate over this period and are likely to continue attracting attention in the years ahead. Available in English, (paper) ISBN 1-55775-472-1 Stock #S125EA The Adoption of Indirect Instruments of Monetary Policy, by a Staff Team headed by William E. Alexander, Tomds J.T. Balino, and Charles Enoch. No. 126. 1995. viii + 67 pp. This paper examines the experience of implementing indirect instruments of monetary policy. The experiences of country studies illustrate the variety of circumstances under which indirect instruments of monetary policy have been introduced. Case studies are presented for Chile, Egypt, Ghana, Indonesia, Mexico, New Zealand, and Poland. Available in English, (paper) ISBN 1-55775-489-6 Stock #S126EA Road Maps of the Transition: The Baltics. Hie C/ecli Republic, Hungan. and Russia, by Biswajit Banerjee, Vincent Koen, Thomas Krenget; Mark S. Lutz, Michael Marrese, and Tapio O. Suavalainen. No. 127. 1995. v i i i + 70 pp. Four papers analyze the process of transition to a market economy in the Baltics, the Czech Republic, Hungary, and Russia through early 1995. Available in English, (paper) ISBN 1-55775-519-1 Stock #S127EA Price: US$15.00 each. ($12.00 for full-time faculty members and students) TO ORDER, PLEASE WRITE OR CALL: International Monetary Fund Publication Services Box FD-504 700 19th Street, N.W. Washington, D.C. 20431 U.S.A.

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Can Inflation Targets Help Make Monetary Policy Credible? T I M O T H Y D. L A N E , M A R K G R I F F I T H S , AND A L E S S A N D R O PRATI

convince the public of its determination to bring about price stability, its task is made much easier, since it does not have to battle against the inflationary expectations, built into wage contracts and interest rates, that can make disinflation socially costly.

Credibility is an essential element of monetary policy and can immensely increase its effectiveness. This is particularly true for a central bank that is trying to bring about disinflation—whether from moderate inflation rates or from hyperinflation. If the central bank can

Important as it is, credibility is elusive: there is no obvious prescription for convincing financial markets and the public that the central bank is actually pursuing its stated goals. One obvious solution is for the central bank to establish a track record: as the public watches the central bank pursuing consistently tight policies and sees inflation gradually coming down, it comes to believe that low inflation will prevail. This can take many years of hard slogging, though. Is there any way to accelerate the process—and thereby reduce the years of lost output and employment as the central

bank tries to achieve price stability in the face of skepticism from the public and the markets? The achievement of central bank independence is generally believed to enhance credibility, but how can the public be sure that a newly independent central bank would pursue disinflationary policies? Perhaps one way a central bank could build credibility is through greater transparency: clarifying its goals to the public and the links between these goals and its day-to-day policy actions—that is, establishing a monetary framework. Intermediate targets. One kind of framework is based on intermediate targets. For example, if monetary policy is oriented toward keeping the exchange rate within a narrow band, this framework has three desirable properties: (1) it provides a guiding rule for monetary policy actions over the short and medium terms; (2) achievement of the exchange rate target is consistent with

Timothy D. Lane, a Canadian national, is Deputy Chief of the Southern European Division I in the IMF's European I Department.

Mark Griffiths, a UK national, is an Economist in the Central European Division II of the IMF's European I Department.

Alessandro Prati, an Italian national, is an Economist in the Southern European Division I of the IMF's European I Department.

OW can central banks best establish the credibility of monetary I policy? Devising a transparent framework for monetary policy, this article suggests, may be an effective way to achieve this.



Building credibility

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the longer-term goal of disinflation (provided that inflation abroad is lower); and (3) the target and its link with monetary policy instruments are transparent to the public, enabling the authorities' performance to be assessed continuously. As an alternative, some central banks have pursued moneysupply targets, which offer other advantages—notably, under some circumstances, they may offer a better guide to price stability, and they are not as subject to testing by the markets—although they are neither as closely controllable nor as directly observable as the exchange rate. Many central banks have now lost their intermediate targets. Many of those that had been pursuing money-supply targets in the early 1980s found that their ability to control monetary aggregates and to set appropriate growth targets for them was weakened as econometric estimates of money demand disintegrated—as one central banker said, "We didn't abandon Ml—Ml abandoned us!" Market pressures forced some European countries—Italy and the United Kingdom—to abandon their exchange rate bands in September 1992, while some others—Finland and Sweden—were forced to discontinue their policies of shadowing the exchange rate mechanism (ERM) of the European Monetary System. Monetary policy in all these countries lost its anchor, leading to a quest for an alternative monetary policy framework. Inflation targeting. Several countries— including Canada, Finland, New Zealand, Sweden, and the United Kingdom—have chosen to target inflation itself. This entails, first of all, setting a target—a quantified objective for inflation over the medium term. Setting such a target might, by itself, have little effect on the public's expectations; it might very well be dismissed as a pious wish. The key issues are, therefore, how to pursue this target and how to convince the public that hitting the target is the foremost objective of monetary policy. Since policy actions taken now do not affect inflation for several quarters, or even years, inflation targeting is necessarily forward-looking; merely reacting to the inflation already experienced would be a recipe for stop-go policy. Therefore, inflation targeting, in practice, uses forecasts of inflation as the central policy variable—tightening policy if inflation is projected to be above target and easing policy if inflation is projected to be below. Inflation targeting enhances transparency, including public monitoring of key information variables, and is designed to build credibility more quickly than an intermediate target. Using such a framework sacrifices some of the observability that can be achieved with an intermediate target but avoids the drawbacks

involved in focusing policy on one variable. Like an intermediate target, inflation targeting may establish a clear standard against which the monetary authorities can be judged and may help them establish credibility more quickly. Inflation targeting thus involves three steps: • setting targets for inflation (together with conditions under which the authorities should accept deviations from these targets); • forecasting inflation conditional on unchanged policies; and • formulating and implementing changes in policy in response to deviations of forecast inflation from the target—possibly, as a subsidiary element, also taking account of developments in the real economy in the shorter term.

Inflation targeting in practice In countries that have adopted inflation targets, such targeting did not cause any substantial change in the goals of monetary policy but did entail an increase in the transparency with which policy was presented to the public. For instance, in the United Kingdom, periodic inflation reports were published, providing an inflation forecast based on an array of indicators. For several central banks, inflation targeting has also brought greater accountability; most radically, the tenure in office of the Governor of the Reserve Bank of New Zealand depends explicitly on whether inflation targets are achieved. Some other features are common to most or all of the country cases this article discusses: inflation targets are set for a time horizon of 2-3 years ahead, based on the estimated lags in the effects of monetary policy; and the inflation targets are set as a range 2-3 percentage points wide, which reflects recognition of the imprecision of monetary control of inflation while giving the authorities a relatively welldefined goal. In most cases, the targets were not adopted unilaterally by the central bank, but instead with a joint commitment by the central bank and treasury—although, in most cases, the momentum to establish clear targets came from the central bank. In some countries (Canada and New Zealand), there is an explicit contingency protecting the central bank from blame for missing the target for reasons truly beyond its control. At the same time, contingencies are limited to avoid excessive accommodation of internal or external shocks—avoiding, for instance, accommodating the inflationary consequences of excessive wage increases or fiscal laxity. In other cases (Finland and the United Kingdom), an inflation measure is used that excludes such influences on the inflation

rate as mortgage interest or indirect tax payments. (See box for further information on inflation targeting in New Zealand, Canada, and the United Kingdom.) It is still too early to assess how inflation targeting has worked in practice. Up until now, however, it has seemed to be a useful approach that might help build credibility through greater transparency—provided it is combined with a genuine commitment, on the part of the central bank, to price stability that is accepted by the government and by the public. It is a potentially promising approach that should be considered by other countries that have no workable intermediate targets.

Issues in implementation Applying inflation targeting in other countries would require that several issues be addressed. The solution to these issues depends on considerations that may differ across countries. Time horizon. The horizon over which the target is pursued affects both the target's attainability and its role in holding the central bank accountable. Here, two elements are key: first, current monetary policy affects inflation with a long lag; and second, monetary policy now affects inflation not just at a particular date in the future, but over a longer period. This implies that inflation targets need to be forward-looking and cover a significant period of time. Pursuing inflation targets for a rolling average of, say, the following two years would leave the authorities some scope for adapting monetary policy to changing economic conditions, as well as finding the appropriate adjustment strategy. Form of target. Should the target be set as a range, as in most of the countries discussed, or as a single number? A range is more likely to be credible than a given figure, since there is virtual certainty that the central bank will miss any absolute target. It is also desirable for the sake of accountability, since the range states the magnitude of deviation that is considered tolerable. If a range is adopted, there is also the question of its appropriate width, with a trade-off between having too wide a range—which does not provide an anchor for expectations and provides a less clear guide for policy—and too narrow a range—which would make outcomes outside the range more likely, thus making credibility harder to achieve. In some countries, there may be concern that a target range may not provide an adequate focus for expectations and contracts. In Italy, for instance, the Government already announces official inflation targets, which are used as the basis for norms for government expenditures as well as for wage contracts Finance & Development /December 199b

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Inflation Targets in New Zealand, Canada, and the United Kingdom Three countries that have adopted inflation targeting are New Zealand, Canada, and the United Kingdom. New Zealand's adoption of this approach was the most thoroughgoing. The 1989 Reserve Bank Act defines the primary function of the Bank as formulating and implementing monetary policy with "the economic objective of achieving and maintaining stability in the general level of prices." This objective is made operational through Policy Targets Agreements (PTAs) negotiated periodically between the Governor of the Reserve Bank and the Minister of Finance. Thus, the Government retains power over monetary policy objectives, while the Bank is given the freedom it needs to meet these goals. Failing to meet the target can lead to the Governor's dismissal before the end of a normal five-year term. The PTAs are explicitly contingent on events beyond central bank control (including major changes in indirect taxes, government-administered prices, the terms of trade, or a natural disaster), as well as the direct effects of mortgage interest rates on consumer prices. In such circumstances, the Reserve Bank is allowed to breach the inflation target, as long as it presents a plan that ensures that any overshooting of the inflation target is temporary. Progress is monitored in the

Reserve Bank's Monetary Policy Statements, which are issued at least every six months and placed on Parliament's agenda. In Canada, price stability was made the operational goal of monetary policy in February 1991, when the Minister of Finance and the Governor of the Bank of Canada jointly announced inflation targets. This decision marked the culmination of widespread debate on the merits of price stability. The targets set a gradual downward glide for inflation. The 12-month rate of consumer price index (CPI) inflation was to be kept within a 2-4 percent range by the end of 1992,1.5-3.5 percent by mid-1994, and 1-3 percent by the end of 1995. The 1-3 percent target has since been extended through the end of 1998. Progress is monitored regularly and, in particular, in the Bank of Canada's Annual Report. As in New Zealand, an exception is made for the effects of changes in indirect taxes: the Bank of Canada would adjust the inflation target to accommodate the "firstround" effects, but would counteract any "secondround" effects associated with increases in wages intended to preserve after-tax real wages. The United Kingdom's adoption of inflation targets was prompted by sterling's departure from the exchange rate mechanism of the European

Monetary System. The Chancellor of the Exchequer announced that retail price inflation excluding mortgage payments (RPIX) would be kept within a 1-4 percent range and brought into the bottom half of that range by the end of the current Parliament (April 1997 at the latest). Monetary policy transparency was enhanced: the Bank of England's quarterly Inflation Report presents a comprehensive assessment of inflationary pressures, as well as the inflation forecast on which it bases policy advice. Since the Treasury is officially responsible for UK monetary policy, such advice is regularly presented at the monthly meetings of the Chancellor and the Governor of the Bank of England. The UK Treasury publishes a monthly monetary report containing background material for these meetings, and six weeks after each meeting is held, the minutes are made public. In all three countries, inflation declined after inflation targets were first announced. (See chart.) More recent experience has been mixed: in recent months, inflation has been rising in all three countries, although it has remained well below the levels reached before the inception of inflation targeting.

Selected countries: inflation performance, 1989-95 (percent)

Source: IMF, International Financial Statistics. Note: Vertical lines show the dates of announcement of the first inflation targets in (a) New Zealand, (b) Canada, and (c) the United Kingdom.


