Economic Reforms in Latin America: Symposium held in November 1992 at the Georg-August- Universität Göttingen. 9783964562784

Citation preview

Hermann Sautter (ed.)

Economic Reforms in Latin America

Göttinger Studien zur Entwicklungsökonomik de Desarrollo Econömico in Development Economics 1

Göttinger Studien zur Entwicklungsökonomik

Economic Reforms in Latin America Symposium held in November 1992 at the Georg-August-Universität Göttingen

Hermann Sautter (editor)

Vervuert Verlag * Frankfurt am Main 1993

Managing editor: Anne Brooks-Senftleben

Die Deutsche Bibliothek - CIP-Einheitsaufnahme Economic reforms In Latin America : symposium held In November 1992 at the Georg-August-Universität Göttingen / Hermann Sautter (ed.). - Frankfurt am Main : Vervuert, 1993 (Göttinger Studien zur Entwicklungsökonomik, de desarrollo económico, In development economics ; 1) ISBN 3-89354-171-3 NE: Sautter, Hermann [Hrsg.] ; Universität ; Göttinger Studien zur Entwicklungsökonomik

© Vervuert Verlag, Frankfurt am Main 1993 Alle Rechte vorbehalten Printed in Germany

Contents

Foreword

7

Hermann Sautter

Reorienting the Economic Order of Latin America. Toward a New Relationship Between State and Economy

9

Manfred Mols

The Relationship between State and Economy In Latin America Its Significance In the Current Period of Transition

45

Uzardo A Sosa L.

Guatemala: External Debt and PovertyThe Role of International Finance Organizations

55

Peter Nunnenkamp

Economic Policies and Attractiveness for Foreign Capital. The Experience of Highly Indebted Latin American Countries

73

RolfSchinke

Debt-Equity Swaps: Costs and Benefits

97

Heinz Gert Preuße

Mexico and the North American Free Trade Association (NAFTA)

131

Roberto Guyer

Liberalization in Latin America: The Experience of the 1980s

153

Text tables

163

Figures

165

Abbreviations

167

List of authors

169

7

Foreword

With this book, the Ibero-America Institute for Economic Research of the GeorgAugust-Universitat Gottingen initiates a new series of publications. The first volume in this series is based on the revised and edited version of papers presented at a symposium on the economic reform process in Latin America during the 1980s and early 1990s. This symposium, organized by the Institute, was held in November 1992 at the University of Gottingen. The papers include essays from Latin-American and German academics and policy makers, providing a fine contribution to the Institute's ongoing research program on economic and socio-economic issues of concern to Latin America. The symposium was made possible by a grant from the "Deutsche Forschungsgemeinschaft". Special thanks go to Anke Scholz and Ingo Tschach for research assistance, and to Mrs. Margret von Schierstaedt who did the typewriting. Finally, I want to thank the members of the Institute's administrative staff. Without their help the symposium could not have been realized. I am obliged to ail of them.

Hermann Director

Sautter

9

Reorienting the Economic Order of Latin America Toward a New Relationship Between State and Economy Hermann Sautter *)

Political events are fixed in one's mind rather deeply when they are combined with personal experiences. Let me therefore start by recounting my experiences on a 1987 visit to Peru. At that time I was asked to make recommendations for a reform of Peruvian industrial policy. For decades, industrial production in this country had been protected by high import restrictions, resulting in low international competitiveness of the domestic industry. Contributing to this was an overvalued real exchange rate, a direct consequence of the political decision in the mid-1980s to fight inflation by means of a fixed nominal exchange rate. The distortions resulting from this policy, given persistent differentials between domestic and external inflation rates, were expected to be removed by means of an ingenious system of export subsidies and import duties. The administration of this system was so complicated that the export of non-traditional products practically came to an end. This exchange rate policy was part of the so-called heterodox structural adjustment policy which simultaneously tried to improve income levels and stop inflation by means of wage increases, price controls, and credit expansion. This strategy was a dedicated application of traditional populist recipes, and its results were according to expectations: Price controls led to shortages, the ensuing increase of import quotas depleted currency reserves, and resulted in an intensification of import restrictions of so-called non-essential products. Wealth-holders, increasingly irritated by public interventions, transferred their capital abroad; investment activity declined severely. The desparate attempt to influence domestic investment activities via the nationalization of banks resulted in a complete loss of confidence in governmental actions. The end of the story is well-known: economic chaos, mass pauperization, and a deterioration of the political order. This has become obvious to the full extent only after 1987, but already at that time this development was foreseeable. Yet, it was absolutely impossible to make government *)

Prof. Dr. Hermann Sautter, Director of the Ibero-America Institute for Economic Research, GeorgAugust-Unlversitat Gdttingen.

10

officials realize the risks of their populist strategy. There was strong opposition to any proposal for a deregulation of industrial production. The conviction was held that the stimulation of competitive markets was no solution. On the contrary: according to Peruvian officials, in order to get the problems under control, interventionist instruments had to be refined. Self-regulation of the economy by market forces was thought of as a theoretical construct which may be practicable in some industrial countries but not in Latin America. Following this view, the sub-continent had to go its own way, namely that of regulating the economy by a strong government. Having those experiences in mind, economic policies presently pursued in Peru and other Latin American countries can only be observed with amazement. Old populist recipes are being rejected. A very orthodox policy of budget discipline is pursued, and the liberalization of markets is demanded today just as vehemently as it was rejected before. A dramatic 180 degree turnaround in the economic order is taking place. So far, this has hardly been recognized in Western European countries where everyone is preoccupied with events in Eastern Europe. In section 1, this amazing economic reorientation will be reviewed in some detail. I do not intend to diminish the recognition of the courage and the determination of Latin American governments when pointing to the so far unsolved problems of this process (section 2). Section 3 deals with the question how the industrial countries - with the focus on Europe - can support the reform process in Latin America.2

1. Economic and political reforms since the mid-1980s The debt crisis of the 1980s revealed the weak points of the Latin American economy, and by doing so it initiated the present reform process. As a first step, this process involves a redefinition of the relationship between state and economy. This task has to be accomplished on different levels, including: corrections in fiscal policy, a general deregulation of the economy in combination with the privatization of public enterprises, and the clarification of property rights. The eagerness for reforms is not the same on all these levels. But it is especially strong with regard to fiscal policy. 2

The following overview of reform-steps and remaining problems Is based on Williamson (1990 a, 1990 b), supplemented by an evaluation of country reports as published in the "LatelnamerikaJahrbuch 1992" and in the 'Spiegel der lateinamerikanlschen Presse 1991*. Wlllamson (1990 a, 1990 b) gives a summary of reform-measures until 1988/89; the annex of this paper presents a synthesis of measures taken by selected Latin American countries In 1990 and 1991.

11

1.1. Improved fiscal discipline The "soft budget-restriction" may be called the main nuisance of state economics. Generally said, it consists of the fact that expenditures are not restricted by earned revenues. The possibility of falling back upon other funds seems to be an easy way to pay for desired expenditures, systematically weakening any efficiency-calculus. For the fiscal budget as a whole this means that, without an efficient constitutional restriction, politicians are tempted not to limit public spending to the sum of tax revenues and of non-inflationary public debts. Instead, they tend to fulfill spending aspirations beyond this constraint threshold. The results are inflationary processes which render the government dependent on the inflation tax to the same degree as real tax receipts decrease (Olivera-Tanzi-Effect), initiating a vicious circle of monetary decay. Today in Latin America hardly anyone denies that such a budgetary policy has been the main cause for the high inflation of past years. It has become obvious that neither bottlenecks in physical infrastructure can be lifted nor rival distributional demands can be satisfied through monetary financing of expenditures. Instead, this policy approach paralyzes the development of productivity, and persistently obstructs economic efficiency. The structuralist school, which showed a certain indulgence in creditfinanced expansions of public spending, has lost much of its attractiveness. This is reflected in decisive efforts to restrict public expenditures, combined with the attempt of restructuring spending priorities, and a reform of the tax system3. Argentina might serve as an example for this. The modernization of the tax system, in particular the more effective combat against tax evasion, resulted in a threefold increase in revenues from the value-added tax since 1990. In the first six months of 1992 a budget surplus could be obtained 4 , even without consideration of the receipts from privatization. The annual inflation rate, at about 5000 % before the beginning of reforms, has been decreased to about 20% in 1992 s . Considering Argentina's long experience with inflation, these are in fact amazing results, made possible by the growing autonomy of the Central Bank.

•» 4 5

Williamson, John (1990), p. 10 ff. NZZ from August 12th, 1992: 'Kritischer Blick auf das 'Argentinische Wirtschaftswunder". Ibid.

12

One can adequately assess the importance of this recent budget discipline only with due consideration of the fact that 110 000 employees have been discharged from the public service and that another 250 000 redundancies are projected 6 . This political feat was carried out under a President who is the head of a political movement with a long populist tradition. His party, the "justicialistas", for many years pursued a policy of employment-creation by means of public service expansion. The "lean" state, which represents the goal to be achieved through the cut in expenditures, also requires a reformulation of priorities in public spending. An increase in expenditures for education and health is in the interest of human capital accumulation, and there is room for cuts in military spending. Argentina seems to recognize this: it plans to reduce its military personnel by 40 %! (see annex) In other countries, however, efforts toward a revision of spending priorities seem to make only slow progress 7 . The improved fiscal discipline is one of the most outstanding results not only in Argentina but in other Latin American countries as well. Nominal deficits of up to 27 % of GOP (Bolivia in 1984) were reduced or changed into surplus. Next to Argentina, Bolivia, Mexico, Columbia, Venezuela, and Costa Rica can serve as examples 8 . One of the main inflationary forces has been diminished in these countries, although it is not certain whether this success will last; recently there has been another increase in prices.

1.2. Liberalization of financial markets and foreign trade regimes The regulation of investments through interest rate management and discretional credit allocation represented an integral component of the import substitution policy pursued in Latin America for many years. Negative real interest rates, resulting from fixed nominal rates and high rates of inflation, caused capital flight and inefficiency of the investment structure. Managed exchange rates supplemented the instruments of "financial repression"9. The resulting inefficiency of capital markets induced govern-

NZZ from July 11th, 1992: "Zwischenbilanz in Argentinien". Williamson, John (1990), p. 14. See Williamson, John (1990), p. 12 (table 1), and annex. Mc Klnnon, Ronald I. (1973); Shaw, Edward S. (1973).

13

ments to extend their market interventions in accordance with the "oil-spot theory" of interventionism. 10 Chile was the first Latin American country to break out of this circle of increasing regulation and inefficiency in the 1970s. Shortly after Argentina followed but without success. Since the mid-1980s it is generally recognized that economic growth cannot be achieved by manipulating interest rates and selective rationing of credits. A growing number of Latin American countries are liberalizing their capital markets, e. g. Bolivia, Mexico, Columbia, and partly Costa Rica 11 . An increase in real interest rates is accepted more easily than before, and is primarily interpreted as a signal of concerted efforts toward macro-economic equilibrium, considered a precondition for moderate real interest rates. The attempt to enforce low real interest rates against prevailing market forces has been completely discredited. It is evident that this policy finds opposition. In Venezuela middle-class house owners claimed to be unable to pay the higher mortgage rates resulting from financial market reform, and they succeeded in passing a bill in congress in order to protect them against interest rate increases 12 . This example illustrates that populism is not completely defeated. Yet, in situations where it is practised not in the name of the poor but to the benefit of the wealthy it does not even have the appearance of legitimacy. The pursuit of exchange rate policy reform has been even more determined than the liberalization of financial markets. Almost all countries in Latin America have given up the traditional system of multiple exchange rates, and adopted a system of uniform and more or less flexible rates 13 . The objective of this system is to avoid market distortions so as to realize "competitive rates". In contrast, policies supporting the creation of an anchor of stability by means of fixing the national currency to the US-Dollar take a back seat. The experiences of Chile and Argentina, which pursued such a policy in the 1970s and 1980s, are not encouraging.

Once initiated, interventions tend to extend themselves like an oil spot on the water surface. 11

Williamson, John (1990), p. 20.

12

Hausmann, Ricardo (1990), p. 238. According to Hausmann, interest subsidies in favor of 70 000 families amounted to 2 % of GDP.

13

Williamson, John (1990), p. 21 f.

14

The resulting real exchange rate appreciation of national currencies grotesque distortions in foreign trade

14

caused

. Nevertheless, Mexico and Argentina are

again fixing their currencies to the US-Dollar, hoping to avoid possible disadvantages by consistently stabilizing the domestic economy. Yet, both countries show tendencies of real exchange rate appreciation, in Mexico as a result of the monetary elements of the "Solidarity Pact" of 1987 1 5 , in Argentina as a result of the "Conversion Law" of 1991, which represents the essence of the Argentine stabilization- and reformprogram 16 . It seems that both countries still have to learn what every good sailor knows: One should not throw the anchor over bord before the boat has come to a halt. It is in the interest of regaining international competitiveness not only to reform the exchange rate system but also to liberalize foreign trade policy. Nearly sensational was the reform step taken in Bolivia where literally overnight a very complex system of highly protective duties was changed into a uniform tariff of 20 %, which was then gradually reduced to 10% 1 7 . Keeping in mind how difficult it is e. g. for the European countries to liberalize their agricultural trade only partly, one can imagine the importance of this step, which of course may not have been possible had the country not been in economic chaos. When all reliable structures break down radical reforms can be enforced more easily 18 . There are other examples of foreign trade liberalization. Chile has been pursuing trade reform since the 1970s. In 1989, Mexico abolished all import quotas which had protected about 90 % of domestic production. Joining the GATT, the country also committed to a gradual reduction of the existing tariff rates 19 . In Venezuela, during the presidency of Carlos Andrés Pérez who was not at all reputed to be a free trade protagonist, the government ordered a drastical liberalization of imports 2 0 . It seems that the trust in the stimulating effects of import competition is just as strong as the 14

See: de Pablo, Juan Carlos (1990), p. 115,123.

15

Beristain, Javier; Trigueros, Ignacio (1990), p. 161; Williamson, John (1990), p. 22.

16

NZZ from August 12th, 1992: "Kritischer Blick auf das 'Argentinische Wirtschaftswunder".

17

Cariaga, Juan L (1990), p. 41, 48; Williamson, John (1990), p. 36.

18

According to Cariaga, Bolivia had no alternative to Its drastic reforms. It was forced to materialize them "sin querer queriendo' (wanting yet not wanting to); Cariaga, Juan L (1990), p. 42.

19

Williamson, John (1990), p. 25; Beristain, Javier; Trigueros, Ignacio (1990), p. 159.

20

Hausmann, Ricardo (1990), p. 242.

15

faith in the growth-stimulating effects of high protective duties was in earlier years, whereby in both cases some tendency of exaggeration cannot be overlooked. In this context, it is worth mentioning the new policy towards foreign direct investments (FDI). The debt crisis has shown that shifting capital inflows from direct investments to bank credits, characteristical for the 1970s, was not appropriate to widen the scope of national economic policies. With "debt equity swaps", materialized by a number of countries, present policies are supportive of equity investments. New investment-friendly legislation is designed to contribute to increased FDI in Bolivia, Chile, Argentina, Peru, Mexico, and Venezuela 21 . The earlier resentment toward FDI can hardly be perceived anymore in official policy. Summarizing, it is safe to say that in spite of some inconsistencies and oppositions Latin America is in the process of replacing its traditional "inward-looking" strategy by a strategy of development open to the world market.

1.3. Deregulation, privatization and clarification of property rights The heritage of the import substitution strategy is a comparatively high public share in the manufacturing industry. During the 1950s and 1960s, the real or pretended shortage of dynamic entrepreneurs led the government to establish its own productive capacities. Furthermore, many markets were regulated 'in the public interest'. At the same time, many countries failed to establish a reliable legal framework for private economic activities due to governmental over-activity with interventionist traits on the one hand, and political passivity concerning the establishment of growth-inducing property rights on the other. In this respect many things have changed, too. A number of countries have proceeded to privatize public enterprises, in Argentina with particular determination. After having sold the state-owned airline company and the biggest electricity company in the country, several television stations, the statal oil company, and the public telecommunications system are being prepared for privatization22. Chile started privatizations already in the 1970s. Until the beginning of this decade, Mexico had

Williamson, John (1990), p. 27. See also annex. 22

WHIiamson, John (1990), p. 29.

16

already privatized more than half of its roughly 1200 public enterprises. In Venezuela, Brazil, and other countries as well there are plans for selling public firms 23 . Two objectives seem to be pursued here: (1) balancing government budgets with the proceeds from privatization, and (2) increasing the efficiency of the enterprises sold. In Latin America - and beyond it - it is not without controversies whether such sales can appreciably contribute to achieving these objectives. Apart from the fact that balancing the budget is a once-for-all-effect, it has become evident that the receipts are lower than expected. With respect to efficiency gains, these depend, according to experience, at least as much on the degree of economy-wide competition as on the property form; many regard the property form as comparatively unimportant. Privatization does not automatically intensify competition. Efficiency gains can fail to materialize when public monopolies are replaced by private monopolies. Apart from all that there is the justified fear that privatization will lead to yet more concentration of wealth. Despite these doubts, privatization in Latin America has gained momentum and, according to survey results, a large share of the population seems to be in favour of it 2 4 . Sometimes one even gets the impression that privatization is regarded as a kind of "miracle therapy" against the malaise of the Latin American economies 25 . With respect to deregulation, there seems to be less decisiveness which makes the gains from privatizations uncertain. Efforts toward a reduction of market regulations can be perceived in Argentina, Bolivia, Mexico, Columbia and Costa Rica, whereas Brazil prefers to extend public interventions 26 . Regarding the clarification of property rights there seem to be only few results until now. Constitutional thinking hardly has a tradition in Latin America. Accordingly, concepts are vague for a reform of the constitutional system conducive to an aggregation of individual economic actions to a "common good" - however under-

23

Melier, Patricio (1990), p. 88 ff.; Beristain, Javier; Trigueros, Ignacio (1990), p. 160; Hausmann, Ricardo (1990), p. 235; Cardoso, Eliana A. und Dantas, Daniel (1990), p. 143. See also annex: Bolivia, Venezuela, Peru.

24

According to an opinion poll realized in 1988 in Peru 49 % of interviewed people supported the argument "state enterprise must be sold", 35 % refused it. See: Kuczynski, Pedro-Pablo (1990), p. 93.

25

Williamson, John (1990), p. 30. Patricio Melier, who has the Chilean sltuatin in mind, raises some critical arguments against privatization (Meiler, Patricio (1990), p. 80 ff.).

26

Williamson, John (1990), p. 31. See also annex.

17

stood 2 7 . Strangely, in view of this very basic requirement of market systems there is only little awareness of what has to be done. One gets the impression that above all the release of private initiative is sought, and that comparatively few reflections are made about how to improve the legal conditions for this private initiative once it is released so as to achieve better results for everyone.

1.4. Results of the reform process It seems appropriate to conclude this survey of reform steps in Latin America by asking which economic achievements can be claimed. It is difficult to answer this question. In many countries reforms have started only recently and have not had time to succeed in all sectors of the economy. Besides, it is difficult to relate specific economic processes to political decisions. So we have to restrict ourselves to taking a look at recent developments of economic indicators. Lower levels of inflation in many Latin American countries indicate that some success in monetary stabilization has been achieved, although the results are not perfectly satisfactory yet. But at least in Argentina and Bolivia the hyper-inflation of the 1980s has been overcome. The income situation is of particular interest (figure 1). Eight of the eleven countries that had negative growth rates in GNP per capita in the 1980s showed positive growth in 1991; in Brazil, Peru, and Nicaragua a further slide into recession could be stopped, resulting in the slow-down or halt of negative GNP per capita growth. Particularly noteworthy are economic recoveries in Argentina, Bolivia and Mexico, countries that have been pursuing a comprehensive reform policy. (Chile compares especially well to other countries in the region, as this country started its economic reorientation already in the 1970s). Summarizing these results, it can be concluded that the recession which persisted in the 1980s seems to have been overcome in several countries, with particularly encouraging results in countries where a resolute reform policy is pursued. Other data can supplement this overview. Since 1986 capital inflows for foreign direct investments have been increasing again (figure 2). The growth in foreign direct It Is revealing how de Pablo answers the question on the progress Argentina has made in clarifying property rights: The issue is Ignored" (de Pablo, Juan Carlos (1990), p. 121).

18

Figure 1 : Growth of GNP per Capita in Latin America, 1984-1992

Ik.—

>

V V

A-s.

^

/

\

r--Jf^-yV

;r

Vl

/Í

/ Peru

1989

1990

1991

1992

Sources: CEPAL: Balance Preliminar de la Economía de America Latina y el Caribe, Diciembre de 1992, for 1992 data: Latín American Economy and Business: Quarterly Update, No.2, May 1993 for GNP growth and World Development Report 1992, Table 26 for Population Growth.

19

Figure 2: Foreign Direct Investment

1970 1980 1985 1986 1987 1988 1989 1990 1991 Source: World Debt Tables 1991-92, External Debt of Developing Countries World Bank, Washington D C., 1991

20

investments is a valid indicator for the renewed trust in the economic development of Latin America. Finally, some observations regarding the development of the external indebtedness of the sub-continent. At the beginning of the 1980s the debt burden got out of control, giving rise to the international debt crisis. In retrospect, this was the initiating factor for Latin America's economic reorientation. It has been shown that the policy change has been successful in so far as the reorientation in economic policy may have contributed to an increased willingness on the part of creditor countries to make concessions within the framework of the Brady-initiative. The debt problem can be said to be under control 28 . Nearly all countries in the region have, in cooperation with their creditors, agreed to debt reduction or debt restructuring programs with reduced debt service obligations. Is this the beginning of a new "decade of hope" after the "lost decade" of the 1980s, as some people say? There are many indications supporting this opinion. This optimistic view is not undermined by reviewing some of the problems which remain to be solved. The reform process can be pursued with greater efficiency and purpose the more distinctly the remaining problems are identified. 2. Unsolved Problems 2.1. Continuing legal Instability Like any form of social interaction, economic interaction in free markets is dependent on a minimum of expectational security. If the market partner does not act according to certain regularities and, therefore, if his conduct is unforeseeable, market relationships break down. Such regularities can result from respecting informal rights; but increasing social differentiation causes a growing need for written laws and for a reliable system of the formal jurisdiction. In this respect Latin America suffers from severe deficits. The example of Bolivia, a model country in terms of economic liberalization, demonstrates them very distinctly. One can hardly speak of an impartial jurisdiction in this country. Arbitrary judgements

NZZ from August 6th, 1992: "Verhaltener wirtschaftlicher Optimismus in Lateinamerika".

21

of the courts are the order of the day, i. e. justice is treated as a private good and thus has stopped being "just" in the sense of a public good. The result is extreme legal insecurity, leading to widespread distrust in business 29 . To put it differently: due to missing legal security transaction costs are extremely high. Without any doubt, the expanding coca-business which is systematically corrupting the public authorities has been contributing to this situation. One of the priorities, therefore, in stabilizing the legal situation is the anti-drug campaign strongly supported by the U. S. (not without opposition among the Bolivian population - see annex). Bolivia is not the only case. Other countries - or at least parts of their territory- are in a similar situation. In many regions "state-free" sectors have evolved in which public authorities do not dare to interfere, and in which the guerilla as well as paramilitary organizations and the drug business enforce their own right. The decay of public authority is a typical phenomenon of the 1980s 30 . Without a constitutional framework property rights remain unclear. Long-term investments are impeded because the investor cannot count upon getting the proceeds of his investment. Given the fact that economic development is not possible without long-term investments in human and physical capital, the present legal insecurity in Latin America is an essential aspect which cannot be neglected in pursuing economic liberalization. Clearly defined and enforceable property rights are an essential foundation for a successful liberalization process. To put it more generally: If one does not want the result of market-oriented reforms to become a "bellum omnia contra omnes" according to Hobbes, the establishment of a reliable system of economic rights and regulations is an essential part of any reform policy. 2.2. Low acceptance of market-based rules due to increasing pauperization The reductions in real incomes experienced in the 1980s did not have the same effect on all population groups. It affected particularly those at the lower end of the income spectrum. In many countries poverty rates are very high (see annex): One of many examples is the worsenig of the nutritional situation in the metropolitarian area of Mexico-City. The deep recession in the 1980s has substantially diminished poor

29

NZZ from September 10th, 1992: "Prekäre Stabilität In Bolivien".

30

Hurtado, Osvaldo (1991), p. 127 f.

22

peoples's consumption of animal proteins 31 . Taken alone the pauperization of large parts of the population makes the implementation of social policy measures very urgent. Such measures are equally desirable in order to secure compliance with market rules by guaranteeing a certain minimum protection against pauperization. An impoverished rural familiy living on the margin of subsistence can hardly be expected to comply with private property rights with respect to land ownership. Neither an authoritarian nor a democratic government could protect property rights effectively in such cases. This is demonstrated by the so-called "wild" land occupations occurring in Brazil, Paraguay, and in other Latin American countries. Insofar as an efficient economy is not feasible without the protection of property rights, a minimum guarantee of social security is essential in the interest of efficiency alone. This minimum level of social security cannot be left to a "trickle-down"-effect expected to take place sometime in the future. This opinion is shared by a growing number of officials at the World Bank, an institution that no one will accuse of neglecting the object of efficiency and growth. The Bank positively cites the argument that a more equal income distribution facilitates market-oriented reforms as social equality weakens the opposition against these reforms 32 . Therefore it is simply essential to connect the liberalization process with poverty reduction programs. Without doing so, the reform process cannot be sustained. The new generation of structural adjustment programs of the World Bank and the IMF include some social plans 33 . But in spite of the inclusion of social measures in adjustment programs (see annex), Latin American governments in general do not seem to realize the urgency of this dimension of the reform process, and the necessity to take forceful actions so as to improve the situation of lower income groups. This is one of the most severe deficits of the reform process, and it is threatening its continuation. [An efficient social policy seems to be possible without falling back into the traps of populism. Chile is about to demonstrate this.]

31

Leff, Enrique (1991), p. 419.

32

World Bank (1991), p. 166, 168.

33

IMF (1990), p. 54.

23

2.3. Neglected environmental protection It cannot be the object of a market-oriented reform policy to achieve short-term welfare gains by destroying the natural resource base. The resulting shortage of natural resources would sooner or later result in a breakdown of policy reforms. Equally, an increase in production without due consideration of the consequences for the environment cannot be the objective of a market-based development strategy. The deterioration of the natural environment is too high a price to pay for economic growth, and apart from that, the degradation of the environment also affects the resource-base, i. e. the very essence of long-term economic development 3 4 . It cannot be expected that the market alone will solve these problems as the environment is a public good. Governmental actions are indispensable here. It is the task of the government to organize property rights in such a way that the private actor is induced to protect natural resources while pursuing private goals. Furthermore, the government has to adjust its fiscal and economic intruments in support of environmental protection. In this context, severe deficits exist in Latin America as well as in other parts of the world. The results are obvious. Some examples to illustrate this: -

Severe land-erosion, which has been accelerating in the last years, is affecting about 10 % of the territory in Argentina 3S .

-

Uncontrolled deforestation has increased to a threatening extent. If the rate of deforestation does not change, some countries will hardly have any forests left by the beginning of the next century with devastating consequences for the water balance and soil-quality

-

36

.

The uncontrolled use of insecticides in the cotton- and sugar-cane fields in Eastern Bolivia has caused severe damage to soil-quality 37 . Likewise, has water quality

34

On the relationship between development and environmental protection see: World Bank (1992); Sautter, Hermann (1992).

35

Moreilo, Jorge; Marchetti, Beatriz; Cichero, Paula (1991), p. 57 f.

36

Kakabadse, Yolanda (1991), p. 322.

37

Ubermann, Máximo (1991), p. 108.

24

deteriorated due to the dumping of chemical residues from the production of cocapaste 38 . -

The disposal of sewage water in large towns is inadequate. The sewerage system in Buenos Aires was built 50 years ago for a population of one million. In the meantime it has become completely obsolete and is far from being adequate for a population of more than ten millions 39 .

-

Air pollution in the large industrial centres has increased to a health-threatening extent. The situation of the metropolitarian area of Mexico-City is a particularly dramatic example for this 40 .

The list of severe environmental problems and threats to the natural resource base could be continued. Prompt and consistent actions of Latin American governments are indispensable to protect the natural base and thus facilitate environmentally sustainable development - but this is obviously not on top of the political agenda of governments and parliaments. Some progress has been made, e. g. the new forestpolicy in Bolivia and the reduction in Brazil's rate of deforestation (see annex). However, environmental law remains incomplete and contradictory. Only few countries have institutions that enforce the existing law, and there are hardly any financial resources available to improve the ecological information base essential for any purposeful action. 41 If economic reforms do not lead to distinct improvements in environmental policy, this process will not be rewarded with durable success.

2.4. Effectiveness of the political system Economic liberalization combined with social policy reform and pollution control measures is a fire-test for the political system. Efforts to reach not only efficiency objectives but also a minimum of social equality and a secure standard of living for coming generations complicates the process of balancing interests. Only on the surface authoritarian regimes have advantages solving this task. They might be able to eliminate an opposition for the moment, but in the long-run they fail owing to their 38

ibid., p. 109.

