1 Chapter 20 Sequencing and Speed of Reforms © Pierre-Richard Agénor and Peter J. Montiel

2 l Sequencing of Reforms. l Uncertainty and Gradualism. l Adjustment Costs, Credibility, and the Speed of Reforms.

Sequencing of Reforms

4 l Macroeconomic Stabilization, Financial Reform, and the Opening of the Capital Account. l Capital and Current Account Liberalization. l Macroeconomic Stabilization and Trade Reform.

5 Macroeconomic Stabilization, Financial Reform, and the Opening of the Capital Account l First principle of sequencing: macroeconomic stabilization and fiscal adjustment should precede financial reform. l Relationship between stabilization and capital account liberalization: è Adequate flexibility of policy instruments is required to counteract effects of capital movements.

6 è If fiscal consolidation is not achieved before the capital account is opened, looser fiscal policy may not be adopted in response to contractionary shocks. l Domestic financial system must be reformed before opening the capital account of the balance of payments. è 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. è Avoidance of immiserizing external borrowing. è If domestic financial system is repressed, any resulting capital inflows may be misallocated. è Social rate of return on the use of these external funds may fall short of the cost of these funds to the domestic economy.

7 Fischer and Reisen (1994): l Fiscal control is needed before the capital account is opened up, because without such control financial repression will result in capital outflows or inflation. l 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. l Even if opening up financially would leave some domestic monetary autonomy, capital account opening should be delayed, because of the needs to è establish and deepen domestic money and securities markets to permit sterilization of capital flows; è develop the domestic banking system to ensure that financial opening does not lead to high domestic interest rates and financial overintermediation.

8 4 Enforcement of competition to foster allocative efficiency in the financial sector. 4 Strengthening of prudential regulation and supervision, establishment of legal and accounting systems to cope with systemic risks. 4 Removal of excessive bad loans to increase the franchise value of banks. Proposed sequence of reform: l Liberalization of foreign direct investment and trade finance should come first. l Fiscal consolidation is the most important next step for two reasons: è It is needed to do without revenues from financial repression and to provide a stabilization instrument.

9 è Healthy fiscal position is required to cope with potential bad loan problems in the financial sector. l Next is the implementation of measures for improved bank regulation and supervision. l Domestic interest rates can be freed, after è macroeconomic stability is achieved; è institutional mechanisms are in place for the domestic financial sector; è any bad loan problems are resolved. l At the same time the authorities should take steps to foster deepened securities markets. l Then it is prudent to liberalize capital outflows and complete domestic financial reform.

10 l At this point, the entry of foreign banks into the domestic financial system can be permitted. l Liberalization process can be completed by opening up to short-term capital inflows. l Under this sequence, interest rate convergence will be achieved, new external resources will be allocated efficiently, and crises will be less likely.

11 Capital and Current Account Liberalization l Appropriate sequencing of trade and capital account liberalization: experiences of è Asian countries in the 1960s, è Southern Cone countries of Latin America in the late 1970s. l Argentina and Uruguay opened their capital account before removing impediments to trade transactions. l Chile reduced barriers to international trade before lifting capital controls. l Korea opened its trade account before relaxing controls on capital movements.

12 l Indonesia reduced trade barriers and simultaneously eliminated most controls on capital movements. l Opening the capital account prior to liberalizing the external trade regime is not a desirable reform strategy. l If the domestic financial system is liberalized prior to the removal of capital controls, massive capital inflows occur, leading è to buildup of reserves; è if not sterilized, to monetary expansion, domestic inflation, and appreciation of real exchange rate. l Successful liberalization of the trade account requires real depreciation of the domestic currency to è offset the adverse effect of cuts in tariff protection; è stimulate exports and dampen imports.

13 l On the contrary, real appreciation associated with removal of capital controls è reduce profitability in export industries; è have adverse effect on reallocation of resources, è lengthen the adjustment process. l Opening the current account first is desirable, followed by gradual opening of the capital account. l Reason: if trade and capital account reforms are implemented simultaneously, net outcome can be an appreciation of real exchange rate due to è slow response of real sector to changes in relative prices in the short run; è relatively faster response of capital flows.

14 l Edwards (1984) and McKinnon (1973, 1993): tariffs should be reduced prior to lifting capital controls. l Rodrik (1987): è Trade liberalization may have a contractionary effect in the short run if it is preceded or accompanied by capital account liberalization. è Mechanism: effect of trade reform on real interest rate. è Without restrictions on capital movements, trade liberalization raises consumption rate of interest if future price of traded goods is expected to fall. è Private agents react by switching spending from the present to the future. è Result: contraction in activity; increase in unemployment.