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nationwide. These targets as yet have no direct bearing on monetary policy. There are concerns that, if Italian monetary policy adopted inflation targeting using a target range around the official inflation objectives, wage settlements would be based on the top of the range, in the belief that this was the most likely outcome within the range. This may be a temporary difficulty, but it should not be an insurmountable obstacle to inflation targeting. The present incomes policy is not a permanent feature of the Italian economy. In the longer term, what will matter is whether the trade unions and general public really believe that the inflation target is likely to be achieved. Contingencies. Another question is whether the inflation target should be made contingent on shocks affecting the economy, as, for instance, in Canada and New Zealand. There is also a good theoretical case for making a commitment contingent on events that can be readily observed: the central bank can deal with adverse shocks with less loss of credibility if it explicitly adjusts the targets to deal with such shocks, rather than simply allowing slippage without explicit justification. Valid contingencies, subject to which the targets could be revised might, for example, include oil price shocks or other uncontrollable changes in the terms of trade. However, it is important to put some restrictions on the use of contingencies. One would be (as in Canada) to restrict the adjustment of the target to cover only direct effects of the shock and not any secondary pass-through to wages. A second would be to give at most partial accommodation for contingencies, such as adverse fiscal and wage developments, that may be influenced by monetary policy, since full accommodation would introduce a moralhazard problem which would limit the central bank's ability to brake inflation. Modeling. Another issue in implementing inflation targeting is the design of the model used to forecast inflation. If monetary policy is to react to deviations of inflation from the target, the direction, extent, and timing of this reaction are key—and these depend critically on the model of the economy used by the central bank. Paradoxically, given most central banks' responsibility for price stability, the econometric models used by many central banks provide little analysis of the monetary transmission mechanism, which would indicate when and how monetary policy affects inflation. For example, the Bank of Italy's mainstream quarterly econometric model allows almost no influence of monetary policy on inflation for a given exchange rate, and the exchange rate is taken as external to the model. These shortcomings should be reme-

died, insofar as is possible, to increase the models' usefulness in guiding monetary policy in pursuit of inflation targets or, indeed, any macroeconomic objectives. To a certain extent, though, modeling difficulties are inherent: it is difficult, even in principle, to pin down the monetary transmission mechanism within an econometric structure, given the potential multiplicity of channels through which monetary policy may have its effects and the importance of expectations in determining its impact. This consideration suggests a role not only for building bigger and better macroeconometric models but also for consulting a range of different models, especially simpler models such as reducedform, VAR, or P-star models. Simpler models frequently imply a tighter link between monetary policy and inflation than can be traced in more complex models. The policy cycle. A clear monetary policy framework should specify the cycle of policy decisions and announcements—what is decided, when, and by whom; and what information is released. A monetary framework could, for instance, specify a timetable as follows: targets would be announced annually. Official inflation forecasts could then be made three or four times a year, as in those countries that have already adopted inflation targeting—a compromise between very frequent, and therefore costly, forecasts and policy reevaluations, with perpetual shifts in course, and very infrequent forecasts, which would not allow the authorities to revise policy in the light of new information. Information variables. Combined with the inflation forecasts would be projections of a set of economic variables whose value over the coming months is predicted by the same model used to forecast inflation. These might be divided into three categories: for the first set of variables, the closest thing to intermediate targets in this approach, monitoring ranges could be set at each forecasting round for the four-month horizon until the next round. Money and credit aggregates—for example, Ml (currency plus checking account deposits) and the public sector borrowing requirement—would seem to be good candidates for inclusion in this category. Monitoring ranges for these variables would be set to be consistent with projections derived from the same model generating the inflation forecasts that are the ultimate target of policy. Bands, or ranges, around this target would be set wide enough to be attainable but narrow enough to provide some guidance to policymakers—that is, for the monitoring ranges to be relevant, it should sometimes happen that variables go outside their monitoring ranges, occasioning a policy adjustment. These monitoring ranges

might be announced to the public, in part to give the latter a benchmark against which to evaluate the central bank's performance in pursuit of its stated inflation objective. A second set of variables would consist of indicators that would be monitored weekly or monthly. For these variables, the central bank would set a reference level associated with the inflation forecast judged to be consistent with the attainment of the inflation target. Deviations of indicators from their reference levels would then be a focal point in the monthly review of policy. Indicators might include money and credit aggregates other than those selected as intermediate targets. A third set of intermediate variables would consist of indicators that can be monitored on a continuous basis; a short list would include the exchange rate and current (short-term) and forward interest rates. These indicators would be incorporated in day-to-day and minute-to-minute policymaking, and would probably not be announced to the public. One way of incorporating these short-term indicators would be in the form of a monetary conditions index, which would assign weights to key indicators for use in policymaking. Use of this index would imply that a sign of easing in one variable—for example, a depreciation of the currency or a rise in forward interest rates—would signal the need for a rise in short-term interest rates to permit the central bank to maintain the same overall stance visa-vis the inflation target. However, this could not be done mechanically, since the appropriate response depends on the nature of the shock affecting the exchange rate for a given interest rate.

Conclusion Building credibility in the absence of an obvious nominal anchor, such as an exchange rate target, and, often, in the face of uncertainties about fiscal and monetary policies is a key task facing the architects of monetary policy in many countries. If a policy oriented toward price stability can overcome the skepticism of the markets and the public, this will limit the adverse effects on interest rates, output, and employment. A formal monetary framework based on inflation targeting is one approach that may be worth considering.

This article is based on the authors' paper "An Inflation Targeting Framework for Italy," IMF Paper on Policy Analysis and Assessment No. 95/4 (March 1995).

Finance & Development /December 1995

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Corruption, Governmental Activities, and Markets VITO TANZI


ORRUPTION distorts the role of government and is costly to society. I Governments can minimize the opportunities for individuals to engage in corruption by reducing the role of the state in the economy.

Corruption comes in many shapes and forms. It is very difficult to define and, at times, even more difficult to identify. Here we shall simply define it as the intentional noncompliance with the principle of "arms-length relationship," which states that personal or family relationships ought not to play a role in economic decisions by private economic agents or government officials. This principle is essential for the efficient functioning of markets. The term corruption comes from the Latin verb rumpere, to break, implying that something is broken. This something might be a moral or social code of conduct or, more often,

an administrative rule. For the latter to be broken, it must be precise and transparent. Another element is that the official who breaks the rule derives some recognizable benefit for himself, his family, his friends, his tribe or party, or some other relevant group. Additionally, the benefit derived must be seen as a direct quid pro quo for the specific act of "corruption." This simple description reveals several potential difficulties. First, there must be evidence that a particular rule has been broken. This requires that all the rules be precisely stated, leaving no doubt about their meaning and no discretion to public officials. But what about cases where rules are not precise or where bureaucrats are specifically given some discretion? For example, legislation in many countries has left the granting of tax incentives or import licenses to the discretion of officials. It is up to them to decide whether an investment or import is "essential" or "necessary" to the country. These officials are often the sole interpreters of what those terms mean. Thus, in a way, they are in a position of monopoly, since they can grant or deny these permits and the permits cannot be obtained from other sources. But are rigid rules the answer? Over the years, there has been a lot of controversy

among economists on whether economic policy should be guided by precise rules or whether it should have an element of discretion. Evidently, the greater the element of discretion, the greater the possibility that it might be used to someone's (rather than the public's) advantage. Thus, the simplest course to prevent corruption might be to create precise and rigid rules. But, of course, some rules may be created just to give some government officials the power to benefit from their application. Often, it is precisely the excess of rules that creates a fertile ground for corruption. Furthermore, if rules are too rigid, they can create obstacles to the smooth functioning of the economy or a particular organization. Second, when social relations tend to be close and personal, it may be difficult to establish a direct link between an act that could be assumed to reflect corruption and a particular payment for it (see box). An employee who uses his official position to favor acquaintances—say to help them get a valuable license, a government contract, or a government job—may be compensated with an immediate or explicit payment (clearly a bribe). Alternatively, he may be compensated, at a much later time, with a generous gift to his daughter when she gets married, or with a

Vito Tanzi, a US national, is Director of the IMF's Fiscal Affairs Department.


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good job offer for his son when he completes his studies. In other words, there may not be any direct, explicit, and immediate compensation for the favor. The payment may be delayed in time and, when made, it may appear completely unconnected with the favor received. In many cases, the "corrupted" and the "corruptor" may never even have discussed the payment. It would simply be understood that a favor granted today creates a presumption or even an obligation for a reciprocal favor tomorrow. In other words, it contributes to the growth of the giver's "social capital." In some societies, a "shadow market" for favors develops with demand and supply and with implicit prices. This market often does not use money but trades in what could be considered the equivalent of lOUs. Implicit prices for favors—and, possibly, even for future favors—are established. In this market, it becomes very difficult to separate genuine favors from those that are close to being bribes, and it is thus difficult to clearly identify bribes and punish those who receive or pay them. This takes us to the third and final difficulty. In societies where family or other kinds of relationships are very strong, and especially where existing moral or social codes require that one help family and friends, the expectation that the public employee will routinely apply arm's-length principles in his relations with friends and relatives is unrealistic.

In these societies, the type of ideal bureaucracy advocated by Max Weber will prove very difficult to install. In the Weberian ideal, bureaucrats would work within a set of principles in which there is no place for personal relations or cronyism and, above all, there would be no confusion of public with private interests. Life in the real world, however, is likely to be very different. Centuries-old and widely accepted social norms will often prove more powerful as guides to behavior than new and often imported rules based on arm'slength, impersonal, and universal principles. When this reality is ignored, disappointment is likely to follow. This explains why some reforms imposed in developing countries, promoted by foreign advisors and which may implicitly require or assume arm's-length relationships, often do not survive the test of time. In these societies, the cost of the corrective role of the government in the market is likely to rise. Economic relationships within the private sector will also be affected, thus rendering more difficult the establishment of a well-functioning market economy. To argue that the personal relationships that come to be established between public sector employees and individuals who deal with them reflect a "corrupt" society may be correct in a legalistic sense, but it misses the point that these relationships simply reflect different social and moral norms.

Economic consequences The instruments that make corruption possible are many. Important examples include: (a) administration of government regulations (such as the issuance of licenses and permits, and zoning and other sorts of regulations that may have great economic value); (b) fines for alleged or actual violations of legal norms; (c) control over government procurement contracts; (d) control over public investment contracts that can favor some areas or contractors over others; (e) tax incentives, subsidized credits, and multiple foreign exchange rates; (f) controls over hiring and promotions; (g) controls over the assignment of entitlements and other benefits (disability pensions, scholarships, subsidies); (h) controls over access to underpriced public services (such as electricity, telephone, and water); and (i) tax administration decisions (auditing, determination of presumptive income, etc.). These examples are far from exhaustive. The greater the use of these instruments by a country, the greater the potential for corruption. Control over these instruments can give government employees great power, which—given the right social environment, the right incentive systems, and weak and uncertain penalties—may allow them to extract large financial advantages (rents) for themselves or for their families and friends.

Corruption: in the eye of the beholder? On January 25,1992, the Economist reviewed a paper by Prakash Reddy, an Indian social anthropologist who, reversing the common pattern of Western scholars going to study developing countries' social behavior, obtained a research grant to study a village in Denmark. He spent a few months in this village and registered his impressions of the relations among its inhabitants. Professor Reddy was amazed to observe that the villagers hardly knew one another. They rarely exchanged visits and had few other social contacts. They had little information on what other villagers, including their neighbors, were doing and apparently little interest in finding out. According to Professor Reddy, even relationships between parents and children were not very close. When the children reached adulthood, they moved out, and after that, they visited their parents only occasionally. Professor Reddy contrasted this behavior with that prevailing in a typical Indian village of comparable size. In the latter, daily house visits would be common. Everyone would be interested and involved in the business of the others. Family contacts would be very frequent and the members of the extended families would support one another in many ways. Relations with neighbors would also be close. This story has implications for the concept of arm's-length and, in turn, for the role of corruption. Arm's-length relationships in economic exchanges would be much more likely to prevail in the Danish village than in the Indian village. In the latter, the concept of arm's-length relationships would seem strange and alien. It would even seem immoral. The idea that, economically speaking, one should treat relatives and friends in the same way as strangers would appear bizarre. Relatives and friends would simply expect preferential treatment whether they were dealing with individuals in the private or public sector.

If a government were established in each of the two villages, with each having a bureaucracy charged with carrying out its functions through the instruments described earlier, it would be far easier for the Danish bureaucrats to approximate in their behavior the Weberian ideal than for the Indian bureaucrats. In the Indian village, the attempt to create an impersonal bureaucracy that would operate according to principles in which there is no place for personalism, cronyism, etc., would conflict with the accepted social norm that family and friends come first. In this society, the government employee, just like any other individual, would be expected to help relatives and friends with special treatment or favors even if, occasionally, this behavior might require bending, or even breaking, administrative rules and departing from universal principles. The person who refused to provide this help would be seen as breaking the prevailing moral code and would be ostracized. The Indian and Danish villages represent polar or extreme cases of how individuals may interact within a community. Whether Professor Reddy's description of them is accurate or not, they provide convenient polar cases. Most societies probably fall somewhere between these two extremes, with Northern European and Anglo-Saxon countries closer to the Danish village model, and many other countries closer to the Indian village model. The Anglo-Saxon concept of privacy is probably just a manifestation of arm'slength relationships. Many developing countries would probably be closer to the model represented by the Indian village. Sadly, the very features that make a country a less cold and indifferent place are the same ones that increase the difficulty of enforcing arm's-length rules that are so essential for modern, efficient markets and governments.