39

Morello, Jorge; Marchetti, Beatriz; Cichero, Paula (1991), p. 64.

40

Leff, Enrique (1991), p. 435.

41

See the country surveys in: CIEDLA (1991).

25

lack of acceptance. An authoritative government produces passive opposition, thus being rendered incapable in the long-run to meet the challenges of a market economy compatible with environmental protection and social security 42 . Democratic systems cannot suppress contradictions but have to balance them in order to find workable solutions. Those systems live by compromises, by the capability of partially renunciating one's own interests, and by the willingness for pragmatism. This must be manifested in the ability of subordinating the pursuence of individual interests to the acceptance of common rules. The law must be accepted even in cases where it gives right to the other one; it must be observed inspite of the possibility that illegally exercised power might be more successful. However, Latin America's democracies have little experience in balancing contradictory interests in a pragmatic way. The inheritance of authoritarianism is still alive and puts a burden on the democratic process 43 . Apart from this, the pressure to produce prompt results gives little time for the constitutional state to develop. This is a problem all Latin American countries have. Everywhere the urgency of reforms is in conflict with the capabilities of the democratic system. Leaving behind a governmentally planned economy and regulated markets, improving environmental protection, strenghthening the constitutional state and fighting against poverty: all this requires time. The German experience aptly demonstrates this. But politicians in a democratic regime have to show prompt results if they want to be re-elected. In other words: the time-horizon of reforms is beyond that of the electoral period. In Argentina, thought has been given to the possibility of permitting the re-election of Carlos Menem by means of modifying the constitution 4 4 This can only be a solution if he succeeds in continuing his reform course, and if he is not grinded by the conflicting interests of different power groups. Brazil is an example for the difficulty of pursuing reform policies in new democracies. Attempts to reform the economy, which had not been very determined anyway, are in

42

See World Bank (1991), p. 155 ff.

43

Opinion polls realized in Venezuela showed a strong tendency towards authoritarianism. 83 % of interviewed people agreed with the statement: "Without a strong hand nothing works in this land1' (Keller, Alfredo (1991), p. 107).

44

NZZ from August 1 st, 1992: "Carlos Menem in der Mitte seiner Amtszeit".

26

danger of being suppressed in the battle between the executive and the legislative. 45 The fact that for the first time in Brazilian history a president has been legally suspended from his post due to his involvement in corruption can be considered as progress toward constitutional development. But given this progress, it is still far from being clear that the political system of the country can really tackle the huge reform necessities. The reform program Latin America finds itself confronted with would be a gruelling test even for the established democracies of the Western world. For the less well-established democracies of Latin America this test may be explosive.

2.5. Entrepreneurial dynamism or continued rent seeking? For many years the populist state in Latin America supported a mentality of "rent seeking". Profits were not expected to be gained by finding new markets and by using new techniques of production but by exploring politically caused scarcity rents and by advocating protectionism and subsidies. This was a Latin American experience already in the last century when the elites were fond of the ideals of liberalism. It did not prevent them from using the state as guarantor of their export interests. The government had to provide the infrastructure necessary for the export of primary goods, it had to provide cheap labor and secure low taxes, and in some cases also a guarantee for profits 46 . Since the 1940s, public functions extended with the increasing industrialization, and with this, the possibilities of gaining incomes without productive efforts, i. e. rents, by means of influencing public activities. An increasingly irrational patchwork of production licences, import quotas, credit restrictions, tax privileges etc. helped "rent seeking" to become the most lucrative private economic acticity 4 7 . The re-definition of the relationship between state and economy forces private actors to change their way of business. They cannot rely anymore on public protection but have to face worldwide competition. Profits can no longer be expected as the 45

NZZ from September 4th, 1992: "Vor der Wende In Braslllen?"

46

Topik, Steven (1985), p. 76.

47

A good illustration is given by de Pablo referring to de Pablo/Martinez (1989): "The typical day of the Argentine private-sector entrepreneur or executive starts very early In the morning with two hours of news on the radio, supplemented by two or three newspapers. The morning office hours are devoted to meetings with bureaucrats, followed by working lunches with high government officials or with "competitors". Then it is back to the office for still more news on the radio. The typical Argentine entrepreneur is too busy to work!" (de Pablo (1990), p. 123)

27

automatic result of successful lobbying. What matters is entrepreneurial dynamism and flexibility. There are some promising signs of entrepreneurs in Latin America facing up to this challenge.48 The strongest dynamic forces might not be coming from large enterprises which, for many years, used to have arrangements with the populistic state. The driving force might rather come from the small and medium-sized enterprises to which de Soto attributes creativity to an amazing degree. 49 Indeed, recent experience has shown that a reduction in bureaucratic regulations has stimulated the initiative especially of enterprises of this size. There is also opposition against this new course. Protected privileges, in effect for many years, are not easily waived. In Brazil, at least part of the entrepreneurial class seems to be little convinced of the advantages of a competitive economy, and prefers the continuation of traditional protectionism.50 Their opposition against marketoriented reforms renders the reorientation of offical policy more difficult. Similar observations can be made in other countries. The success of market-oriented reforms will depend on the extent and the force of entrepreneurial creativity. Latin America is in need of a new class of entrepreneurs who do not shrink from intensified competition. 3. The external support of the Latin American reform process - the role of the industrial countries The unresolved problems in Latin America do not affect the legitimacy of the present reform process. On the contrary: they make its continuation and its deepening even more urgent, mainly to be undertaken by Latin America itself. The industrial countries cannot replace the decisiveness for reforms. Nevertheless, the support of industrial countries is important in areas where it is possible. This is the case in international trade, environmental protection, and with respect to their own fiscal policy. Liberalizing trade policy in industrial countries improves export opportunities for Latin America, and facilitates the liberalization process. In this context, the countries of the EC have a particular responsibility. They have caused severe damage to the traditional agricultural export countries in Latin America due to their common 48

Wooton, Leland M. (1988), p. 9.

49

de Soto, Hernando (1987).

50

NZZ from July 30th, 1991: "Opposition gegen Brasiliens Stabilisierungsplan".

28

agricultural policy. Argentina serves as an example for this. The Single European Market threatens to intensify European protectionism. The growing interest in regional integration, guided by the United States, may be seen as a reaction to this. An even stronger formation of blocs in the international trading system seems to be inevitable. EC countries may avoid such a development by pushing forward the multilateral liberalization efforts within the current GATT Round. Also in the area of environmental policy Latin American efforts may be supported. In this context, there is no contradiction of interests between Latin America and the industrial countries. When industrialized countries intensify their efforts toward energy conservation and the reduction of pollution, environmentally sustainable development is facilitated in those countries, and similar efforts in Latin America are encouraged through the increased access to and supply of non-polluting techniques. The possibility that the conservation of energy and natural resources could cause shortterm export losses in Latin America cannot be raised as a grave objection to such a policy. It is in the long-term interest of the region to reinforce the diversification of their export base. Furthermore, industrial countries can also support environmental protection in Latin America by offering "debt for nature swaps" and by means of other forms of environment-conscious financial assistance. Finally, it is mainly the responsibility of industrial countries to stabilize international capital markets by improving their fiscal policy, so as to avoid further external shocks for Latin America. High U.S. budgetary deficits have significantly contributed to the international interest rate shock at the beginning of the 1980s, and it is widely viewed as one of the main determining factors of the debt crisis. German budgetary policy is following a similar model, even if its international impact may not be as grave - due to the lower share of the German economy in world output. In view of the high additional capital requirements resulting from German unification, and considering the financial requirements of the numerous states of the former Soviet Union as well as developing countries, Germany's policy makers should make use of all possible tools to increase public and private savings. This might contribute to an easing of liquidity constraints on international capital markets, thus helping to improve the external conditions for a durable economic recovery in Latin America. As mentioned before, the 1990s are said to be a "decade of hope" after the "lost decade" of the 1980s. There are indeed a number of hopeful signs: Former mistakes

29

are being corrected, investment activities are starting to recover, the recession of the last years seems overcome. But there is much that remains to be done: strengthening the constitutional state, fighting against poverty, protecting the environment, developing lasting private entrepreneurial dynamism. Latin America deserves the continuing support of Europe. In doing so, European countries do not have to make any sacrifices.

An outward-looking

policy

is to their own

advantage,

and

simultaneously assists Latin America in the pursuit of its difficult process of economic reorientation.

30

References Beristain, Javier, and Ignacio Trigueros. 1990. "Mexico." In John Williamson, ed. Latin American Adjustment: How much has happened? Washington, D.C. Cardoso, Eliana A., and Daniel Dantas. 1990. "Brazil." In John Williamson, ed. Latin American Adjustment: How much has happened? Washington, D.C. Cariaga, Juan L. 1990. "Bolivia." In John Williamson, ed. Latin American How much has happened? Washington, D.C.

Adjustment:

CIEDLA, Centra interdisciplinario de estudios sobre el desarrollo latinoamericano. 1991. La situación ambiental en América Latina. Buenos Aires. de Pablo, Juan Carlos. 1990. "Argentina." In John Williamson, ed. Latin Adjustment: How much has happened? Washington, D.C.

American

de Pablo, Juan Carlos, and Alfonso José Martínez. 1989. Argentina: A Successful Case of Underdevelopment Process. Washington. World Bank. Cited from: de Pablo, Juan Carlos. 1990. de Soto, Hernando. 1987. El otro sendero. Lima. Hausmann, Ricardo. 1990. "Venezuela." In John Williamson, ed. Latin Adjustment: How much has happened? Washington, D.C.

American

Hurtado, Osvaldo. 1991. "Handlungsperspektiven und -Orientierungen für Staat und Gesellschaft in Lateinamerika." In Josef Thesing, ed. Lateinamerika: Tradition und Modernität. Mainz. IWF, Internationaler Währungsfonds. 1990. Jahresbericht Kakabadse, Yolanda. 1991. "Ecuador." In CIEDLA. América Latina. Buenos Aires.

1990. Washington D.C. La situación

ambiental

en

Keller, Alfredo. 1991. "Grundlagen der politischen Kultur." In Josef Thesing, ed. Lateinamerika: Tradition und Modernität. Mainz. Kuczynski, Pedro-Pablo. 1990. "Peru." In John Williamson, ed. Latin Adjustment: How much has happened? Washington, D.C.

American

Leff, Enrique. 1991. "México." In CIEDLA. La situación ambiental en América Buenos Aires.

Latina.

Libermann, Máximo. 1991. "Bolivia." In CIEDLA. La situación ambiental en América Latina. Buenos Aires. Me Kinnon, Ronald I. 1973. Washington. D.C.

Money

and

Capital

in Economic

Meiler, Patricio. 1990. "Chile." In John Williamson, ed. Latin American How much has happened? Washington, D.C.

Development. Adjustment:

31

Morello, Jorge, Beatriz Marchetti, and Paula Cichero. 1991. "Argentina." In CIEDLA. La situation ambientai en América Latina. Buenos Aires. Sautter, Hermann, ed. 1992. Entwicklung und Umwelt. Schriften des Vereins für Socialpolitik. Band 215. Berlin. Shaw, Edward S. 1973. Financial Deepening in Economic Development. New York. Thesing, Josef, ed. 1991. Lateinamerika: Tradition und Modernität. Mainz. Topik, Steven. 1985. "The Evolution of the Economic Role of the Brazilian State, 1889- 1930." In Alfred H. Saulniers, ed. Economic and Political Roles of the State in Latin America. Austin. Weltbank. 1991. Weltentwicklungsbericht "Entwicklung als Herausforderung". Washington, D.C. Weltbank. 1992. Weltentwicklungsbericht "Entwicklung und Umweif. Washington, D.C. Williamson, John. 1990. Washington, D.C.

The Progress of Policy Reform in Latin America.

Williamson, John, ed., 1990. Latin American Adjustment: How much has happened? Washington, D.C. Wooton, Leland M. 1988. A Revolution in Arrears. The Development Crisis in Latin America. New York et al.

32

Annex

Reform Steps in Selected Latin American Countries 1990 and 1991

33

Argentinia 1990 3/90 Discontinuation of credit financing by the central bank 8/90 A 14 % reduction of government employees is planned. 3/90 Tax increases. Advance import deposit requirement abolished. 7/90: Privatization of state-owned telephone and oil company: 10/90: Restriction of the right to strike. Poverty rate: from 9% inl980 to 13% in 1986; absolute poverty: from 2 % in 1980 to 4 % in 1986. IMF targets: Maintenance of the exchange rate at 10000 Australes per US dollar until April 1992; no increase in tariff rates, reduction of the inflation rate to 10.6 %; reduction of public expenditures by 20%, including a freeze of public sector salaries, and a reduction of government employees by 82000 persons.

Fiscal Discipline Public Expenditure Priorities Tax Reform Trade Liberalization Privatization Deregulation Poverty alleviation

Argentina 1991 2/91: Coverage of money supply in circulation by US dollar reserves achieved Public Expenditure Priorities 6/91: Reduction of military personnel by 40 % is planned. Tax Reform Economic policy measures to raise tax revenues: increase in tax rates for value added tax, energy tax; price increases for government services. 2/91: Value added tax was raised from 15.6% to 16%; measures were taken to improve the willingness to pay taxes. 3/91: lull convertibility of the national currency; discontinuation of Financial Liberalization all indexation measures. Exchange Rates Legal fixing of the maximum exchange rate at 10000 Australes per US dollar. The central bank is legally obligated to maintain this exchange rate. Trade Liberalization Removal of the export tax for agricultural products; discontinution of special credit-granting measures. New customs regulations: external tariffs are reduced and unified in three categories; non-tariff duties are abolished. The foreign minister signs an investment and trade agreement between the United States and the members of MERCOSUR. Bilateral trade agreements with Bolivia,Chile, and Brazil. Foreign Direct Investment Foreign investment protection agreements are signed with Germany, Spain, and the United States. Permission of joint ventures with foreign partners in the oil industry. Privatization Transformation of the state-owned oil company YPF into a private shareholding company. The World Bank grants a loan for the support of privatization programs in the oil sector allowing the unlimited participation of private investors in the exploitation of oil and gas reserves. President Menem signs a bill for the preparation for privatization of nearly all remaining state-owned enterprises in 1992. Deregulation Economic policy measures for the reduction of government regulations and further reforms in the public sector. World Bank credit to support public sector reforms. Creation of a special task force for the fight against drug traffic. Legal Issues Reconnaissance by air in cooperation with the U.S. Drug Enforcement Agency. Creation of a justice ministry.

Fiscal Discipline

34 Bolivia 1990 1/90: Public sector credit financing on private markets; government surplus in 1987, 1991: government deficit = 1.5% GDP Public Expenditure Priorities 1/90: subsidies abolished; Financial Liberalization 11/90:fi-eeconvertibility of the national currency

Fiscal Discipline

Exchange Rates Foreign Direct Investment

Privatization Deregulation Legal issues Environmental

Fiscal Discipline

1/90: unified exchange rate New investment law covering all sectors except mining and hydrocarbons approved. Law put domestic and foreign investors on equal footing. 1/90: equal treatment of foreign investors 1/90: extensive privatizations 1/90: guarantee of free prices; tariff autonomy, administrative deregulation Commission for the protection of international law 1/90: no new concessions fo forestral use during the next five years Bolivia 1991 Government announces a reform program for the public sector, including the dismissal of40000 employees during the next 5 years.

Public Expenditure Priorities Tax Reform Financial Liberalization BID and IDA grant credits for the reform of the financial system and the promotion of private investments. Exchange Rates Trade Liberalization From January 1992 on, membership of Bolivia in the free trade zone of the Andes. Due to Bolivia's close trade relations to the MERCOSUR countries, an application for membership to MERCOSUR is planned. Foreign Direct Investment Mining sector: liberalization of foreign investment regulations in the security zone along the national border, and permission of joint ventures. Investment agreement with the United States to facilitate U.S.American investments in Bolivia. Privatization The government plans the privatization of 60 to 150 small stateowned enterprises. Contracts with productivity and profitability targets envisioned for 12 large public enterprises. The president of the state-owned mining company announces the closing of unprofitable mines. Deregulation Political and administrative decentralization is planned. Strong pressure from the United States forced the President to Legal Issues dismiss high-level officials on several occasions, and include the military forces in the fight against drug traffic. The assignment of military personnel has provoked resistance due to the strong U.S. presence. 2/91: Agreement for renewal of judicial institutions. Poverty Alleviation Environmental Protection

35

Brazil 1990 Annual import programs and the negative import list largely Trade Liberalization eliminated; elimination of the monopoly of federal government agencies for imports of products for reasons other than health, national security and other specified public interests. External financing requirements on certain imports abolished. Foreign Direct Investment Repatriation of capital liberalized. 11/90: so far 238,000 jobs redundant. Deregulation Legal Issues 10/90: genocide in Brazil Poverty Alleviation Poverty: from 39 % in 1980 to 40% in 1986; absolute poverty: from 17% in 1980 to 18% in 1986. 10/0: forest burning reduced by 65% in 1990; initiatives for satellite Environmental Protection watch Letter of Intent for a credit line from the International Monetary Fund includes the following policy targets: budget surplus of 3%, declining inflation rate, tax increases, liberalization of prices, continuation of the privatization program and reduction of money supply. Brazil 1991 Public Expenditure Priorities 3/91: Tax holidays for selected sectors. Financial Liberalization The government grants a 2-months bridge loan to national banks to prevent their closing by the central bank. Exchange Rates Prices rose by more than 60% as a reaction to the 15% devaluation of the Cruzeiro. Signing of a treaty with the MERCOSUR countries. Trade Liberalization 3/91: Imports will be facilitated for selected sectors. Foreign Direct Investment Equal treatment of national and foreign capital is one of the objectives of the "Project of national reconstruction". Privatization Planned: the breaking up of all state monopolies (including oil). First phase of the privatization program: auctioning of the steel company - 840,000 share packages with 1,000 shares each are offered to the public. Critics point to the high level of state participation in an iron ore company (14.65 %) as well as in the pension fund (14.94%). Deregulation Implementation of a price and wage stop to bring down inflation. Supply constraints due to merchandise held back for speculative reasons. Following the implementation of price liberalization measures price controls are reintroduced due to dramatic price increases. 1/91: introduction of a cartel law. Security There are frequent reports about increasing violence. After a drug scandal Brazil plans to apply for support from the United Nations and NATO. Fight against corruption was enhanced due to the publicity on several corruption cases; the government remained rather reactive. Poverty Alleviation Objective: improved social justice through income distribution and public investments in education, housing, and health. Environmental Protection US$50 mill, in debt-nature swaps have been committed for the Amazone rain forest project (total project amount: US$1.57 billion). The government makes public that in 1990 the forest was reduced by 14,000 square kilometres compared with 19,000 in 1989. Cancellation of all financial support for agricultural projects in the Amazones. Germany commits US$180 mill, in support of environmental protection measures as well as sanitation and electrification programs. 3/91: Deforestation has been reduced by 36% in two years.

36 Financial Liberalization Trade Liberalization Foreign Direct Investment

Legal Issues Poverty Alleviation

Tax Reform Financial Liberalization Exchange Rates Trade Liberalization

Foreign Direct Investment Privatization Deregulation Legal Security

Poverty Alleviation

Environmental Protection

Chile 1990 Repatriation period for export proceeds extended from 90 days to 120 days. Elimination of foreign exchange restrictions for travel allowances. Minimum import financing requirement (120 days) abolished. 10/90: Free trade with Mexico Non-resident individuals and legal entities meeting specific conditions are granted access to official exchange market for remittances abroad, including (1) proceeds from sales of stocks of registered Chilean corporations purchased with funds from abroad, and (2) dividends and profits accruing from such stocks. 11/90: USA plan investments of US$13 billion. 9/90: Bill is introduced to allow free unions. 11/0: CEPAL: finds that 44% of the population live in poverty. Chile 1991 6/91 : New taxes on capital gains and fuels in exchange for lower tariffs. 6/91 : banks permitted to finance external activities 6/91 : Devaluation of the peso. Numerous bilateral trade treaties are signed with Latin-American countries. The US American government reintegrates Chile into the general preference system for customs duties. 6/91: General reduction of tariff rates from 15% to 11%. 1/91: 1990 Increase of foreign direct investments by 26% to a record amount ofUSS 1.13 billion. Unions called for a protest march against the participation of private capital in public enterprises and the lowering of import tariffs. Participation was limited to only 400 workers. Constitutional change to enhance the decentralization and déconcentration processes on a regional and local level. The government is accused of systematically violating human rights and criticizes the inactivity of the justice system during the military administration. Bill guaranteeing the freedom of the press is introduced. Membership of Chile in the UN Human Rights Commission. A bill is introduced allowing collective bargaining by unions. Increase of minimum wage levels from 26,000 pesos per month to 33,000 pesos. The World Bank grants Chile a credit for improvements in basic education. 7/91: "Ecological state of emergency" in Santiago de Chile

37

Financial Liberalization

Trade Liberalization

Legal Issues Armutsbekämpfung Tax Reform Financial Liberalization Trade Liberalization

Foreign Direct Investment Deregulation Legal Issues

Poverty Alleviation Environmental Protection

Colombia 1990 Elimination of the system by which the central bank retained a portion of the exchange proceeds surrendered by exporters to repay debts on imports under the Vallejo Plan. Raising of ceilings on foreign exchange purchases for travel abroad, elimination of ICETEX authorization for foreign exchange purchases. Discontinuation of central bank redemption of exchange certificates for services. Raising of ceiling from 8-15% for holding of foreign currency deposits by domestic commercial banks and financial corporations. Elimination of import licensing. Period of surrender requirements for export proceeds changed to three months after the date of receipt of payment as declared by the exporter. 8/90: numerous human rights violations Poverty: from 39% in 1980 to 38% in 1986; absolute poverty: from 16% in 1980 to 17% in 1986. Colombia 1991 Increase in value added tax from 10% to 12% for purchases above 71,000 pesos. Liberalization of foreign currency trade. Elimination of import tariffs for machines and capital goods has been advanced due to improvements in the trade balance and the level of foreign currency reserves. Elimination of protective customs duties for agricultural imports (exception: grain). Signature of a loan agreement with the IDB for the promotion of private enterprise and private investments by foreign investors. Fixing of the coffee price by coffee producers and government. This implies liabilities of 30 billion pesos fof the Fondo Cafetero. Passing of the statute for the protection, defense, and the respect of the indigenous population. The government passes an action plan against the spread of violence, including the regionalization of corrective measures, strengthening of the judiciary, and the defense and protection of human rights. Proclamation of the new constitution. In spite of all efforts, the level of violence remained high in 1991. 11/91: 26,000 persons were murdered. The president announces the development plan for 1991-94. A priority of the plan is the fight against extreme poverty. Signature of a cooperation agreement between Columbia and Germany.

38 Fiscal Discipline Public Expenditure Priorities Tax Reform Financial Liberalization Exchange Rates Trade Liberalization Foreign Direct Investment Privatization Deregulation Legal Issues Poverty Alleviation

Costa Rica 1990 Deficit in 1990: 3 .1% of GDP 11/90: IMF plan without a social program Price and tax increases, broadening of the tax base.

Ratio of import deposit requirements raised from 1% to 30%.

Poverty: from 22% in 1980 to 27% in 1986; absolute poverty: from 6% in 1980 to 8% in 1986.

Environmental Protection Costa Rica 1991 Fiscal Discipline Public Expenditure Priorities Austerity budget is passed in preparation toward a credit agreement with the International Monetary Fund, including the commitment to reduce the budget deficit. The dismissal of 7,000 government employees is planned. Tax Reform Passing of a tax reform bill. 10/91: competitive interest rates, increase in open market operations. Financial Liberalization Exchange Rates Trade Liberalization Program for the third phase of structural adjustment (1992): maximum tariff rate = 20%; continued elimination of non-tariff trade barriers. Principal agreement on free trade treaty with Columbia, Mexico, and Venezuela. Foreign Direct Investment Privatization Program for the third phase of structural adjustment (1992): Privatization of public enterprises and services, and reduction of employees in the public sector. October.: Pres. Calderon announces a temporary halt of privatizations and the reduction of public sector jobs. Deregulation Legal Issues Poverty Alleviation

Environmental Protection

Objective: Reduction of government intervention in the economy, particularly with respect to price controls. Indigenous peoples obtain the right to a national passport. The private police force is criticized for lack of objectivity and efficient controls. The government announces a plan for the fight against poverty. The creation of 200,000 jobs is planned during the Calderon administration. The plan is received with scepsis due to the perceived lack of concrete measures.

39

Jamaica 1990 Fiscal Discipline Public Expenditure Priorities Tax Reform Financial Liberalization Authority for private sector import payments delegated to commercial banks. Export receipts from exports of nontraditional goods can be deposited in commercial bank accounts, and are permitted to be used for business transactions with supporting documentation. Exporters of non-traditional goods and services are allowed to deposit 7.5% of their earnings in convertible currencies in a retained account in a commercial bank; these balances may be used without restrictions. Residents and non-residents permitted to maintain "A" and "B" accounts. Exchange Rates Trade Liberalization Foreign Direct Investment Privatization Deregulation Jamaica 1991 Fiscal Discipline Public Expenditure Priorities Tax Reform October: Implementation of the value-added tax. Simplification of the tax system through unification of several tax categories into a General Consumption Tax (GCT) of 10%. Financial Liberalization Exchange Rates Exchange rate is set at Jam $ 10 to 1 US$, an appreciation compared with the previous exchange rate of Jam $ 14 to 1 US$. This results in parallel market operations where the US$ is traded with mark-ups of up to 50%. September: The government completely eliminates foreign currency market restrictions, resulting in a drastic devaluation of the national currency to Jam$ 21 per US$. Trade Liberalization Measures are passed for the promotion of export production. Tax deductibility possible for up to 100% of costs; more liberal handling of foreign currency accounts of exporters. Foreign Direct Investment Privatization Deregulation Elimination of private sector wage guidelines within the context of economic promotion measures. Wage increases are limited to 12.5 % per annum. Legal Issues Poverty Alleviation National minimum wage levels are raised by 23% to 160 Jam $ per week. Basic foods, medications, and other goods consumed mainly by lower income groups are exempted from the GCT. Environmental Protection

40 Fiscal Discipline Trade Liberalization Foreign Direct Investment Privatization Deregulation Legal Issues Poverty Alleviation Environmental Protection

Fiscal Discipline Tax Reform Financial Liberalization

Exchange Rates Trade Liberalization

Mexico 1990 9/90: Increase in oil export revenues to more than US$500 mill due to the Gulf crisis. Decline in the budget deficit from 10% of GDP in 1988 to 5.5% in 1989. Free trade with Chile. 6/90: Privatization of state-owned oil companies; record inflows of foreign direct investments. 9/90: Lowest wage levels since 1983. 8/90: wide-spread poverty. Poverty rates moved from 32% in 1980 to over 30% in 1986; absolute poverty:: 10% in 1980 and 1986. 3/90: Successful implementation of a program for the reduction of automobile traffic in Mexico City. Mexico 1991 ( 6/91: Membership in OECD) 2/91 : In 1990 smallest budget deficit since 1970. Planned reduction of the value added tax from 15% to 10%. First public emission of Eurobonds for a total amount of DM 200 million. Reprivatization of 18 banks nationalized in 1982. Completion of the first bank privatization ofMultibanco Mercantil. Privatization of two of the largest Mexicon banks. Planned elimination of foreign exchange controls. Devaluation of the peso vis-à-vis the US dollar is reduced from 40 Centavos per day to 20 Centavos per day. Economic cooperation treaty with Costa Rica, Honduras, Guatemala, £1 Salvador, and Nicaragua. Excludes a concrete time schedulre for tariff reduction. Economic cooperation treaty with the European Community, including trade expansion. Bilateral treaties with Costa Rica, Chile. Negotiations for membership in the North American Free Trade Area (NAFTA).

Foreign Direct Investment

Privatization Deregulation Legal Issues

Poverty Alleviation Environmental Protection

The state-owned railway company is to be opened up to foreign capital. German policy makers announce investment plans in the automobile industry, in the tourism sector, and in the petrochemical sector. Treaty with Italy about private capital for Mexican industrial projects. Up to 100% privatefinancingallowed in the oil sector. Since 1988, 227 companies have been denationalized. Reform of the Ejido-system: discontinution of land distribution; leasing and sale of Ejido property is allowed. Special regulations are planned for foreign investments. Amnesty International reports about torture and other human right violations. AI criticizes de facto impunity of the violators. The president intends to institutionalize the human rights commission as part of the constitutional framework. Announcement of the move of an oil refinery for environmental reasons.