15 l Krueger (1985): è Liberalizing capital movements in a country where capital/labor ratio is low reduces 4 rate of return to capital; 4 rate of accumulation; 4 long-term growth. è Opening the current account first may stimulate output to compensate for this negative effect. l Edwards (1989), Khan and Zahler (1985), and Edwards and van Wijnbergen (1986): role of intertemporal considerations; effect of distortions prior to reform. l Edwards and van Wijnbergen (1986): è relaxing capital controls in the presence of tariffs amplifies existing distortions;

16 è reverse sequence is neutral or may be positive. l Calvo (1987a, 1989): è Lack of credibility plays the role of an intertemporal distortion. è Capital account should not be liberalized before agents have sufficient degree of confidence in the sustainability of the trade liberalization program. è Credibility affects both speed of reform and optimal sequencing strategy. l Capital mobility in developing countries may be higher than what is suggested by the intensity of legal restrictions. è Reason: agents use alternative, unofficial channels to transfer funds.

17 è Result: removing legal restrictions on capital controls may not have much effect on the portfolio structure of private agents. l Similarly, if large portion of external trade is unofficial, removal of tariffs affect mostly the distribution of transactions between official and unofficial markets. l In these cases, appropriate order of sequencing can be determined by evaluating real efficiency gains of legalizing illegal activities under alternative strategies.

18 Macroeconomic Stabilization and Trade Reform l Successful trade reforms must be preceded by depreciation of real exchange rate. l Reason: ensure the sustainability of the liberalization process by dampening the excess demand for importables that removal of tariffs induces. l Real exchange rate can be influenced by nominal devaluations and restrictive demand policies. l Stabilization is precondition for the implementation of full-fledged trade liberalization program: è Macroeconomic instability distorts the signals transmitted by changes in relative prices brought by trade reforms.

19 è If trade liberalization takes the form of substantial tariff reductions and has an adverse effect on tax revenue, macroeconomic imbalances may constrain 4 scope of measures that can be taken; 4 pace of tariff reductions. è Real devaluation is brought about by large nominal devaluations, which may exacerbate inflation if monetary and fiscal policies are not tight enough. è Devaluations affect the role of the exchange rate as a nominal anchor and may damage the credibility of the stabilization effort. l Disadvantage of reducing taxes on trade è In many developing countries these taxes are an important source of government revenue.

20 è Reduction in revenue may lead to increased money financing and higher inflation. l Advantage of trade liberalization: increase in output and domestic revenue. 4 Increase in imports (tax base) compensates for reduction in tariff rates, bringing an increase in revenue. 4 Reducing tariff rates reduces incentives for smuggling, under-invoicing, and engaging in rent- seeking activities, so tax revenue may rise. l Greenaway and Milner (1991): no significant relationship between trade reform and amount of revenue collected from taxes on external trade.

21 l When concern over the fiscal impact of trade reform is important, tariff reductions should proceed in steps: è gradual reductions in the level and structure of tariffs; è progress in expanding the domestic revenue base. l Falvey and Kim, (1992): è as alternative domestic revenue sources develop, relative importance of the fiscal objective will diminish; è this allows an acceleration in pace of trade reform and removal of tariffs. l Role of credibility factors: important element in the timing of trade and macroeconomic reforms. l Since trade reforms require real exchange-rate depreciation, it is regarded as a source of conflict from credibility point of view.

22 l In practice two issues arise: è Lack of fiscal reform does not explain liberalization failures in some developing countries. è Trade reforms have been implemented in conjunction with macroeconomic stabilization programs rather than after stabilization has been achieved. l Supportive macroeconomic environment is required to ensure that real depreciation is not eroded by upward pressure on domestic prices. l Consistency between macroeconomic policy measures and trade reforms is essential to foster credibility and ensure success of the overall reform program.

Uncertainty and Gradualism

24 Conley and Maloney (1995): l Even under full credibility of policymakers, important source of uncertainty that related to the effect of reform on the economy's structure remains. l Changes caused by the reform occur over time and their precise magnitudes are not fully perceived. l Implications of them for speed of reform can be investigated using a two-period model. l Economy is initially closed financially and government policies are fully credible. l Reform program consists of two parts. è Part that affects real sector: once-and-for-all increase in the marginal product of capital.

25 è Complete freeing of capital account: private agents can smooth intertemporal consumption through lending and borrowing on world capital markets. l Magnitude of the rise in the marginal productivity of capital is not known ex ante. l Private agents must form a prediction of its size to determine their consumption path. l Agents' prior distribution corresponds to the objective distribution of the new marginal product of capital. l New marginal product of capital has higher mean and variance. l There is a single consumption good available in the economy.