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When civil servants appropriate, for their own use, the instruments that the government has at its disposal to influence the economy and to correct the shortcomings of the private market, they reduce the power of the state and its ability to play its intended, and presumably corrective, role. Assuming that government policies had been, or would have been, guided by the traditional criteria that justify governmental action, corruption distorts the end result in the following ways. It distorts the allocative role of government: • By favoring taxpayers who, because of the special treatment they receive from tax inspectors, are able to reduce their tax liabilities. The loser will be the market, which will function less efficiently. • Through the arbitrary application of rules and regulations. This may be particularly important in the allocation of subsidized credits and import, zoning, and other permits. If, for example, these instruments had been developed to assist genuine "infant industries" but ended up assisting others, the corrective role of the government would be distorted, and, once again, the functioning of the market would be damaged. • Through the allocation of public works or procurement contracts to enterprises that win competitive bids not because they can do the job at the lowest cost but because of their connections and the bribes they pay. • Through the arbitrary hiring and promotion of individuals who would not have been selected or promoted on the basis of fair and objective criteria. The selection of these individuals will damage the economy not only because of the poor decisions and the number of mistakes they make but also because of the resulting labor-market distortions—discouraging more able but less well-connected individuals from pursuing particular careers. • Some individuals will try to get jobs not in the areas in which they might use their particular ability for productive use but in areas that provide scope for taking advantage of their special positions. Such behavior, termed "rent seeking," will be stimulated by corruption. Corruption distorts the redistributive role of the government in myriad ways. If the well connected get the best jobs, the most profitable government contracts, the subsidized credit, foreign exchange at overvalued rates, and so forth, government activity is less likely to further the goals of improving the distribution of income and making the economic system more equitable. Finally, in all its ramifications, corruption is likely to have negative implications for the stabilization role of the government, if that role requires, as is often the case, a reduction of the fiscal deficit. This will occur because 26

corruption will most likely raise the cost of running the government while it reduces government revenue. The allocation of disability pensions to people who are not disabled, the granting of government contracts to people who pay bribes to obtain them and thus raise their costs, and other corrupt practices that distort spending decisions increase the total cost of providing government services. By the same token, government revenue falls when potential tax payments are diverted or are never collected. In some developing countries, the effective tax burden—that is, the ratio of all tax-related payments made by taxpayers to national income—may be significantly higher than the official tax burden because some payments end up in the pockets of tax inspectors. Overall, corruption has a corrosive effect. The belief that everyone does it is likely to lead to a situation where many people, if not everyone, will do it. As with tax evasion, imitation will prove to be a powerful force.

Policy implications Several factors determine the extent to which corruption plays a significant role in a country: (a) the role of the state and the range of instruments it uses in fulfilling that role; (b) social characteristics of the society (for example, the extent to which arm's-length relationships prevail in social and economic relations); (c) the nature of the political system; and (d) the penalty system for acts of corruption that are uncovered. Especially in societies where arm's-length relationships are unlikely to be enforceable (because of the close and continuous contacts among closely knit groups of citizens who tend to personalize most relations), the larger the role of the state, the greater the probability that its instruments will be used by public officials and civil servants to favor particular groups in addition to themselves. When this happens, the cost of government rises while the ability of government to correct the shortcomings of the market falls. In other words, the effective control that the government has over the economy is reduced. In this situation, the best policy for decreasing corruption will be to reduce opportunities to engage in it by scaling down the government's role in the economy. Both the demand for, and the supply of, corruptive practices can be contained by a sharp reduction of that role in all its aspects, such as spending and taxing activities and, especially, issuing and enforcing economic regulations. When corruption in the Weberian sense characterizes modern states, it can be reduced by increasing penalties on those who engage in it; by increasing the transparency of the rules, regulations, and laws; and by strengthening controls on civil servants. However, in

more traditional societies, this option, while still worth pursuing, is not likely, by itself, to give very positive and, especially, permanent results. History is full of examples of campaigns against corruption (and against tax evasion) that started with great fanfare but did not accomplish much over the long run. By the same token, one should not officially sanction corruption by, for example, reducing the wages of civil servants on the assumption that they are getting payments under the table. Unrealistically low wages always invite corruption and, at times, lead society to condone acts of corruption. This is why repression of public sector wages, if carried too far, is never a good policy. Because social intimacy creates the environment that promotes corruption, a policy that has been effective in some cases (for example, tax administration) in reducing corruption is that of forced and periodic geographical mobility for civil servants, to remove them from the region where they have their closest social or family relations and prevent the formation of new relations. Some forms of social relations take time to develop, so that, for a while, after a government official has moved to a new region or taken up a new function, such relations will not play a large role in the contacts between bureaucrats and the citizens who depend on them. Thus, periodic mobility, especially in a large country, could effectively reduce bureaucratic corruption.

Conclusion Economists have developed elaborate and elegant theories about the workings of markets and the role of the public sector in those markets. A normative role has been assigned to the government to correct market failures. In recent years, public choice economists have stressed that, in addition to market failure, political failure could result when political actions or the actions of civil servants are influenced by objectives other than the need to correct market failures and to promote the public interest. The more that real-life bureaucracies diverge from the Weberian ideal—the more they are permeated by corruption—the less control the government will have over its policy instruments and the less able it will be to correct the imperfections of the market. In other words, the less legitimate and justified will be the corrective role of the government. A scaling down of that role is likely to reduce the scope of corruption.

This article was derived from the author's paper, "Corruption, Governmental Activities, and Markets," IMF Working Paper No. 94/99, August 1994.

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International Monetary Cooperation Since Bretton Woods This comprehensive history, published jointly by the IMF and Oxford University Press, was written to mark the fiftieth anniversary of international monetary cooperation. From the establishment of the postwar international monetary system in 1944 to how the framework functions in a vastly expanded world economy, historian Harold James describes the tensions, negotiations, challenges, and progress of international monetary cooperation. This narrative offers a global perspective on the events and decisions that shaped the world economy during the past fifty years, xiii + 752 pp. 1996. Available in English, (hardbound) ISBN 0-19-510448-X TO ORDER, PLEASE WRITE OR CM.!.: International Monetary Fund Publication Services Box FD-504 700 19th Street, N.W. Washington, D.C. 20431 U.S.A.



Telephone (202) 623-7430 Telefax: (202)623-7201 INTERNET: [email protected] American Express, MasterCard, and VISA credit cards accepted

Crisis and Reform in Latin America: From Despair to Hope Tells the story of Latin America's reforms from 1982 to 1994. Starting with the debt crisis of 1982, it shows how a new consensus—spurred by failing traditional policies and pioneering countries—has emerged as nations have begun to stabilize their economies, open up to international trade, privatize and deregulate firms, and improve social security, all while seeking to reduce poverty and provide a social safety net. Devotes particular attention to the recent Mexican currency crisis, the implications of the crisis for Latin America, and the challenges facing the region in its aftermath and in the long term. In the economic history of Latin America, unfortunate events have seemed to repeat themselves endlessly. But the region's recent reforms are beginning to break this melancholy circularity. In spite of the Mexican crisis, there are rays of hope in the story of reform told here—a story that will engage business people, policymakers, teachers, and students alike. Published for the World Bank by Oxford University Press. 372 pages. ISBN 0-19-521105-7. Order # 61105 • $22.95

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Read the executive summary on the World Wide Web: http://www.worldbank.org Click to Publications. Finance & Development /December 1995

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Policies for Achieving Sustainable Growth in the Industrial Countries


ROSPECTSforsustainedeconomic vate investment, and making labor markets

I growth in the industrial countries lare generally good, especially I because inflation rates have I remained well contained—in many cases, close to their lowest levels since the early 1960s. However, large budget deficits and high structural unemployment rates are hobbling economic expansion in many countries, according to the IMF's World Economic Outlook, October 1995 (WEO). To foster stronger, sustainable growth, industrial countries should pursue fiscal consolidation and labor market reforms more boldly.

Benefits of bolder adjustment

Lowering fiscal deficits would reduce demands on world saving and stimulate pri-

more flexible would lower structural unemployment rates and contribute to fiscal consolidation. Today's climate of growth with subdued inflation (see chart) provides an excellent opportunity to pursue these policy efforts more vigorously, which would improve productivity and raise real incomes. Unsustainable pension plans, rising healthcare costs, distortionary subsidies, and overly generous indexing schemes have contributed to fiscal deficits in a number of countries. Governments need to restrain spending; some may also need to increase tax revenues. These efforts at fiscal consolidation should help stimulate private investment and other interest-sensitive components of demand. Industrial countries that successfully tackle

Long-term interest rates and consumer price inflation in the major industrial countries Recent swings in long-term interest rates contrast with generally subdued inflation

Source: IMF, World Economic Outlook, October 1995. 1 GDP-weighted average of ten-year (or nearest maturity) government bond rates for Canada, France, Germany, Italy, Japan, the United Kingdom, and the United States. 2 Percent change from four quarters earlier.


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their budget deficits should be able to ease monetary conditions gradually without triggering more rapid inflation, and long-term interest rates should decline. Labor market reforms should include the reduction of payroll taxes and unemployment compensation benefits and elimination of other labor market rigidities. If governments manage by the year 2000 to balance their budgets and reduce structural unemployment rates by 1-2 percentage points, the outlook would be considerably brighter, as shown in Table 1. Long-term interest rates could drop by 1-2 percent; short-term interest rates would also likely decline as monetary policies reflected the improved fiscal environment. Investment would therefore be stimulated, and the capital stock would grow faster, improving productivity and tending to reduce inflation. This tendency toward lower inflation, even with higher output, would be reinforced by more flexible labor markets, bringing about a decrease in unemployment rates, which would improve fiscal positions. GDP would be permanently higher. The short-term costs of fiscal consolidation would be small, the long-term gains substantial.

Table 1

Benefits of policy reform in the industrial countries Soft landing: balanced government budgets in five years and reduced structural unemployment rates (percentage deviation from baseline unless otherwise noted)

Real GDP Capital stock Inflation (GDP deflator) 1 Unemployment rate




Long run


1.5 0.9

1.2 2.1

2.3 5.5 -

0.2 0.5 0.2

Short-term interest rate 1 Long-term interest rate 1 Real long-term interest rate 1 General government balance/GDP Government debt/GDP '


Contribution to real GDP Real government spending 1 Real consumption 1 Real investment 1 Real net exports 1

-0.5 -0.6

-1.0 -0.9


-0.3 -0.1 -0.1

-1.2 -1.9 -1.5

-2.2 -1.9 -2.0

-0.4 -0.4 -0.4

0.8 -1.7

1.9 -4.5

3.4 -9.3

0.9 -17.9





1.5 1.3 -

1.4 1.9 0.1

0.2 -

1.3 1.0 0.1

Source: IMF, World Economic Outlook, October 1995. Note: The simulation assumes that a gradual reduction in public debt stocks is achieved through cuts in real spending and nondistortionary transfers. The fiscal consolidation is enough to achieve fiscal balance by 2000 but is not credibly viewed as permanent until 1998. In addition, it is assumed that revenue-neutral cuts in unemployment compensation and labor taxes reduce the natural rate of unemployment by approximately 1.5 percent in Europe, more than 2 percent in Canada, and 1 percent in the United States. 1 In percentage points. -: Indicates zero.

Costs of policy slippages

A less attractive outcome, shown in Table 2, is possible, however, if policymakers overreact to the recent softening of growth by inappropriately relaxing both fiscal and monetary policies. Signs of sluggish growth have already led to monetary easing in some countries; there is also a risk of fiscal backsliding in several countries. The benefits of this approach would be fleeting, while the longterm costs would be high. GDP might rise at first, but inflation would soon pick up, requiring severe monetary tightening, while larger budget deficits would boost long-term interest rates. Investment would thus be dampened. Higher interest rates in the industrial countries could provoke capital outflows from developing countries and slow economic expansion worldwide. A switch to more expansionary policies is not justified by the current economic outlook for the industrial countries. The risk of recession or persistently sluggish growth in North America or Europe is small, and Japan should be on the path to recovery in 1996. There are few signs of inflationary pressures. By putting their fiscal houses in order and improving the functioning of their labor markets, the industrial countries could, in the next few years, embark on a path of stronger and more durable economic growth.