41

Peru 1990 Fiscal Discipline 11/90: Gas prices are raised by 65%: "brutal alza de precios y tarifas" (Inflation reduced from 347% in August to 5 % in September) Public Expenditure Priorities 10/90: Elimination of all subsidies. Tax Reform Financial Liberalization Period for surrendering export proceeds to the central bank shortened to five calendar days from the day of receipt of payment. Payments of insurance premiums and repayments of external credits with foreign exchange certificates no longer permitted. Maximum transfer abroad for banks that had not completed transfers of surrendered export proceeds reduced from $100,000 to $50,000. Restrictions on debt-service payments on non-guaranteed private sector debt eliminated. 9/90: Unification and liberalization of the exchange rate. Exchange Rates Trade Liberalization January.: Non-interest-bearing advance import deposit requirement imposed on imports subject to controlled (MUC) exchange rate. Deposit rate must equal 50% of import value and be lodged for 30 days. Imports financed with credits of over 90-day maturity exempted. April: Imports purchased at the MUC exchange rate subject to advance payments authorization. August.: Non-interest-bearing advance import deposit requirement abolished. Januarv.: Percentage of FENT credit financing (subsidized credits for non-traditional exports) without advance accounts reduced from 90% to 40%. April.: System of FENT credits without advance accounts abolished. FENT advance account credits for exporters to be disbursed in intis exchanged at free market rate. May: Line of credit in intis equivalent to about US$20 million approved as working capital for exporters. June: System of FENT credits with advance account abolished. 10/90: tariffs have been readjusted. Foreign Direct Investment Privatization 10/90: Sale of state-owned enterprises. 11/90: ' Discontinuation of the state monopoly for oil imports. Deregulation Legal Issues 11/90: Non-judicial executions by the military and para-military. Poverty Alleviation Poverty: from 46% in 1980 to 52% in 1986. Absolute poverty: from 21% in 1980 to 25% in 1986. Environmental Protection

42

Peru 1991 Fiscal Discipline Public Expenditure Priorities Total government expenditures: US$ 4 billion, of which 13 % for debt service, 20 % for health and social expenditures, and 25 % for security. Tax Reform Financial Liberalization Exchange Rates Trade Liberalization

Foreign Direct Investment Privatization

Deregulation Legal Issues

Poverty Alleviation Environmental Protection

March: Reforms in the financial and exchange rate system: e.g. permission of foreign currency deposits in another country. Reintegration of Peru into the international financial community. Liberalization of foreign trade: reduction of import tariffs to between 15-25%; removal of all non-tariff trade barriers. Export tax reductions. November.: Senate announces state of emergency for the agricultural sector and plans to implement protective import tariffs. The president reacts by freezing the bill on the state of emergency. Promotion of foreign direct investments. Promotion of private investments in the agricultural sector. Limitations of the role of the state in entrepreneurial activities. Start of the privatization program with the sale of shares valued at over US$ 1 billion. The plan for the fight against drug traffic includes military cooperation with the United States. Incentives for coca farmers for alternative crop cultures. Signature of a bilateral anti-drug treaty with the United States. Armament of self-help groups organized by farmers for the fight against terrorism. October.: Between Mav and September. 23,916 persons died as a result of political violence. During the administration of Fujimori, 3,761 persons were killed by terror and anti-terror acts. November: According to Amnesty International, 250 persons disappeared or have been executed since the start of the Fujimori administration. 3/91: Indicator for poverty: increased incidence of cholera.

43

Fiscal Discipline Trade Liberalization Foreign Direct Investment

Venezuela 1990 Budget deficit: from 7.3% of GDP in 1988 to 1.2% in 1989. Tax incentives for exports consisting of a negotiable bond that may be used for tax payments; tax reduced to 5% of the f.o.b. value for manufactured products and to 6% for agricultural products. Foreign direct investments liberalized as follows: (1) elimination of investment authorization and investment restrictions in several sectors; (2) foreign firms are permitted to open subsidiaries in Venezuela, to contract technology without restriction, to invest in Venezuelan securities and stocks, and to obtain financing through shares or debt notes in Venezuelan capital markets.

Poverty Alleviation Fiscal Discipline Tax Reform

Trade Liberalization

Foreign Direct Investment Privatization

Deregulation Poverty Alleviation

Venezuela 1991 10% budget cut in 1991 after a decline in the average export price for Venezuelan oil to US$18 per barrel. Reduction of the maximum tax rate on profits from 50% to 20-30% (split rate) and the tax on interest receipts from 20% to 5%. Reduction of the maximum income tax rate from 45% to 30%. Public transportation prices raised by 70%. Agreement with Columbia and Mexico about the free trade zone to be created by 1994. Bilateral trade and investment treaty with the United States. Resignation of the director of the foreign trade institute due to perceived obstacles to non-traditional export promotion as a result of the President's economic policy. Preferential free trade treaty with CARICOM Principal agreement on the creation of a preferential free trade zone with Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua. Venezuela expresses the desire for membership in NAFTA. Principal agreement with Brazil on the creation of a free trade zone. 3/91: Announcement of a US$ 2 billion debt-equity swap in the aluminium industry. Sale of a 60% share in the state-owned airline VIASA to a consortium directed by the Spanish airline Iberia. Sale of a 40% share of the state-owned telephone company to a consortium directed by a U.S. American telephone company; a further 11% will be sold to the staff. 4/91: Participation of private investors in an energy project (gas). Reinstitution of constitutional economic rights. These fundamental rights had been drastically curtailed in 1962, clearing the way for government involvement in the economy. Implementation of a new labor law, including 1 year maternity leave for women, enhanced participation of employers in social security. General salary increases of between 17 and 21 % for private sector employees without a collective labor contract. Increase by 50% in the minimum wage rate in urban regions, and by 80% in the minimum wage rate in rural regions.

Sources: IMF. June 1992. "Development in International Exchange and Payments Systems". World Economic and Financial Surveys. Lateinamerika Jahrbuch 1992. Spiegel der lateinamerikanischen Presse. 1990 and 1991.

45

The Relationship between State and Economy in Latin America its Significance in the Current Period of Transition Manfred Mols **

During the 1980s, Latin America suffered the most severe political, social, and economic crisis in this century. At stake was no less than the continuity of civilized statehood and a minimum of orderly societal cohesion without which countries risk falling apart. Moreover, the most basic economic order was seriously endangered. Some of the better known indicators of this crisis were galopping inflation, in some cases at 5-digit rates, a gigantic burden of external debt amounting to roughly 70 percent of GNP, and stagnating or negative growth rates, reducing the real incomes of Latin American economies to the level of the early 1970s. Other symptoms were the relinquishment of internal and external sovereignty to the guerilla or powerful drug cartels as in Peru or Colombia, and to international financial organizations or, as in the case of Central America, to the U.S. American political administration for w h o m peace meant pacification viewed from the perspective of a one-sided interpretation of the East-West contrast. In Argentina, President Alfonsin's premature departure from office in 1989 can be viewed as an admission of government's failure to manage the crisis following the promising democratic renewal in 1983. In Brazil, the former period of milagre

had

reached its end. Honduras was about to loose its national dignity to foreigners as it tolerated on its soil one of the dirtiest de facto wars in Central America in this century. El Salvador, Nicaragua, and Guatemala seemed incapable of putting an end to an undeclared civil war. In summary: An atmosphere of hopelessness and despair had enveloped a subcontinent that, until the mid- to late 1970s, seemed one of the most promising regions of the world. Many officials observed that Latin America was standing with its back against the wall. What made its round was the terrible double threat of a

Lebanization

(Latin America as a marionette of foreign interests). Many were beginning to abandon

'

Prof. Dr. Manfred Mols, Johannes-Gutenberg-Universität Mainz, Institut für Politikwissenschaft.

46

all hope for Latin America or their own country. I have been scoffed by some highlevel Latin American officials for persistently pointing out, among all the pessimism, the continuing positive potential and new signs of hope for the region. It was like swimming against the current of wide-spread doom in which many doubted the survival of Latin American society and statehood, its ability to provide for the most basic needs, the reinstatement of fundamental economic functions, and the respect for human dignity. Today, it looks as though much of this can be filed away in history books. Many countries seem to have passed the trough of the severe economic depression, leaving behind the decada perdida. Latin America is once again being taken seriously in the international economic community. And no less important: Latin America takes itself much more seriously than just a few years ago. The feeling that the worst was over started to emerge in the late 1980s, and the beginning of the 1990s. In the fall of 1990, the cover story of the Far Eastern Economic Review wrote about the Latin American resurgent rivals 2 , and the British Economist published an article on "Latin America Reborn". 3 The cover of the December 1991 edition of the Mexican periodical Cambio was entitled "Una América se despierta".4 How did this sudden change come about? On which events in Latin America and in the international community is this new optimism based? What justifies it, in view of autogoipe in Peru, and in spite of the attempted coup in Venezuela, continuing mass poverty in most countries in the region, and the still vulnerable internal peace accord in Colombia or in Guatemala? It is possible to recount plenty of indications of change, for example: Mexico's path towards democracy; the successful peace talks between the warring factions in El Salvador; Argentina's and other countries' remarkable economic recovery; constitutional reform in Paraguay,5 viewed as nearly impossible just a few years ago;

Far Eastern Economic Review. Hong Kong. September 9,1990. Economist. October 19,1991. Cambio. December 2,1991. no. 1045. For a discussion of constitutional reform in selected countries see Carlos Mateo Balmelli. 1992.

47

and the unanticipated self-cleansing power of Brazilian politics. All these events are doubtlessly correct and appropriate to mention, yet they are just a few positive developments among other, more wide-reaching, trends. Here, I shall restrict myself to shedding some light on four main elements: 1. Reassessment of past economic policies One of the most important developments may be seen in Latin America's attempt at discarding its self-pity and outdated narcism. The reintegration into, and the opening to, the world economy is known as reinvindicacion, which can be translated as redemption, or reinstatement of the original legal property or title. In a dictionary, the word is defined as "reclamer una cosa que pertenece a uno pero que esta en manos de otro", i.e. reclaim something that belongs to one but is in the hands of another. 6 Latin America spent a vast amount of energy and wasted valuable time on their expectations of changes in the international community, the international economic order, and the international income distribution (CEPALISMO of the 1950s and 1960s, the enthusiasm for OPEC, and the catalogue of demands in the North-South dialogue of the 1970s), without giving enough consideration to its own contribution, responsibility, and initiative. If the expectations on third parties exceed the responsibilities and demands on oneself, then - assuming that the others do not act as one expects- the ensuing situation will be unbalanced. In this context, an important contribution to the new thinking is Aldo Ferrer's book Vivir con lo nuestro 7, as well as the famous 1984 letter from Henrique Iglesias (the former chairman of CEPAL) and Carlos Alzmora (at the time Secretario Permanente of the Latin American economic system SELA) to the Ecuadorian President Osvaldo Hurtado Larrea, containing the honest appraisal that many of Latin America's problems are homegrown and that the reform of government and economy should begin at home and be based on own initiative.

Pequeño Larousse Ilustrado.

Ferrer. 1983.

1975:885.

46

2. Redesign of development strategies Some of the bigger countries in Latin America have been able to summon up enough willpower to reconsider their development strategies and instigate a debate on economic policy, departing from former rigidities, especially from the classic CEPALISMO of the 1950s and 1960s (Sangmeister, 1992). The more recent economic strategy applied in the majority of countries in the region has been entitled neostructuralism. In some cases, however, notably Chile, the economic reorientation has been based on neo-liberal economic theory (Ominanmi, 1991). Neo-structuralist approaches attempt to overcome the so-called false dilemmas, i.e. import-substitution vs. export-oriented industrialization strategies or central planning vs. market economy, which are the central themes of the ideologically tainted discussions between structuralists and neoliberalists (Thiery, 1991). Some of the indicators of the new economic policy are: pragmatism, the opening of domestic economies to the world market, more respect for individual investment decisions and market strategies of individual firms, and the welcoming of foreign capital. Latin America's political and economic leaders, at least those who feel responsible for the conceptualization of an appropriate development strategy, are reevaluating their former views. The new approach to economic policy is evident from the writings of CEPAL of the early 1980s (Gurrieri and Sainz, 1983). It has gained influence since then, and is beginning to bear fruit. The most important CEPAL document of spring 1990, Transformación productiva con equidad (CEPAL, 1990) points in the direction of this new thinking which is slowly transforming the policy agendas in Santiago de Chile and Buenos Aires, in Mexico City and in Caracas, in Asuncion and in Managua, in La Paz and Montevideo. This turnaround is closely related to the crisis of the decada perdida, and to the outlived usefulness of former development strategies (Mols, 1991). The lessons from the decade of painful learning, of aprendizaje doloroso, have come to good use. According to the Heidelberg economist Hartmut Sangmeister, the economic policy of the last decades put too high demands on the government, and too little demands on private enterprise, so that development was blocked rather than promoted. 8 Today, many of the political and economic leaders in Latin America would probably agree with this assessment. Chile began early to reform its economic policies. Mexico, Argentina, as well as others are catching up with

compare Mois, Manfred. 1991:15.

49

surprising success, and are withdrawing the government from its (almost always unprofitable) meddling in all kinds of economic activities. 3. The new role of government Within the framework of the new economic policies, the state continues to play a key role. In this context, several elements are important: (a) Despite the enormous pressures due to the economic crisis, Latin American governments have in general remained functional. Mexico is an excellent example. Nicaragua is another. Argentina shows an impressive record, as well as Bolivia, Chile, Paraguay, and El Salvador. The functionality of government does not only mean the return to governmental routine, but includes the strength to revise existing models, as well as the strength for reform, compromise, and, depending on the circumstances, for conflict (as President Carlos Menem quite effectively demonstrated by toppling the crown of the Peronistic trade unions). (b) Government is not solely viewed in its former role of omnipotence, which Norbert Lechner criticized as the "estadolotria" or glorification of the state. If there has ever been a central, reoccurring, theme in the Latin American discourse on democracy and constitution, I would like to describe it as the will to improve civil society. 9 (c) An operative government, one that is able to plan and implement policy measures, is no longer equated with an overblown government. Carlos Santinas de Gortari spoke of this in his 1989 speech to congress: "La crisis nos mostró que un Estado más grande no es necesariamente un Estado más capaz; un Estado mas proprietario no es hoy un Estado más justo." 10 (The crisis has shown us that a bigger government is not necessarily a better government; more government ownership does not necessarily imply more social justice.) As a result of this new thinking, there is a move to untangle the formerly gigantic parastatal sector, not just in Mexico, but almost everywhere in Latin America.

a

This was illustrated already In the early 1980s. See Mois. 1985a.

10

November 1,1989. "Primer Informe de Gobemio." Government documents 13. Mexico.

50

4. Latin America's new international role From a politological viewpoint, a particularly impressive indicator of change is Latin America's newly defined international role (Mols, 1992). Latin America is playing a more active role than ever before in international politics, whereby

certain

eccentricities and romanticisms reminiscent of the 1970s have been left behind (e.g. tercermundismo, the founder's philosophy of SELA, the praise for the international formation of cartels such as OPEC). In the context of regional relationships, cooperation and integration dynamics have emerged among almost all countries South of the Rio Grande, a circumstance nobody would have imagined even in recent years. The most important outcome of this process is what Latin Americans call the "concertacion", not unlike the former European method of high-level political consensus building, the Rio-group being one of the more prominent examples. 11 Another is the establishment of MERCOSUR, the "Group of Three" (Mexico, Venezuela, and Colombia), and the revitalization of Central American cooperation. All in all, the subcontinent has attained a remarkable acceptance in the international community, a situation that has few precedents in the history of Latin America. European-Latin American relations may show some weakness, and vice versa. But on the whole, the linkages have become tighter. Concerning U.S. foreign policy toward Latin America, the Bush-initiative Enterprise for the Americas may be interpreted as a sign that the era of benign neglect is coming to an end, partly due to the recognition in Washington of the need to face the forces toward a new order of the international system in which the role of Latin America can no longer be ignored (Mols, forthcoming). It is interesting to observe that these considerations also seem to play a role in Japan's policy toward Latin America. In Tokyo, a reprise of the pax americana is perceived as just as unlikely as a pax nipponica. But judging from the views of Mladen Yopo, the idea of a pax consortis, including Latin America, seems to be gaining influence. 12 This is not as far fetched as it may seem, considering the efforts

for details see Emmes. 1990. see Yopo H., Mladen. 1991. "Japón y América Latina: relaciones cautelosas en un contexto de opciones estratégicas." In Jorge Heine, comp. Anuario de políticas exteriores latinoamericanas 1990-1991: 346-358. Venezuela.

51

of a number of Latin American countries to apply for full membership to the Asian Pacific Economic Council (APEC). All this sounds very optimistic, and I am convinced that the rediscovery of Latin American abilities is more important than the perpetual ranting about its deficits and incapacities. If policymaking is the design, preferably the conscious design, of human living conditions, then the finding and pointing out of active potentials is highly desirable. However, this does not preclude a realistic assessment that Latin America still has a long way to go before the end of the crisis can firmly be declared. Nevertheless, I do not share the pessimism of those who speak of a steady loss of the functionality of government (Hurtado, 1991) or who even proclaim a loss of the future and a return to the middle ages. 1 3 The positive results of the aprendizaje

doloroso

cannto be overlooked. This view should not be interpreted as calling off the alarm. Klaus EBer rightly draws the attention toward the weak point of current reorientations, i.e. the continuing political-instrumental nexus of an outdated inward orientation: a transition with weak actors; a professionally weak bureaucracy; the traditional unwillingness on the part of firms or trade unions to accept direct responsibilities for distributive policies; political parties which are not fully functional and which lack program modernizations; and the traditional value and ideological systems which have been able to survive within the framework of inward orientation, favoring internal development, yet not internally-created development processes (EBer, 1991). The inertia of traditional Latin American society is evident in the political and social culture and its institutional instruments. These severely interfere with the process of transformation, democratization, policy reorientation, and generally thinking in new categories of international interdependence. 14 Yet, even with some remaining reservations, it cannot be denied that a hopeful new beginning is taking place in Latin America which few observers would have imagined just 5 or 10 years ago. Simón Bolívar coined the phrase "América es ingobernable". This can no longer be confirmed at the beginning of the 1990s. However, the wish remains - and I take up my earlier concerns, 1 5 as they were also touched upon by Prof. Dr. Hermann

13

Weffort. 1990: 44.

14

see Mols, 1985a, on political culture.

15

compare Mols, 1985b.

52 Sautter- that the West take a greater responsibility for a subcontinent that has been called the extreme part of itself, "l'Extrême Occident", by the famous French social scientist and diplomat Alain Rouqié (1987). Will the West be able to take on this challenge considering its anxieties - also passing through Latin America- about the definition of a new international order? Such a redefinition of the international framework would need to address issues like the effects of perestroika, the continuation of West European integration, and the economic as well as political processes in the Far East. Given this setting, one can only advise Latin Americans to adhere to the course they have chosen, and signal to the West that Latin America remains interesting and important, and that it should not be discounted as a continent in crisis.

53

References Balmelli, Carlos Mateo. 1992. Zur gegenwärtigen Verfassungsdiskussion in ausgewählten lateinamerikanischen

Main.

Ländern:

Chile, Paraguay, Argentinien.

Frankfurt a m

CEPAL. 1990. Transformación productiva con equidad. La tarea prioritaria del desarrollo de América Latina y el Caribe en los años noventa. Santiago d e Chile. Emmes, Manfred. 1990. Äquivalente

zur Europäischen

Politischen

in Lateinamerika. Dissertation phil. Mainz.

Zusammenarbeit

Eßer, Klaus. 1991. Entwicklung einer Wettbewerbsstrategie: Herausforderung der Länder Lateinamerikas in den 90er Jahren. Schriftenreihe des Deutschen Instituts

für Entwicklungspolitik. Berlin.

Ferrer, Aldo. 1983. Vivir con lo nuestro. Buenos Aires. Gurrieri, Adolfo, and Padro Sainz. 1983. "Is there a fair and democratic way out of the crisis? Some proposals in the light of the EC LA philosophy." CEPAL Review 20: 127-148. Hurtado, Osvaldo. 1991. "Handlungsperspektiven und -Orientierungen für Staat und Gesellschaft in Lateinamerika." In Josef Thesing, ed. Lateinamerika: Tradition und Moderne. Mainz. Mols, Manfred. Forthcoming. 'The integration agenda. A framework of comparison." In Peter H. Smith, ed. The politics

Hemisphere. Madrid and La Jolla. 297-305.

1992.

of regional integration:

Europe and the Western

"Lateinamerikas internationale Situation." Aussenpolitik 43 (3):

1991. "Wandel der lateinamerikanischen Leitbilder für Entwicklung: Enttäuschung und neuer Prgamatismus." In Albrecht von Gleich, Gerd Kohlhepp,

Manfred MoTs, eds. Neue Konzepte in der Entwicklungszusammenarbeit mit Lateinamerika? Ein Dialog zwischen Entwicklungspolitik und Wissenschaft.

Hamburg.

1989. "Staat und Demokratie in Lateinamerika." In Peter Hünermann

u n d Margit Eckholt, eds. Katholische

und München.

Soziallehre-

Wirtschaft-

Demokratie.

Mainz

1985a. Demokratie in Lateinamerika. Stuttgart. 1985b. "Möglichkeiten Europas bei der Konsolidierung lateinamerikanischer Demokratie." Europa-Archiv AO (19): 581-590. Ominanmi, Carlos. 1991. "Deindustrialziation and Industrial Restructuring in Latin America: The Examples of Argentina, Brazil, and Chile." In Patricio Melier, ed. Neostructuralism,

Neomonetarism,

and Adjustment

Process:

7 9 - 9 9 . Boulder, Co.

54

Pequeño Larousse Ilustrado. 1975. 11th edition. Paris. Mexico, government of. 1989. documents. No. 13.

Primer Informe de Gobierno.

Rouquié, Alain. 1987. Amérique latine. Introduction

Mimeo. Government

ä l'Extréme-Occident.

Paris.

Sangmeister, Hartmut. 1992. Lektionen aus dem Verschuldungsjahrzehnt: Reformpolitik in Lateinamerika. Diskussionsschriften der Wirtschaftswissenschaftlichen Fakultät der Universität Heidelberg No. 42. Thiery, Peter. 1991. "Entwicklungsvorstellungen in Lateinamerika- Eine Neuauflage des CEPALISMO?" In Manfred Mols, Peter Birle, eds. Entwicklungsdiskussion und Entwicklungspraxis in Lateinamerika. Südostasien und Indien. Münster and Hamburg. Weffort, Francisco C. 1990. "La América equivocada." In Julio cotler, ed. Estrategias para el desarrollo de la democracia: en Perú y América Latina. Lima. Yopo, Mladen H. 1991. "Japón y América Latina: relaciones cautelosas en un contexto de opciones estratégicas." In Jorge Heine, ed. Anuario de políticas exteriores latinoamericanas 1990-1991. Venezuela.

55

Guatemala External Debt and PovertyThe Role of International Finance Organizations Lizardo A. Sosa L. *)

1. Introduction Controversial views are held about the role played by the international finance institutions in Latin America. More than a few times they have been held responsible for the economic crises these countries have experienced, in particular the worsening of poverty which, in the opinion of many, was brought on through the implementation of economic adjustment programs by those institutions. Taking a small Central American country as an example, this paper presents the economic and social consequences of a situation in which stable macroeconomic conditions are not maintained, and the circumstances do not permit a prompt application of realistic and consistent macroeconomic policies, generally similar to the ones implicit in the conditionally of the IMF and the World Bank. The repercussions on poverty and indebtedness will also been discussed. 2. Socioeconomic characteristics of the country Guatemala has a population of 9.4 million inhabitants, distributed across an area of 108.9 thousand square kilometers. Among the most important indicators, the following stand out: The majority of the population (52%) has native roots of MayaQuiche ascendancy; the illiteracy rate lies at 47 percent (national average), although this figure is - according to region- drastically higher for rural areas, especially among the indigenous population. The most important social and economic indicators reveal that the country faces grave poverty problems which have worsened during the last decade. This occurred

*)

Lie. Lizardo Sosa Lopez was appointed Director of the Central Bank of Guatemala, formerly Director of the Instituto de Investigaciones Económicas y Sociales (IDIES).

56

at a time of regressive income redistribution, rendering the traditional problem of high income and property concentration even more acute. To illustrate this phenomenon, it is important to outline that the structure of land ownership shows that, according to a 1979 survey, 89 percent of all Guatemalan farms occupy 16.4 percent of the land, whereas only 2.2 percent held 64.9 percent2. Equally important is the structure of income distribution which is similar to the distribution of ownership. The results of the most recent poll of family income and expenditures carried out in 1989 3 show that 50 percent of the economically active population has a yearly income below Q 1,800 (ca. DM 553.00 or US$ 340). Less than 1 percent of the employed population reported yearly earnings above Q 48,000 annually, equivalent to some DM 14,770 or US$9,150. The analysis of long-term structural variables is not a fundamental concern of international finance institutions which, in general, condition their support upon the application of policies of a more short-term nature4. Nevertheless, the existing structural framework has to be kept in mind when reviewing socio-economic data relating to Guatemala, due to its determining effect on the global structural configuration of the economy as well as on short-term economic trends. 3. Evolution of social and economic variables in the 1980s Macroeconomic policy During the last decade, Guatemala attempted to face short-term economic imbalances while guiding economic development policy toward policies more in accordance with the world-wide modernization process. The imbalances produced by the world-wide econmic crisis in the early 1980s demonstrated the need for economic policy changes. Yet, the government was confronted with strong resistance from the predominant political interest groups unwilling to bear the cost of adjustment

Instituto Nacional de Estadística, National Agrarian Census, 1979 Instituto Nacional de Estadística, INE. June 1990. Encuesta Nacional Sociodemográfíca Volume II: 63. Guatemala.

1989.

Some of the programs financed by the World Bank are oriented to structural change, even though generally they are restricted to the modernization of the economy, expected to have an impact on the long-term structure.

57

measures. The difficulties created by the internal strife made it virtually impossible to consistently apply policy reforms. These circumstances help to explain the marked differences between the economic policies implemented in the first half of the decade (1981-1985), and those implemented therafter. The first stage (1981-1985) could be entitled the "nonadjustment" stage due to the fact that no significanct changes occurred in the basic parameters, indicated by a persistent fiscal deficit, the lack of monetary control, and the government's regulation of prices, interest and exchange rates. The maintenance of the 1:1 parity with the US dollar generated a sizeable deficit in the balance of payment and an increase in the short-term debt of the central bank (Banco de Guatemala). The second stage (1986-1991) coincides with the beginning of a democratization process, and could be denominated the "partial adjustment" stage. Important changes were put into effect with respect to exchange rate policy, interest, and tax rates. Even though basic problems could be solved, these policy changes did not achieve the necessary coherence to guarantee better adjustment results. The economy was marked by tensions brought about by the absence of clearly defined economic rules. Operating conditions In the difficult economic environment of the 1980s the government was compelled to accept assistance from the international finance institutions. For a variety of reasons, however, the conditionality targets set within the framework of economic reform programs with the International Monetary Fund, the World Bank, and other international development agencies could not be met. The lack of realistic and consistent policies made it impossible to continue the cooperation with international finance institutions. This situation affected the preservation of favorable macroeconomic conditions necessary for orderly economic development. There was a loss in control over the fiscal deficit, the money supply, and the level of net reserves, as well as delays in the execution of investment projects important for sustained development and the alleviation of the most pressing social problems.

58

Non-fulfillment of the conditions set by the international finance institutions made it impossible to implement a macroeconomic policy consistent with objectives of longterm stability and modernization. Economic policies were no longer oriented toward long-term solutions, but attempted to address immediately pressing problems without the overview necessary for an improvement in macro-economic conditions. Important credits from the World Bank and other international institutions, designed for the development of export capacity, structural adjustment, the modernization of the financial system, and the establishment of a social investment fund, could not be used, thus significantly worsening social conditions. Evolution of the main macroeconomic variables Gross national product. The country's productive capacity was seriously impaired throughout the decade: even though during 1981-1991 real GDP increased by 11.9 percent, equivalent to a yearly average of 1.2 percent, economic performance strongly fluctuated between the first five years of the decade, the "non-adjustment stage", and the last five years, the "partial adjustment stage". As a matter of fact, from 1981 to 1986, real GDP declined by 6.1 percent, equivalent to an annual average contraction of 1.2 percent. During 1987-1991, GDP increased by 19.2 percent, averaging 3.8 percent per year (see table 1). Per capita income. The detoriation of per capita income was significant: In real and absolute terms, per capita income shrank by a total of US$70 from 1981-91, equivalent to 15.9 percent. In the "non-adjustment" period, the reduction was dramatic (US$ 81.34 or 18.5 percent), in contrast to the increase during the "partial adjustment" stage of US$ 11.49 (3.2 percent). This indicator is strongly affected by a population growth rate of 2.9 percent annually. Money supply. Total domestic money supply rose significantly, increasing by 28.3 percent in 1985, by 20.1 percent in 1986 and by 21.7 percent in 1991. The volume of currency in circulation also increased considerably during this period, in 1985 by 56.2 percent over the 1984 level, and in 1990 by 34 percent over the 1989 level. Generally, the variations in money supply have been erratic throuthout the decade. Efforts to moderate monetary expansion are seen in some years, but total loss of control over money supply in others, a situation that had a notable impact on other parameters (balance of payment, pressure on the exchange rate and prices).