26 l Representative agent's utility function: U(c 1, c 2 ) = c 1/2 +  c 2, c 1 (c 2 ): consumption in period 1 (2);  > 0: discount factor. l Agent is endowed with  in the first period. l It can either consume  entirely or invest for c 2. l Budget constraints: c 1 =  - s, c 2 = F(s), s: saving; F(s): production function, (F ` > 0, F `` < 0). 1

27 l Production function: F(s) = s 1/2. l Government introduces a two-part reform program. l First part: distortion that leads to a positive increase, z, in the marginal productivity of capital is removed. l z is assumed to be a random variable uniformly distributed over the interval [0, z m ]. l First part of the reform converts production function to F(s) = (1+z)s 1/2. (4)

28 l Agent's second-period budget constraint becomes c 2 = (1+z)s 1/2. l Second “leg” of liberalization program: government opens the capital account. l This enables private agents to borrow abroad and to increase their resources by, b in the first period. l Loans must be repaid in the second period with r denoting the world interest rate. l Using (4): c 1 =  - s + b, c 2 = (1+z)s 1/2 - (1+r)b.

29 l c 1 and c 2 are both assumed nonnegative, and agents are able to repay their debts in an expected sense: (1 + Ez)s 1/2 - (1+r)b  0, Ez: mean value of z. l Three alternative scenarios: no reform, “real” sector liberalization only, “financial” sector liberalization only, and full liberalization. No reform: l Agent's optimization problem is to choose s so that max (  - s) 1/2 +  s 1/2. s

30 l First-order condition is given by from which the optimal level of first-period saving can be written as s =  2 /(1+  2 ). 2(  - s) 1/2 2s 1/2  += 0,

31 Open access to world capital markets only: l Representative agent's optimization problem becomes that of determining s and b so that max (  - s + b) 1/2 +  [s 1/2 - (1+r)b]. l First-order conditions: s,b 2(  - s + b) 1/2 2s 1/2  + = 0, 1 2(  - s) 1/2 -  (1+r) = 0.

32 l Solutions: s = 1/4(1+r) 2, b = Liberalize only the “real” sector: l Agent's optimization problem: max (  - s) 1/2 +  (1 + zg(z))s 1/2 dz, g(z): distribution function of z. l z is taken to be uniformly distributed over [0, z m ]; its mean value is thus Ez = z m /  2 4  2 (1+r) 2 - . s  zmzm 0

33 l After integration, optimization problem: max (  - s) 1/2 +  (1 + z m /2)s 1/2. l First-order condition: l Optimal value of s: s 2(  - s) 1/2 2s 1/2  (1 + z m /2) + = 0.  2 (1 + z m /2) 2 s = 1 +  2 (1 + z m /2) 2

34 l If the government proceeds with the second part of its program: l Agent's problem: max (  - s + b) 1/2 +  [(1 + zg(z))s 1/2 -(1+r)b]dz. l After integrating: max (  - s + b) 1/2 +  (1 + z m /2)s 1/2 -  (1+r)b.  zmzm 0 s,b s

35 l First-order optimality conditions: l Solutions: 2(  - s + b) 1/2 2s 1/2  (1 + z m /2) + = 0, 1 2(  - s) 1/2 -  (1+r) = z m /2 s = 4(1+r)  2 (1 + z m /2) 2 4  2 (1+r) 2 - . b =

36 l Suppose that the government's expected welfare function takes into account both è agent's utility and è whether the economy's standard of living increases or not. l Formally, l 0 <  < 1: reduction in welfare when consumption does not grow between the two periods (c 2  c 1 ). W(c 1, c 2 ) = (1-  )U(c 1, c 2 ) if c 2 > c 1, (1-  )U(c 1, c 2 ) -  if c 2  c 1.

37 Conley and Maloney’s simulation results: l There are cases in which welfare is maximized by liberalizing only the “real” sector. l This result depends on the fact that there is uncertainty about the realization of z. l There is a range of realizations of z for which the ex post consumption path is decreasing when both sectors are liberalized. l If the mean increase were realized with certainty, consumption would not fall, and expected welfare would be EW(c 1, c 2 ) = EU(c 1, Ec 2 ). l 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.

38 l When there is a cost associated with the downside risk of reform, it may be optimal to liberalize gradually. l Government that cares about a fall in living standards may find it optimal to liberalize the real sector first.

Adjustment Costs, Credibility, and the Speed of Reform

40 l Trade liberalization has strong effects on income distribution, because it affects industries differentially. l Social conflicts can be exacerbated if there are more “losers” than “winners,” depending on è power structure; è relative strength of sectoral lobbies. l Reform may have a large output cost in the short run because reallocation of resources across sectors è takes time; è is limited by the degree of intersectoral labor mobility. l Large increase in unemployment may affect endogenously the credibility of reform and weaken political support.

41 l Gradual liberalization program may be the optimal response when policymakers aim at è minimizing adjustment costs; è maximizing the probability of sustaining the reform effort. l But doubts will be created about the commitment to reform if the adjustment process is too slow. l Providing sustained external assistance may be crucial in such circumstances.