Table 2

Costs of policy slippages in the industrial countries Hard landing: easing of fiscal and monetary policies (percentage deviation from baseline unless otherwise noted)

Real GDP Capital stock Inflation (GDP deflator) 1 Unemployment rate




-0.5 -0.8



1.2 1.0 1.2

1.4 0.6 0.7

0.3 0.3 0.3

-2.5 4.5

-2.1 8.8

-0.5 9.9

Short-term interest rate 1 Long-term interest rate 1 Real long-term interest rate 1

0.9 0.5

General government balance/GDP 1 Government debt/GDP 1

1.4 0.5


-1.7 -5.3 -


0.6 0.4

-1.0 -1.5 -0.1

Long run




Contribution to real GDP Real government spending 1 Real consumption 1 Real investment 1 Real net exports 1


1.0 -0.5 -1.0

1.0 -0.9 -1.1



-1.6 -1.0

Source: IMF, World Economic Outlook, October 1995. Note: The simulation assumes that the growth rate of money increases by approximately 2 percent a year in 1996 and 1997 before returning to its baseline rate of growth. It is also assumed that fiscal policy is eased so as to increase debt stocks by about 10 percent of GDP, phased in gradually over five years. It is assumed that these policy changes are known in 1996 and consequently are reflected in expectations. The estimates for the long run represent the permanent effects of the shocks. 1 In percentage points. --: Indicates zero.

This article is based on the World Economic Outlook, October 1995, prepared by IMF staff. Finance & Development /December 1995

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Commercializing Africa's Roads R U P E R T P E N N A N T - R E A AND IAN G. H E G G I E

| HYnot bring roads into the marketplace, I put them on a fee-for\ service basis, and manage them like a business?


Road transport is the dominant form of transport in sub-Saharan Africa. It accounts for 80 to 90 percent of the region's passenger and freight movements and provides the only access to most rural communities. By the end of the 1980s, Africa had nearly 2 million kilometers of roads, after a surge of construction during the 1960s and 1970s by African governments and foreign donors seeking to meet the region's enormous need. Little was done to maintain these roads during the 1980s and early 1990s, however, and years of neglect have left them badly damaged. This situation is not peculiar to roads. Buildings, ports, dams, and irrigation schemes have all suffered from the same kind of neglect;

the importance of maintenance has been overlooked in budgets in favor of other political priorities. In 1988, in an attempt to reverse the damage to road networks, which constitute one of Africa's largest assets, the World Bank and the donor community launched the Road Maintenance Initiative (RMI) (Box 1). Because the neglect of roads and other physical infrastructure has such deep roots, the RMI has taken a fundamental, long-term approach: procedures cannot be changed until attitudes have changed. The task of changing attitudes begins with two steps. First, the costs of inadequate maintenance must be established; second, the group with the power to decide how much should be spent on roads needs to be enlarged to include the people who actually use the roads.

The cost of neglect There have been many studies to identify the costs bad roads impose on an economy. In Africa, where congestion is rarely a problem, even in cities, these costs are more likely to be related to the damage suffered by vehicles and delays resulting from the need to drive slowly

Rupert Pennant-Rea, a UK national, is a consultant. He was Editor of the Economist, 1986-93, and Deputy Governor of the Bank of England, 1993-95.


because of potholes and other road-related problems. A study carried out by road haulers in Zambia in 1992 estimated that potholed roads boosted vehicle operating costs by at least 17 percent a year. Neglect is also expensive at an aggregate level. In 1993, the RMI estimated that Kenya's $40 million shortfall in road maintenance expenditure increased vehicle operating costs by about $120 million per year. The lesson: when roads are poorly maintained, a $1 increase in road maintenance reduces road transport costs by up to $3. Poor road maintenance also results in increased long-term costs of maintaining the road network. Over a 15-year period, these costs are about one third higher when roads are rehabilitated infrequently than they would be with regular road maintenance. In many African countries, responsibility for roads is divided among half a dozen ministries and a number of local government agencies. Roads are managed like a social service instead of as part of a market economy. There is no clear price for using them; road expenditures are financed from general tax revenues; and the agencies that manage roads

Ian G. Heggie, a UK national, is Principal Infrastructure Economist and Task Manager for the Road Maintenance Initiative in the World Bank's Africa Technical Department. He was Special Adviser to the UK Transport Minister in 1979-80.

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The Road Maintenance Initiative are not subjected to rigorous market discipline. Management objectives are vague. Managers have few incentives to cut costs and are rarely penalized for poor performance. Funds allocated for maintenance are well below what is needed. In most countries, they are less than half of estimated requirements—and, in some, less than a third. There are two main reasons. First, road users pay very little for use of the road network. Second, funds are allocated as part of the annual budget process—maintenance is at a disadvantage here, since it can always be postponed. The people who know most about the costs of neglect are not government officials, but road users, who have to cope every day with the deteriorating condition of Africa's roads. By creating road-management boards to involve road users in the decision-making process, the RMI introduced an important commercial element that had been strikingly absent: the customers' point of view. It turned out that customers were keen that more should be spent on maintaining the road network. And this was not idle talk—they were prepared to pay more themselves. They had only one proviso: whatever form their extra payment took, it should be earmarked for maintenance. And users also wanted to be involved in choosing the means to this end, helping to decide how much to pay and overseeing how the road agencies and road funds spent their budgets. The theme that permeates every aspect of the RMI program is that of a more commercial approach—the language of customers, mar-

The RMI was launched by the United Nations Economic Commission for Africa (UNECA) and the World Bank in 1988, under the auspices of the Sub-Saharan Africa Transport Policy Program, in an effort to identify the underlying causes of poor road maintenance policies and develop an agenda for reforming them. The program is administered by the World Bank's Africa Technical Department and is financed by the Governments of Denmark, Finland, France, Germany, Japan, the Netherlands, Sweden, Switzerland, and the European Union. Finland, France, Japan, and Norway provide senior staff members to work on the program. Cameroon, Kenya, Madagascar, Tanzania, Uganda, Zambia, and Zimbabwe joined the RMI in 1990-91. Other countries that are also currently receiving assistance from the program include Benin, Ghana, Lesotho, Malawi, Mozambique, and Togo.

kets, tariffs, procurement practices, and value for money being applied to the maintenance and management of roads. Many of the benefits of the marketplace can be replicated within the RMI framework, even though the RMI is not a privatization initiative (it does not envisage transferring the ownership of roads from the state to private companies). Instead, what the RMI is promoting is a public-private partnership.

service basis, and manage them like any other business enterprise. However, since most roads will remain in government hands for some time to come, commercialization requires changes in four important areas: • involving road users in the management of roads; • securing enough money for road maintenance, year after year; • ensuring that all parties know what they are responsible for; and • establishing a system for managing road programs, with clear accountability. The four are interconnected. The financing problem cannot be solved without the strong support of road users. But this support cannot be won without steps to ensure that resources are used efficiently. And resources will not be used more efficiently until ways are found to control monopoly power and constrain road spending to what is affordable, and managerial accountability is increased. Furthermore, managers cannot be held accountable unless they have clearly defined responsibilities. These building blocks have far-reaching implications and could be applied to other sectors in Africa.

Economic, fiscal perspectives

Does the concept of commercialization make sense from an economy-wide viewpoint? Four building blocks It is impossible to dispute the economic case The RMI framework is comprehensive, so it for spending more on maintaining Africa's cannot be easily or quickly put in place. The roads. Road maintenance and rehabilitation key concept is commercialization: bring roads projects typically produce economic rates of into the marketplace, put them on a fee-for- return well over 35 percent. The harder question is how the money should be raised. As a general fiscal rule, earmarking of tax revenues is undesirable. It can lead to a seriFuel levies are closely related to variable ous misallocation of resources, with certain road maintenance costs1 types of spending being boosted merely because they have a supporting base of earmarked taxes while others languish because they have no convenient sponsor and are denied access to the earmarked revenues. To avoid the earmarking trap, road programs must be financed as much as possible by user fees rather than by taxes. This distinction is not purely semantic. User fees link what is available for spending to what is being demanded and can be calibrated so that individual customers pay only for what they consume. The cost of a road is not just the price of its initial construction. Maintaining it through a long life is just as important and needs to be Source: Ian G. Heggie, Management and Financing of Roads.1 an Agenda for Reform, World Bank Africa Technical Series, No. 275 (Washington, 1995). properly costed into any calculation. If users Note: Diesel fuel levy at $0.09/liter. 1 Based on data from a selection of developing countries that do not have any extremes of climate. pay according to how much of the road Finance & Development /December 1995

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The Sub-Saharan Africa Road Information Network (SSARIN) The RMI program found that sharing experience on best practices was one of the best ways of introducing new ideas and building consensus. Initially, RMI staff regularly visited participating countries and gave presentations on experience gained under the RMI program in other countries. This was supplemented by study tours, newsletters, and annual meetings between RMI staff, country coordinators (individuals in participating countries formally designated to head a local secretariat), and members of the donor community with an interest in roads. The sharing of experience turned out to be so successful that the countries participating in the RMI program decided to formalize it by setting up a simple, faxbased information exchange network. Each country wishing to join the network must have two things: a working fax connection and a designated country coordinator. SSARIN currently has more than ten members. I. Kimambo, the RMI country coordinator from Tanzania, is Secretary of the Network, which is managed by a small committee consisting of the Secretary and the country coordinators from Kenya and Uganda. SSARIN reports on progress every six months in the SubSaharan Africa Transport Policy Program newsletter published by the World Bank's Africa Technical Department and is planning to start a newsletter of its own. Since fax connections in Africa are problematic, the management committee is exploring the feasibility of connecting SSARIN to the Internet.

they "consume," the financing arrangements are qualitatively different from a conventional budgetary model in which governments raise general revenues and spend them on a chosen menu of programs. On a spectrum of financing options, with user fees at one end and taxes at the other, roads can fortunately be pushed far toward the user-fee end. License fees can be higher for heavy vehicles than for cars. Fuel levies are closely related to variable road maintenance costs (see chart). And tolls are even more precisely linked to use, though they are harder to administer. Revenues earned from these three financing mechanisms, which together would constitute a road tariff, could be funneled directly into a road fund for spending on maintenance as well as on new construction. This type of financing makes it possible to impose the valuable discipline of a hard budget constraint on road agencies. Road-management boards, which set the road tariffs, ensure that road agencies can spend only what road users are willing to pay and, hence, what road funds can supply. Agencies will thus be forced to be responsive to the needs of road users and will be unable to overspend. Both these notions are consistent with the broad principle of commercialization. But it is a principle that needs extending beyond the issue of macroeconomic probity, important though that is. Being commercial is usually associated with the most micro aspects of behavior, such as incentives given to individual staff members. Here, too, the RMI uncovered some serious weaknesses in the way road programs were being run. For example, it found that, in 1993, engineers in Zambia could earn eight times more in the private sector than in the public sector. Not surprisingly, the road agency had only 11 professional and technical staff members—and 85 vacancies. It is difficult for road agencies to correct these flaws, so long as they are seen as inflexible bureaucracies offering uncompetitive salaries. The problem of uncompetitive salaries is particularly troublesome in Anglophone Africa. The RMI also uncovered flaws in the way road funds were set up and financed. 32

Because the credibility of these funds depends on their being genuinely independent of day-to-day pressures on government finances, the RMI encourages African countries to set up special boards to manage road funds, with a majority of non-official members representing road users and the business community, an independent chairman, clear terms of reference, and independent outside audits. The goal is to avoid the fate of the Central African Republic's fund, which was raided by the Government in 1993 to pay the salaries of civil servants and other unrelated expenses. It is also possible for road funds to raise more money than should ideally be spent on roads. This is what happened in the 1980s in South Africa, whose road fund was receiving as much as one third of the pump price of fuel. The fund built up a big surplus. This led to concern that the roads department might go on a spending spree, which eventually led to the fund's being abolished in 1989. Most African countries are still far from suffering problems of excess revenues, but South Africa's example demonstrates the dangers of an inflexible system for raising revenues. To avoid this, all road funds set up under the RMI program have built-in mechanisms for regularly adjusting the road tariffs. A road fund managed by a representative roads board offers many other advantages. Road users, accustomed to market discipline in the private sector, expect clear lines of responsibility and sound business practices. They are concerned by two questions, in particular: who is being paid for what, and are

users getting value for money? At the heart of the RMI's agenda is the creation of a surrogate form of market discipline to ensure that roads are managed like a business, not a bureaucracy.