59

The excessive money supply was one of the main obstacles to the compliance with the targets established in the economic programs negotiated with the International Monetary Fund (see table 4). The trade balance. The current account of the balance of payments has been negative throughout the decade due, in part, to distortions in the exchange rate system, and the fixed interest rate policy maintained through August of 1989. It is remarkable that the balance was positive in only two years, 1983 and 1986. In 1991, the current account was in equilibrium, coinciding with the effects derived from the efforts to improve the control over the fiscal deficit, money supply, and the credit to the public and private sectors. During the second half of the 1980s, the current account's deficit increased, which can be attributed to the expansionary money supply, especially of currency in circulation (see tables 2 and 4). Public finance. The onset of the economic crisis was marked by a strong increase in the fiscal deficit, reaching a value equivalent to 7.4 percent of GDP in 1981. During the following years efforts were made to limit the size of the fiscal deficit. These efforts were rewarded with success only from 1985 to 1988. As the share of tax revenue to GDP was subject to fluctuations, it was difficult to maintain tax revenues in real terms; in nominal terms, the value of tax revenues declined throughout the decade (see table 3). The impossibility of meeting public finance targets was another important reason for the country's failure to comply with the conditionality of economic programs signed with international finance institutions. Interest and exchange rates. Interest and exchange rates have traditionally been set by the monetary authorities, with little or no adjustment over long periods of time. During the first half of the 1980s foreign exchange rates were maintained at artificially low levels in order to provide cheap credit and lower effecitve import prices. The interest and exchange rate restrictions resulted in major financial and exchange rate distortions, and created serious economic imbalances, characterized by inefficiencies in capital markets, an acute scarcity of foreign exchange, and speculative pressure on foreign currency markets. This situation led to the application of credit ceilings for bank portfolios, and to the practice of exchange controls, assigning currency based upon listings of products and raw materials catalogued as essential. A side-effect of these policies has been the

60

development of non-bank credit and foreign currency markets, and a black market for import products. Domestic prices. Changes in the general level of prices have been very erratic throughout the decade, parallel to movements in broad money supply and currency in circulation. The highest rates of inflation occurred in the 1985-1986 period and later in the years 1989-1990, coinciding with high variations in money supply and the fiscal deficit. Frequent price increases combined with interest rate restrictions resulted in negative real interest rates and outflows of capital (see table 5). The evolution of external debt and poverty External debt. Guatemala's foreign debt has maintained moderate dimensions compared with the debt stocks of the majority of countries in Latin America. Still, external debt increased drastically during 1981-1985, doubling the stock of debt registered at the beginning of the decade. In the following years, the level of debt was held constant, and then began to shrink. During the first half of the last decade, foreign indebtedness grew by almost 100 percent, in contrast to the next five years, when the debt stock was reduced by 16.4 percent (see table 1). Looking at the origins of this foreign debt, evidence exists that it increased partly due to the artificial 1:1 parity of the national currency (Quetzales) and the U.S. dollar, in effect in Guatemala for over forty years. In order to maintain this parity, debt was contracted with private creditors on very unfavorable terms with regard to repayment costs and maturity. Throughout the 1980s, the contracting of new debt for development projects and the utilization of existing credits for that purpose was practically stopped, leading to serious deficiencies in basic infrastructure development and worsening social indicators 5 .

As a result of this, according to statistics reported by the Secretaria General de Gobierno (1990), the country maintained undisbursed credits for a sum close to US$ 550 million for projects that could not be executed due to the lack of domestic counterpart funds, and due to frequent suspensions caused by poor economic performance. Nevertheless, contractual commissions became due in significant amounts.

61

Poverty. In the following table, data provided by the Secretaría General de Planificación Económica (SEGEPLAN) of the government of Guatemala show that the evolution of poverty in Guatemala has been dramatic during 1980-1986 and continued to deteriorate in 1986-1989.

GUATEMALA Development of poverty Years 1980-1989 (data given in %) YEARS

Average yearly evolution 1980/86 1986/89

Levels of povertv

1980

1986

1989

Extreme poverty

31.6

64.5

67.0

+ 5.5

+0.8

Poverty

31.8

18.9

22.0

-2.1

+ 1.0

Total poverty

63.4

83.4

89.0

Non-poor

36.6

16.6

11.0

-3.3

-1.8

100.0

100.0

100.0

TOTAL

Source: Secretaría General de Planificación, 1991, based on data of the National Socio-demographic Census carried out by the Instituto Nacional de Estadística, Guatemala, 1980,1986, and 1989.

62

During the "non-adjustment" years (1980-1986) the share of the population in poverty increased by 20 percentage points, with a significant expansion of the groups in extreme poverty accounting for roughly 33 percent of the country's total population 6 . The groups classified as poor decreased by 13percentage points7. The dramatic evolution of poverty is confirmed by reviewing related data: the non-poor population, equivalent to 20 percent of the total population of the country, decreased from 36.6 to 16.6 percent. In the first years of the "partial adjustment" period (1986-89), poverty continued to worsen in large sectors of the population, albeit at a slower pace. While the extreme poverty group expanded at an annual rate of 5.5 percent on average in the "non adjustment" period, the increase in extreme poverty was reduced to an annual average of 0.8 percent in the "partial adjustment" period. The share of the poor declined in the first period and increased again during 1986-89. The non-poor population decreased drastically in the first period at a 3.3 percent rate, and at a lower rate in the second period (1.8 percent). 4. Probable effects of the conditionality of international finance institutions On several occasions during 1981-1991, the Guatemalan authorities approached the international finance institutions for support, signing accords with the IMF and the World Bank. 8 Disbursements were suspended when economic targets were not reached with respect to current account balance, level of international reserves, fiscal deficit, money supply, liberalization of interest and exchange rate policies, as well as debt service. Possible economic development had the treaties been fulfilled Undoubtedly, the Guatemalan economy would have behaved differently if stable macroeconomic conditions had been maintained. It is certain also that improved 6

The extreme poverty group includes all families whose annual income does not cover basic nutritional needs, defined as the cost of a minimum diet providing all the necessary caloric-protein nutritional intake.

7

In the poverty group are all families whose income is sufficient to cover the cost of a minimum diet but insufficient to meet other needs (housing and clothing).

8

Most recently, Guatemala completed an agreement with the IMF in late 1992.

63

macroeconomic conditions would have been possible if the terms negotiated with the International Monetary Fund and the World Bank had been appropriately met. The conditions agreed to in the three stand-by agreements with the International Monetary Fund could not be carried out even though they seemed reasonably within reach. 9 . The terms of the World Bank, agreed to by Guatemalan authorities to receive financial support for a US$ 80 mill, exports promotion program, fundamentally established an economic policy framework consistent with an outward orientation and the promotion of international competitiveness They encompassed an appropriate interest rate and trade policy based on the assumption of orderly economic processes. The first tranche could not be disbursed in 1988, mainly due to the failure to comply with commercial policy targets regarding import duties 10. In summary, analyzing the evolution of the main macroeconomic variables during the decade, the following can be stated: First, the "non-adjustment" period has been more expensive in economic and socio-economic terms than the disorganized and isolated application of adjustment measures during the "partial adjustment" period. Second, had agreed policy targets been met, the fiscal deficit and stable monetary variables could probably have been maintained consistent with macroeconomic conditions. Further, it is likely that the balance of payments objective would have been met, international reserve targets would have been reached, and macroeconomic policy would have been consistent with the objectives of an increased outward orientation and the promotion of international competitiveness. Certainly, the compliance with all policy targets would have demanded important efforts in fiscal, monetary and credit policies, as well as interest and exchange rate policies. Given political resistance among some groups against the adjustment measures, and the fear of having to face the political "cost" of carrying them out, the

For example, in 1981, faced with an expected fiscal deficit equivalent to 7.2 percent of GNP, the Fund accepted the country's proposed goals limiting to 6.4 percent in 1981 and 4.2 percent in 1982 (Letter of Intent signed by the President of the Central Bank and by the Minister of Finance, October 1981). As an example of the flexibility of the terms it is worth pointing out that initially the World Bank demanded a duty reduction of 20 percent in the first year, and accepted a ceiling of 45 percent and a gradual semestral reduction over three years. At the end of 1989, all conditions had been met, but by then, the country had again failed to meet the targets of a stand-by program with the International Monetary Fund.

64

agreed policy changes proved infeasible, leading to the failure of economic reform programs. 11 Scenario of full compliance with policy targets In a scenario of full compliance with agreements, the necessary macroeconomic adjustment measures to be implemented are as follows: In fiscal policy a greater effort of tax collection is needed (throughout the 1980s the tax burden in Guatemala was one of the lowest in Latin America and the world). Alternatively, a gradual restriction of public spending needs to be implemented as well as expenditure-switching (more spending on investment using local financial support for investment projects, and less current expenditures). The central bank needs to practice a monetary and credit policy consistent with monetary stability, avoiding excessive credit expansion to the public sector as well as subsidies of foreign exchange and interest rates. Interest rates are to be determined by market conditions instead of restrictions authorized by the monetary policy makers, thus preventing the persistence of negative real interest rates over long periods of time. In the external sector, more consistent and realistic monetary policy conditions are expected to avoid continually high deficits in the balance of payments, and facilitate the maintenance of adequate levels of international monetary reserves so as to sustain a progressive and ordered development process. Realistic and stable exchange rates stimulate exports and avoid currency speculation which in the past led to capital flight and increased the volume of imports.12

The absence of a consistent and realistic macroeconomic policy led to a worsening of the government's financial conditions and to the depletion of International reserves, unwinging an acute crisis, in the middle of which, with urgency and without financial or technical support of the international financial organisms and in the context of important fiscal imbalances, measures were adopted to increase interest rate and exchange rate flexibility. The social costs of "non-adjustment" include rapid devaluation of the national currency, and the increase of the inflation to levels not seen In the last fifty years. 12

According to a study published by Ifo-lnstitut für Wirtschaftsforschung in München, Guatemala suffered an export of capital (Kapitalflucht) of US$400.0 million during 1985 alone (Gemaelich, Diana. 1989. "Kapitalexport und Kapitalflucht aus Entwicklungsländern." Ifo-Studien zur Entwicklungsforschung. München: Weltforum Verlag.

65

With regard to inflation, abrupt price variations are avoided through more stability in the main economic indicators, in particular as pertaining to the money supply, the fiscal deficit, and its subsequent effects on the rate of exchange. During the 1980s, the authorities repressed the inflation resulting from inconsistencies in macroeconomic policies using as anti-inflationary measures price controls and exchange rate overvaluation, as well as the granting of huge fiscal subsidies (i.e. the exchange rate subsidy for fuel imports). While these measures temporarily repressed price increases, they created distortions and shortages in production and supply. As a result, upward price adjustments became necessary and were abruptly implemented in 1985/86 and 1989/90. Economic strategy. Guatemala's economic policy strategy has moved from interventionist populism to free market policies. This ambivalence has had significant negative effects on private sector activities due to the perception among private agents of a lack of credibility, trust, and clear rules, characteristics which are helpful in serving as a stable frame of reference. Efforts toward the provision of a more consistent orientation of economic policy can be strengthened significantly through compliance with agreements signed with the World Bank, particularly in the area of export promotion. Yet better results could be achieved with a structural adjustment program from this institution. In the absence of these instruments, the economic authorities have so far found it politically impossible to carry out consistent economic policies. The result has been the application of policies without a clearly determined strategy and goals, thus effectively preventing increases in private investment, economic growth, and sustained social development. External debt. In a scenario of assumed compliance with policy targets external debt is undoubtedly higher, but its structure, with regard to repayment terms and type of creditor, has improved. Terms are designed so as to be more in accordance with the country's long-term development objectives than the present debt structure turned out to be. Undoubtedly, the short-term debt contracted by the central bank is not allowed to reach 50 percent of the country's total debt stock as is presently the case. The growth in debt obligations related to development projects is substantially greater due to the maintenance of an open credit line from international credit entities. In recent years there has been a backlog of US$ 500 million in undisbursed credits due to the great disorder that prevailed in the management of macroeconomic affairs, which also resulted in the ineligibility to negotiate new long-term credit lines.

66

Debt owed to multilateral institutions and bilateral creditors represents a greater proportion of the total long-term and concessional debt whereas the significant share of private and commercial debt is lower. In synthesis, financing for medium- and longterm development projects has increased while debt resulting from the short-term financing of balance of payments gaps is lower. Poverty. The compliance with policy targets promotes a continuing flow of capital for infrastructure projects and social development financed with resources from international finance institutions. The public sector's execution capacity can be maintained, favorably affecting employment levels in the short- and medium term so as to sustain greater levels of development and promote poverty alleviation.

Conclusion In summary, it is reasonably safe to assume that a scenario of compliance with structural adjustment targets is likely to entail significant short-term social costs. Nevertheless, given better macroeconomic conditions and the potential of higher inflows of foreign resources, these short-term costs will affect the population in a less severe manner than the economic costs that ultimately have to be incurred as a result of a series of adjustment measures implemented in a disorderly and isolated manner.

67

1 8 ? o « So I •8&

m o co

y -—^

O NI M o 00 CO Π'e w TI i.

n a O c o> S £

CM

O

co CM

S

co

00

CM

o in n! O)

00 00

a>

o

o CM 00 O) co co co c\T cm"

o co O) O) co

CM O}

co cri

00 co [v. co

o

o I«d co r-

o m

co

o co

c

ioo

co

in oo

co oo

O Ql

o O)

flj

E o. o S a «3

O

tí

o

3 ? T3 O

a

evi

O) CM

eg CD

co O)

52 O)

co

CT)

CO

O)

C _ O (0 "íri c as g

¡I

T-

m

in r^- o r-' 00

CM cd

t cri

CO

CD co

N. co

co in

co in

co co

in s.

CM o

c» co

T}h-

O) o

o co

O co

o CM od s CM co in o O) O) co" co" cm" CM"

co co O) CM"

O CO cri co O) cg"

o T Tt o co"

o co co m co"

o co n! oo CM co"

in co 05

8 o>

fco O)

IN

ai

in ai

H £L

O É? o c6

o o

S" ccg?

hCM

M (A O b. O n

^

CM" O>

io o ® Q-D

y ¡H < «A

E

(O c

CO

Or

ÜSgr

c

T" 0)

in 0) oj

Tiio co t^ in"

8 T— r^. rv."

CM ro 0 00 «? 1

co T— LI") a> CM i

3

CM CO in o" CM

hco s 8 8CM oo" CM s

8 CÒ co o K Tj-

00

O) 1— eco oa.

oo c m LLÌ O ir 3 o OT CO

1991

8 E Qo

Q. a. 3

sO co oq

f•

o

0) S OD S gfe « « a

?

o IO o co h-

"O c (0

5'5 o o o» c oc a> b: O co o co >.o co ? 3 c "O co >r c/> JO ® co "a Eni>«ai ® co c 3 a) OO 8'8 c a> CO mo LU O a: D O co

73

Economic Policies and Attractiveness for Foreign Capital The Experience of Highly Indebted Latin American Countries Peter Nunnenkamp

1. Introduction The 1980s have commonly been labelled the lost decade for developing countries. High foreign indebtedness has been blamed for economic stagnation and decline of Latin American countries in particular. The dismal picture is sometimes projected into the future. Given the fiercer worldwide competition for foreign capital, it is feared that Latin America's position in international capital markets may be further eroded in the 1990s. As argued in the following, such an undifferentiated assessment neither held for the past, nor does it provide a reasonable forecast for the rest of this century. Significant differences between individual countries are evident. After the outbreak of the debt crisis in 1982, real GDP growth per annum more than doubled the Latin American average (1983-1991: 1.9 per cent) in Chile (4.6 percent) and Colombia (4 per cent) [ECLAC, 1991, p. 37]. By contrast, economic growth was considerably below average in Mexico (1.4 per cent) and even more so in Argentina (0.6 per cent). The private investment ratio recovered most impressively in Chile in the 1985-1990 period (by 129 per cent), 2 whereas this ratio decreased by 41 and 53 per cent in Argentina and Venezuela respectively [Pfeffermann, Madarassy, 1992, p. 4], The economic policies of debtor countries were of major importance as concerns the degree and speed by which debt problems could be alleviated. The future attractiveness for foreign capital is also likely to depend on internal reform efforts in the first place. This proposition is discussed from different angles in the following. Cross-

*v '

Prof. Dr. Peter Nunnenkamp, Kiel Institute of World Economics, Department IV, Kiel.

p This represented the highest increase within a sample of 35 developing countries of various regions.

74

country estimates on the role of domestic economic policies with regard to the availability of foreign capital are summarized in Section II. Section III provides a short overview on the policy options which heavily indebted countries faced after the outbreak of the crisis. Section IV analyzes the reform process in selected Latin American countries and its consequences for capital inflows. The focus is on Argentina, Brazil, Chile and Mexico, which all belonged to the most heavily indebted economies in Latin America, but differed remarkably in their policy reactions to the debt crisis. Section V summarizes and concludes. 2. Domestic Policies and International Capital Flows: Cross-Country Evidence The determinants of different types of international capital flows are not necessarily the same. The subsequent summary of empirical studies differentiates between debt flows and foreign direct investment (FDI) in order to reveal similarities and differences in the behavior of foreign creditors and investors. The presentation concentrates on results indicating how credit constrained countries, such as the major Latin American debtors, may contain capital outflows and regain access to international capital markets. 3 2.1. Determinants of International Creditworthiness Even after the risk illusions of lenders had been destroyed in the early 1980s, it continued to be heavily debated whether the access to foreign loans could be encouraged by favorable domestic policies and good economic performance. Conflicting hypotheses may apply to different lending regimes. Most importantly, a distinction has to be drawn between voluntary lending and defensive lending (which is sometimes called "involuntary" lending):4 -

Ample evidence suggests that the borrowers' economic policies figured prominently in determining whether external debt became unmanageable in the

Therefore, lending to non-constrained borrowers is not con sideredjn the following. Defensive lending is defined according to Watson et al. [1988]. This lending regime comprises countries for which concerted credit extension, i.e., equiproportional increases in loan exposure coordinated by bank advisory committees, took place. The lending to countries without such concerted credit exten sion is considered voluntary.

75

early 1980s. 5 Hence, better performing countries should have had easier access to voluntary lending recently. -

Under conditions of defensive lending, however, favorable policies and better performance may even lead to reduced, rather than increased bank lending [Krugman, 1988; 1989]. It may be in the banks' interest to provide loans "involuntarily" to problem debtors in order to protect existing claims. According to this reasoning, the incentive of banks to orchestrate new loans is weakened if the market valuation of the inherited debt improves due to policy reforms and better economic performance of the debtor.

These hypotheses were tested by running separate (pooled cross-country) regressions for 14 developing countries for which defensive lending was orchestrated in the 1980s and for 12 developing countries not benefiting from such lending [Nunnenkamp, 1990]. The empirical results strongly contest the notion of bad policies inducing further lending [see also Lensink, van Bergeijk, 1991], The estimates rather indicate that private creditors honored favorable policies by relaxing credit constraints. The access to international credit markets was improved, e.g., by higher investment ratios, better world-market performance and real exchange rate devaluation. 6 This result also held for developing countries for which defensive lending took place, as was the case for major debtors in Latin America. This provides a first indication that it was a losing proposition if Latin American countries attempted to attract more (defensive) lending by unfavorable economic policies. Cross-country evidence also indicates, however, that narrowly defined adjustment programs were an insufficient condition for a resumption of commercial bank lending. This qualification is particularly relevant for Latin American economies where sovereign risk and credibility problems have become evident since the early 1980s [El-Erian, 1991], The estimates support standard sovereign-risk arguments, according to which rational lenders will consider the borrowers' incentives to default when deciding on

5

For a discussion of domestic policies with regard to debt problems, see e.g. Baneth [1986]; Khan and Knight [1983]; Nunnenkamp [1986] and Zaidi [1985].

6

The latter result Indicates that real exchange rates were overvalued In many developing countries [Edwards, 1989].

76

further credit extension (for an analytical overview, see Eaton, Gersovitz, Stiglitz [1986]). Voluntary lending was hypothesized to be negatively related to the benefits to be reaped from defaulting on external debt, and positively related to the potential costs of such debtor behavior. 7 The evidence on the approximated costs of default turned out to be inconclusive, which may indicate that the threat of sanctions by creditors was not credible. However, net transfers were negatively related to the potential benefits of default [Nunnenkamp, 1990], The counterhypothesis was clearly rejected, namely that the expectation of default may induce, rather than prevent further lending to constrained borrowers once debtservicing problems have emerged [Krugman, I988; Cohen, Sachs, 1986, pp. 539f.]. Defensive loan disbursements did not improve the borrowers' access to international credit markets in terms of net transfers. Hence, it was not very promising for Latin America to threaten with default in order to stimulate further bank lending. 2.2. Determinants of the Attractiveness for Foreign Direct Investment With hardly any new lending forthcoming, expectations were pinned increasingly on FDI to alleviate foreign debt problems. The chances to induce FDI can only be assessed realistically, however, if sovereign risk considerations, the impact of political and economic instability as well as the host country's attitudes towards FDI are considered as possible determinants in addition to the traditional set of explanatory variables 8 [Agarwal, Gubitz, Nunnenkamp, 1991]. Major results from pooled cross-country regressions for the 1980s that are relevant in a Latin American context can be summarized as follows. First, foreign investors accounted for risks originating from difficulties of developing countries to service their external debt. Under conditions of a debt overhang, foreign investors refrained from further engagements (for an opposing view, see Perasso [1992]). The underlying fear was that income from productive investment may decline due to higher future taxes (in order to service the inherited debt) [Sachs, 1989] and stagnating markets.

The borrowers' benefits from default primarily depend on the contractual debt-service burden [Eaton, Gersovitz, 1981, p. 302). When considering the default costs, the borrowers have to take into account the sanctions that may be imposed on them by the creditors [Sachs, 1984, pp. 17f.]. The latter include: trade relations, the size and the growth of the host countries' domestic markets, currency valuation, and labor costs.

77

Consequently, overindebted countries in Latin America are likely to face difficulties in attracting further FDI unless debt problems are overcome. Secondly, the expectation of continued political and economic instability rendered it more difficult for entrepreneurs to undertake cost-benefit analyses for investment projects. Hence, it is not surprising that instability clearly reduced the attractiveness of a country for foreign investors (see also Edwards [1991]; Schneider, Frey [1985]). Thirdly, FDI inflows were negatively affected by overly restrictive attitudes of host countries towards foreign investors. In the 1980s, many countries moved towards more liberal ownership regulations, non-bureaucratic approval procedures and favorable rules on the repatriation of profits and capital [UNCTC, 1988]. This trend impaired the attractiveness for FDI of host countries that maintained relatively strict regulations (for the case of Brazil, see Funke, Nunnenkamp, Schweickert [1992]). Moreover, sovereign risk considerations influenced the behavior of foreign investors in relatively restrictive countries. Potential benefits from expropriations - proxied by the ratio of FDI stocks over G D P - discouraged further inflows to such countries [Agarwal, Gubitz, Nunnenkamp, 1991]. By contrast, high FDI stocks induced even more flows to countries with favorable attitudes towards FDI. The latter result indicates that a liberal treatment of FDI and a cooperative stance of host countries towards foreign investors help to enhance the attractiveness for FDI through reputation building. Furthermore, government interventions in goods and factor markets hindered the inflow of risk capital [Hiemenz, Nunnenkamp et al., 1991]: -

Discriminatory taxes and subsidies, administrative price fixing, and similar measures interfered with the relative profitability of production among sectors. Empirical evidence also suggests that excessive trade interventions induced an inefficient use of resources, which ultimately undermined a country's position in the international competition for risk capital (see also Krueger [1990, Part III]). This result challenges the widespread belief that import protection is a promising means to attract FDI.

-

A country's competitive position in international capital markets was further affected by unfavorable capital and labor market conditions. Financial repression characterized by low or even negative real interest rates discouraged domestic

78

savings and the transmission of savings into loanable funds. Complementary domestic capital required to attract FDI remained insufficient. Notwithstanding relatively low unit-labor costs, a country was unlikely to become an attractive investment location if a particularly poor endowment with human capital was a binding constraint for economic development, or ineffective collective bargaining arrangements led to excessive labor market disputes. All in all, foreign investors responded to restrictive regulations, policy induced distortions and transfer risks in a similar way as did foreign lenders. Parallel behavior of capital suppliers has as a consequence that the chances of debt-ridden Latin American countries to restructure their external financing are limited at best unless the attractiveness for both types of foreign finance is restored. 3. Debt Strategies of Major Debtors in Latin America The cross-country evidence presented so far supports the proposition that the attractiveness of developing countries for foreign capital critically depends on their own economic policies. Locational advantages were enhanced if macroeconomic instability and government interference into goods and factor markets were kept to a minimum. A cooperative stance vis-à-vis foreign capital suppliers signaled the government's willingness to contain sovereign risk and added to its credibility. However, it may prove difficult to regain access to international capital markets once the creditworthiness of debtor countries and the credibility of governments have been seriously eroded, as was the case for major Latin American countries. Governments in Latin America faced a critical choice after the sudden reversal of international capital flows in the early 1980s. 9 The chances to contain capital outflows in the short run and the longer-term consequences on the attractiveness for foreign capital were of utmost importance in deciding on the appropriate debt strategy. None of the major Latin American debtor countries grasped the most radical option, i.e., outright debt repudiation. It was feared that this strategy would have resulted in

In 1980, Latin America received net transfers (including aid, commercial credits and foreign direct investment) of US$ 7.2 billion. By contrast, annual outflows in the order of US$ 1 5 - 2 1 billion were recorded in the 1984-1989 period. Subsequently capital outflows decreased, but still remained significant (1990: US$6.3 billion; 1991: US$8.6 billion) [World Bank, 1991a].

79

persistent isolation from international capital markets and the discontinuation of multilateral financial assistance. The majority of countries rather followed a muddling-through approach which was characterized by partial default, temporary and unilateral debt-service moratoria, and protracted debt renegotiations with foreign creditors. Initially, a thorough review of misguided economic policies to tackle the internal causes of payment problems figured low on the agenda. Brazil represents the most telling example of a non-cooperative debt strategy [Funke, Nunnenkamp, Schweickert, 1992]. Within two years (1983-1984), the government submitted seven letters of intent to the IMF. The result were two waivers, three modifications of targets, and two suspensions [Cardoso, Fishlow, 1989, p. 84]. Negotiations with the IMF broke down in late 1985, and Brazil declared a moratorium on interest payments to commercial banks in early 1987. Resumed IMF negotiations were again suspended in 1989 because of the government's failure to meet the targets on public sector deficits.10 Throughout the 1980s, frequent stabilization episodes were bound to fail because they were not based on sustainable fiscal consolidation. Interventionist government policies in goods and factor markets continued, e.g., in the form of price controls, bureaucratic control over imports and export permits,11 highly selective access of enterprises to credit facilities, and labor market regulations [Carneiro, Werneck, 1989]. Similar to Brazil, Argentina did not adjust appropriately to the debt crisis, but rather accommodated the disappearance of capital inflows by printing money and creating domestic debt [Hiemenz, Nunnenkamp et al., 1991, pp. 119ff.; de Pablo, 1990], Five stabilization plans failed during 1983-1989, largely because of insufficient adjustment in the public sector. Due to the lack of structural reforms, the private sector remained highly distorted. After having received bridge loans in 1983, the debt situation of Argentina continued to be unsustainable. The country began debt rescheduling at a 10

An agreement on soaring interest arrears (end-1990: US$ 9.6 billion; World Bank [1991a]) with commercial banks was achieved In May 1991, which was again followed by negotiations with the IMF. In mid-1992, it was principally agreed to restructure a major portion of Brazilian bank debt on a longer-term basis under the umbrella of the Brady Plan [Frankfurter Allgemeine Zeitung, 7 July 1992]. Since the late 1980s, import restrictions have been liberalized. Most importantly, the extensive system of discretionary non-tariff barriers has been tackled [EIU, a].

80

substantial scale in 1985, and various rounds of rescheduling took place in the subsequent years [World Bank, 1991a, Vol. 1, pp. 73ff.]. It was only in March 1991 that the government seriously attempted to restore its credibility [EIU, b, 1991, No. 2], The convertibility of the domestic currency was guaranteed at a fixed rate to the USdollar. It was announced that the monetary base would be backed entirely by dollar and gold reserves. This commitment was accompanied with numerous structural measures, including de-indexation of wages and prices, privatization, and import liberalization. Mexico changed course much earlier than Argentina. Supported by the international community, the Mexican government implemented a growth-oriented adjustment program in 1987, which yielded considerable progress in trade liberalization, privatization of state enterprises and monetary control [Aspe, 1992], The policy reforms strengthened the tax base, reduced public sector deficits, and encouraged non-traditional exports. Previously, Mexico (the first large debtor country that defaulted in August 1982) represented another example of the preferred muddlingthrough approach. Various debt reschedulings and myopic adjustment measures, including import compression, were ingredients of this strategy. In the early 1980s, Mexico was a classical case of public overspending [Kaufman, 1990, p. 95], First attempts at macroeconomic stabilization remained futile and basically restricted to cutting public investment. Underlying the widespread muddling-through approach was the agreement among most Latin American policy-makers that if they had to choose between servicing the external debt and domestic economic growth, they would choose to grow. It is extremely doubtful whether there was such a simple choice. Foreign capital continued to be required to fully exhaust Latin America's growth potential. Ceteris paribus, any unilaterally decreed or enforced reduction of debt-service payments saves the debtor country resources which could be invested productively. However, the second-round effects of this option on total investment funds may not be too different from outright debt repudiation:

81

-

Capital outflows from Latin America were due to dramatically reduced credit disbursements, rather than a higher debt-service burden. 12 This indicates that resources retained through partial default may be overcompensated by forgone inflows of new credits.

