Transcript Document

Chapter 20
Sequencing and Speed of
Reforms
© Pierre-Richard Agénor and Peter J. Montiel
1



Sequencing of Reforms.
Uncertainty and Gradualism.
Adjustment Costs, Credibility, and the Speed of
Reforms.
2
Sequencing of Reforms



Macroeconomic Stabilization, Financial Reform, and the
Opening of the Capital Account.
Capital and Current Account Liberalization.
Macroeconomic Stabilization and Trade Reform.
4
Macroeconomic Stabilization,
Financial Reform,
and the Opening of the Capital
Account


First principle of sequencing: macroeconomic
stabilization and fiscal adjustment should precede
financial reform.
Relationship between stabilization and capital account
liberalization:
 Adequate flexibility of policy instruments is required to
counteract effects of capital movements.
5
If fiscal consolidation is not achieved before the
capital account is opened, looser fiscal policy may not
be adopted in response to contractionary shocks.
Domestic financial system must be reformed before
opening the capital account of the balance of payments.
 If real domestic interest rates are much below world
levels, the removal of capital controls will lead to
capital outflows and balance-of-payments crisis.
 Avoidance of immiserizing external borrowing.
 If domestic financial system is repressed, any
resulting capital inflows may be misallocated.
 Social rate of return on the use of these external
funds may fall short of the cost of these funds to
the domestic economy.


6
Fischer and Reisen (1994):
 Fiscal control is needed before the capital account is
opened up, because without such control financial
repression will result in capital outflows or inflation.
 Possible loss of monetary autonomy with a fully open
capital account would leave no instruments for
stabilization policy if fiscal policy cannot be used flexibly.
 Even if opening up financially would leave some
domestic monetary autonomy, capital account opening
should be delayed, because of the needs to
 establish and deepen domestic money and securities
markets to permit sterilization of capital flows;
 develop the domestic banking system to ensure that
financial opening does not lead to high domestic
interest rates and financial overintermediation.
7
Enforcement of competition to foster allocative
efficiency in the financial sector.
 Strengthening of prudential regulation and
supervision, establishment of legal and accounting
systems to cope with systemic risks.
 Removal of excessive bad loans to increase the
franchise value of banks.
Proposed sequence of reform:
 Liberalization of foreign direct investment and trade
finance should come first.
 Fiscal consolidation is the most important next step for
two reasons:
 It is needed to do without revenues from financial
repression and to provide a stabilization instrument.

8
Healthy fiscal position is required to cope with
potential bad loan problems in the financial sector.
Next is the implementation of measures for improved
bank regulation and supervision.
Domestic interest rates can be freed, after
 macroeconomic stability is achieved;
 institutional mechanisms are in place for the domestic
financial sector;
 any bad loan problems are resolved.
At the same time the authorities should take steps to
foster deepened securities markets.
Then it is prudent to liberalize capital outflows and
complete domestic financial reform.





9



At this point, the entry of foreign banks into the domestic
financial system can be permitted.
Liberalization process can be completed by opening up
to short-term capital inflows.
Under this sequence, interest rate convergence will be
achieved, new external resources will be allocated
efficiently, and crises will be less likely.
10
Capital and Current Account
Liberalization




Appropriate sequencing of trade and capital account
liberalization: experiences of
 Asian countries in the 1960s,
 Southern Cone countries of Latin America in the late
1970s.
Argentina and Uruguay opened their capital account
before removing impediments to trade transactions.
Chile reduced barriers to international trade before lifting
capital controls.
Korea opened its trade account before relaxing controls
on capital movements.
11




Indonesia reduced trade barriers and simultaneously
eliminated most controls on capital movements.
Opening the capital account prior to liberalizing the
external trade regime is not a desirable reform strategy.
If the domestic financial system is liberalized prior to the
removal of capital controls, massive capital inflows
occur, leading
 to buildup of reserves;
 if not sterilized, to monetary expansion, domestic
inflation, and appreciation of real exchange rate.
Successful liberalization of the trade account requires
real depreciation of the domestic currency to
 offset the adverse effect of cuts in tariff protection;
 stimulate exports and dampen imports.
12



On the contrary, real appreciation associated with
removal of capital controls
 reduce profitability in export industries;
 have adverse effect on reallocation of resources,
 lengthen the adjustment process.
Opening the current account first is desirable, followed
by gradual opening of the capital account.
Reason: if trade and capital account reforms are
implemented simultaneously, net outcome can be an
appreciation of real exchange rate due to
 slow response of real sector to changes in relative
prices in the short run;
 relatively faster response of capital flows.
13


Edwards (1984) and McKinnon (1973, 1993): tariffs
should be reduced prior to lifting capital controls.
Rodrik (1987):
 Trade liberalization may have a contractionary effect
in the short run if it is preceded or accompanied by
capital account liberalization.
 Mechanism: effect of trade reform on real interest
rate.
 Without restrictions on capital movements, trade
liberalization raises consumption rate of interest if
future price of traded goods is expected to fall.
 Private agents react by switching spending from the
present to the future.
 Result: contraction in activity; increase in
14
unemployment.