Sharing experience

One of the strengths of the RMI program is the way it helps countries learn from each other. Disseminating the lessons learned in different countries was originally done by word of mouth and through study tours, but the process has now been formalized into an information exchange network (Box 2). Donors, too, are deeply involved in supporting the RMI program, and often have experiences to share. The world's two biggest economies, the United States and Japan, have road funds financed by earmarked user fees. New Zealand also has a road fund and has gone further in commercializing its roads than any other country in the world. Finland, Japan, New Zealand, and the United Kingdom have road boards that participate in the management of roads. By pooling their knowledge, all countries involved in the RMI program can find cost-effective solutions more quickly than they could through conventional bilateral contacts. This is the justification for the World Bank's role in administering the RMI program. Although the Bank has long been associated with large investment projects, its future may now lie less in the construction of new roads than in providing technical assistance and facilitating sustainable maintenance policies. Under the RMI, the Bank is acting as an impresario, helping others to make things happen. That task may not make headlines, but it is important—and the RMI's approach seems to be working.

This article is based on a more extensive study by Ian G. Reggie, Management and Financing of Roads: An Agenda for Reform, World Bank Technical Paper No. 275, Africa Technical Series, Washington, DC, World Bank, 1995.

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How Government Ownership Impedes Growth And What to Do About It Bureaucrats in Business: The Economics and Politics of Government Ownership This landmark study provides the first detailed assessment of a decade of divestiture and reform of state-owned enterprises. It looks at how the sale of public enterprises and other reforms can improve the economy; why politics often impedes enterprise reform; and how countries that reformed have successfully overcome these obstacles. The report analyzes the experience in twelve countries: Chile, China, the Czech Republic, Egypt, Ghana, India, the Republic of Korea, Mexico, the Philippines, Poland, Senegal, and Turkey. It finds that state-owned enterprises are often inefficient and that the resulting losses to the economy hinder growth, making it harder for people to escape poverty. It offers guidance for more successful reform and suggests ways that foreign assistance could more effectively support reform efforts.

Published for the World Bank by Oxford University Press. 350 pages. ISBN 0-19-521106-5. $24.95

"Absolutely first-rate... I have never seen anybody before lay out as clearly and as concisely the nature of the political problems involved in making changes of that kind." Professor Douglas C. North, Nobel Laureate and Luce Professor of Law and Liberty, Washington University "An important study, one that deserves the widest possible circulation for the guidance it contains." Professor Raymond Vernon, Clarence Dillon Professor of International Affairs Emeritus, Harvard University

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Can Eastern Europe's Old-Age Crisis Be Fixed? L O U I S E FOX

N T H E r t a n s o i tn e c o n -


\ omies of Eastern and Central Europe, the high I tax rates required to finance existing pension systems are impeding efforts to promote economic growth and improve resource allocation. This article examines the difficult choices involved and suggests ways in which a better balance between income security and long-term fiscal sustainability might be achieved.

The transition from central planning to a market orientation in the former centrally planned economies of Eastern and Central Europe (ECE) has not been easy. Since the Berlin Wall fell, these countries have faced declining incomes, inflation, and unemployment. One of the biggest obstacles to restoring stable growth and increasing saving and investment has been persistent fiscal deficits, caused in part by rapidly growing expenditures on pension benefits. Eastern and Central Europeans spend much more on pensions than their incomes or demographics would predict (see chart). These expenditures have been rising rapidly since the transition began, with an increasing share of these countries' falling GDPs being captured by pensioners. In many countries, pension expenditures are the largest single item in the government budget, accounting for about 15 percent of GDP in Poland and Slovenia, and 10 percent in Bulgaria,

Hungary, Latvia, and the Slovak Republic. Unlike in Organization for Economic Cooperation and Development (OECD) countries and middle-income developing countries—where funded, privately managed programs cover a growing share of the work force—ECE countries have only public, pay-as-you-go (PAYG) pension systems financed entirely by payroll taxes from their working populations (see Estelle James, "Averting the Old-Age Crisis," Finance & Development, June 1995; two related articles on pension reform that appear in the same issue; and Kathie Krumm and others, "Transfers and the Transition from Central Planning," Finance & Development, September 1995). Under central planning, the state was able to finance these expenditures through high tax rates. In market economies, however, these high tax rates are dysfunctional and increasingly inequitable. How did this crisis come about?

Louise Fox, a US national, is a Senior Economist in the Municipal and Social Service Division, Country Department IV of the World Bank's Europe & Central Asia Regional Office.


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Pension spending in selected transition, OECD, and middle-income economies

funded pension systems, in order to take the pressure off the PAYG pension systems in the medium term.

Early mistakes

Percentage of population over 60

Sources: Louise Fox, "Old Age Security in Transition Economies," World Bank, Policy Research Department Working Paper No. 1257, February 1994; World Bank, Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth, Oxford University Press, New York, 1994. 1 1991.

Under central planning, the command economy promised cradle-to-grave income security, including pensions replacing roughly 80 percent of wages upon retirement. This has been viewed as compensation for relatively modest wages during the working years. Retirement ages were set very low, with lots of exemptions and special privileges. As a result, the average effective retirement age in the ECE countries is currently about 57 for men and 53 for women, compared with 65 and 67 for most OECD countries. Despite recent declines in health indicators, the average postretirement life span in most Eastern and Central European countries is still longer than in most OECD countries. In other words, these countries, with much lower incomes and taxcollection capabilities, have promised pension benefits whose accumulated value after the

retirement period is higher than some of the richest countries in the world (many of which are now finding their own generous welfare systems unaffordable). Aging societies in both OECD and ECE countries imply that the fiscal burden will only become heavier in the future. Fixing this problem involves, first and foremost, a strong effort to convince the population of the need for reform. This effort must be combined with plans for a new, economically viable system that is affordable, equitable, and promotes growth. Key elements of this plan will have to include reforms of the public pension system, such as increasing the retirement age (either through incentives or legal limits, or both), removing the inequitable and costly special regimes for favored occupations and other groups, tightening up disability regulations, and developing privately managed,

The policy measures many ECE countries took to cope with the social costs of transition have significantly worsened the financial positions of their public pension systems. In hopes of reducing unemployment, some countries allowed workers to retire up to five years earlier than usual and still receive a full pension. This well-intentioned move swelled the ranks of pensioners while reducing the ranks of taxpayers. Since pension benefits are reduced if the pensioner continues to work, most quit the formal sector to work in the informal sector. Today, an estimated 50-70 percent of pensioners continue to work during the first decade of their "retirement," but most of their income is outside of the tax net. Although the average pension in ECE countries is only about $15-25 per month, recent results derived from survey research show that most pensioners are not poor and have not suffered disproportionately during the transition. It is working families with children who tend to be poor. To pay for social insurance benefits, countries raised payroll taxes from 10-25 percent of employees' gross wages to 40-60 percent. This substantial differential between the cost of labor to firms and employees' take-home pay has lowered real wages and probably exacerbated unemployment. Many working-age people have fled these tax rates by moving out of the formal sector entirely (with up to a third of them employed in the informal sector in some countries), leaving the burden of paying for pension benefits to those who cannot evade taxes.

Shock therapy? In its study, Averting the Old Age Crisis, the World Bank argued that the best way for most countries to meet their populations' needs for income security is by setting up a multipillar pension system that includes the following elements: • pillar 1: a mandatory PAYG public pension system designed to provide an income floor for all elderly persons; • pillar 2: a mandatory privately managed, funded pension system—that is, one whose current reserves are equal to or greater than the present value of all future pension payment liabilities, based on personal accounts (the Latin American approach) or occupational plans (the OECD approach); and • pillar 3: a voluntary system (also funded and privately managed), with strong government regulation, to provide for additional saving and insurance. Finance & Development / December 1995

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Missed opportunities for pension reform Although Estonia, Hungary, Lithuania, and Poland all began their transitions with similar, Soviet-style systems, they have taken different paths to pension reform over the past five years. Nevertheless, the medium-term prospects of all of them are compromised by large implicit pension debts. Missing the boat in Central Europe. Both Hungary and Poland started their transitions with favorable initial conditions for pension reform. Possibly as a result of these more favorable conditions, the seriousness of the problem was not grasped and hard decisions on pension reform were not taken. On the contrary, the policy choices made have exacerbated their problems. Poland began the transition with a system that provided for higher retirement ages than those of all other ECE countries—60 for women and 65 for men—which should have been an advantage during the transition period. However, throughout the stabilization period (1990-92), the retirement age was lowered as an "employment-generating" measure. During this period, the number of pensioners grew by more than 10 percent per year. Poland already had a lax disability policy—in 1989, there were almost as many disability pensioners as oldage pensioners. At the same time that Poland's ratio of pensioners to contributors (dependency ratio) was increasing, pensions were indexed to wages, starting when real wages were at their lowest point since the transition began. Today, Poland spends a higher percentage of GDP on pensions than almost any other transition economy—approximately 16 percent in 1995, which is roughly 50 percent higher than the corresponding share of GDP of an OECD country with comparable demographics. Six years into the transition, Hungary has a large fiscal deficit and a large pension debt. Unlike some other countries, Hungary has not raised the retirement age. Legislation to equalize the minimum retirement age for women and men (at 60) was passed in 1992 but rescinded later the

Applying this multipillar approach is more complicated in ECE countries than in the recently reformed and currently reforming Latin American countries or in countries elsewhere that are in the early stages of developing formal social security systems, owing to the ECE countries' large existing pension debts. Adding a funded pillar implies capitalizing some of the future pension debt while continuing to service the current pension liabilities. This is similar to making payments for two home mortgages at the same time—one on your own house and one on your parents'


same year. Early retirement has been on the increase since 1989, and the growth rate of disability pensions has doubled since the transition. Given that Hungary has the highest payroll taxes of all the ECE countries, payroll tax evasion is growing. Today, each Hungarian contributor supports two thirds of a pensioner. If the retirement age in Hungary were similar to that of the OECD average, pension expenditures would be about 20 percent lower. Incomplete reforms in the Baltics. Estonia and Lithuania have avoided the early mistakes made by their southern neighbors. Faced with demographics and labor-market dilemmas similar to those of Hungary, Poland, and the Balkan countries, these two Baltic countries did not permit pension expenditures to get out of

hand during the initial transition period. Both countries introduced flat-rate pensions and discretionary nominal pension adjustments as stabilization measures. Early retirement was not used to facilitate the shedding of workers in the state sector. Reformed public pension systems were introduced in 1993 (Estonia) and 1994 (Lithuania). Nevertheless, despite their success in controlling current expenditures, both countries face the same

house. If your parents' house is small and your income is rising (which is analogous, for example, to the situation in Chile during the past decade), the payments are manageable. If, however, your parents' house is large and your income is low and/or shrinking, the burden on the working generations will be high. In the ECE countries, the pension debt is large—about 1.5 times GDP. The large debt is caused mostly by the large number of current pensioners, for whom pensions must still be paid for long periods out of current revenues, but also by the number of labor force participants near the current, low retirement age.

dilemma—how to cope with looming fiscal problems owing to incomplete reforms, on the one hand, and increasing voter discontent with the public system, on the other. Although these two countries have taken the politically painful step of cutting PAYG entitlements, their failure to capitalize on these cuts by introducing a funded scheme or addressing the remaining problems in the system may have undercut efforts to boost economicgrowth. Lithuania still spends a smaller share of GDP on pensions than any of its neighbors. But the recent reform of its public system included creation of an earnings-related benefit, which is indexed to the average wage in the economy, implying that the pension burden grows as real wages grow. The system also allows credits for noncontributory periods (such as time spent at home taking care of children). Retirement ages were also raised rather slowly—by two months per year for men and four months per year for women. The law originally provided for increasing the retirement age—from 55 for women and 60 for men—to 65 for both sexes, but subsequent legislation halted this in 2009 at 60 for women and 62.5 for men. Estonia's reform of its public pillar raises retirement ages faster—by six months per year for men and women—from their former levels of 55 for women and 60 for men, to maximums of 60 for women and 65 for men. But, in addition to Lithuanian-style credits for noncontributory periods, the Estonian system continues most of the entitlements to early pensions that prevailed before the transition, which entails an additional costly intragenerational redistribution. The disability pension system is also weak—the number of disability pensioners has jumped by 30 percent since 1990. With Estonia's payroll taxes already at 38 percent of gross payroll, the scope for increasing taxes in order to finance the looming liabilities is very limited.