-

The cross-country evidence presented in Section II suggests that the adverse effects of non-cooperative debt policies are not confined to Latin America's relations with international bank creditors. Also foreign investment might be discouraged by persistent debtor-creditor confrontation.

-

Under unfavorable economic policy conditions, resources retained through partial default may be used for consumption or fuel capital flight, rather than being invested productively.

Among the countries considered here, it was only Chile which attempted to avoid the drawbacks of non-cooperative debt policies from the beginning. This country followed a strategy based on the expectation that sustained internal adjustment efforts would be supported by voluntary and market-based debt concessions by the creditors. Chile implemented major reforms in the 1970s already. State enterprises were privatized, prices decontrolled, large fiscal deficits abolished, trade and financial markets liberalized. Nevertheless, the debt shock of the early 1980s hit Chile as well. In contrast to other Latin American countries, however, the Chilean government timely subscribed to IMF standby programs in order to remain current on external debt service. This "no-confrontation principle" [Meller, 1990, p. 69] went hand in hand with serious adjustment efforts, e.g., tight fiscal and monetary policies, export-enhancing devaluation, and wage de-indexation. Sustained adjustment to the debt crisis was considered by the Chilean government to be an investment in the country's reputation in international capital markets. It helped the agreement with commercial creditors on a menu of market-based debt and debtservice reduction operations. 13 In this way, Chile's total bank debt was reduced by 12

Debt-service payments of Latin America were roughly the same In 1980 and 1985 (US$ 30 billion). At the same time, credit disbursements dwindled from US$ 33 billion to US$ 8.7 billion, resulting in the reversal of net transfers (out of bank loans) from US$ 2.8 billion to US$ -21 billion [Funke, Nunnenkamp, Schwelckert, 1992, p. 4], The picture for 1985 did not change significantly until the late 1980s.

13

This menu Included debt-equity conversions, direct cash buybacks, conversions of debt into collateralized discount bonds, reduced interest par bonds, etc.

82

more than half within four years, from US$ 14.5 billion in 1985 to US$ 6.7 billion in 1990 [El-Erian, 1991, p. 5]. 1 4 Nevertheless, it continued to be debated whether the perceptions of country risk could be lowered by a cooperative debt strategy. Especially commercial banks have been blamed to "have provided words of praise but no access to medium-run voluntary credit" [Meller, 1990, p. 84], The question remains whether the timely adjustment in Chile, the later change from non-cooperative to cooperative debt policies in Mexico and the most recent reform efforts in Argentina were worth their costs. This question is addressed in two respects in the following. First, the effects of different debt strategies on the countries' competitive position in international capital markets are evaluated by refering to major elements of the "attractiveness portfolio" as revealed by the cross-country studies presented in Section II. Secondly, it is assessed whether adjustment efforts have resulted in a better access to foreign financing recently. 4. Consequences of Domestic Policies and Debt Strategies 4.1. The "Attractiveness Portfolio" of Major Latin American Debtors According to the results reported in Section II, the attractiveness of a country for foreign capital critically depends on macroeconomic stability, overall economic performance, the level of government interference into goods and factor markets, and sovereign risk perceptions. For some of these areas, it is relatively straightforward to construct meaningful indicators. In other respects, this proves fairly difficult especially if cross-country information is required for the very recent past. Because of data limitations the subsequent discussion focuses on selected indicators of economic performance and stability, and some proxies reflecting the risk perceptions of foreign capital suppliers. The evidence on government encroachment on private economic activities is particularly deficient.15

14

Direct cash buybacks in 1988/89 extinguished US$ 440 million of bank debt at a cost of US$ 250 million, involving an average discount of 43.5 per cent.

15

On conceptual questions and data constraints In analyzing goods and factor market distortions, see Hiemenz, Nunnenkamp et al. [1991].

83

Notwithstanding these limitations, Table 1 presents fairly strong evidence supporting the proposition that internal adjustment efforts help to enhance and restore the country's attractiveness for foreign capital. In nearly all respects, Chile as the country with the longest reform history clearly outperforms its neighboring countries. Mexico which changed course relatively early ranks second. By contrast, the most unfavorable "attractiveness portfolio" is recorded for Brazil, i.e., the country most reluctant to abandon the traditional muddling-through approach. Economic performance: The impressive growth and investment record of Chile has been mentioned in the introduction already. More interestingly, economic growth picked up in Mexico and Argentina after economic reforms had been introduced, whereas it proved unsustainable in Brazil where the 1980s were characterized by several short-lived consumption booms. Economic recovery of Mexico is also revealed by the rising private investment ratio. The favorable investment response provides a clear indication that the reform program of 1987 was considered credible and sustainable by economic agents. Chile occupies the top position with regard to world market performance as well. All other sample countries lost export market shares during the 1980s. The decline was similarly strong for Brazil and Mexico when comparing 1991 with 1983-85. However, such a comparison conceals important differences. Brazil experienced a steady decline of market shares. By contrast, the sudden drop of Mexico's market share in 1986 was mainly due to depressed oil prices. Subsequently, market shares remained stable. A more favorable world market performance was prevented by the real appreciation of the Mexican peso since the late 1980s. This points to serious risks of applying fixed exchange rates as an anchor in stabilization programs [see also Corbo, 1992], Macroeconomlc stability: Chile has been characterized by sustained macroeconomic stability since the mid-1970s. Inflation rates and budget deficits have been exceptionally low by Latin American standards. Since the late 1980s, the same applies to Mexico. The reform program resulted in impressive fiscal consolidation which, in turn, helped to contain inflation. Although the more recent stabilization program in Argentina was initiated under extreme, i.e., hyper-inflationary conditions, success is looming in overcoming the tradition of pronounced macroeconomic instability. Again,

84

Table 1 Major Elements of the "Attractiveness Portfolio" of Latin American Debtor Countries, 1983-1991

Argentina

Brazil

Chile

Mexico

Real GDP growth (per cent)

1983-85® 1986-88® 1989 1990 1991

0.2 1.8 -4.6 -0.2 4.5

3.3 3.7 3.2 -3.8 1.0

1.8 6.3 9.8 2.0 5.0

0.7 -0.2 3.1 3.9 4.0

Private investment ratio b (per cent of GDP)

1983-85® 1986-88® 1989 1990

7.7 5.8 4.8 4.5

n.a. n.a. n.a. n.a.

6.3 8.5 13.7 15.6

11.6 13.5 14.4 14.8

Inflation rate c (per cent)

1983-85® 1986-88® 1989 1990 1991

502 215 4924 1344 91

204 473 1864 1585 466

24 17 21 27 18

68 106 20 30 20

Budget deficit (per cent of GDP)

1983-85® 1986-88® 1989 1990

-8.4 -3.0 -0.8 n.a.

-6.7 -13.6 -16.1 n.a.

-2.7 -0.2 n.a. n.a.

-8.0 -12.3 -4.5 0.8

Real interest rate® (per cent)

1983-85® 1986-88® 1989 1990 1991

(-102) (3 (n.a.) (242) (-31)

(36) (-16 (4058) (7803 (447)

5.5 2.6 6.3 13.0 4.5

-13.7 -23.7 16.6 1.3 -2.8

Financial deepening'

1983-85® 1986-88® 1989 1990 1991

28.7 28.0 23.4 n.a n.a.

2.5 20.0g n.a. n.a. n.a.

44.4 42.0 44.1 43.6 43.3

28.0 21.7 19.0 25.8 n.a.

Real effective exchange rate" (1980-82 = 100)

1983-85® 1986-88® 1989 1990 1991

107 153 151 152 150

103 104 81 70 85

118 158 165 175 165

131 135 114 115 104

- to be continued -

85

Table 1 - continued

Imports (per cent of GDP)

Export market share (per cent of world exports) Debt-service ratio (per cent)

Interest arrears (US$ billion) Secondary market notation1

® ® e

' jj

Argentina

Brazil

Chile

Mexico

1983-85® 1986-88® 1989 1990 1991 1983-85®

9.2 9.8 9.5 n.a. n.a. 0.46

8.0 6.1 5.1 5.5 n.a. 1.40

24.3 28.8 34.2 33.7 31.0 0.21

9.8 13.2 15.5 n.a. n.a. 1.28

1986-88® 1989 1990 1991 1983-85®

0.32 0.33 0.37 n.a. 60.3

1.16 1.18 0.94 0.92 46.7

0.23 0.28 0.25 0.26 54.3

0.82 0.79 0.81 0.79 51.8

1986-88® 1989 1990

65.0 36.2 34.1

45.7 29.8 21.8

33.8 27.1 25.9

47.4 37.9 27.8

0.8 2.1 5.5 7.2 66 34 22 13 20 38 50

0.3 0.6 3.8 9.6 75 47 43 22 25 31 33

0 0 0 0 67 61 55 59 74 90 91

0 0 0 0 56 50 44 36 46 62 65

1985 1988 1989 1990 1986 1987 1988 1989 1990 1991 1992

Period average. Comparable data for Brazil not available. Consumer prices. Surplus Indicated by positive figures. Deposit rates deflated by consumer price indices; calculation results in extremely implausible results for Argentina and Brazil. M2 in per cent of GDP. 1986-87. Index of national currency in terms of the basket of currencies of the country's main trading partners (weighted by the share of partner countries in national exports); deflated by wholesale price indices. In per cent of face value of loans; 1986: annual average; 1987-1991: fourth quarter; 1992: second quarter.

Source:

IMF [a]; ECLAC [1991]; Pfeffermann, Madarassy [1992]; World Bank [1991a; 1991b; 1992], Funke, Nunnenkamp, Schweickeit [1992].

86

it is the country least prone to comprehensive and consistent policy adjustment which represents the tail-light in terms of attractiveness. Notwithstanding periodic price freezes and controls, Brazil continues to suffer from excessive and volatile inflation fuelled by extremely high fiscal deficits.16 Furthermore, high volatility of the real exchange rate creates considerable uncertainty with respect to both external trade and capital flows. Recent evidence suggests increased rather than reduced exchange rate fluctuation in Brazil [EIU, a]. Domestic financial markets: Extremely high and volatile inflation seriously impaired the functioning of financial markets in Argentina and Brazil. Real interest rates can not reasonably be calculated for these countries. Nevertheless, it can be safely concluded that erratic financial market conditions prevailed throughout the period under consideration. The inflationary environment contributed to the demonetization of these economies. Financial deepening, proxied by broad money supply relative to GDP, was found to be particularly poor in Brazil. Not surprisingly, Chile represented the antipole again. Financial deepening was significantly more advanced, and real interest rates were moderately positive. For Mexico, there is some evidence that economic reforms helped to overcome financial repression. Openness of domestic goods markets: Information on subsidies, discriminatory taxes, effective rates of protection, etc. would be required to correctly assess the degree of government interventions in goods markets. If at all, such data are not available on a current basis. Even the rather crude indicator of the degree of openness to import competition, presented in Table 1, is not free from limitations.17 Nevertheless, the typical ranking of the sample countries is revealed once again. Although Chile had opened up to world market competition in the 1970s already, import penetration continued to rise until recently. The Mexican reforms had a similar effect, though from a seriously depressed level of imports after the outbreak of the debt crisis. In sharp contrast, the

16

An astounding turnaround in public sector accounts was reported at the beginning of the 1990s [EIU, a]. However, the drastic reduction of deficits in Brazil was largely achieved through the accumulation of arrears on the external debt and the deferment of internal debt service [see also Ohana, Mussl, 1991 ]. Hence, fiscal consolidation is not sustainable and suffers from low credibility.

17

Large countries typically reveal a lower level of import penetration than smaller countries. Because of this large country bias, the subsequent interpretation is restricted to the change of the applied indicator.

87

isolation of Brazil from import competition became even more pronounced during the 1980s, which is reflected in the declining share of imports in GDP. 18 Risk perceptions: In Section II, the debt-service ratio was used as a proxy for sovereign risk since default becomes more likely, the more resources could be saved in this way. According to this reasoning, sovereign risk has declined significantly for all four debtor countries. In 1990, the debt-service ratios were roughly half those registered in 1983-85. However, this picture conceals important differences. The improvement started much earlier in Chile than elsewhere. More importantly, the improvement was due to voluntary and market-based debt reduction operations. The same applies to Mexico, which recently agreed with its private creditors on an effective gross bank debt reduction of US$ 15 billion. Together with appropriate economic policies, mutually agreed debt relief operations have reduced debt overhang concerns in the case of Chile and Mexico [El-Erian, 1991], This is clearly reflected by the secondary market notations for Chilean and Mexican debt paper. Chile outperformed all other sample countries by far. Secondary market discounts reached a maximum of 45 per cent in 1988, as compared to 80-90 per cent for Brazil and Argentina. Recently, the notation of Chilean debt paper approached its face value. The notation for Mexico, which was down to about 40 per cent of face value in the late 1980s, recovered quickly when the Mexican government regained credibility through sustaining economic reforms and the comprehensive restructuring of bank debt took place. Notwithstanding declining debt-service ratios, the risk perceptions of foreign capital suppliers continued to be rather unfavorable in the case of Argentina, and even more so in Brazil. This is not surprising since the improvement of debt indicators was largely due to non-cooperative debt policies, in particular the accumulation of huge interest arrears since 1988. Consequently, secondary market notations were dramatically below Chilean and Mexican standards in 1990. Subsequently, the notation of Argentine debt paper responded favorably to the sudden turnaround of economic policies in early 1991. Brazil's agreement on interest arrears with commercial banks in May 1991 resulted in slightly higher secondary market notations. But the country's rating fell considerably behind

Recently, the Brazilian government liberalized import regulations especially for Industrial inputs [Funke, Nunnenkamp, Schweickert, 1992], But the sustainability of trade liberalization is threatened as long as the domestic currency is overvalued in real terms (Table 1).

88

Argentina. This relative decline points to continued uncertainty of foreign capital suppliers with respect to Brazil's economic policy course in the future. In summary, all major elements of the "attractiveness portfolio" considered above support the proposition that domestic policy reforms and cooperative debt strategies contributed significantly to better economic performance and helped to overcome unfavorable risk perceptions of foreign capital suppliers. What remains to be evaluated is whether these achievements translated into better access to international capital markets. 4.2. Access to International Capital Markets After international capital markets had been a major source of external financing for Latin America until the early 1980s, the outbreak of the debt crisis resulted in a virtual drying up of all major sources of voluntary financing. It was only recently that several Latin American borrowers regained limited access to voluntary financing from international capital markets [Funke, Nunnenkamp, Schweickert, 1992]. Scattered evidence suggests that credit rationing has been relaxed for Chile, Mexico and Venezuela in the first place [El-Erian, 1991]: -

Chile used trade and project financing as a major source of external funding in 1989-90. The loan of US$ 20 million raised by Chile in September 1990 was reported to be the first fully voluntary, unsecured general bank loan to a Latin American country since 1982.

-

International bond markets became an important source of voluntary financing for Mexico (and Venezuela). In the period January 1990- March 1992, Mexico raised US$ 3.2 billion on these markets [World Bank, 1992], The relaxation of rationing has been accompanied with significantly reduced risk premiums for Mexican bond issues [El-Erian, 1991]. The improved creditworthiness of selected borrowers is revealed by the drastic fall of spreads over US government bonds from 530-820 basic points in mid-1989 to 200-250 basic points two years later.

-

A remarkable turnaround occurred with regard to capital flight. In the case of Mexico, is has been estimated that capital repatriation exceeded US$ 10 billion in 1989-90, while outflows of US$18 billion had been recorded during the period 1983-88. Repatriation continued in early 1991 [Lustig, 1991].

89

Comprehensive and consistent data on net resource flows to Latin American debtor countries are difficult to obtain on a current basis. 19 However, the available evidence reveals significant differences between the four sample countries (Table 2). Total net resource flows in per cent of GNP were significantly higher in Chile than elsewhere immediately after the outbreak of the debt crisis. Resource flows to Chile declined slightly during the second half of the 1980s, but more than doubled in 1990. In relative terms, Chile outperformed its neighboring countries throughout the period under consideration. Though the recovery of total net resource flows started from a seriously depressed level in Mexico, the figures for this country clearly indicate a much more favorable development of international creditworthiness as compared to Argentina and Brazil. Also the comparison of the latter two countries reveals the by now well-known ranking. The contraction of net resource flows was most pronounced in Brazil, which remained the only country suffering from negative net resource flows in 1989-90. For all four countries, total net resource flows mainly consisted of debt flows in the early 1980s. Hence, it is not surprising that the development of net debt flows largely resembles the picture on total flows. The only noteworthy difference is that Argentina's position was not better than Brazil's position. As shown before, both countries had accumulated huge interest arrears. The drastic change of economic policy in Argentina occurred only in early 1991 and was not anticipated by external creditors. The figures on private non.-guaranteed debt indicate that the reversal of capital flows after the outbreak of the crisis was, mainly due to the drastically changed lending behavior of international commercial banks. Furthermore, the banks were more reluctant to resume lending on a non-guaranteed basis immediately after economic reforms had been implemented. This applies to Mexico in particular. Though their favorable response was sometimes delayed, the banks honored internal adjustment efforts of debtor countries by relaxing the rationing of private nonguaranteed debt. In 1990, access to this type of external finance appeared no longer to be a problem for Chile, and Mexico's creditworthiness was considerably improved. Negative flows of non-guaranteed debt were again restricted to Brazil.

Subsequently, the focus is on net resource flows rather than net transfers, i.e., interest payments are not subtracted from (gross) disbursements. In contrast to Section II, it would be strongly misleading to concentrate on net transfers as an Indicator for the access to voluntary external financing in recent years. This is because net transfers are heavily influenced by the accumulation of Interest arrears in the case of Argentina and Brazil.

Table 2 Net Resource Flows to Major Latin American Debtor Countries, 1983- 1991 (US$ billion) gentina Total

a,b

Mexico

5.04 (2.5) 2.05 -0.68 -0.09 (-0.0)

1.24 (7.5) 1.00 0.98 2.17 (8.4)

1.82 (1.1) 3.48 2.84 8.42 (3.7)

1.34 (2.1) 0.93 -0.43 -0.75 (-0.8)

3.51 (1.7) 0.51 -1.99 -0.17 (-0.0)

1.13 (6.8) 0.88 0.67 1.51 (5.8)

1.32 (0.8) 0.95 -0.24 5.72 (2.5)

-0.04 (-0-1) -0.07 0 0 (0.0)

-1.39 (-0.7) -0.65 -0.91 -0.13 (-0.0)

-0.15 (-0.9) 0.21 0.58 1.27 (4.9)

-0.17 (-0.1) -1.28 -0.73 0.44 (0-2)

1991

0.46 (0.7) 0.57 1.03 2.04 (2.1) 2.35

1.50 (0-7) 1.50 1.27 1.34 (0.3) 1.60

0.09 (0-5) 0.10 0.27 0.60 (2.3) 0.32

0.45 (0-3) 2.45 3.04 2.63 (1.1) 4.24

1989 1990 1991

-0.04 1.59 5.10

0.69 3.45 -0.40

1.49 3.30 1.39

4.29 8.82 19.59

1986-883 1989 1990° 1983-85a'b 1986-88 1989 1990"

3

Private nonguaranteed (long-term) debt

1983-85a'b

Foreign direct investment

1983-85a,b

memo item: Net movement of capital0

Chile

1.81 (2.9) 1.50 0.65 1.33 (1.3)

1983-85

Long-term debt

Brazil

1986-88 1989 1990°

3

1986-883 1989 1990"

Period averages. In parentheses: in per cent of GNP. Not comparable to other figures in the table; includes short- and long-term capital flows, unrequited official transfers, and errors and omissions; 1991: preliminary estimates. Source:

World Bank [1991a; 1992]; ECLAC [1991].

91

The favorable consequences of internal policy reforms on the access to external financing were most pronounced with regard to foreign direct investment flows. FDI stagnated in Brazil, which had traditionally been the favorite location of foreign investors in Latin America. In per cent of GNP, Brazil suffered from a serious decline of FDI. This was in sharp contrast to the other three countries: -

Though the absolute figures continued to be relatively small, FDI increased steadily in Chile throughout the 1980s.

-

Economic reforms in Mexico triggered a quick response by foreign investors. Recently, the NAFTA agreement provided a further stimulus to FDI flows to this country. In 1991, Mexico attracted net FDI flows of an amount that matched the aggregate figure for the three other countries and was about ten .times the annual flows to Mexico in 1983-85.

-

Foreign investors responded favorably to the more recent reforms in Argentina as well. In the early 1990s, net FDI flows more than doubled the amount reported for 1989.

All in all, the available evidence strongly supports the earlier proposition that policy reforms and cooperative debt strategies not only result in better economic performance, but also help considerably to regain access to voluntary external financing. V. Summary and Conclusions Inflows of foreign capital continue to be required to fully exploit the growth potential of major Latin American debtor countries. The basic hypothesis of this paper was that domestic policy reforms and cooperative debt strategies are best suited to break out of the vicious circle of economic decline or stagnation and impaired attractiveness for foreign capital. This proposition remained heavily disputed even after the crucial role of domestic economic policies in determining whether foreign debt became unmanageable had been firmly established in empirical analyses. Cross-country estimates on the determinants of foreign capital inflows in the aftermath of the debt crisis clarified the ongoing discussion in several respects:

92

-

Private creditors honored favorable policies by easing the access to international credit markets. However, narrowly defined adjustment measures were an insufficient condition for a resumption of bank lending when private lenders perceived serious sovereign risks to persist.

-

Foreign investors responded to policy induced distortions and transfer risks in a similar way as private lenders. Consequently, the chances of debt-ridden countries to restructure their external financing remained limited at best unless the attractiveness for debt and FOI inflows was restored.

The requirements to regain access to international capital markets were particularly difficult to be fulfilled by Latin American countries, the creditworthiness and credibility of which had been seriously eroded. In view of these difficulties, major debtors were fairly reluctant to revise their economic policies in a comprehensive and consistent manner. Sustained internal adjustment efforts combined with cooperative debt policies were largely restricted to Chile over much of the period under consideration. Brazil represented the best example of a persistent muddling-through approach and protracted confrontation with its creditors. Mexico, and most recently also Argentina, changed policy course and initiated comprehensive reform packages after their earlier reaction to the debt crisis had largely resembled the Brazilian strategy. Arguably, the change in domestic policies and debt strategies in Mexico and Argentina was encouraged by Chile's relative success in terms of economic performance and access to external financing. Throughout the 1980s, Chile outperformed the less reform-minded neighboring countries with respect to GDP growth, the recovery of private investment, and world market performance. Macroeconomic stability was maintained. The risk perceptions of foreign capital suppliers were alleviated tremendously so that the secondary market notations of Chilean debt paper approached its face value. These achievements had as a consequence that credit rationing was significantly less severe in Chile than elsewhere. Furthermore, FDI inflows increased steadily during the 1980s. When economic policy reforms followed suit in Mexico in 1987, similarly favorable consequences could be observed. Economic growth and private investment picked up, macroeconomic stabilization was impressive, and mutually agreed debt relief operations resulted in improved risk perceptions. Due to the restoration of the government's credibility, Mexico regained access to international capital markets at a

93

significant scale. Bond issues became an important source of voluntary external financing, and the country benefited from a boom in FDI. It is still too early to reach a definite conclusion on the outcome of the more recent reforms in Argentina. However, preliminary evidence on the country's "attractiveness portfolio" and the reaction of foreign capital suppliers suggest that Argentina might become another telling example for the usefulness of internal policy reforms. Shortly after the policy change, Argentina surpassed Brazil in terms of

economic

performance, risk perceptions, and access to foreign capital markets. Brazil represented the tail-light of the four major Latin American debtor countries in nearly all respects. Economic growth proved to be unsustainable, export market shares declined steadily, and macroeconomic instability remained unchecked. Hence, it is not surprising that foreign capital suppliers remained concerned about sovereign risk and were reluctant to relax credit constraints and channel more investment funds to Brazil. In summary, the analysis reveals a nearly perfect correspondence between the degree of reform-mindedness and the attractiveness of major debtor countries for foreign capital. Furthermore, economic performance indicators and capital inflows responded fairly quickly to domestic policy reforms and cooperative solutions to persistent payment problems. These results should encourage countries such as Argentina, which initiated comprehensive reforms recently, to stay on course. Countries such as Brazil, which are still lagging behind with regard to economic adjustment, are well advised to follow suit. Otherwise, these countries will be the first candidates which cannot stand the fiercer worldwide competition for foreign capital in the 1990s. Adjustment pessimism is not justified on the ground that the benefits of domestic policy reforms will be reaped by the country's foreign creditors exclusively. To the contrary, it is mainly the debtor country that benefits in terms of improved economic performance and easier access to international capital markets.

94

References

Agarwal, Jamuna P., Andrea Gubitz, and Peter Nunnenkamp. 1991. Foreign Direct Investment In Developing Countries: The Case of Germany. Kieler Studien No. 238. Tubingen. Aspe, Pedro. 1992. "Macroeconomic Stabilization and Structural Change in Mexico". European Economic Review 36: (2/3): 320-328. Baneth, Jean. 1986. "Government Policies in Developing Countries: Was Capital Wasted?". In Herbert Giersch, ed. The International Debt Problem: Lessons for the Future. Tubingen. Cardoso, Eliana A., and Albert Fishlow. 1989. "The Macroeconomics of the Brazilian External Debt". In Jeffrey D. Sachs, ed. Developing Country Debt and the World Economy. National Bureau of Economic Research. Chicago. Carneiro, Dionisio D., and Rogério L.F. Werneck. 1989. "Brazil: Medium-Term Development Issues." Paper prepared for the WIDER Seminar on Medium and Long Run Strategic Issues, Oslo (mimeo). Cohen, Daniel, and Jeffrey D. SACHS. 1986. "Growth and External Debt under Risk of Debt Repudiation". European Economic Review 30: 529-560. Corbo, Vittorio. 1992. "Economic Transformation in Latin America: Lessons for Eastern Europe". European Economic Review 36 (2/3): 407-416. De Pablo, Juan Carlos. 1990 "Argentina". In John Williamson, ed., Latin American Adjustment: How Much Has Happened? Institute for International Economics. Washington. Eaton, Jonathan, and Mark Gersovitz. 1981. Poor-Country Borrowing in Private Financial Markets and the Repudiation Issue. Princeton Studies in International Finance No. 47. Princeton. Eaton, Jonathan, and Joseph E. Stiglitz. 1986. "The Pure Theory of Country Risk". European Economic Review 30: 481-513. Economic Commission for Latin America and the Caribbean (ECLAC). 1991. Preliminary Overview of the Economy of Latin America and the Caribbean 1991. United Nations. LC/G. 1696. Santiago. Economist Intelligence Unit (EIU) [a]. Various issues. London. Various issues.

Brazil:

Country

Report.

[b]. Various issues. Argentina: Country Report. London. Edwards, Sebastian. 1989. Real Exchange Rates, Devaluation, and Exchange Rate Policy in Developing Countries. Cambridge, Mass.

Adjustment.

95

1991. "Capital Flows, Foreign Direct Investment, and Debt-Equity Swaps in Developing Countries". In Horst Siebert, ed. Capital Flows in the World Economy. Tubingen. El-Erian, M o h a m e d A. 1991. The Restoration of Latin America's Access to Voluntary Capital Market Financing: Developments and Prospects. International Monetary

Fund. Working Papers WP/91 /74. Washington.

Funke, Norbert, Peter Nunnenkamp, and Rainer Schweickert. 1992. Brazil: Another Lost

Decade?

Domestic

Policies

and Attractiveness

for Foreign

Discussion Papers No. 188, Institute of World Economics, Kiel.

Capital.

Kiel

Hiemenz, Ulrich, Peter Nunnenkampet al. 1991. The International Competitiveness of Developing

Countries

for Risk Capital. Kieler Studien No. 242. Tubingen.

International Monetary Fund (IMF) [a]. Various issues. International Statistics. Washington,

Financial

Kaufmann, Robert R.. 1990. "Stabilization and Adjustment in Argentina, Brazil and Mexico". In J o a n M. Nelson, ed. Economic Crisis and Policy of Adjustment in the Third World. Princeton.

Choice.

The

Politics

Khan, Moshin S., and Malcolm D. Knight. 1983. "Sources of Payments Problems in L D C s " . Finance

and Development

20, (4): 2 - 5 .

Krueger, Anne O. 1988. Perspectives on Trade and Development. New York. Krugman, Paul. 1988. Development

"Financing versus Forgiving a Debt Overhang". Journal of

Economics

29: 253-268.

"Private Capital Flows to Problem Debtors". In Jeffrey D. Sachs, ed. Developing

Country

Debt and Economic

Performance.