Krueger (1985):
 Liberalizing capital movements in a country where
capital/labor ratio is low reduces
 rate of return to capital;
 rate of accumulation;
 long-term growth.
 Opening the current account first may stimulate
output to compensate for this negative effect.
Edwards (1989), Khan and Zahler (1985), and Edwards
and van Wijnbergen (1986): role of intertemporal
considerations; effect of distortions prior to reform.
Edwards and van Wijnbergen (1986):
 relaxing capital controls in the presence of tariffs
amplifies existing distortions;
15
reverse sequence is neutral or may be positive.
Calvo (1987a, 1989):
 Lack of credibility plays the role of an intertemporal
distortion.
 Capital account should not be liberalized before
agents have sufficient degree of confidence in the
sustainability of the trade liberalization program.
 Credibility affects both speed of reform and optimal
sequencing strategy.
Capital mobility in developing countries may be higher
than what is suggested by the intensity of legal
restrictions.
 Reason: agents use alternative, unofficial channels to
transfer funds.



16
Result: removing legal restrictions on capital controls
may not have much effect on the portfolio structure of
private agents.
Similarly, if large portion of external trade is unofficial,
removal of tariffs affect mostly the distribution of
transactions between official and unofficial markets.
In these cases, appropriate order of sequencing can be
determined by evaluating real efficiency gains of
legalizing illegal activities under alternative strategies.



17
Macroeconomic Stabilization
and Trade Reform




Successful trade reforms must be preceded by
depreciation of real exchange rate.
Reason: ensure the sustainability of the liberalization
process by dampening the excess demand for
importables that removal of tariffs induces.
Real exchange rate can be influenced by nominal
devaluations and restrictive demand policies.
Stabilization is precondition for the implementation of
full-fledged trade liberalization program:
 Macroeconomic instability distorts the signals
transmitted by changes in relative prices brought by
18
trade reforms.
If trade liberalization takes the form of substantial tariff
reductions and has an adverse effect on tax revenue,
macroeconomic imbalances may constrain
 scope of measures that can be taken;
 pace of tariff reductions.
 Real devaluation is brought about by large nominal
devaluations, which may exacerbate inflation if
monetary and fiscal policies are not tight enough.
 Devaluations affect the role of the exchange rate as a
nominal anchor and may damage the credibility of the
stabilization effort.
Disadvantage of reducing taxes on trade
 In many developing countries these taxes are an
important source of government revenue.


19
Reduction in revenue may lead to increased money
financing and higher inflation.
Advantage of trade liberalization: increase in output and
domestic revenue.
 Increase in imports (tax base) compensates for
reduction in tariff rates, bringing an increase in
revenue.
 Reducing tariff rates reduces incentives for
smuggling, under-invoicing, and engaging in rentseeking activities, so tax revenue may rise.
Greenaway and Milner (1991): no significant relationship
between trade reform and amount of revenue collected
from taxes on external trade.



20




When concern over the fiscal impact of trade reform is
important, tariff reductions should proceed in steps:
 gradual reductions in the level and structure of tariffs;
 progress in expanding the domestic revenue base.
Falvey and Kim, (1992):
 as alternative domestic revenue sources develop,
relative importance of the fiscal objective will diminish;
 this allows an acceleration in pace of trade reform
and removal of tariffs.
Role of credibility factors: important element in the timing
of trade and macroeconomic reforms.
Since trade reforms require real exchange-rate
depreciation, it is regarded as a source of conflict from
credibility point of view.
21



In practice two issues arise:
 Lack of fiscal reform does not explain liberalization
failures in some developing countries.
 Trade reforms have been implemented in conjunction
with macroeconomic stabilization programs rather
than after stabilization has been achieved.
Supportive macroeconomic environment is required to
ensure that real depreciation is not eroded by upward
pressure on domestic prices.
Consistency between macroeconomic policy measures
and trade reforms is essential to foster credibility and
ensure success of the overall reform program.
22
Uncertainty and Gradualism
Conley and Maloney (1995):
 Even under full credibility of policymakers, important
source of uncertainty that related to the effect of reform
on the economy's structure remains.
 Changes caused by the reform occur over time and their
precise magnitudes are not fully perceived.
 Implications of them for speed of reform can be
investigated using a two-period model.
 Economy is initially closed financially and government
policies are fully credible.
 Reform program consists of two parts.
 Part that affects real sector: once-and-for-all increase
in the marginal product of capital.
24
Complete freeing of capital account: private agents
can smooth intertemporal consumption through
lending and borrowing on world capital markets.
Magnitude of the rise in the marginal productivity of
capital is not known ex ante.
Private agents must form a prediction of its size to
determine their consumption path.
Agents' prior distribution corresponds to the objective
distribution of the new marginal product of capital.
New marginal product of capital has higher mean and
variance.
There is a single consumption good available in the
economy.