Unlike a mortgage, however, the pension debt of ECE countries increases every year, despite the payments made to pensioners during the previous year. This is because demographic trends cause pension benefits to grow faster than GDP at current retirement ages. Putting in place an additional funded pillar in a manner affordable to generations of current workers requires renegotiating the informal agreement between generations embodied in the current pension system—in effect, forcing the parents to pay part of the mortgage on their house by accepting lower pensions and/or longer periods of employment before

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retirement. This has proved to be difficult to achieve, however, since older workers know they will not benefit directly from the development of additional funded pillars. Simulations prepared for ECE countries show substantial gains in the future accruing from a "shock-therapy" approach to pension reform. The main shock required is a one-shot, three-to-five-year increase in the effective retirement age—to be achieved by taking the measures recommended above. Payroll taxes could then be cut by at least one third. Part of the reduction in contributions made possible by implementing these reforms could be used to start a funded pillar, which would build up savings in order to finance the retirement of the generations currently working. In return for accepting the increased retirement age, older workers could also be offered an actuarially fair structure in the PAYG system—which rewards delayed retirement—and a partial wage indexation, which would allow workers over 50 to share in the benefits of the economic growth their sacrifices have helped to create.

Modest reforms to date Unfortunately for most ECE countries, there is not yet a consensus in favor of this type of shock therapy. Indeed, most pensioners feel they have already endured enough shocks. Raising the retirement age has been fiercely resisted by the generation that suffered the most under central planning and political repression. Even among today's workers, few understand the full costs of the current system in savings and economic growth terms. Nor do many of them understand that the only way they can avoid the trap that their parents' generation fell into—in which inadequate old-age security for all was created by paying too little, too early, to too many people—is to reform the system now. Reducing entitlements—a necessary condition for restoring a sustainable fiscal balance, as well as restoring incentives for efficient resource allocation—is no more popular in transition economies than anywhere else. Finally, recent banking system crises have made some countries hesitant about the ability of capital markets to effectively intermediate funds. The strategy in most ECE countries seems to be to muddle through, hoping that a resumption of economic growth—including real wage growth—combined with the gradual increases in the retirement age that countries have enacted or are about to enact (to about 60 for women and 65 for men by about 2020) and a policy of holding the value of pensions constant in real terms will resolve the problem. Economic projections do not support this expectation. ECE demographic trends point to aging populations in these countries,

and as their baby-boom generations reach retirement age, existing pension systems will simply not be able to support the entitlements, even in countries that have already implemented partial reforms (see box). In addition, the distortions and heavy fiscal burdens embodied in the current systems impede saving and growth, implying that pension reform is a precondition for economic growth and not the reverse. The experience of Hungary and Poland also suggests that the longer reforms are delayed, the harder the problems of pension debt are to solve.

The path to successful reform Many ECE countries view West European countries as models on which to base their plans for transition to multipillar pension systems. The latter countries' experience may offer ECE countries only limited guidance today, however, because, in Western Europe, the funded pillars were put in place when public pension systems were young, economies were growing rapidly, and much lower benefits were promised (for example, in the Netherlands, Sweden, Switzerland, and the United Kingdom). Thus far, none of the OECD countries has needed to carry out a shock program (although some countries may come to this if they do not implement reforms soon). What ECE countries can learn from OECD countries is how to build the consensus needed, in a democratic society, for reform of social policy. The experience of Latin American countries that have reformed their pension systems, such as Argentina and Peru, can also offer lessons for ECE reformers, since it demonstrates that radical reform is possible in a democracy. As in other key areas of ECE countries' transitions, progress on pension reform is unlikely to be made unless the authorities are willing to take bold and innovative steps. (The experience of voucher privatization—a whole new approach developed in ECE countries—is instructive here.) The proposed new Latvian system is one such model. The principal elements of this proposed system are as follows: • Improved incentives and a lighter fiscal burden. The existing pension debt (and thus the fiscal burden) will be reduced by tying benefits in the public PAYG system completely to contributions through adopting a "notional defined-contribution" approach. This involves reducing promised benefits to those who retire before 65 to much less than the target of a 50-60 percent replacement rate—that is, the percentage of workers' average wages that are replaced by their pensions—and increasing substantially the benefits for those who work longer and continue to contribute. Favorable

treatment for special groups is also to be abolished, although those who have already begun to receive their pensions will not have them taken away; and • Increased savings resulting from introduction of a funded pillar. By 2000 or so, the savings from the reform of the first pillar will allow roughly one quarter of expected contributions to be channeled to the second, funded pillar. These contributions will be held in reserve or invested by private managers. Croatia is also developing a reform program involving a major reduction in benefits for future retirees and a proposed mandatory second pillar. In one version currently under discussion, the second tier would be financed initially by privatization proceeds, which would allow it to have a wide coverage at an early stage. Using privatization of government assets to pay off pension obligations is an often-discussed idea in transition economies. However, it has not been used effectively to date, since it inevitably involves concentrating illiquid assets whose value is uncertain in the hands of the age group most in need of liquidity and income security. In Estonia, where privatization vouchers were given to workers on the basis of their years of service, pensioners' dissatisfaction with the weak voucher market has created pressure to allow them to swap vouchers for an annuity—a potentially costly transfer to this age group, given that vouchers are currently trading at less than 20 percent of their face value. One important lesson drawn from other countries is that a successful pension reform strategy in an open political system must offer something to most of the key stakeholders. Systemic reform, including the creation of a multipillar system, does this by offering the working generations more generous future pensions in return for increased savings. Systemic reform could also benefit older generations by offering them more secure pensions in the future. But the starting point for change has to be a recognition that the promises made by the centrally planned system cannot be honored and that attempting to do this will ensure a slower and more painful transition to a robust market economy.

This article is based on the author's study, "Old Age Security in Transition Economies," World Bank, Policy Research Department Working Paper No. 7257, February 1994. Suggestions for further reading: World Bank, Averting the Old Age Crisis: Policies to Protect the Old and Promote Growth, Oxford University Press, New York, 1994.

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Quantifying the Outcome of the Uruguay Round G L E N N H A R R I S O N , T H O M A S R U T H E R F O R D , A N D DAVID TARR

What developing countries can do to improve their relative position is to limit selfinflicted costs by reducing their trade barriers and other distortions further. The postUruguay Round world presents a more open global trading environment. Unilateral tariff reduction or the reduction in other distortions in developing countries will lead to a change in developing countries' production and exports based on comparative advantage, and the export expansion that follows is less likely to be impeded by global protectionism. Moreover, in the long run, higher income levels are expected to result in gains for almost all countries that lose in the short run. This suggests that all countries at least have the potential to gain from the Uruguay Round.

How large are the global welfare benefits to be derived from the Uruguay Round agreement? What are the quantitatively most important aspects of the Round? How are developing countries affected by the Round? Are there countries or regions that will lose from the Round and, if so, why? Subject to a statistical margin of error, our study (see box) found that the world as a whole will gain substantially from the reforms agreed under the Uruguay Round: about $96 billion annually in the short run and $171 billion in the long run. However, the short-run gains are concentrated in developed countries, especially in Japan, the European Union (EU), and the United States.

This outcome reflects the fact that the industrial countries, especially the United States and the EU, "gave up" the most in the Uruguay Round. In other words, these countries are modifying policies that are very costly, in terms of forgone welfare, to themselves, most notably distortionary agricultural policies and the import quota protection in textiles and apparel afforded through the Multifiber Arrangement (MFA), which is to be dismantled. In contrast, under the Uruguay Round agreement, the developing countries reduce agricultural distortions relatively less (although the reduction of production subsidies is important in some cases) and do not restrict imports under the MFA. The only general exception is that developing countries reduce protection in manufactures by more than Organization for Economic Cooperation and Development (OECD) countries, since the latter now have relatively lower protection, on average, in this area. In fact, some developing countries will be net losers from the Uruguay Round in the short run. These short-run losses derive primarily from two effects. First, the reduction of agricultural subsidies in the member countries of the EU and the European Free Trade Association (EFTA), and the United States results in terms of trade losses for some countries. Second, MFA liberalization induces losses for some developing countries because the elimination of the MFA quotas will reduce the prices received by all exporters to OECD countries (this is known as capturing the quota rents), and less efficient developing country clothing exporters will lose market share.

Glenn Harrison, an Australian national, is Professor of Economics at the University of South Carolina.

Thomas Rutherford, a US national, is Assistant Professor of Economics at the University of Colorado.

David Tarr, a US national, is Principal Economist in the International Trade Division of the World Bank's International Economics Department.

SING a large-scale empirical model, the authors quantify the I welfare benefits of the Uruguay Round. Their results suggest that because industrial countries liberalized the most, they stand to gain the most from the agreement in the short run. However, in the long run, the gains to all countries would be much larger, and virtually all regions are expected to gain.



Results of the study The Uruguay Round is a complex agreement that includes:

The model Given the complexity of the Uruguay Round agreement, the study by the authors used a 24region, 22-commodity model of world trade to quantify the impact of the Uruguay Round. This model is considerably more disaggregated than other models and presents results for many more regions and countries. For a thorough discussion of the data and the methodology used in the study, see the authors' discussion paper (cited below under "Suggestions for further reading").

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Table 1 Welfare effects of the Uruguay Round Agricultural reform

MFA reform

Manufacturing sector reform

Complete Uruguay Round

Complete reform as a percentage of GDP

Short-term effect

Long-term effect

Short-term effect

Long-term effect

Short-term effect

Long-term effect

Short-term effect

Long-term effect

Short-term effect

Long-term effect

Australia New Zealand Canada United States Japan

0.7 0.3 0.3 1.8 15.1

0.9 0.5 0.2 3.2 16.8

0.0 0.0 0.9 10.0 -0.6

0.1 0.0 1.0 9.2 -0.5

0.5 0.1 0.1 1.2 2.2

2.3 0.9 1.3 13.7 6.2

1.2 0.4 1.3 13.3 16.9

3.3 1.4 2.6 26.7 22.7

0.4 1.0 0.2 0.2 0.5

1.1 3.6 0.5 0.5 0.6

Korea European Union 2 Indonesia Malaysia Philippines

4.6 28.3 0.2 1.2 0.7

5.2 26.4 0.3 2.2 1.1

-0.5 7.6 0.6 0.1 0.0

-0.4 7.8 0.9 0.3 0.2

0.7 3.0 0.6 0.7 0.4

2.7 14.9 1.4 2.6 1.1

4.8 39.3 1.3 1.8 0.9

0.5 0.9 2.6 5.0 2.4

1.5 0.6 1.1 3.3 1.6

2.5 0.7 2.1 8.8 4.4

Singapore Thailand China Hong Kong Taiwan Province of China

0.6 0.8 -0.5 0.6 0.0

0.5 1.4 -0.8 0.6 0.0

-0.2 0.1 1.0 -1.7 -0.4

-0.2 0.8 1.7 -1.5 -0.3

0.5 1.8 0.9 -0.1 0.8

0.4 10.3 1.2 -0.2 1.3

0.9 2.5 1.3 -1.2 0.4

0.7 12.6 2.0 -1.1 1.1

2.1 2.1 0.3 -1.4 0.2

1.7 10.9 0.5 -1.1 0.5

Argentina Brazil Mexico Latin America Sub-Saharan Africa

0.4 0.3 -0.0 1.5 -0.2

0.7 0.1 0.7 2.0 -0.5

0.0 -0.0 -0.1 -0.5 -0.0

0.1 0.1 0.2 0.3 -0.1

0.3 1.2 0.3 0.3 0.1

1.6 4.0 1.4 3.2 0.2

0.7 1.4 0.2 1.3 -0.3

2.3 4.3 2.3 4.7 -0.7

0.3 0.3 0.0 0.4 -0.2

1.0 1.1 0.7 1.7 -0.4

Middle East and North Africa Eastern Europe 3 South Asia Other European countries

-0.3 -0.1 0.3 2.2

0.1 -0.0 0.2 1.6

-0.4 -0.5 0.9 -0.2

0.2 -0.3 1.9 -0.8

0.8 0.8 3.1 1.7

1.9 2.3 5.3 7.0

-0.3 -0.2 3.7 4.2

1.5 1.2 6.7 8.8

-0.1 -0.1 1.0 0.3

0.3 0.1 2.0 0.7

Developing countries (total) 9.9 Industrial countries (total) 48.7

13.9 49.8

-1.5 17.9

3.4 16.9

12.9 8.7

40.5 46.3

19.4 76.7

55.2 115.4

0.4 0.4

1.2 0.6












Source: Authors' calculations. Note: The first three headings represent the effect of each reform by itself. The fourth heading (Complete Uruguay Round) reports the welfare effects of all of the reforms combined. 1 1992 dollars. 2 Membership in 1994. 3 Also includes the Baltic countries, Russia, and the other countries of the former Soviet Union.

• tariff reductions in manufactured products; • tariffication of nontariff barriers in agriculture and binding commitments to reduce the level of agricultural protection; • the reduction of export and production subsidies in agriculture; • the elimination of Voluntary Export Restraints (VERs) in textiles and apparel and the elimination of the MFA; • institutional and rule changes, such as the creation of the World Trade Organization (WTO) and safeguards, as well as antidumping and countervailing duty measures; • new areas such as Trade-Related Investment Measures (TRIMs), Trade-Related Aspects of Intellectual Property Rights (TRIPs), and the General Agreement on Trade in Services (GATS); and • areas receiving greater coverage, such as government procurement.