Vol. 1: The

Financial System. National Bureau of Economic Research. Chicago.

International

Lensink, Robert, and Peter A.G. van Bergeijk. 1991. 'The Determinants of Developing Countries' Access to the International Capital Market". Journal of Development

Studies 28, (1): 8 6 - 1 0 3 .

Lustig, Nora. 1991. "Dollar Waves: Mexico's Experience with Capital Flight and Repatriation". The International Economy 5, (November/December) 67-71. Meller, Patricio. 1990. "Chile". In John Williamson, ed. Latin American Adjustment: How Much Has Happened? Institute for International Economics. Washington. N u n n e n k a m p , Peter. 1986. The International Debt Crisis of the Third World. and Consequences for the World Economy. Brighton.

Causes

1990. "Determinants of Voluntary and Involuntary Bank Lending to Developing Countries in the 1980s". Kyklos 43: 555-577. Ohana, Eduardo Felipe, and Carlos Henrique F. Mussi. 1991. Payment

Capacity

of Brazil: From Theory to Concept.

The External Debt

Brasilia (mimeo).

96

Perasso, Giancarlo. 13 August 1992. Directinvestment

A Note on the Determinants of Foreign

in LDCs: Don't Forget Macroeconomic

Policy. Milano (mimeo).

Pfeffermann, Guy P., and Andrea Madarassy. Trends in Private Investment in Developing Countries, 1992 Edition. International Finance Corporation. Discussion Papers 14. Washington. Sachs, Jeffrey D. 1984.

Theoretical

Issues in International

Borrowing.

Studies in International Finance 54. Princeton. 1989.

Princeton

"The Debt Overhang of Developing Countries". In Jeffrey

D. Sachs, ed. Developing

Country Debt and Economic

Performance.

Vol. I: The

International Financial System. National Bureau of Economic Research. Chicago.

Schneider, Friedrich, and Bruno S. Frey. 1985. "Economic and Political Determinants of Foreign Direct Investment". World Development 13 (2): 161-175. United Nations Centre on Transnational Corporations (UNCTC). 1988. Transnational Corporations

in World Development.

Watson, Maxwell et al. 1988.

Trends and Prospects.

International

Capital

New York.

Markets.

Prospects. International Monetary Fund. Washington.

Developments

World Bank. 1992. "Financial Flows to Developing Countries. Developments". Quarterly Review (March and June). Washington. [1991a]. World Debt Tables 1991-92.

and

Current

Washington.

[1991b]. World Tables 1991. Washington. Zaidi, Iqbal M. 1985. "Saving, Investment, Fiscal Deficits, and the External Indebtedness of Developing Countries". World Development 13: 573-588.

97

Debt-Equity Swaps: Costs and Benefits Rolf Schinke *>

1. Introduction In the second half of the eighties debt-equity swaps (DES) played an increasingly important role in financing foreign direct investment (FDI) in some highly-indebted countries (HICs). From 1985 to 1989 on average 43 per cent of all foreign direct and portfolio investments in Argentina, Brazil, Chile, Mexico and the Philippines were financed by DES 2 . As an average this value conceals that the importance of DES has been even greater in individual countries. In Chile around eighty per cent of all FDI have been financed with the help of DES. The literature shows a controversial picture of pros and cons of DES. While banking journals favoured them partly enthusiastically, reception in academic journals was slow and more often than not with scepticism. Proponents regard them as the "market solution" to the debt crisis (Feldstein, 1987, p.21), while for those who oppose them they represent nothing but a "boondoggle" (Bulow/Rogoff, 1988). The controversy encompasses direct and indirect costs and benefits of DES for banks and for debtor countries 3 . With special emphasis given to debtor countries this paper focusses on the following problems: a) With respect to the direct effects it is not clear whether the debtor country benefits from a lower nominal value of foreign debt and if so, whether foreign exchange receipts foregone in DES transactions represent opportunity costs for the country, something that proponents of the "additionality" argument (Bergsman/Edisis, *)

Dr. Rolf Schinke Is Academic Director of the Ibero-America Institute for Economic Research, Universität Göttingen.

2

Own calculations from data in: United Nations, Worid Investment Report 1991. The Triad In Foreign Direct Investment. New York 1991, p. 27.

3

For the third party involved in a typical DES, the foreign direct investor, it Is normally assumed that he benefits from the deal.

98

1988,) would deny: When a DES-financed investment is additional in the sense that it would not have been realized in the absence of a DES programme, there is no investment foregone and, therefore, there is no loss of foreign exchange. b) DES involve a subsidy to the investor when the debt is redeemed at a higher price than that prevailing in the secondary market. This is usually the case in DES programs. A fact which is not always recognized is that the cost of the subsidy rests on the debtor country when there are no countervailing measures in the investment contract that favour the debtor. As a consequence of the latter part of this argument Bulow and Rogoff (1988, p.690) point to the unimportance of this cost to the debtor country. c) With respect to the indirect effects of DES it is open to doubt whether they are efficiency enhancing or not and, furthermore, whether they are necessary for a reduction of the debt overhang. When a high level of indebtedness is a barrier to new investments 4 any kind of debt reduction is a precondition for growing out of the debt crisis. With a sufficiently high subsidy DES can help to solve the debt problem on both ends: they reduce the level of foreign indebtedness while at the same time encouraging higher investments. Debt reduction and additional investments are, therefore, two sides of the same coin. d) DES can damage stability when the latter is mostly needed. This can be done directly when redemption of debt is financed by printing money. This is the reason why some of the swap programs had to be abandoned shortly after their introduction. But there are indirect channels as well. A proper evaluation of the costs and benefits of DES programs has to take them into account. e) A high level of indebtedness is not only a barrier to new investments but also to the supply of credits needed to finance them. Creditworthiness of HICs had been so severely reduced that they had virtually no access to voluntary loans (apart from so called "fresh money" in concerted lending). In empirical studies5 several indicators have been found to influence significantly the creditworthiness of countries. Among them are the debt-GNP ratio, the ratio of debt service to exports,

What the debt overhang thesis suggests, see Kmgman, 1989, p.263, and with a different kind of reasoning Dooley, 1989, p. 75. For further details on some of these studies see Schinke (1990).

99

and the ratio of reserves to income. Some of these variables vary directly (debtGNP ratio) or indirectly (debt service-exports ratio) with the volume of DES. Hence, debt-equity swaps can enhance creditworthiness. f) Even when DES have net costs with respect to the effects listed so far, introduction of DES programs may be worthwhile when they are seen as a necessary part of larger projects that provide net benefits such as reform programs. Then DES cannot be evaluated on their own merits. The plan of the paper is as follows. The second section reviews the essential elements of DES and the role they play in reform programs. Section three is devoted to the discussion of the direct (3.1.) and indirect (3.2.) costs and benefits of the swaps. This is followed in section four by a more thorough discussion of the relationship between DES and the reform programs undertaken in some Latin American countries. Conclusions are presented in section five.

2. Debt-Equity Swaps DES involve the exchange of foreign debts for equity claims in debtor countries. Foreign investors have an incentive to realize their investments with DES when they can buy the debts at depressed secondary market prices and when redemption is done immediately and at (or close to) face value in domestic currency or in domestic bonds that can be sold on the capital market of the debtor country. Thus, the investor gets the domestic currency he needs for his investment at a highly preferential exchange rate. DES consist of two different transactions: a) a bank sells debt instruments to an investor at secondary market prices and b) the investor converts the debt into an equity claim in the debtor country. Essentially, these transactions are equivalent to the following sequence of deals (Bulow/Rogoff, 1988, p.691): a) An investor purchases subsidized equity in the debtor country and

100

b) the debtor's central bank uses the foreign exchange proceeds for a buyback of own debts in the secondary market. This equivalence clarifies that in economic terms conventionally financed foreign direct investments are a perfect substitute of and the alternative to DES when both embody the same subsidy and when the foreign exchange receipts of the debtor country's central bank are used to buy back its own debt. From the description given so far it should be clear that DES involve a subsidy which consists of the investor's gain that results from buying the debtor's currency at a preferential rate. This can be demonstrated by the following example. In February 1990 Chilean debts were sold at 64 cents per dollar face value (ANZ 1990). If the investor succeeded in redeeming the debt at 90 per cent in Chilean pesos he paid only 71 per cent of the amount he would have had to pay instead if his funds had been converted at the exchange rate applicable to FDI. Prices in the secondary market vary over time and from country to country. Table 1, which contains only price quotations from September 1992, reveals two groups of countries: -

One group with prices between 60 and 95 cents per dollar face value consisting of Argentina, Chile, Costa Rica, Colombia, and Mexico 6 .

-

The second group with prices that oscillate around 10 cents comprises countries like Bolivia, Cuba, Nicaragua, and Peru.

This leaves Brazil in an intermediate position. The majority of countries which belong to the lower and intermediate category did not succeed in structurally adjusting their economies and in implementing debt conversions on a larger scale. The only exception is Bolivia. It managed to stabilize the economy, to realize a buyback of nearly 50 per cent of its debts with foreign banks, and to introduce economic reforms. Positive results, however, did not show up before 1991 7 when - for the first time since the stabilization- growth of GDP exceeded that of Bolivia's population by more than one percentage point.

As Mexican bonds are traded at a discount of equal size Mexico belongs to this group as well. CEPAL, 1992 p.43.

101

Table 1 Offer Price Indications for Value Impaired Debt in the Secondary Market at 24th September 1992 (US Cents per US $ 1 nominal value)

Argentina Brazil Bolivia Chile Colombia Costa Rica Cuba Nicaragua Peru Mexico-Bonds Mexico-Bonds, Discount Series C

Source:

63.5 37.00 11.00

93.00 70.00 63.00 10.50 8.50 16.00 66.375 84.875

ANZ Grindlays Bank pic. Emerging Markets Group (1992).

The successful reformers in Latin America belong to the upper price category. Also, countries that implemented successful swap programs or buybacks are in this group. This is possibly the reason why some scholars maintain that DES programs are an important element in the reform packages. They argue that these programs foster privatization of public enterprises, promote confidence of foreign and domestic investors and improve profitability of existing domestic enterprises (Williamson, 1991). These assertions seem to imply that DES are a necessary or at least an important tool in the implementation of reform programs. As section 4 will show the reversal of this reasoning is more appropriate. Only after successful reforms DES are attractive to foreign investors.

102

3. Benefits and Costs of Debt-Equity Swaps Part of the literature on DES seems to suggest that participating parties always gain from swaps since they are voluntary transactions. A subsidy increases the profitabiliy of the investor's FDI. The debtor country gains from a reduction of its nominal debt and from FDIs while banks get rid of poorly performing loans whose supervision binds scarce resources that bring higher returns in alternative uses. This picture needs corrections in some important respects. In the following section benefits and costs will be analyzed from a debtor country's perspective. DES effects on banks are introduced only when necessary for a better understanding of what will happen to debtors. 3.1. Direct Benefits and Costs In section two it has been demonstrated that DES are equivalent to two different transactions: the execution of FDIs and the buyback of foreign debts. The following analysis concentrates on buyback aspects since in this respect DES differ from a normal FDI where the central bank is free to use the foreign exchange received from the investor. 3.1.1. The Change In the Market Value of Debts At low levels of indebtedness debtors are expected to repay 100 per cent of the value of their debt in good as well as in bad economic times. However, when the face value of the debt stock grows creditors may become increasingly worried about the level of indebtedness. When the debt stock passes a certain threshold, they might be convinced to receive only part of the amount due, particularly in times of economic difficulties. Up to this threshold the expected value of debt will equal its nominal value. At levels higher than the threshold the expected value of debt repayments may be less than 100 per cent of the face value. Thus, on the assumption that there are only two economic states, a good one with probability p and a bad one with probability (1-p), the expected value of debt repayment (E(D)) is given by E(D) = p * D + (1-p) * D' with

103

D the nominal value of debt and D' repayment in bad states. Further, if one assumes that in bad states the capacity to repay is virtually zero, the expected value is E(D) = p * D and the average price of debt (the price in the secondary market) P s = (E(D)/D) is equal to the probability of full repayment p. Then the market value of debt (D * P s ) equals the expected value, and the secondary market price reflects the probability of good states. Normally, however, the expected value of debt repayments is the weighted arithmetic mean of the state-dependent debt repayments with the weights being the state probabilities. Thus, the secondary market price is the ratio of the expected to the face value of debt and equals the sum of the state probabilities multiplied by the share of repayment in nominal debt in all possible states. Figure 1 illustrates the case. The nominal value of debt (D) is on the horizontal and the expected repayments (E(D)) are on the vertical axis. At low levels of indebtedness creditors expect full repayment. Therefore, the loci of the expected values of debt (E(D)) are on a 45° ray from the origin. Once the face value of the debt stock passes the threshold value (D*) expected debt repayments deviate from the face value of debt. They still increase but in decreasing absolute amounts until the expected value reaches its maximum. Afterwards it declines. Figure 1 illustrates that once the level of indebtedness has passed D*, the secondary market price of debt (p s ) declines continuously when debt increases (p s = E(d)/D). Because of its resemblance to the Laffer Curve in Public Finance, Krugman baptized the line OAI Debt Relief Laffer Curve. Deviation from the 45° line and its special form of an inverted "U" is explained by two arguments that link the probability of default to the absolute level of nominal debt: a) With levels of debt higher than D* any improvement of the debtor's economic situation is likely to accrue to the creditors. They will receive each additional dollar earned in foreign trade. High repayment obligations have two consequences: Investments will not be undertaken since investors may fear that they have to bear the cost by paying higher taxes in the future and governments will refrain from painful adjustment programs (Krugman, 1989).

104

Figure 1

Expected Repayments and Indebtedness

E(D)

E(D)»

E(D) H

Source: Krugman (1989, p.264)

K

D

105

b) When the debtor refuses to comply with his foreign obligations there are only a few sanctions the creditor can use. Seizure of the debtor's assets is difficult and of limited success. 8 Curtailment of short-term credit may hurt the debtor's foreign trade but is without any direct gain for the creditor, even worse, the creditor himself can be damaged by the reduction of trade to barter levels. Comparing the benefits of nonfulfillment that increase with the level of indebtedness and the costs of repudiation which to a large extent are independent of the debt level may reduce the debtor's willingness to pay when his indebtedness increases 9 . Evidence from Figure 1 suggests that with declining levels of indebtedness the secondary market price (equal to the slope of line Ol) increases. Therefore, reducing indebtedness via buybacks or DES can be detrimental to debtor countries when they are "on the wrong side" of the debt relief Laffer Curve as the expected value of repayments increases 10. While banks may be interested in a reduction of the nominal level of debt, the debtor country will benefit only when the reduction is substantial. According to Figure 1, the face value of debt must be reduced to levels lower than D* to be beneficial for the debtor. With buybacks a reduction of debt by A D will have the following consequences: a) The debtor country uses (own) resources in an amount that equals A D • p s . When the reduction is marginal, p s may be the pre-buyback price in the secondary market. Resources used for the buyback are given by BC when the debtor country repurchases HK of nominal debt. However, in the case of a substantial reduction in the nominal level of debt, p s must be the post-deal price, indicated by the slope of line OM. The use of the post-deal price is necessary to make banks indifferent with respect to selling or holding debt as they realize the same capital gain per dollar of debt. This will raise the use of own resources to EM which is substantially larger than BC.

°

There are widely differing views on the sanctions available to the creditor. The more pessimistic perspective in this study is shared by Bulow and Rogoff (1988, p.682). An example of a more optimistic view Is the discussion in Goldberg and Spiegel (1992) who base their main argument of the existence of pareto improvements from OES on the possibility to seize the output of a whole sector.

9

Bulow/Rogoff, 1988, p.682; Krugman, 1989, p.263.

10

Krugman, 1989, p.265.

106

b) The market value of the debtor's foreign obligations increases from IK to GH. c) Alternatively, if the debtor country is able and willing to service the debt, the expected value of debt repayments is reduced by PN = AD. In a stylized manner the Bolivian buy-back example given in Rogoff (1992) and illustrated in table 2 below demonstrates results a) and b). In 1988 Bolivia realized a

Table 2 The Bolivian Buyback from 1988

After Buyback (April 1988)

Before Buyback (September 1986)

Secondary Market Price Face Value of Debt Market Value Million Cost Benefit

Source:

$0.06 $ 670 Million $ 40.2 Million

$0.11 $ 362 Million $39.8 $ 34 Million $ 0.4 Million

Rogoff, 1992, p.480

buyback with a market value of 40.2 million dollars. The funds used consisted of own resources and grants from other countries. With these funds and a post-deal secondary market price of 11 cents to the dollar of face value Bolivia managed to buyback 308 million dollar or nearly 50 per cent of its debt with foreign banks. With a

107

secondary market price of 6 cents prevailing before the deal was executed, the market value of Bolivia's foreign debts decreased from 40.2 million dollars to 39.8 million dollars evaluated at post-deal prices. Therefore, the gain from the buyback was 0.4 million dollars valued at post-deal market prices while the cost summed up to 34 million dollars. Thus, Bolivia gained 1.2 cents per dollar spent in the buyback. For a better understanding of this result, it is necessary to have a closer look on the underlying assumptions. a) The resources used in the buyback (34 million dollars) have opportunity cost by the same amount. There are three reasons why the opportunity cost argument is especially relevant in the case of DES. First, with respect to the buyback aspect of DES. When the country uses its own funds gained from international trade, the resources have opportunity cost. A decrease in the level of indebtedness may lead to lower growth as the reduction of debt reduces own savings which can be no longer used to finance investment. However, things are different when the debtor receives a foreign grant earmarked for the buyback (Dornbusch, 1988). In this case spending funds in buybacks means there is no foreign exchange foregone since without buybacks there will be no grants. For DES this argument lacks relevance. However, in the case of debt-for-nature swaps where environmental groups make donations for a specified purpose funds may have no opportunity cost. The second reason concerns the importance that international reserves have as an indicator of creditworthiness of debtor countries. Empirical studies have demonstrated the overwhelming importance of reserves in explaining creditworthiness. This argument will be discussed at more length in section 3.2.3. Finally, it is asserted that DES can never imply opportunity cost of foreign exchange when the swaps are additional. Additionality means that DES are a necessary condition to realize foreign investment in the debtor country (Bergsman/Edisis, 1988). When the relevant alternative is a situation without such investments, then Bergsman/Edisis are right. In that case, DES do not displace alternative foreign investments and, therefore, there is no foreign exchange

108

foregone, and hence there is no loss for the country. However, the assumption of a situation without FDI as the relevant alternative is questionable. Instead, the argument used in this study is that DES are not a substitute for FDI but are only a different way of financing them. Therefore, the alternative to DES can only be conventionally-financed FDI if both have the same subsidy. Leaving aside for a moment the existence of high transaction costs incurred when FDI is financed by DES, an investor will be indifferent as to whether he finances his investment conventionally or by DES. Evaluated against this background, DES will always have opportunity cost in foreign exchange. However, since DES may entail several deals on the side of the banks in order to offer the debt issues the investor needs to realize the swap, he may incur much higher costs than in the case of conventionally-financed FDI. In their study Bergsman/Edisis asked investors whether they would have realized their FDI in the absence of DES. When the answer was negative, they concluded the swaps were additional. By this criterion, all DES where banks themselves were the investor are reported to be additional. They explain the banks' attitude towards additionally with two arguments. First, DES allow them to restructure their poorly performing portfolios. More indirect is the second argument insofar as banks are distinguished from multinational corporations. For the latter group of enterprises it is found that: "MNCs, on the other hand, take advantage of the discounted prices at which they can buy the debt to make investments at lower cost." 11 What the authors seem to have in mind is the following: DES imply either additionality or subsidy-capturing, but not both. Banks, unlike multinational corporations, will not buy the debt instruments necessary for the swap at secondary market prices because they already own them; consequently, they cannot capture the subsidy. Therefore their swaps must be additional. However, banks gain from DES in a manner similar to that of non-banks. They know that they have poorly performing loans in their portfolio, the prices of which are not in line with their book values. If the banks had adjusted the value of these loans according to the prices prevailing in the secondary market, they would gain from debt swapping in the same way as non-banks did.

Bergsman/Edisis, p.vi.

109

This suggests that the additionally argument is not very convincing and that DES have opportunity cost as foreign exchange is foregone. However, viewed from a different angle, swaps may entail some additional FDI when redemption of debt is organized in such a way that the investor receives domestic bonds in exchange for the debt instruments. To realize his investment he has to sell these bonds in the domestic capital market, the capacity of which is normally quite limited. Selling the bonds means that most of his investments will substitute for a domestic one. But if demand for bonds is not completely inelastic, there will be some incremental investment that is additional and which, therefore, has no opportunity cost of foreign exchange. b) Banks refuse to accept the pre-deal price in the secondary market. This corresponds to the view expressed in Dooley (1989) and in World Bank (1991). In the latter publication it is stated that "... banks would not willingly give up their claims for anything less than their pre-deal value."12 This is in accordance with the explanations given above with respect to Figure 1. Although the transaction is substantial, the market value of debt declines only marginally. As indicated above banks' attitude resulted from the free-rider position that they may take to avoid (future) capital losses when they sell and other banks not. As Figure 1 shows, lowering the face value of debt increases the expected value of debt repayments. Hence, banks have an incentive to promote the sale of debt issues by other banks while they hold the debt. In the Bolivian example, in spite of the buyback, the market value of debt remained more or less constant, indicating that this case is more properly reflected by the dotted line AM. It is worth noting that for the debtor country this makes the deal more beneficial than the application of the Al curve in Figure 1. The relevance of the free-rider argument depends on differences in the probabilities the banks attach to good or bad economic states (DiLeo and Remolana, 1989). In larger buybacks, and distinct from DES, the face value of debt which the more pessimistic banks are willing to sell may be insufficient to realize the transaction. Hence, it is necessary to offer a price that will make the selling banks as well off as those who hold the debt. Compared with the total amount of debt a country owes to its banks the buyback involved in DES is marginal. Here, 12

World Bank, 1991, Vol.I, p.39.

110

holdings of debt by the more pessimistic banks may always be sufficient to execute the swaps. c) The model behind Fig. 1 is that of a one-sector-economy where in the case of default the probability of seizure is dispersed evenly throughout the economy. However, using a two-sector-model, Goldberg and Spiegel (1992) have shown that DES-caused Pareto-improvements are possible when the negative buyback effect is more than balanced by positive output effects that result from a reallocation of capital caused by expected debt reductions. When a country defaults creditors may seize production only from the part of the economy (seizable sector) where exportables and raw materials are produced. The non-seizable sector is the producer of domestic and import-competing goods. Debt reduction increases the probability of seizure-adjusted profitability in the seizable sector leading to a reallocation of capital between both sectors. When production increases sufficiently to compensate for the negative buyback effect Pareto-improvements may be possible. In such cases separability of DES into two steps (buyback and FDI) is no longer desirable as time inconsistencies may arise when the alternative of DES, i.e. a conventionally-financed FDI and a separate buyback, are realized. Only when the debt reduction precedes the equity sale expected returns will change resource allocation as indicated above. It is worth noting that a conventionally-financed FDI and the use of foreign exchange receipts for the repurchase of debt afterwards cannot lead to the same result as DES when the foreign investor allocates his funds in the non-seizable sector (where he is expected to invest). Doubts may arise with respect to the relevance of the reallocation argument. As Goldberg and Spiegel have pointed out their argument crucially depends upon the seizure assumption

13

. If in this respect both sectors differ only in degree

reallocation may be insufficient to bring about a positive output effect, let alone one that is sufficient for Pareto-improvements. But even if a sector exists whose output is completely unseizable seizure of output in the rest of the economy is usually difficult to enforce. Creditors will acknowledge those difficulties, and seizure will not be the main obstacle to investment in an 13

Goldberg/Spiegel, 1992, p.81.

111

economy that suffers from debt overhang. Then, reducing the face value of foreign debt will not change profitability between both sectors as much as is necessary to provoke a sufficient reallocation of capital. Up to now seizure has not been the preferred strategy lenders pursued when debtors got into troubles. Instead, involuntary concerted lending was expected to provide time for new financial arrangements between the debtor and his creditors (Krugman, 1989). This leads to the conclusion that in reality DES will not provide the incentives necessary for Pareto-improvements. The image given so far is rather pessimistic. Using funds that have opportunity cost to lower the face value of debt either by buybacks or by DES raises the expected value of debt repayments (or at best keeps the value constant) and lowers the amount of foreign exchange available to the country. More specifically, in the case of DES the country foregoes foreign exchange receipts of BC while at the same time the expected value of debt repayment increases by CG or remains constant (Figure 1). However, how can the costs and benefits of DES be evaluated when a country whose debt trades at a discount is nevertheless ready to service all its debt. Evidently, for the monetary authorities of this country line AP, not line Al, is relevant. Reducing the face value by A D is equivalent to a reduction of the expected repayments (PN) by the same amount. In this case costs equal benefits and the country must be indifferent as to the choice of a reduction of the nominal value of its debt. Against this it may be argued that in such a situation the agents of the monetary authority lack rationality. Either the E(D) schedule is given by Al or by AP but not by both and if a central bank perceives AP as the relevant schedule while the banks hold Al as the relevant loci of expected payments, then the debtor's monetary authorities base their decisions on irrelevant alternatives. In reality, however, things are not that simple. A country like Colombia has never sought to restructure its foreign debt and fulfilled all foreign obligations in time. Hence, there is no reason why creditors should be worried about Colombia's indebtedness. Nevertheless, its debt trades at a discount of 30 per cent. Perhaps the same is true in the Chilean case where the government and the Central Bank always declared that they will completely service Chile's foreign debt although the country went through several debt restructurings. But even in such cases where expected payments decrease by the same amount as

112

the face value of debt DES may have disadvantages as will be shown in the next sections. 3.1.2. The Cost of the Subsidy From the description of a typical DES it is evident that the investor gets foreign exchange necessary for his investment at a lower exchange rate than that prevailing in the market. Discussion of the incidence of this subsidy is controversial especially if the results from the last section are taken into account. When debtor and creditors alike perceive line Al as the relevant schedule of expected repayments, then redemption of debt at a price higher than that reflected by 13 (Fig. 1) involves a subsidy to the investor. In this case the debtor country bears the cost of the subsidy even if the banks still have booked their claims at face value and have to write them down to market value when the swap is realized. As writing off the debt inflicts a cost on the bank it might seem that the bank bears the cost of the subsidy. However, the bank's loss and its timing are completely irrelevant, incidence of the subsidy's cost is indicated by those who pay higher than market prices. The situation may be judged to be different when the debtor regards line AP as the schedule of expected repayments while the creditor banks still perceive line Al as relevant. A debtor could argue that he would have paid an amount equal to NP anyway to redeem HK of nominal debt. In this case the bank looses when it sells the claim at market prices. However, this reasoning is only convincing when the debtor redeems the bank's claim without the execution of any FDI. For several reasons the debtor may not redeem the debt at face value in the absence of additional gains: a) Any buyback or DES will lower the base for future debt restructurings and hence the possibility of receiving "fresh money" in future debt rounds. b) When the flow of funds caused by the debt is tailored to the cash flow of an investment project any premature redemption inflicts a cost on the debtor that has not been foreseen in the calculation of the project's profitability. c) Normally, redemption of debt before maturity involves the necessity to get new loans from other sources. As troubled debtors face severe constraints in international capital markets, they have to resort to domestic financial markets to

113

raise funds. In a typical debtor country with debt overhang problems real interest rates are higher than outside 14. Therefore, premature redemption of debt means high-cost loan substitution. Effectively, the country substitutes high-interest domestic loans for low-cost foreign debt. This leads to the conclusion that it is not very convincing to regard AP as the relevant schedule for debtors. At best the country will pay a price that covers this extra cost. To give an example: In DES transactions Chile usually redeemed foreign debt at 90 cents to the dollar face value. But even such high prices will only be paid when the debtor gains from other transactions. If he would be ready to redeem at 90 cents the dollar of nominal debt the creditor could sell the debt directly to the debtor without intervention of an investor. Evidently this does not happen. Just to mention a further example: In buybacks debtors never accepted a price that was at or nearly at face value when their foreign debts traded at heavy discounts. They were only ready to pay higher than market prices when they got FDIs in return. This points to the fact that the debtor effectively pays the subsidy. However, against the argument that incidence of the subsidy's burden rests on the debtor one may point to the following line of reasoning: The subsidy may be part of a package of agreements where the cost of the subsidy is balanced by other advantages the debtor receives. Normally, in DES contracts the investor's rights to repatriate profits and principal are restricted. Further, his freedom of action may be limited by other trade related investment measures (TRIMS) whose main purpose is to diminish the investor's rents (Greenaway, 1992). Also, the exchange rate investors are forced to use may be severely distorted, and a subsidy may be necessary to balance the distortion (Bulow/Rogoff, 1988). However, this counter-argument to the subsidy thesis is only valid when the investment would not have been realized in the absence of the subsidy. As we have seen in the previous section, the additionally argument (which states that the investment is due to the subsidy) does not apply. Therefore, the debtor country loses, and it can never balance the subsidy by other measures. Debtors' losses resulting from redemption of debt at higher than market prices are considerable. As indicated earlier and for illustrative purposes it can be pointed out 14

Velascoand Larrain, 1990, p. 179.