25

Representative agent's utility function:
U(c1, c2) = c1/2
1 + c2,



c1 (c2): consumption in period 1 (2);
 > 0: discount factor.
Agent is endowed with  in the first period.
It can either consume  entirely or invest for c2.
Budget constraints:
c1 =  - s,
c2 = F(s),
s: saving;
F(s): production function, (F ` > 0, F `` < 0).
26

Production function:
F(s) = s1/2.




Government introduces a two-part reform program.
First part: distortion that leads to a positive increase, z,
in the marginal productivity of capital is removed.
z is assumed to be a random variable uniformly
distributed over the interval [0, zm].
First part of the reform converts production function to
F(s) = (1+z)s1/2.
(4)
27

Agent's second-period budget constraint becomes
c2 = (1+z)s1/2.




Second “leg” of liberalization program: government
opens the capital account.
This enables private agents to borrow abroad and to
increase their resources by, b in the first period.
Loans must be repaid in the second period with r
denoting the world interest rate.
Using (4):
c1 =  - s + b,
c2 = (1+z)s1/2 - (1+r)b.
28

c1 and c2 are both assumed nonnegative, and agents
are able to repay their debts in an expected sense:
(1 + Ez)s1/2 - (1+r)b  0,
Ez: mean value of z.
 Three alternative scenarios: no reform, “real” sector
liberalization only, “financial” sector liberalization only,
and full liberalization.
No reform:
 Agent's optimization problem is to choose s so that
max ( - s)1/2 + s1/2.
s
29

First-order condition is given by
-1
2( - s)1/2

+
= 0,
2s1/2
from which the optimal level of first-period saving can be
written as
s = 2/(1+2).
30
Open access to world capital markets only:
 Representative agent's optimization problem becomes
that of determining s and b so that
max ( - s + b)1/2 + [s1/2 - (1+r)b].
s,b

First-order conditions:
-1
2( - s + b)1/2
1
2( - s)1/2

+
= 0,
2s1/2
- (1+r) = 0.
31

Solutions:
s = 1/4(1+r)2,
1 + 2
- .
b=
42(1+r)2
Liberalize only the “real” sector:
 Agent's optimization problem:
max ( - s)1/2 + 
s


zm
(1 + zg(z))s1/2dz,
0
g(z): distribution function of z.
z is taken to be uniformly distributed over [0, zm]; its
mean value is thus Ez = zm/2.
32

After integration, optimization problem:
max ( - s)1/2 +  (1 + zm/2)s1/2.
s

First-order condition:
-1
2( - s)1/2

+
(1 + zm/2)
2s1/2
= 0.
Optimal value of s:
s=
2(1 + zm/2)2
1 + 2(1 + zm/2)2
33


If the government proceeds with the second part of
its program:
Agent's problem:

zm
max ( - s + b)1/2 +  [(1 + zg(z))s1/2 -(1+r)b]dz.
s,b

0
After integrating:
max ( - s + b)1/2 +  (1 + zm/2)s1/2 -  (1+r)b.
s
34

First-order optimality conditions:
-1
2( - s +
b)1/2
+
1
2( - s)1/2

(1 + zm/2)
2s1/2
= 0,
- (1+r) = 0.
Solutions:
s=
1 + zm/2
4(1+r)2
b=
1 + 2(1 + zm/2)2
42(1+r)2
- .
35


Suppose that the government's expected welfare
function takes into account both
 agent's utility and
 whether the economy's standard of living increases or
not.
Formally,
W(c1, c2) =

(1-)U(c1, c2)
if c2 > c1,
(1-)U(c1, c2) - 
if c2  c1.
0 <  < 1: reduction in welfare when consumption does
not grow between the two periods (c2  c1).
36
Conley and Maloney’s simulation results:
 There are cases in which welfare is maximized by
liberalizing only the “real” sector.
 This result depends on the fact that there is uncertainty
about the realization of z.
 There is a range of realizations of z for which the ex post
consumption path is decreasing when both sectors are
liberalized.
 If the mean increase were realized with certainty,
consumption would not fall, and expected welfare would
be EW(c1, c2) = EU(c1, Ec2).
 In this case, agent's expected utility would be the sole
determinant of the government's action, and it would
choose to liberalize both sectors simultaneously.
37


When there is a cost associated with the downside risk
of reform, it may be optimal to liberalize gradually.
Government that cares about a fall in living standards
may find it optimal to liberalize the real sector first.
38
Adjustment Costs,
Credibility,
and the Speed of Reform




Trade liberalization has strong effects on income
distribution, because it affects industries differentially.
Social conflicts can be exacerbated if there are more
“losers” than “winners,” depending on
 power structure;
 relative strength of sectoral lobbies.
Reform may have a large output cost in the short run
because reallocation of resources across sectors
 takes time;
 is limited by the degree of intersectoral labor mobility.
Large increase in unemployment may affect
endogenously the credibility of reform and weaken
political support.
40



Gradual liberalization program may be the optimal
response when policymakers aim at
 minimizing adjustment costs;
 maximizing the probability of sustaining the reform
effort.
But doubts will be created about the commitment to
reform if the adjustment process is too slow.
Providing sustained external assistance may be crucial
in such circumstances.
41