Our study evaluated the changes in the first four of these areas. To the extent that there are additional benefits (or, possibly, costs) from Uruguay Round changes in the other areas, our findings may underestimate (or overestimate) the gains from the Uruguay Round. Our results suggest that the world as a whole stands to gain about $96 billion annually, and that the gains in dollar terms are concentrated in the developed countries, especially in the EU, Japan, and the United States, which gain $39 billion, $17 billion, and $13 billion annually, respectively, from the change (see Table 1). Nevertheless, some smaller countries also gain significantly: Malaysia gains 3.3 percent of GDP, Singapore and Thailand about 2.1 percent of GDP each, and the Republic of Korea and the Philippines about 1.6 percent of GDP each. Since our model is the most geographically disaggregated one available, we produce

results for a number of countries and regions not otherwise available. On the one hand, although developing countries as a whole gain from the Round, a few developing regions are estimated to lose, on balance, in the short run. Countries in sub-Saharan Africa would lose about 0.2 percent of GDP annually, while for countries in the Middle East and North Africa, the effect would be slightly negative (a loss of 0.1 percent of GDP). On the other hand, the study by Frangois and others finds that the combined Africa and Middle East region will gain from the Uruguay Round, owing largely to beneficial terms of trade effects resulting from the Round's reduction of manufacturing protection. While developing countries gain less overall than industrial countries, the opposite would be true if we considered only the reduction of protection in manufacturing, since industrial countries have relatively lower protection, on average, in this area. Compared Finance & Development /December 1995

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Table 2 Decomposing the welfare effects of agriculture reform

All distortions1

Export subsidies

Production subsidies

Import distortions

Australia New Zealand Canada United States Japan

0.7 0.3 0.2 1.7 15.2

0.1 0.1 0.0 -0.0 -2.2

0.1 0.1 0.3 1.5 -0.5

0.4 0.1 -0.1 -0.1 17.7

Korea European Union 2 Indonesia Malaysia Philippines

4.6 28.5 0.2 1.2 0.6

-0.2 11.5 -0.0 -0.0 -0.1

-0.0 17.8 0.1 0.1 0.0

4.7 -1.2 0.1 1.2 0.9

Singapore Thailand China Hong Kong Taiwan Province of China

0.6 0.7 -0.6 0.6 0.0

-0.0 -0.0 -0.2 0.1 -0.0

-0.0 0.2 -0.1 0.0 -0.0

0.6 0.6 -0.3 0.2 0.1

Argentina Brazil Mexico Latin America Sub-Saharan Africa

0.4 0.3 -0.0 1.4 -0.3

0.1 -0.0 -0.0 -0.0 -0.4

0.2 0.2 -0.0 1.4 -0.1

0.1 0.1 0.1 0.1 0.3

Middle East and North Africa Eastern Europe3 South Asia Other European countries

-0.4 -0.2 0.1 2.4

-0.8 -0.6 -0.0 -0.6

0.2 0.3 0.1 2.1

0.1 0.0 0.0 0.5

Developing countries (total) Industrial countries (total)

9.2 49.1

-2.3 9.0

2.4 21.5

8.8 17.3






Source: Authors' calculations. 1 Import distortions and export and production subsidies on agricultural goods. Membership in 1994. 3 Also includes the Baltic countries, Russia, and the other countries of the former Soviet Union. 2

with the industrial countries, the developing countries reduce agricultural distortions relatively less under the agreements (although the reductions in their production subsidies are important in some cases), and developing countries do not restrict imports under the MFA. MFA reform. In fact, countries such as the members of the EU and the United States that used import quotas under the MFA to protect their home-market producers are expected to gain from the removal of the MFA, while developing countries in the aggregate are estimated to lose. The reasons for this pattern are as follows. Countries that remove import quotas can obtain more imports, which will drive down import prices for their consumers (thus capturing quota rents). In addition, they will experience efficiency gains as they shift their productive resources into sectors where they have a comparative advantage. Net importing countries that do not constrain imports under the MFA, such as Japan, will lose from MFA removal owing to a terms of trade loss. Net exporting nations shift their 40

sales to the previously constrained markets, such as those in the EU and the United States, and this diversion of sales drives up prices in markets such as Japan. Among developing countries that are net exporters, the results vary. The most efficient suppliers also typically gain, but their gains vary substantially. These exporters suffer a terms of trade loss in the previously quotaconstrained markets but gain on the terms of trade in previously unconstrained markets such as Japan, and they also experience an efficiency gain from shifting more productive resources into textiles and apparel where they possess a comparative advantage. Most of the marginally inefficient suppliers among developing countries lose, because they lose quota rents and, in the long run, lose market share to more efficient suppliers in developing countries. Without a change in their competitiveness, that loss of welfare and market share will be larger in the long run. Agricultural reform. A distinguishing feature of our study is that we decomposed

the overall agricultural reform scenario into its three major components (see Table 2): export subsidies, production subsidies, and import protection. Reducing agricultural export subsidies would result in welfare gains for the EU of $11.5 billion. The principal food exporting nations—Argentina, Australia, Canada, and New Zealand—gain slightly, whereas most other countries lose. This component of agricultural reform was the one feared by the "net food importing" countries, which expected to suffer a terms of trade loss. Regarding production subsidies, almost all of the economies included in the study have at least some agricultural production subsidies. In some cases, such as grains in the Middle East and paddy rice in Korea, the subsidy is extremely high, although it is often paid on a low volume of output. Thus, the reduction of this production distortion produces benefits for most countries, although several net food importers of wheat and nonrice grains suffer losses (Japan, Korea, Mexico, Singapore, subSaharan Africa, and Taiwan Province of China). The EU again enjoys substantial welfare benefits, with other European countries and the United States enjoying the next largest, although considerably smaller, gains. As for reducing import protection in agricultural products, the two dominant gainers are Japan and Korea, which is not surprising given their extremely high level of agricultural protection. The other regions with relatively high agricultural protection also gain. The EU loses in this scenario because we assume that its export and production subsidies in agriculture are maintained. Hence, the additional exports the EU countries would obtain from the reduction of import protection in the rest of the world aggravate their already costly export position. Combining all effects, the EU gains over $28 billion owing to the reduction of subsidies. Japan gains from the reduction of its high import protection. Although China and some other developing regions lose small amounts, there are few overall losers, which is surprising given the concern about losses of the net food importing countries. This is explained by the fact that most regions have something to gain by reducing their own production subsidies and most also export some food, even if they are net food importers overall. Clearly, countries need to reduce agricultural production subsidies if they wish to avoid losses from this component of the Uruguay Round. Dynamic effects. While the dynamic benefits of trade liberalization and the Uruguay Round are often described, they are rarely estimated. Our study estimated these effects, assuming a sufficiently long adjust-

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ment period so that the capital stock in each country could readjust to its optimal "steadystate" level after the initial changes induced by the Uruguay Round. The resulting calculation may overestimate the potential welfare gains in a long-run neoclassical growth model, because forgone consumption to achieve the higher capital stock is not taken into account; the model may underestimate the long-run gains, however, since it fails to capture endogenous growth effects such as those arising from induced improvements in productivity or innovation. The results from our long-run, steady-state model appear in Table 1. The obvious difference with respect to the short-run model is that the global welfare gains from the Uruguay Round rise from $96 billion to $171 billion, nearly half a percentage point of world GDP. Using this approach, the gains for developing countries are striking—they rise from 0.4 percent to 1.2 percent of total developing countries' GDP. In addition, the Middle East and North Africa, as well as Eastern Europe and the Baltic countries, Russia, and the other countries of the former Soviet Union are now estimated to gain.

Comparisons with other models In addition to our model, there are two other general models that employ the actual changes agreed in the Uruguay Round by the Contracting Parties to the General Agreement on Tariffs and Trade (GATT): the GATT/WTO team of Frangois, McDonald, and Nordstrom; and Hertel, Martin, Yanagishima, and Dimaranan (see references), who used the GTAP (Global Trade Analysis Project) model. Estimates of the gains from the Uruguay Round from all three of our models were presented at a conference organized by the World Bank and entitled "The Uruguay Round and the Developing Economies" (held January 18-20, 1995, in Washington). Where significant differences in the estimates exist, they may be intuitively explained. Indeed, subject to a statistical margin of error, what is remarkable is our ability to interpret the reasons for the differences and their broad consistency in terms of the overall benefits and the relative importance of various components. In one of their earlier models, the GATT Secretariat estimated that the gains from the Uruguay Round would equal about $510 billion annually. This relatively high estimate was obtained by projecting the world economy forward to the year 2005 (when all the Uruguay Round changes would be implemented). Given a much larger world economy in 2005, the same percentage cuts in tariffs and export subsidies, and the same percentage gains expressed as percentages of GDP

yield larger absolute dollar gains. That is, even though the gains from the Uruguay Round estimated in the GATT study are quite comparable to the long-run estimates from our study in percentage terms, the dollar value of the former is much higher owing to the size of the economy on which the tariff and export subsidy cuts are applied. In their later World Bank conference paper, the GATT/WTO authors estimate the impact of the Uruguay Round changes based on the economy of 1992, as we do; they then obtain estimated gains of $193 billion in their steadystate, increasing-returns-to-scale model, rather than $510 billion. There is nothing inherently correct about using either 2005 or 1992 as the base year of the model, but when the estimates are in terms of dollars rather than percentages of GDP, it is important to keep the year of the estimate in mind. There have been earlier studies of the impact of the Uruguay Round, including that of Goldin, Knudsen, and van der Mensbrugghe using the RUNS model. In general, earlier estimates were based on assumed formula cuts in tariffs and subsidies. These cuts were overly optimistic, especially with respect to developing countries. Consequently, those authors who have updated their welfare estimates have revised them downward as it became apparent that the Round would achieve somewhat less than expected. The estimate by the GATT/WTO team of $193 billion is comparable to our estimate of $171 billion, since both estimates were obtained using models that evaluated the Uruguay Round in a long-run steady state with increasing returns to scale. In the static or short-run version of their increasingreturns-to-scale model, these authors obtain $99 billion per year of estimated gains, compared with our estimate of $96 billion. That is, taking into account dynamic or steady-state effects roughly doubles the estimated gains from the Uruguay Round in both of our models. Model variants with lower elasticities produce lower estimated gains in both models; but, given that the Uruguay Round will be implemented over ten years, we do not report estimates from low-elasticity versions. Hertel and others have estimated the global gains from the Uruguay Round at about $258 billion. Since they do not incorporate dynamic, steady-state, or increasing-returnsto-scale effects, the appropriate comparison with their model is our static constantreturns-to-scale model. But their estimates are based on the world in the year 2005, and the projection of the world forward from 1992 roughly doubles the dollar estimates. Even after adjusting for the forward projection the estimates of Hertel and others

remain somewhat larger than ours. This is due to two factors: they project that the MFA quotas will grow at a somewhat slower rate than the world economy, so the gains from removing the MFA are slightly larger than those calculated using our model; and they employ slightly larger (but plausible) elasticities. The remaining differences between our estimates and those of the GATT/WTO and GTAP teams are not significant. The broad themes emphasized elsewhere in this article are quite similar across the models. In particular, all the models indicate that those countries that liberalized the most gained the most. The gains may be expected to be larger in the long run when the capital stock can adjust, and the responsiveness of firms and consumers to price changes (as indicated by elasticities) will be greater.

Implications Our evaluation of the quantitative effects of the Uruguay Round suggests that although there may be some losers in the short run, in the long run almost all countries will gain, and unilateral liberalization (both of tariffs and of production distortions) can be implemented to ensure that all regions can gain. In fact, our additional estimates for sub-Saharan Africa confirm that it will gain substantially if it allows its exporters to capitalize on the improved export opportunities presented by the post-Uruguay Round environment. ••

Suggestions for further reading: Will Martin and L. Alan Winters (editors), The Uruguay Round and the Developing Economies, World Bank Discussion Paper No. 307, Washington, World Bank, 1995; Joseph F. Francois, Bradley McDonald, andHdkan Nordstrom (WTO team), "Assessing The Uruguay Round," in Martin and Winters; General Agreement on Tariffs and Trade (GATT), "The Results of the Uruguay Round of Multilateral Negotiations," Geneva, GATT Secretariat, November 1994; Ian Goldin, Odin Knudsen, and Dominique van der Mensbrugghe, Trade Liberalization: Global Economic Implications, Paris, OECD, and Washington, World Bank; Glenn Harrison, Thomas Rutherford, and David Tarr (World Bank team), "Quantifying the Uruguay Round," in Martin and Winters; Thomas W. Hertel, Will Martin, Koji Yanagishima, and Betina Dimaranan (GTAP team), "Liberalizing Manufactures Trade in a Changing World Economy," in Martin and Winters; Merlinda Ingco, "Agricultural Liberalization in the Uruguay Round: One Step Forward, One Step Back?" Washington, World Bank, 1994.