114

that Chilean institutions usually redeemed their debts at 90 cents to a dollar of nominal debt at face value when DES were executed. Their 10 per cent "gain" may be seen as a counterpart to balance the higher cost of refinancing and does not cancel the subsidy involved in any important respect. Only when the debtor manages to capture the discount he is not subsidizing foreign investments. Normally, therefore, DES involve high opportunity cost for debtor countries when they are realized in the usual way. With a swap volume of $ 3.2 billion Chile lost nearly $ 1 billion as subsidies for investments that would have been realized anyway. 3.2. Indirect Effects of DES Apart from the direct effects discussed in the previous section DES exert indirect costs and benefits. Space constraints limit discussion of the swap effects on stability, investment, and creditworthiness. 3.2.1. Stability A cursory revision of literature on DES reveals that these transactions are said to be destabilizing. The reasoning is as follows: Without sterilization money supply increases when debts are redeemed by simply printing money. For this reason Chile regulated redemption such that the investor, who exchanges domestic for foreign debt papers, has to sell them in the domestic financial market to be able to buy Chilean equity. The Chilean system has been regarded as non-destabilizing. However, this argumentation is not completely convincing. As Vial (1991) has pointed out Chile experienced a big expansion in money supply in 1987/88. At that time the central bank pursued the objective to influence the interest level, and it provided all the liquidity demanded at these rates. In this case DES did not exert pressure on interest rates, as one might expect, but on money supply. However, this inflationary effect usuallly ascribed to DES is not the consequence of debt conversions as every conventional FDI would have a destabilizing effect when the same circumstances apply. Therefore, conversion programs cannot be accused of creating an inflationary effect. This result has already been pointed out by Bergsman and Edisis (1988) who limited their argument to additional swaps.

115

Stability may be endangered by a different consequence of DES programs. As indicated in the previous section, when swaps are realized without monetary financing DES simply imply a substitution of high-cost domestic for low-cost foreign lending. This "currency substitution" (Franke, 1989) has two effects: a) It increases the market value of total (i.e. foreign and domestic) debt outstanding as the market value of new domestic debt is not depressed by sovereign risk as in foreign lending, and the market value of foreign debt may increase as a consequence of lower nominal indebtedness vis-a-vis foreign creditors. b) As Velasco and Larrain (1990) have shown, real interest rates are usually much higher in debtor countries than in international financial markets (see Table 3). They estimated that from July to December 1988 Argentina paid nearly eight, Mexico six, and Brazil nearly four times as much as they would have paid in international financial markets for the same amount of debt service. To this it must be added that in Latin American HICs domestic public and private indebtedness has already climbed to extremely high levels (Kohne, 1990). Creditor substitution caused by DES leads to higher expected repayments to foreign and domestic creditors, and to higher interest payments while the level of all domestic and foreign nominal debt remains unchanged. For this reason, and as far as public indebtedness is concerned, debt conversion programs are expected to cause stability problems. For countries undertaking IMF and/or World Bank supported adjustment programs conflicts may arise as budget deficits are usually subject to tight limits. 3.2.2. Capital Formation As mentioned above, reduction of the nominal debt stock can be important when a country suffers from debt overhang. In this situation -

capital formation is depressed as investors and lenders of capital fear that new claims will be traded with the same discount as old debt because they will face difficulties to document superiority of their claims even when the investment (taken in isolation) is profitable, and

116

Table 3 Real Interest Rates in Four HICs and Real LIBOR, 1988 (in per cent)

Argentina Brazil Chile Mexico

Source:

-

real Libor (r*)

domestic real interest rate (r)

r/r. (factor)

5.2 5.2 5.2 5.2

42.9 19.0 5.9 29.9

8.3 3.7 1.1 5.8

A. Velasco and F. Larraín (1990): La macroeconomía básica de los intercambios (swaps) de deuda. El Trimestre Económico, Vol. LVII, p.179.

governments may be unwilling to initiate painful policy reforms that are politically difficult to realize although the reforms may be necessary to attract additional capital and to overcome the capital shortage in the debtor country.

Empirical evidence of the debt overhang thesis is seen in the fact that HICs have suffered from depressed investment ratios since the debt crisis broke out. However, the causal relationship between decreasing investment ratios and the debt crisis seems to be questionable (Rogoff, 1992). Dating the beginning of the debt crisis to August 1982 when Mexico declared a moratorium on its debt, critics point to the fact that there was a remarkable decline in the investment ratio in the years preceding the crisis. Further, evaluating an investment ratio as being low depends on what is

117

regarded to be normal. The investment ratios of the 1980s may be judged to be low in comparison to those prevailing during the 1970s but not when they are compared with the respective ratios in the interval 1960-73. There are good reasons to suspect that decreasing investment ratios have the same origin as the debt crisis. Both can be seen to be caused - at least partly- by the decline of commodity prices and the increase in real interest rates. As low investment ratios have preceded the outbreak of the debt crisis this demonstrates that high indebtedness is possibly not the sole reason why investment in HICs is low. At least for the time elapsed since 1990 the statistical information given in CEPAL 1992 shows that an increase in per capita GDP is consistent with slightly increasing indebtedness accompanied by a decreasing real LIBOR rate and declining prices of Latin America's principal exports. Therefore, neither the debt overhang thesis nor the counter-hypothesis advanced by Rogoff (1992) completely fits into the picture. The only conclusion that can be drawn is that simply reducing nominal debt is not sufficient for higher GDP growth. In this context, reliance on DES is not sufficient to achieve higher levels of welfare.

3.2.3. DES and Creditworthiness Lack of creditworthiness is seen as an important constraint limiting access to new loans. As DES and their alternative, conventionally financed FDI, influence a debtor's creditworthiness to a different extent when the reserves are not used for a buyback, a closer inspection of their effects on a developing country's creditworthiness is necessary. With the outbreak of the debt crisis there has been a growing interest for an estimation of the default probability of troubled debtors by means of objectively measurable indicators. In spite of their methodological differences the studies prepared on this issue show a remarkable uniformity in the indicators used to detect the determinants of creditworthiness defined as the probability to be able to service foreign debt. 1 5 The debt-GNP-ratio, debt service to exports ratio, investment as a percentage of GDP, the growth rate of GNP, and the ratio of international reserves to

15

The probabilities of default and of creditworthiness sum up to unity.

118

GNP were among the most uniformly used. 16 As can easily be seen, different methods of financing FDIs may have widely differing impacts on creditworthiness. While both DES and conventionally financed FDIs may exert equally strong influences on investment, production, and exports, they differ in their impact on international reserves 17. Empirical studies of the determinants of creditworthiness reveal that the debt-GNP-ratio and the reserves-GNP-ratio significantly influence creditworthiness. Lower debt to GNP and higher reserves-GNP-ratios both increase creditworthiness. However, their numerical impact is quite different. While in absolute terms the elasticity of creditworthiness with respect to the debt-GNP-ratio is 0.24, elasticity with respect to the reserves-GNP-ratio is 0.4518, In other words, a conventionally-financed FDI without buyback raises creditworthiness nearly twice as much as the same FDI financed by DES. Using a simulation model of the Chilean economy 19 it can be shown that after a three years' duration of the swap program the spread on Chilean debt owed to foreign banks can be lowered by 0.6 percentage points if FDI is realized in the conventional manner without buybacks (Schinke, 1991). Thus, also in this respect DES are at a disadvantage compared with traditional FDI. 4. DES and Economic Reforms The economic reforms that Latin American countries have undertaken are beginning to show impressive results. These reforms are oriented towards the introduction of market elements as the principal allocation mechanism, and towards a strengthening of the private sector, while at the same time aiming at a stabilization of the economy. More specifically, the reforms aim to open up the foreign sector through lower and unified tariff rates as well as reduced non-tariff barriers. Subsidies have been lowered and multiple exchange rates unified. With respect to the public sector, deficits have been reduced by cuts in government expenditures and an expansion of the tax base. 16

A survey of the determinants used is given in Edwards, 1984. Note, that in this exercise the assumption no longer applies that in both cases there is a uniform reduction In the nominal value of debt as a conventional FDI with buyback would lead to the same result as DES.

18

calculated with data given in Schinke, 1990, p.67: The elasticities of the spread over LIBOR with respect to the same variables were— 1.60 and 1.04 interpreting the spread as a measure of risk.

19

The model was developed by J. Vial. See Vial and Le Fort, 1986, and J. Vial, 1986.

119

Public enterprises, frequently a source of high losses, were sold to the private sector. Finally, financial markets have been liberalized,leading to the necessity to offer positive real interest rates. Privatizations have also taken place in the financial sector where public institutions have frequently played a significant role. In this context, it seems straightforward to ask whether DES foster or hinder economic reforms. From the description of DES and the discussion of their effects it is evident that debt conversions interfere with or are related to economic reforms in a variety of ways: They may exert pressure on the budget by creditor substitution or they lower pressure when inefficient public firms are sold. Then, DES foster the private sector, but they do so at the expense of subsidies and discrimination. Therefore it seems to be appropriate to discuss the relationship between conversion programs and economic reforms in a more systematic way. Constraints of space, however, limit the discussion to a few main problems. Essentially, there are five arguments that have to be considered: a) DES are seen to be a market solution to the debt problem (Feldstein). The term "market solution" seems to indicate that DES are an efficient instrument to solve the debt problems 20 whereas other solutions lack efficiency. Thus, the debt strategies of muddling-through and debt forgiveness have the disadvantage that they will not produce efficient results when they are organized on a voluntary basis. In both strategies, collective action is needed to avoid free-riding (Krugman, 1989). Figure 1 clarifies this in the debt forgiveness case. As long as the debtor is "on the wrong side" of the E(D) curve, voluntary debt forgiveness will provoke freeriding 21 . Non-participating creditor banks will benefit from a higher expected value of debt repayments without sharing the cost of the deal. As DES diminish the nominal value of debt, they result in higher expected repayments. Therefore, the

It is not intended to discuss the issue whether DES will indeed lower indebtedness in a volume necessary to solve the debt problem. Instead, it is worth noting the following: Although the Chilean conversion programme was one of the most active swap schemes In Latin America, Chile's external debt amounted to US$ 18.9 billion before the program was started. At the end of 1991 the debt stock at market value stood at $ 16.4 billion (Banco Central de Chile, 1992, p.1876). This implies that with a swap volume of $3.6 billion (only chapter 19 transactions) indebtedness decreased only by $2.5 billion although at the same time other types of debt transactions had been executed: The total amount of all potentially debt reducing transactions amounted to $11.1 billion in the interval 1985 to 1991. However, it must be recognized, that meanwhile the discount on Chilean debts neatly vanished (ANZ Grindlays Bank, 1992). Krugman, 1989, pp.260-265.

120

same reasoning as in the debt forgiveness case applies: Free-riding must be avoided by collective action else the debtor must pay the post-deal price. This, however, renders the deal rather unattractive to the debtors. However, the latter argument overlooks the fact that normally DES contribute only marginally to a solution of the debt problem. When total debt outstanding is high relative to the amount of individual swaps, banks with more pessimistic expectations about the debtor's future economic outlook may be interested in selling the debt they hold at the actual price in the secondary market and may, therefore, offer enough debts to realize the swaps. When this happens and debtors are able to capture a much larger share of the discount, DES might play their role in the reform programs if the same result can not be accomplished cheaper by traditional FDI. This, however, is frequently the case as DES cause higher transaction costs than conventionally-financed FDIs. Usually, the debtor country cannot capture much of the discount so that the investor achieves an additional gain in profits. The existence of this gain demonstrates that the nomer "market solution" is misleading inasmuch as it seems to suggest that these transactions will be executed in competitive markets. As long as DES are approved on a case-by-case basis, decision-making in DES transactions is not completely left to the market. b) A second argument is that DES are an important tool in the privatization of inefficiently operating public enterprises. In a depressed economy domestic investors rarely can afford the funds necessary for the acquisition and modernization of public firms. Foreign investors who possess the capital and know-how needed are necessary for take-overs on a larger scale. Privatization via DES, therefore, presents several advantages in the reform process: When inefficient public firms are sold it is no longer necessary to balance the deficits with funds taken from the budget. Instead, the debtor country gets the proceeds of the sale and, even better, if a foreign investor from a capital-abundant country has a lower discount rate than individuals in the debtor country, he is likely to make a higher offer than domestic competitors. Thus, the debtor country gains from a lower budget deficit which helps to achieve stability and strengthens the private sector in the debtor country. Further, a transfer of technology as well as

121

knowledge of modern management techniques is likely which can be disseminated throughout the economy. One can hardly deny that all these factors make an important contribution to the successful realization of economic reforms. However, the above-mentioned reasons are essentially arguments for traditional FDIs, not for DES. c) A third argument is that successful swap programs foster knowledge about the extent and success of economic reforms pursued in the debtor country. As DES gain publicity, so does the country and its reputation for sound economic policymaking. This, in turn, creates optimistic expectations for the economy's future outlook which further attracts foreign capital and gives an incentive for domestic investment. In short, DES favor the business climate in the debtor country (Vial, and Williamson, 1991). The importance of this argument is difficult to assess. The influence of psychological factors should not be overlooked, and perhaps they are of special relevance in the situation which prevailed in Chile during the second half of the 1980s. During this period, which registered the highest swap transactions, visitors were often impressed by the positive expectations prevailing in the banking community and in investors' circles. However, this positive correlation between swap programs and reforms says nothing about a causal relationship. Contrary to the argument whereby swap programs represent a necessary tool in economic reforms, one may argue that reforming the economy is a necessary precondition to improvements in the economic climate. DES gain importance only when credible, consistent, and durable steps of reform programs are executed guaranteeing stability and growth in an economically sound environment. These steps presumably lay the foundations for a cooperative relationship between the investing principal and the capital-receiving agent which seems to be an important element in the explanation of the Chilean success (Corsepius, Nunnenkamp, Schweickert, 1989). Empirical evidence of the "reforms first" argument may be seen in the fact that studies on the determinants of FDI reveal a significant influence of those variables that are closely linked to and influenced by economic policies pursued in the host countries. In a cross section regression of 58 developing countries Edwards (1991) found coefficients for these variables significant enough to explain the inter-

122

country distribution of FDI as well as the relative share of FDI in GDP. This evidence leads him to conclude: "From a policy perspective these results indicate that, with other things given, countries that (1) reform their foreign sector, opening up international trade; (2) reduce the size of government; (3) maintain (or increase) their degree of international competitiveness; and (4) increase the rate of domestic investment, will tend to see an increase in their level of DFI. This result, of course, suggests that structural reforms are likely to have important side effects not usually measured in traditional analyses." 22 On the other hand, it must be recognized that investment activity, an important indicator of the business climate, is significantly determined by the capital account balance. Hiemenz, Nunnenkamp et al. (1991) found a strong negative relationship between the current account balance and the share of private investment in GDP. Both empirical results, when taken together, may be interpreted in the following manner: First, economic reforms need to be executed. These reforms are necessary for a basic swing in the economic climate and may thus be seen as a necessary precondition for the change. Only then, and as a propagating factor, foreign investments will have a positive influence on economic activity. d) In the relationship between economic reforms and DES, a central problem is how to overcome the disincentives of high indebtedness. The debt overhang may lead to higher present consumption and thus to lower investment as well as to a disincentive for economic reforms. In this situation DES are seen to be especially helpful as they reduce external debt while at the same time increasing the capital stock. The latter part of the argument needs further elaboration. The argument may be criticized at least for two reasons: First, one may point to the fact that FDI - be they financed conventionally by bringing in foreign exchange, or by DES - are essentially a concept of balance of payments accounting and - as they are understood in this study - comprise all forms of equity investment in the host country. Thus, they comprise the full range from the construction of new plants to portfolio investments. This clarifies that by far not all FDIs in the sense the word is used here represent a contribution to the capital stock or are equal to capital formation. The less confidence there is the higher may be the share of portfolio investment in total foreign direct investments. As portfolio investments are 22

Edwards, 1991, p.263.

123

usually rather volatile they may be more an impediment to growth than they favor it. Further, restricting the view to the process of direct asset acquisition is misleading. One has to look beyond to find out what happens with the funds received by the seller of the equity. Second, assuming for a moment that all capital flows entering the country can be restricted to non-portfolio purposes, even in that case the contribution of DES to the capital stock may be comparatively small. As has been demonstrated above (and at more length in Schinke, 1990, and 1989), additionality is weak when the swaps are carried out in a non-inflationary setting. e) One of the major goals of economic reform is the opening of the economy. Next to the static welfare-enhancing effect of foreign trade, open economies may realize dynamic gains, and are usually more efficient in adjusting to external shocks although their openness may contribute to an increased vulnerability to external shocks (Balassa, 1986). One of the main policy guidelines of the reform packages is that the same rules apply to all individuals, and that these rules do not discriminate intertemporarily or between sectors. Thus, if non-discrimination is one of the prime tools of economic reforms, then DES lead to negative results in different areas: There is discrimination

23

:

(i) between foreign investors either when the debt is redeemed at different prices according to the sectoral allocation of the investment (as in the Mexican DES program), or when different FDI regimes are brought into existence in the same debtor country, not allowing the financing via DES (as in the Chilean system); (ii) between foreigners and residents when only foreigners are allowed to finance FDI via DES 2 4 , and (iii) against labor-intensive activities as the subsidy favors the use of physical assets such as land and capital.

23

This is discussed at more length in Lagos, 1992, p.480.

24

This form of discrimination applied to the Chilean scheme. Only with the introduction of chapter 18 1/2 of the Chilean conversion system, residents were able to participate in DES transactions.

124

Further, DES introduce or tend to introduce capital controls as the transfer of profits and principal is constrained (IMF, 1988), and a system of dual exchange rates, one that regulates DES, and the other that is applicable to all other activities. Thus, DES interfere with some of the main policy guidelines of the reform packages. Another issue of the role of DES in Latin American reform programs is how well DES-financed FDI fit into the pattern of economic activities the reforms aim to strengthen. More specifically, do DES tend to further more outward-oriented than inward-looking activities, and what can be said about their factor orientation? Does production in DES-financed activities reflect the scarcities of factor endowments? Available data 2 5 of the Chilean system indicate that from 1985 to 1989 the volume of DES channelled to outward-looking 2 6 activities accounts for no more than 58 per cent of the total (US$ 2.5 billion). More than one third was invested in inward-oriented industries, the rest (8%) being inconclusive. Orientation towards factor abundance was more pronounced. Nearly two thirds of all DES were channelled to sectors that intensively use labor and raw materials as inputs. The latter result fits well into the findings of Hiemenz, Nunnenkamp et al. (1991), providing evidence that in resource-rich countries FDI is to a large extent determined by natural endowments and factor abundance. This, however, points to the fact that without DES a resource-rich country like Chile can expect that to a large extent FDI will be allocated to the same activities as with DES. Once again, this result underlines the suggestion that the DES-subsidy is unnecessary, this time with respect to the activities chosen. f) Finally, DES may provoke stability problems for at least two reasons: First, several countries abandoned their swap programs when they became aware that DES transactions tend to raise the inflation rate. But even in those cases (as in Chile) where regulations of the DES mechanism prevented redemption through monetary financing, stability problems arose when the Central Bank offered all credit demanded by the private sector at constant interest rates (Vial, 1991). Second, 25

A sectoral breakdown of Chilean DES from 1985 to June 30, 1989, is given in Williamson (1991), Table 7, p.34.

26

The following sectors are seen to be outward-oriented: paper, forestry, agriculture, mining, fishing. I regarded as resource-based and /or labor-oriented sectors paper, forestry, agriculture, mining, fishing, textiles, leather and shoes, woods and furniture.

125

another problem lies in the fact that real interest rates tend to be much higher in HICs than in international capital markets. Creditor substitution, a significant element in DES transactions, may contribute to budgetary problems, in turn threatening instability. 5. Conclusions By and large, DES can be seen as an unnecessary instrument whose usefulness is questionable as far as the debtor country is concerned. Expected repayments of foreign debt will most probably increase as a result of DES, raising the market value of the debt stock. At best, the gain from a reduction of nominal debt will be small as demonstrated by Bulow/Rogoff's Bolivian example. Direct costs, however, can be high. Foreign exchange foregone as a consequence of DES has sizeable opportunity costs in capital formation and in terms of growth. Also, it has been demonstrated that the additionality argument does not apply. Another type of cost to the debtor country is the subsidy the investor receives in the form of a discount at which debt issues trade in the secondary market. With respect to indirect effects, DES may threaten stability. Assuming that conventionally-financed FDI is a perfect substitute to DES, investments in debt-equity swaps are no more inflationary than any other FDI when attention is restricted to the effects on money supply alone. However, DES may threaten stability through their effect on the budget deficit from higher domestic interest payments. Most probably, DES will not help to overcome the investment shortage claimed by the debt overhang model as the positive effect of DES on growth is questionable: Empirical evidence suggests that simply reducing nominal debt is not sufficient for achieving higher growth rates. Further, DES will possibly exert a negative influence on creditworthiness while conventional FDI will result in a lower interest rate spread (which is taken as a measure of default probability). Finally, in the context of economic reforms DES have disadvantages as well. First, DES are not executed in competitive markets. There is much discretion and a remarkable subsidy. Therefore, they cannot be regarded as a "market solution" to the debt problem. Second, DES are not necessary for privatizing inefficient public enterprises. With usually lower transaction costs, the same result can be achieved with conventional FDI. Also, there is doubt whether DES foster the debtor country's

126

business climate in the absence of economic reforms. Possibly they can be seen as a propagating factor once the reforms are under way. Similar to conventionally-financed FDI, DES are a balance of payments concept. Therefore, it can be misleading to look at them as contributions to the capital stock of the debtor country. Finally, DES interfere with important policy guidelines of reform packages: They discriminate between foreign investors, between foreigners and residents of the debtor country, and against labor-intensive activities. Further, they tend to introduce distortions in capital and foreign exchange markets.

127

References ANZ. 1992. ANZ Grindlays Bank pic. Emerging Markets Group. Price Indications for Value Impaired Debt, 24 September. ANZ. 1990. ANZ McCaugham: Price Indications for Value Impaired Debt, 22 February Balassa, Bela. 1986. "Policy Responses to Exogenous Shocks in Developing Countries." The American Economic Review 76. 2 (May): 75-78. Banco Central de Chile. 1992. Boletín Mensual 773 (July). Bergsman, J. and W. Edisis. 1988. Debt-Equity Swaps and Foreign Direct Investment in Latein America. International Finance Corporation. Discussion Paper 2, The World Bank, Washington, D.C. Bulow, J. and K. Rogoff. 1988. "The Buyback Boondoggle." Brookings Papers on Economic Activity 2: 675-698. CEPAL. 1992. "Balance preliminar de la economía de América Latina y el Caribe 1992." Notas sobre la economía y el desarrollo (December): 537/538. Corsepius, U., P. Nunnenkamp, and R. Schweickert. 1989. Debt versus Equity Finance in Developing Countries. Kieler Studien. No. 229. Tübingen. DiLeo, P. and E.M. Remolona. 1989. "On Voluntary Conversions of LDC Debt." In S. Rubin, ed. Debt Equity Swaps under the Brady Umbrella. Special Reports. No. 1203. The Economist Publications. London. Dooley, M.P. 1989. "Buy-Backs, Debt-Equity Swaps, Asset Changes, and Market Prices of External Debt." In J.A. Frenkel, M.P. Dooley, and P. Wickham, eds. Analytical Issues in Debt. International Monetary Fund, Washington, D.C. 1989. "Market Valuation of External Debt." In J.A. Frenkel, M.P. Dooley, and P. Wickham, eds. Analytical Issues in Debt. International Monetary Fund, Washington, D.C. Dornbusch, R. 1988. "Comments and Discussion" (to J. Bulow and K. Rogoff (1988)). Brookings Papers on Economic Activity 2: 699-703. Edwards, Sebastian. 1991. "Capital Flows, Foreign Direct Investment, and DebtEquity Swaps in Developing Countries." In Horst Siebert, ed. Capital Flows in the World Economy. Symposium 1990. Institut für Weltwirtschaft, Tübingen. 1984. "LDC Foreign Borrowing and Default Risk: An Empirical Investigation, 1976-80. The American Economic Review 74: 726-734. Feldstein, M. 1987. "Muddling through can be just fine." The Economist (27 July). Franke, G. 1989. "Economic Analysis of Debt-Equity Swaps." In H.-J. Vosgerau, ed. New Institutional Arrangements for the World Economy. Berlin, Heidelberg.

128

Goldberg, Linda, and Mark Spiegel. 1992. "Debt Write-Downs and Debt-Equity Swaps in a Two-Sector Model." Journal of International Economics 33 (November): 267-289. Greenaway, D. 1992. "Trade Related Strategy." Kyklos 4 5 : 1 3 9 - 1 5 9 .

Investment

Measures

and

Development

Hiemenz, Ulrich, Peter Nunnenkamp et al. 1991. "The International Competitiveness of Developing KCountries for Risk Capital." Kieler Studien No. 242. Tubingen. Koehne, G. 1990. "Staatliche Inlandsverschuldung zunehmend problematisch." Kurzberichte über Lateinamerika No. 1/10. Deutsch-Südamerikanische Bank. Krugman, P.R. 1989. "Market-Based Debt-Reduction Schemes." In J.A. Frenkel, M.P. Dooley, and P. Wickham, eds. Analytical Issues in Debt. Washington, D.C.: International Monetary Fund. Lagos, Ricardo A. 1992. "Debt Relief Through Debt Conversion: A Critical Analysis of the Chilean Debt Conversion Programme." The Journal of Development Studies 28 (April): 473-499. Rogoff, K. 1992. "Dealing with Developing Country Debt in the 1990s." The World Economy 15: 475-486. Schinke, Rolf. 1991. "Der Beitrag von Debt-Equity Swaps zur Lösung der Schuldenkrise, dargestellt am Beispiel Chiles." In J. Siebke, ed. Monetäre Konfliktfelder der Weltwirtschaft. Schriften des Vereins für Socialpolitik NF No. 210. Berlin. Schinke, Rolf. 1990. "Debt Equity Swaps, Investment, and Creditworthiness: The Indebtedness. Chilean Example." In M. Borchert and R. Schinke, eds. International London, New York. Schinke, Rolf. 1989. "Wachstum durch Debt Equity Swaps? Bemerkungen zum chilenischen Swap-Programm. In H.G. Preuße, R. Schinke, and V. Urquidi Ansätze zur Lösung der Schuldenkrise Lateinamerikas: Urquidi-Plan, Debt Equity Swaps, Direktinvestitionen. Arbeitsberichte des Ibero-Amerika Instituts für Wirtschaftsforschung No. 24. Göttingen: Schwartz & Co. Velasco, A., and Larrain, F. 1990. "La macroeconomía básica de los intercambios (swaps) de deuda." El Trimestre Económico LVII: 163-193. Vial, J. 1991. "Commentary." In Mary L. Williamson Debt Conversion in Latin America. Panacea or Pandemic? Policy Essay No. 2. Overseas Development Council, Washington D.C. 1986. Ajuste e interdependencia en América Latina. Un ejercicio de simulación. Documento preparado para el proyecto H O L / 8 5 / 5 4 3 "Políticas, macroeconómicas y el ajuste en América Latina". Vial, J., and LeFort, G. 1986. "Deuda externa y perspectivas de crecimiento en América Latina." Integración Latinoamericana (Jan.-Feb.).

129

Williamson, Mary L. 1991. Debt Conversion in Latin America. Panacea or Pandemic? Policy Essay No. 2. Overseas Development Council, Washington, D.C. World Bank. 1991. World Debt Tables 1991-92. Vol. 1. Analysis and Summary Tables. Washington, D.C. United Nations. 1991. World Investment Report 1991. The Triad in Foreign Direct Investment. New York.

131

Mexico and the North American Free Trade Association (NAFTA) Heinz Gert Preuße

1. Introduction On August 12, 1982, president Silva Herzog declared a moratorium on Mexican debt servicing commitments. The declaration marked the beginning of one of the most severe crisis in international financial relations between Western Industrialized Nations and the Third World. Exactly 10 years later Mexico, the USA and Canada successfully completed negotiations for a "North American Free Trade Association". This treaty is a remarkable event in international trade policy for a number of reasons: 1. NAFTA will form a trading block covering about 360 million people with an aggregate GNP of about US$ 6-7 trillion. 2. NAFTA will not be "just another" integration area but a unique arrangement between a developing country and two of the richest industrialized nations. 3. NAFTA substantially increases a world-wide trend towards regionalization. This trend is expected to have a strong impact on the future of the international trading system. The analysis of the potential impact of NAFTA on the future of the liberal international trading system raises some important questions. In the following, these questions will be tackled by discussing the issue on the national, the regional, and the global level, respectively. All three levels are interrelated. In order to provide a clear structure, they will be treated separately in the following sections.

PD Dr. H. G. Preuße, Visiting Professor, Institute for Trade and Development Economics, JohannWolfgang-Goethe-Universität, Frankfurt (Main).