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I LTHOUGHmany coun\ tries have become convinced that they need to invest more in human capital, efforts to improve their educational systems have frequently been disappointing. In this article, the authors suggest specific steps that governments could take, in cooperation with the private sector, to achieve a more efficient, equitable, and sustainable allocation of investment in education.


Nicholas Burnett, a UK national, is Principal Economist in the Education Group of the World Bank's Human Development Department. 42

In recent years, a global consensus has emerged on the importance of investing in human capital, which is viewed as an essential part of efforts to raise incomes and achieve sustained economic growth. The pace of changing technology, economic reforms, and the rapid increase in knowledge have brought about more frequent job changes in individuals' lives. This has created two key priorities for education: it must meet economies' growing demands for adaptable workers who can readily acquire new skills, and it must support the continued expansion of knowledge. Education is a sound economic investment. For individuals and families, education increases income, improves health, and reduces fertility rates. For society, investing in education raises per capita GNP, reduces poverty, and supports the expansion of knowledge. For example, in 1960, only 7 percent of Guatemala's children attended secondary school. Had that share been 50 percent, Guatemala's per capita income today would have been almost 40 percent higher than the actual outcome. Numerous studies have shown that the mone-

tary returns on investment in education are well above the 10 percent yardstick that is commonly used to indicate the opportunity cost of capital. The returns on investments in primary education are the highest (see chart). Investing in education complements investment in physical capital, and the benefits derived from both are highest where macroeconomic policy is sound. Investing in education sets off an intergenerational process of poverty reduction, because better-educated persons are more likely to ensure the education of their children. Massive investment in both primary and lower secondary education—complemented by a pattern of growth that channels labor into productive uses—was one key element in the East Asian development "miracle." Other countries, including India and Mexico, have come to this realization more recently and have started to expand and reform their basic education systems extensively.

Kari Marble, a US national, is a Consultant in the Education Group of the World Bank's Human Development Department.

Harry Anthony Patrinos, a national of both Greece and Canada, is an Economist in tlte Education Group of the World Bank's Human Development Department.

Progress and challenges The economies of low- and middle-income countries have been growing at historically rapid rates. Progress in education—expanded enrollments and longer schooling—has contributed to this growth and so has helped to

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reduce poverty in developing countries. For the first time in history, most children at least start school. By 1990, 76 percent of the 538 million children between the ages of 6 and 11 in developing countries were in school, up from 48 percent in 1960 and 69 percent in 1980. As a result of these gains, in 1990, an average 6-year-old child in a developing country could expect to complete 8.5 years of school, up from 7.6 years in 1980. In Eastern Europe and Central Asia, the norm is 9 or 10 years of schooling. In East Asia, Latin America, and the Caribbean, primary education is almost universal. Countries in South Asia, the Middle East, and North Africa are also making steady progress in increasing primary school enrollments, though South Asian countries lag considerably behind. The number of expected years of schooling rose in the 1980s in every region except Africa, where the gross enrollment ratio for primary school actually fell and 50 percent of 6-to-ll-year-old children were not in school as of 1990. The transition economies of Eastern and Central Europe have high primary and secondary enrollment ratios but need to adjust their entire education systems to better meet the needs of a market economy. It is particularly important for these countries to maintain funding levels for basic and upper-secondary education; to shift away from overspecialization at vocational, technical, and higher education institutions; and to reform the governance and financing of higher education. Despite substantial achievements in the world as a whole, major educational challenges remain: to increase access in some countries; improve equity; improve quality; and, where needed, speed reform.

Finance and management Public intervention in education can reduce inequality, open opportunities for the poor and disadvantaged, compensate for market failures in lending for education, and make information about the benefits of education more generally available. But public spending on education is often inefficient and inequitable. It is inefficient when it is misallocated among competing uses; it is inequitable when qualified potential students are unable to enroll in institutions because educational opportunities are lacking or because of their inability to pay. Present systems for financing and managing education often fail to meet these challenges. Public financing, moreover, is becoming more difficult to provide as enrollments expand. Basic education ought to be the priority for public spending on education in countries that have yet to achieve nearly universal enrollment at the primary and lower-sec-

Social rates of return to investments in education


Source: George Psacharopoulos, "Returns to Investment in Education: A Global Update," World Development, Vol. 22 (1994), pp. 1325^(3. 1 Private rates of return are even higher than social rates of return because of the public subsidization of education. Per capita income levels of country groups, in US dollars per year, are defined as follows: low-income ($610 or less), lower-middle-income ($611-$2,449), upper-middle-income ($2,450-37,619), and high-income ($7,620 or more). 2

Not applicable.

ondary levels. Most countries are already allocating the highest share of public spending on education to primary schools. Public spending on primary education generally favors the poor, but public spending on education as a whole often favors the affluent because of heavy subsidization of the upper-secondary and higher education levels, which usually have relatively few students from poor families. There is no theoretically appropriate proportion of national income or public spending that should be devoted to education. Some countries that spend very little on education could, of course, dramatically improve results simply by increasing public spending. In many countries, however, education could be improved with the same—or even smaller—amounts of public spending by focusing on the lower levels of education and increasing internal efficiency, as has been done in East Asia.

Finding additional money

The inefficiencies and inequities described above, along with expanding enrollments in public schools at all levels, have helped to increase the share of GNP devoted to public spending on education. The result has been increasing pressure on public funds at a time when many countries, especially in Eastern Europe and Africa, are experiencing general fiscal difficulties. As enrollments increase, resources per student will decline, as will the quality of schooling unless public spending becomes more efficient. Although measures to increase the efficiency of public spending on education can make existing funds more productive, such measures alone may not be enough. Some countries have chosen to reallocate public spending to education from other publicly funded activities, such as inefficient public enterprises that can be run better by the private sector. Other countries have found ways, Finance & Development /December 1995

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within macroeconomic policy constraints, to increase government revenues and thereby to spend more on education. For example, several Indian states increased their spending on education from about 2.5 percent of state domestic product in the mid-1970s to more than 4 percent in 1990. Still other countries have sought to supplement public funds for education with private funds. In Asia, the more that higher education costs have been financed through student fees, the broader the overall coverage of the education system has been. Private financing can be encouraged either to fund private institutions or to supplement the income of publicly funded institutions. Although private schools and universities tend to draw their students from more advantaged socioeconomic backgrounds, they nevertheless promote diversity and provide useful competition for public institutions, especially at the higher levels of education.

Reorganizing education

Most education systems are directly managed by central or state governments, which put a great deal of effort into dealing with such issues as teacher salary negotiations, school construction programs, and curriculum reform. This central management, which often extends even to instructional inputs and the classroom environment, allows little room for the flexibility that leads to effective learning. The main ways governments can help improve the quality of education are by setting clear and high performance standards in core subjects, supporting inputs known to improve achievement, adopting flexible strategies for the acquisition and use of inputs, and monitoring performance. Generally, however, these steps are not taken because they go against the grain of existing education spending and management practices and are opposed by groups with vested interests.

Priorities for reform Six key reforms in education finance and management, with priorities among them depending on individual country circumstances, will go a long way toward enabling countries to meet the challenges of improving access, equity, and quality, and will also accelerate the pace of reform. Giving education a higher priority. Because of its important role in enabling countries to achieve both economic development and poverty reduction, education deserves higher priority on governments' agendas—not just those of their ministries of education. This has long been recognized in East Asia and is coming to be increasingly understood elsewhere, particularly in Latin America. Education alone, however, will not reduce poverty; complementary macroeconomic policies and physical investments are also needed. Paying greater attention to outcomes. Educational priorities should be set with reference to outcomes, using economic analysis, standard setting, and the measurement of achievement through learning assessments. Governments need to look at the whole educational sector before setting priorities. Countries that have yet to achieve universal basic education will need to pay attention to all levels of education, using economic analysis to guide their decisions about which investments will have the greatest effect. Focusing on outcomes also entails the establishment of performance standards, particularly for primary and general secondary schools, and development of a system of assessments to monitor what students are learning. Standards, curricula, and monitoring are most effective when they are directly linked through appropriate incentives. Emphasizing investment in basic education. A more efficient, equitable, and sustainable allocation of new public investment in education would do much to meet the challenges that education systems face today. Efficiency is achieved by making publicinvestments where they will yield the highest returns—usually in basic education. Working to improve equity. Equity in education has two principal aspects: (1) everyone's right to a basic education—that is, to acquire the basic knowledge

and skills necessary to function effectively in society, and (2) the government's obligation to ensure that qualified potential students are not denied education because they are poor or female, are from disadvantaged ethnic (including linguistic) minorities or geographically remote regions, or have special educational needs. At the lowest and compulsory levels of education, equity simply means ensuring that schools are available. Beyond that, it means having fair and valid ways of determining potential students' qualifications for entry. Achieving equity requires both financial and administrative measures. Financial measures, such as scholarships, are important at all levels to enable the poor to acquire an education. Scholarships can cover fees and other direct costs, such as transportation, books, and uniforms and, when appropriate, can compensate families for the indirect costs of sending children to school—for example, loss of labor services for the household. Administrative measures can increase enrollment of the poor, females, linguistic minorities, and students with special educational needs. Programs designed to demonstrate the importance of educating children can increase the demand for schooling among the poor. For linguistic minorities, bilingual programs and schools offering a choice of language of instruction are important, especially in primary education. Increasing household involvement by providing real choices. Around the world, parents and communities are becoming more involved in the governance of their children's schools. Effective involvement in school governance does not come about easily, however, and training is generally advisable. Several countries have a long tradition of parental choice, and increased experimentation with school choice is now a worldwide phenomenon. For choice to be effective, students must be able to choose from two or more possible schools. Each of these should have some distinguishing characteristics—for example, in regard to what aspects of the curriculum are emphasized; what teaching styles are used; and, at higher levels, what courses are offered. Finally, teachers need to enjoy considerable autonomy concerning what and how they teach, within limits set by a broad national curriculum. The availability of real choices gives educational institutions an incentive to adapt to demand.

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higher education is politically most Expanding schools' autonfeasible when it is linked to expanomy. The quality of education can Encouraging schools to be autonomous sion of opportunities for higher edubenefit when schools have the autonand accountable cation. Building a national consensus omy to use instructional inputs Financial measures to encourage school and institutional autonomy requires stakeholders in the educaaccording to local school and comand accountability can include the following: tion system to participate in a munity conditions and are account• using local and central government taxation; national consultation mechanism, able to parents and communities. • sharing costs with local communities; such as those developed in Bolivia Fully autonomous institutions have • allocating block grants to communities and schools without and the Dominican Republic, where the authority to allocate their putting restrictions on allocation of funds; reforms recommended by national resources (not necessarily to raise • charging fees at higher levels of education; commissions (composed of stakethem), and they are able to create an • encouraging revenue diversification; holders and all political parties) pereducational environment adapted to • using financing mechanisms in which money follows students, sisted through changes of local conditions inside and outside such as capitation grants, vouchers, and student loans; and government. Increasing the involvethe school (see box). • providing funding to schools and universities based on output ment of parents and communities by Reliance on local funding must be and quality. making schools autonomous and tempered with adjustments by higher accountable can offset the power of levels of government to compensate vested interests; it is also critical for for differing resource levels among localities. Local control of resources need not sidies that are biased in favor of the elite. increasing flexibility and improving instrucimply local raising of revenues. The goal of Prevailing systems of education spending and tional quality. Careful design of reform mealocal financing of schools should be to improve management often protect the interests of sures is necessary to avoid disrupting the vital teachers' unions, university students, elites, links among education subsectors. An essenlearning, not to reduce overall resources. and the central government rather than those tial, although often neglected, step is the of parents, communities, and the poor. There provision of appropriate resources and mechaImplementing change nisms to accompany policy changes. In all countries, entrenched ways of operat- are, however, strategies that can ease change. Financing and management reforms are ing and vested interests will make change difficult. Education is intensely political: it affects best introduced in parallel with the expansion the majority of citizens, involves all levels of of educational opportunities. Sometimes the government, almost always makes up the sin- reforms themselves make for expansion—for This article is based on Priorities and Strategies for gle largest component of public spending in example, when prohibitions on the private sec- Education: A World Bank Review, Development developing countries, and involves public sub- tor are lifted. Increased cost sharing in public Practice Series, 1995, World Bank.

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