132

2. NAFTA and the Institutional Pre-Conditions in Mexico Ideally (and in line with GATT rules), the formation of a Free Trade Area (FTA) should lead to a complete liberalization of the trade and capital accounts between the member countries within a relatively short period of time. According to conventional trade theory, these liberalizations will bring about substantial static and dynamic gains from trade for all participants: improved patterns of specialization will lead to an increase in allocative efficiency, greater markets will allow the better use of economies of scale, and the intensity of the competitive process will increase along with the transfer of technology. However, the gains from liberalized trade which are claimed by those who introduce these reforms will only take place if a number of conditions are fulfilled within the liberalizing countries: First, the productivity effect of improved factor allocation will only take place if capital and labor are allowed to respond freely to new incentives and move from sectors with perceived comparative disadvantages to sectors where comparative advantages are believed to exist. Second, increasing market size will attract new investments and more sophisticated technologies which, in turn, will open up new opportunities for specialization and the utilization of economies of scale. Third, the management of sophisticated technological processes usually requires the application of advanced managerial skills and an active role for R&D in providing and maintaining international competitiveness (Porter, 1991). Alle these new tasks highlight the fact that, due to NAFTA, Mexican industries and markets will not only change in sectoral composition. There will also be changes in the average size of enterprises, the degree of specialization, the level of technological and organizational capabilities, and the intensity of interregional activities. These developments will have to be managed in view of the fact that the intensity of competition will increase within the integration area. By and large, for Mexico, the participation in a large free trade zone along with Canada and USA provides an opportunity for the promotion of economic development. This applies to the upgrading process for the economy as a whole, and the industrial sector in particular. At the same time, it represents a challenge for politicians to provide a legal and institutional framework that is conducive to development and change.

133

Three overriding principles should be brought into operation in order to establish such a framework: First, economic policy must allow or even reward capital and labor to move between different enterprises and industries. Second, technological development must be actively promoted in order to meet international standards. To accomplish this task, a number of different policy measures such as the promotion of the educational system, fostering R&D, and providing various supporting activities will have to be introduced at the national level. Furthermore, and most important for a newly industrializing country like Mexico, international technology transfers must be maximized. Third, the infrastructure must be improved in order to meet the new requirements. A decade ago, when the debt crisis hit the Mexican economy, nearly all these preconditions for a successful performance in international markets were absent. The economy was highly dependent on exports of crude oil. Promotion of industrial activities was viewed only in the context of a highly interventionist development policy based on the principles of import substitution. The exchange rate, suffering from the "Dutch Disease" syndrome, further contributed to the slowdown of Mexican industrial development. Thinking in terms of a continent-wide integration area had been beyond any imagination at that time. Nowadays, things are different. During the second half of the 1980s Mexico has initiated a profound economic reform program which paved the way for a potentially successful integration policy. A far-reaching trade liberalization package has formed the core of the economic reform program. It tackled protectionism in the areas of licensing, official import prices, and conventional tariffs. Up to 1982, the Mexican system of import licensing covered nearly every single tradable sector. It has been suggested that this system has had the most severe impact of all protectionist instruments in use at that time. Any meaningful liberalization approach should, therefore, include a substantial reduction of licensing procedures. In fact, this task has already been met during the first period of the program. During the second half of 1985, coverage of local production by licenses was reduced from 92.2% to 47.1 % (Table 1). After this initial reduction, trade coverage was further reduced in several successive steps to reach 19.8 % on average in December 1989. Disregarding crude oil and petro-chemicals, which have not been liberalized at all,

134

Table 1 Indicators of Protection in Mexico (1982-1989)

Domestic Production Value Covered by Licensing (%)

Average Tariff Rates (%) (productionweighted)

Domestic Production Value Covered by Official Import (%)Prices

1982

100

(100)

u.a.

1985 June December

92.2 47.1

23.5 28.5

18.7 25.4

1986

39.8

24.5

18.7

1987

25.4

11.8

0.6

1988

21.3

10.2

0

1989

19.8

12.5

0

Source: Ten Kate, A. 1992. "Trade Liberalization and Economic Stabilization in Mexico: Lessons of Experience." World Development 20 (5): 659-672.

only transportation (41 %), agriculture (38.4 %) and food and beverages (20 %) are still subject to licenses to a larger extent. Average tariffs were increased temporarily at the beginning of the program in order to compensate import competing producers for the effects of eliminating licenses. In 1986, however, import tariffs were reduced gradually but substantially. At the end of 1989, average tariffs had reached 12.5 %, ranging from 0 - 20 %. Presently they are

135

estimated at an average of 11%. The use of official import prices, which in fact represent a non-tariff barrier, was discontinued completely in 1988. By and large, the trade reforms of the 1980s have transformed Mexico into an open economy. The remaining import restrictions are among the most liberal in the developing world, and are comparable with those of the economically advanced nations. The average tariff is not much above that of the USA; uniformity of the tariff rules is high, and quantitative restrictions such as licenses have only a marginal effect on the economy. Partly due to this liberalized economic environment, international flows of capital are increasingly finding its way back into the Mexican economy. Most remarkable in this context is the fact that foreign direct investments, too, which had been discriminated in Mexico during recent history, are now being given a more gentle treatment. As a consequence, portfolio and direct investment inflows increased dramatically between 1985-1991 (Table 2). The drastic changes in international capital and trade

policies have

been

accompanied by an internal adjustment program which has brought the Mexican economy closer to macroeconomic equilibrium. Progress has been achieved by consolidating the budget and by reducing inflation. However, the most sensitive task of providing full employment is still lagging. Evaluating the Mexican situation just before entering NAFTA from the point of view of recent changes in economic policies reveals that the country is relatively well equipped now to meet the challenges of the coming integration process. However, the forces of change will be especially high under the new NAFTA conditions, because Mexico can be expected to have distinct sectoral comparative advantages and disadvantages vis-à-vis the USA and Canada. Comparative disadvantages will most probably arise in grain production, but are far less obvious in industry. In the latter, past protectionism has created a number of industrial activities which will be unable to survive under a more liberal regime. On the other hand, there are relatively strong competitive advantages to be expected in activities where cheap labor is an important input in production.

136

Table 2 Foreign Investment Flows to Mexico 1980 -1991 (Millions of US$)

Direct Investment

Portfolio Investment

Total

1980

2155

2155

1981

3836

3836

1982

1657

1657

1983

461

461

1984

391

391

1985

491

491

1986

1522

1522

1987

3248

3248

1988

2595

2595

1989

3037

493

3530

1990

2633

1995

4628

1991

4762

7540

12302

Source: Banco de Mexico

Given the present situation on Mexican labor markets, it is clear that further structural change due to the expected new distribution of comparative advantages within the integration area will become a major challenge for economic policies. This challenge will be met only if growth proceeds rapidly in the expanding export industries. Only then can factors which had to be released in declining sectors readily be re-integrated

137

into the production process. Factoral reallocation will be especially difficult when intersectoral changes between agriculture and industry are to be enforced and regional migration is inevitable. Within the modern industrial sector, where job creation is expected to be highest, it is even more important to maintain flexibility. To see whether these structural developments are already under way, it is helpful to look at the effects of recent trade liberalization measures. A clear indication that these reforms have already induced structural adjustments would mean that flexibility is indeed a property of the Mexican economic and social system, and this will lend support to a positive view on the future of the integration process. Recent studies of the Mexican economy do not indicate that structural changes of the kind described above are taking place rapidly (Ten Kate, 1992). From this it can be concluded that the most severe adjustments are still to be carried out. The reasons for the lagged reaction of the economy to the reforms are twofold. First, Mexico is relatively well equipped with a modern industrial sector. Before the oil boom at the end of the 1970s, when the "Dutch Disease" phenomenon effectively hindered modern industrial exports, some Mexican producers had already found their ways to the world market. In 1985, therefore, a latent capacity to export still existed. When the exchange rate depreciated in 1985, exports were ready to be re-vitalized without any time lag, and this expansion was stimulated because, at the same time, macroeconomic adjustment provoked a severe under-utilization of domestic capacities. Second, imports which usually grow rapidly in response to trade liberalization, have been smoothed down in the Mexican case by complementing trade liberalization with a pronounced depreciation of the real exchange rate. The new level of the real exchange rate introduced in 1986 has been kept relatively constant up to 1988 (Table 3) by implementing successive steps of nominal depreciation which closely reflected inflation differentials with major trading partners. It has been argued that during the first years of the reform process, "trade protectionism" has simply been substituted by "exchange rate protectionism" (Ten Kate, 1992, 669).

138

Table 3 Real Exchange1) Rate Indices of Mexico 1980 -1991 (1980 = 100)

1980

100

1985

99.1

1986

144.6

1987

157.5

1988

130.1

1989

118.3

1990

114.5

1991

109.9

1

> Real Exchange Rate = [— j • [ — ]

100

P* = International price index using an international basket of goods and currencies of 133 countries Pi = Domestic consumer price index using a domestic basket of goods and

domestic currency

Ei = Exchange rate per $ in domestic currency International Exchange Rate in baskets of currencies per US$

Source: Banco de Mexico and Kehoe (1992, table 4)

139

Whatever this kind of policy may be called, it is beyond doubt that imports did not immediately respond to the new incentive system while exports started to rise. 2 From the point of view of structural change this means that the necessary adjustments did not come under way until the end of the 1980s. The degree of adjustment flexibility which the new economic system is able to provide still remains to be shown. This state of affairs implies that most of the economic structures that will reign the Mexican economy when the country has become an integral part of NAFTA are still to be developed. The most difficult decisions concerning the reallocation of capital and labor between expanding and shrinking sectors are still to be made. Promoting these decisions means that a consistent concept of positive structural adjustment policies should be designed in order to prevent major economic and social disruptions during the adjustment process. At the same time, growth policy should improve the opportunities for capital accumulation (including human capital) so that employment generation will keep pace with the expected employment reduction in shrinking industries. Neither the policies of growth promotion nor the more defensive social policies of adjustment assistance seem to be adequately established by now, and economic growth, though already under way in the 1990s, is far from impressive3. While the participation in NAFTA will undoubtedly improve overall growth prospects, it may indeed increase the potential conflict between growth and adjustment in the shortand medium-run. Mexican policy makers should be aware of the implications of this conflict. First, there is an ethical problem arising out of the acceptance of sustained poverty caused by growth and structural change, and this problem is far more acute in Mexico than in Canada and the USA. Second, unresolved structural adjustments may become a major threat to the whole reform process. Examples of liberalization programs which had to be abandoned and even reversed abound, and they are frequently found in Latin American countries (Preuße, 1988). Unresolved social conflicts, arising out of changes in the economic

It has been documented by Ten Kate (1989) that relative prices In Mexico did not move to adjust to international prices at least until the end of 1987. See Nunnenkamp, Peter (1993) 'Economic Policies and Attractiveness for Foreign Capital' in this volume.

140

structure with unequal effects on different socio-economic groups, are among the most convincing explanations of these failures. Taking these arguments seriously, it follows that a liberalization of trade and capital accounts along with a macro-economic policy aimed at a balanced budget are not sufficient to guarantee a successful Mexican integration into NAFTA. Instead, a conscious policy to promote growth and structural change would be helpful to alleviate the economic and social upheavals which are undoubtedly to come. Such policies have to be adequately financed, i.e. without using the traditional instrument of inflationary finance. Substantial reforms of the public finance system along with the implementation of an effective social security program are therefore important additional pre-conditions for a successful Mexican participation in NAFTA.

3. NAFTA from the point of view of integration theory Conventional integration theory claims that "Free Trade Areas" and "Customs Unions" are discriminating against non-member countries. This proposition appears to be well founded by the Cooper-Massell argument (1965). According to this argument, the gains for a country to be reaped from a unilateral reduction of tariffs worldwide are equal to those resulting from the same reduction within the Free Trade Area. However, the latter are discriminating against non-member countries but the former are not. A Free Trade Area is, therefore, always second best to unilateral free trade. Drawing on this theory the formation of NAFTA and the participation of Mexico in it in particular, can hardly be justified. Before sharing such a clear-cut negative view of NAFTA, however, it should be remembered that even GATT (Article 24) accepts Free Trade Areas (FTAs) and Customs Unions (CUs) as a major exception to the overriding principle of non-discrimination. This seemingly contradictory position of GATT is founded in the so-called "Nucleus"-theory which has been emphasized by Haberler as early as 1933. According to this theory, FTAs may become some kind of breeding ground for global free trade. That is, initial discrimination is justified because of its positive impact on speeding up global liberalization processes. Recent research on integration areas has emphasized political economic aspects as part of the overall concept of economic integration. Economic geography is considered relevant as well, as soon as transportation costs and economies of scale

141

are considered (Krugman, 1991). These studies, too, lend support to a more positive interpretation of FTAs. Last, the development of trade models based on imperfect competition seems to broaden the scope for welfare-increasing effects of regionally limited preferential trading arrangements (Lorenz, 1992; Kehoe, 1993). FDI, in particular, has been emphasized as a major growth-promoting factor (Brown/Deardorff/Stern, 1991). Evaluating the Cooper-Massell thesis in light of these studies reveals that the integration issue is more complicated than originally claimed. It follows that a straight-forward rejection of the FTA approach based on the Cooper-Massell-argument is not a valid conclusion. Instead, it becomes increasingly evident that success or failure of a FTA or a CU is, to a large extent, dependent upon the institutional arrangements employed in every single case. As far as NAFTA is concerned this means that only a rigorous examination of the most important institutional provisions of the treaty can illuminate the question whether the expected gains can indeed become reality for all participants. This kind of investigation cannot be carried out here. There is neither sufficient information available at present concerning the details of the arrangement nor does the scope of this paper allow such an in depth analysis. However, there are certain aspects of the treaty which may well be used to shed some light on its potential spirit. To begin with, one should recognize that the written version of the NAFTA arrangement covers more than 1000 pages. This simple observation does in fact point to an implicit contradiction which has been spelled out most clearly by Anne Krueger who asked: "Why does it take more than a few sentences to agree on free trade?" (Krueger, 1992,109). This contradiction is explained by modern theories of political economy. These theories claim that protectionism is, by and large, a sectoral phenomenon. Trade liberalization does affect individuals and social groups differently, thus creating winners and loosers at least in the short-run. Those believing to be among the loosers resist any change of their relative position. The political success or failure of economic reform efforts depends on a number of conditions including the ability to organize and influence political decisions. As a rule it can be said that protectionist interests are more likely to succed the more powerful lobbyist groups are acting within the national political arena, the better they manage to hide the costs of subsidies, and the less capable consumers are to organize their free trade interests.

142

Usually the forces pushing for protection and those voting for free trade are distributed differently among sectors and regions, and they even form changing coalitions. Liberalization treaties - globally or regionally- do reflect these different power constellations and therefore turn out to be distorted. That is, they usually depart more or less substantially from the verbally proclaimed goal of multilateral free trade. The NAFTA treaty, too, exhibits this kind of distortion, and it will be illuminating to see just how far the intended regulatory system does indeed depart from the ideal goal of a Free Trade Area as established in GATT, Article 24. To examine this issue, we may ask to what extent the main goals of Mexican integration policies have been substantiated in the treaty. Among these main goals the following three have an overriding importance: 1. Free access to the US and the Canadian markets, 2. improvement of the relative attractiveness of Mexico as a location for US and Canadian foreign direct investment, 3. securing the continuation of the recent economic reforms in Mexico. Disregarding the latter, the treaty will promote or support Mexican interests if it provides adequate access to North American markets, and if it is conducive to capital inflows - especially in the form of foreign direct investment. According to the treaty, the member countries agree to completely abolish tariffs and non-tariff barriers within 15 years. Apparently, this part of the agreement coincides with Mexican interests, at least in the long run. A look at the transitional regulations during this 15-year period reveals, however, that things are not that favourable for Mexico, and this may be the time horizon that matters. Only 50 % of agricultural trade will be liberalized immediately. Successive liberalization steps are planned, covering a period of 5 - 1 0 years. Exports of automobiles will be liberalized only partially. Adjustment periods for a substantial part of this industry are scheduled to reach up to 10 years. Even more restrictive from the point of view of Mexico are a number of non-tariff barriers (NTBs) which are thought to be "constituent" parts of the agreement. That is, they are not fading out during the course of time. Three of these provisions need to be mentioned:

143

1. Rules defining working standards, 2. rules defining ecological standards (green tax), 3. rules defining the "local content" of products which qualify as "intra-regionally" produced. From the economic point of view it is clear that all these regulations are designed to weaken comparative advantages of Mexican producers. This is most visibly so in the case of working standards. Taking average factor productivity in Mexico as given, imposing US working standards inevitably destroys comparative advantages of Mexican producers in products which rely on labor-intensive technologies. There is widespread agreement among economists that policies designed by high-wage countries to prevent "social dumping" of poor competitors do impose a severe additional burden on the latter. On the global GATT level, therefore, the USA did not manage to enforce any policies against "social dumping".4 Against Mexico as a single partner country its dominant position (enforced by similar Canadian interests) was sufficient to introduce this subtle protectionist instrument. Evaluating the impact of the so-called "green tax" on the development of Mexican economic prospects within NAFTA is a more difficult task. The "green tax" is thought to impede the creation of comparative advantages without due consideration of ecological costs. In the case of the gre,en tax, therefore, the economic issue has to be considered with respect to perceived global ecological problems. Taking ecological questions seriously means that producers are to be obliged to internalize the costs arising out of the use of natural resources. In view of the worldwide ecological activities which have culminated in the international environmental conference in Rio in 1992, it is beyond doubt that steps toward more environmentally sustainable development policies have become an important international obligation of economic policy worldwide; and there is no dissent on the need for action in Mexico. From this point of view the green tax cannot be rejected right away as a protectionist instrument. However, the "green tax" may be abused as a protectionist device. In this case, environmental standards are deliberately raised in order to protect national interest

For a detailed discussion of "social clauses" in international trade see van Liemt, Q. (1989).

144

groups rather than the worldwide ecological system 5 . It is a widely shared conviction, underpinned by numerous statements of representatives of US pressure groups, that protectionist abuses of the green tax of this kind will in fact become a matter of concern within NAFTA; and this, in any case, will be at the expense of Mexican interests. Another instrument which will undoubtedly work against Mexican comparative advantages is the "local content" rule. This rule applies to products which are traded within the FTA but include intermediate products from non-member countries. Products containing such inputs will only qualify as area products if they have been transformed substantially within the jurisdiction of the member countries. "Substantial transformation" implies that the end product must belong to a tariff group other than the third country intermediate input. For some important industries the minimum local content has been fixed a priori. Passenger cars and pickups, for example, require a local content share of at least 62.5 %. Other automobiles qualify with 60 % local content. Local content for textiles is determined by the highly discriminating "yarn foreward rule". This rule means that any textile or clothing product must be produced by use of inputs (yarn) originating from the region. It is interesting to note that there are exceptions for shirts made of silk and linen. Both of these inputs are not available at a sufficiently large quantity within the area. Local content rules are especially subtle instruments of trade protection. They distroy the importer's comparative advantage, because he is obliged to substitute costly area production for cheap foreign inputs in order to qualify for the area market. It is also a secret form of protection because this kind of discrimination does not show up directly in the final product. Consumers, therefore, are not able to realize that they have to pay more than the free trade price. In the case of automobiles it has been suggested that the local content of 62.5 % will effectively hinder Mexican producers to use international sourcing efficiently. This in turn will be a hindrance for further productivity increases. Inasmuch as existing inter-

From the point of view of of trade policy theory direct subsidies to Mexican producers (on a temporary basis) should be used instead of region-wide environmental standards to tackle the ecological problems.

145

national sourcing must be given up this may in fact lead to a considerable weakening of the Mexican competitive position vis-à-vis Canadian and US producers. The sectoral provisions of relatively long adjustment periods and the highly discriminatory local content rules highlight another serious defect of NAFTA. This defect is a political one and it arises out of the fact that Mexico, within a new integration area, will have to face the political and economic interests of two nearly omnipotent partners. This provokes the risk that Mexico may have to accept conditions which are against its own interests, and to which it would not have been exposed on the global GATT level. The results of the NAFTA treaties as outlined above do lend support to this hypothesis. Neither in the case of the adjustment procedures nor in the case of standards and local content rules could Mexico's interests be sufficiently secured. Drawing on the preliminary information available at present it may be concluded, that, from the Mexican point of view, the NAFTA agreement will not allow to reap all the potential gains which may be available from a more ambitious integration program. It is obvious that US protectionist interests, which can presently be observed on the global level, too, have succeeded in shaping the character of the NAFTA treaty (Krueger, 1992). Under these conditions, Mexican benefits from participation in NAFTA have been weakened. In order to improve this situation it would be necessary to speed up the envisaged liberalization process within the region, and to eliminate a number of regulations which clearly are at the expense of Mexican comparative advantages. There are no indications that re-negotiations to that effect can be expected. On the contrary, under the new US administration an even more protectionist interpretation of the treaty is not beyond imagination. In summary, the price to be paid by Mexico for a free access to the two big markets in the north seems to be high. Whether this price is an acceptable one may become clearer when considering some repercussions of the formation of this new regional block on the global level of international trade and production.

4. NAFTA and the multilateral trading system The potential implications of NAFTA on the Mexican economy as discussed in the preceding chapters implicitly suggest that the formation of a North American trading

146

block will not have any negative repercussions on the world market. This is a precondition for a successful formation of any free trade area. It did hold in the past when the EC and other regional arrangements of minor economic significance had been established. In the case of the EC, non-member countries did not have to suffer any additional discrimination next to the trade diversion effects which usually apply, and these were estimated to be quite small (...). The reasons are obvious. During the sixties, when most of the structural changes following the formation of the EC took place, a worldwide liberalization process was under way and world trade flourished. The EC integration process during this time was accompanied by outside tariff reductions (Hine, 1992) so that external trade expanded despite the re-direction of trade flows within the Community. Third countries, therefore, were ready to accept the discriminating effect of the EC. Politically motivated acceptance of the EC integration concept by the USA added to the exceptionally positive circumstances at that time. In the case of NAFTA things are different. The worldwide liberalization process of the sixties has come to a hault, and a new wave of protectionism is under way. The EC and the USA in particular, the former promoters of free trade, have changed their trade policies and are now increasingly prepared to use the subtle new instruments of neo-protectionism to shield their industries against foreign competitors. Discriminatory quota regulations apply to large industries such as automobiles, shipbuilding, steel and textiles. These regulations most often take the form of socalled "voluntary export restraints" (VERs) and "orderly marketing agreements" (OMAs). They are negotiated outside the GATT framework and against its very spirit. Politicians claim that these policy interventions are an appropriate solution to shortrun adjustment assistance, because they hinder the escalation of minor trade conflicts to uncontrollable trade wars (Bhagwati, 1991). In reality, however, VERs and OMAs are prolonged and extended year after year and may in fact be the core reason for future trade disputes (PreuSe, 1991). In 1986 a new round of global trade negotiations has been started in Uruguay in order to improve the functioning of GATT, and to stop neo-protectionism. However, in early 1993, the negotiations remain blocked by the transatlantic dispute over the new framework of agricultural policy. Meanwhile, neo-protectionism is expanding on both sides of the atlantic. Keeping in mind this global environment of trade policy, it is not unlikely that the formation of a new FTA in North-America may have a different impact on the world trade order than the formation of the EC had at that time. Apparently the

147

US-NAFTA initiative has been a reaction to the delay in GATT negotiations (Buelens, 1992; Bhagwati, 1992), and it may itself become a major disrupting factor for global trade relations. To underline this thesis, a case in point is the change in US trade policies during the last decade. It is well known that the United States react increasingly aggressive to rising international competition. A number of trade laws which were enacted during the 1980s are evidence of this protectionist behavior. Even more impressive is the fact that new trade legislations such as the Omnibus Trade Act (1988) and especially its famous Section 301 (the so-called Super 301) support these policies by strengthening protectionist trends within the USA. The threat to the free international economic order (as established in the GATT) becomes evident when the motives behind it are examined in more detail. In essence, the concept rests on the conviction that partner countries should be forced to practice "fair" trade with the USA. What has to be defined as "fair", however, is thought to be a matter of the US congress and/or the trade commission respectively. "Unfair trade claims" (Bhagwati, 1992) which may be raised via the administration directly or by making a case in the political arena are the key "tracks" to new protectionist measures. They are not recognized as protection, however, because they are introduced just to enforce "fairness" and safe free trade... This kind of free trade approach may be questioned for quite a number of reasons. Three of them outline the most important aspects of the problem: 1. From the economic point of view, "unfairness" is not defined easily. As has been argued by Bhagwati, it is "a two faced creature" (Bhagwati, 1992, 444). One face is friendly. It emphasizes responsability for the GATT system and attacks those who are not willing to play by the rules. It promises to improve the degree of commitment to the established regulatory system. The other side is fierce. It points to the possibility to abuse the term "fairness" in order to protect its own interests. It is this ambiguity which opens the door to discrimination. Discrimination, however, is "unfair" by its very nature and provokes retaliation. Thus, any claim of unfairness may be followed by the next, and spiraling protectionist policies are the likely outcome. 2. This development may be stimulated when the definition of unfairness is left to those who claim it. And this is exactly what US politicians have done. The Omnibus

148

Trade Act of 1988 is a straight forward legislation of the right to define "unfairness". According to the new Super 301 the administration has to prepare lists of trading partners and show how "unfairness" is taking place and who is responsable. Congress will examine "black lists" regularly. When unfairness is identified, bilateral negotiations are initiated. It is quite obvious that this kind of procedure will be biased by US interests and this is in fact what has been observed:"... the elections of countries as well as of sectors... is dominated by American interests..." (Stoll, 1990, 50) 6 . It is not too hard a judgement, therefore, to claim that actual US policies against "unfairness" of its trading partners will not at all improve the global trading system. On the contrary, it must be suspected that the US practice of bilateral negotiations is appropriate to exploit political and economic power against small countries. To put it clearly, it is feared that US trade policy may be abused to extract economic rents from its partner countries by a strategy of selective rent shifting (Whalley, 1992). 3. Even if one accepts the thesis that US trade policies are exclusively guided by altruistic behavior (a premise which is quite unrealistic) this kind of policy is unacceptable in a world of multilateral trade relations based on independent nation states. This is because defining "unfairness" unilaterally is equal to acting as a benign dictator and thus incompatible with a free international economic system. In view of these arguments against the present US trade policy it is understandable that its partner countries feel threatened. They fear that the hegemon and guarantor of a liberal trading system after World War II is now turning into a risk factor for this system itself. Recent trade policy attacks of the new administration against Japan and the EC do not serve to calm these fears. NAFTA, too, may be seen much more sceptically in this political environment. Apparently its formation has to be interpreted as part of the confrontation between the EC and the USA in GATT negotiations of the Uruguay Round. High-ranked US officials did not hesitate to play this card. "We might be willing to explore a "market liberalization club" approach, through minilateral arrangements on a series of bilateral pacts... This accord could turn out to be an attractive, bipartisan counterweight to (translation by the author)

149

protectionism... If all nations are not ready, we will begin by those that are and build on that success." (Baker, J., 1988, 41) To put it more clearly: The USA are threatening to withdraw from the international platform if their own positions are not accepted worldwide. In this case they are willing to step back to regionalism and bilateralism. For Mexico, a number of important questions arise from this szenario. First, it must pay attention to the potential repercussions from world trade which may be caused by NAFTA. That is, NAFTA, if evolving as an alternative to GATT rather than its complement, will be threatening the world trading system as a whole. In this case, political benefits which are hoped for from the FTA must be balanced against the loss due to rising international disintegration. It is doubtful that NAFTA, in this scenario, would become a net source of growth for Mexico. Second, US trade policy, if conceptionally based on bilateral negotiations and aggressive international reciprocity, may hurt Mexican economic interests, too. It is important to recognize in this context that the NAFTA treaty apparently is dominated by US and Canadian interests. In other words, the Mexican bargain for access to the northern markets involves payment of a relatively high price. Third, an important factor to limit the powerful US bargaining position vis-à-vis Mexico is a strong multilateral trading system. Inasmuch as NAFTA becomes an alternative to the GATT system, due to the failure of the Uruguay Round negotiations, this wall against US dominance within the region breaks down. Consequently, Mexico's hope to secure a "safe haven" in a world of growing regionalism would, most probably, become disillusioned. 5. Conclusions The participation of Mexico in NAFTA raises a number of important questions. Some of these have been analyzed from three different points of view. These points reflect some major Mexican, regional and global aspects of the treaty. On the national level, Mexican reform policies of the 1980s can be seen as an adequate precondition for successful participation in NAFTA. During this time, economic policy shifted towards an open market system. As participation in the FTA will be accompanied by major structural changes within and between almost any sector of the economy, such a system forms a necessary institutional framework for

150

successful regional integration. Nevertheless, some important adjustment problems remain. Economic and social policymakers in Mexico are called to find adequate solutions to these problems in order to make structural adjustment viable. On the NAFTA level it is apparent that Mexican interests have come under severe pressure from North American interest groups. The treaty involves rules defining working standards, and special provisions regarding the so-called "Green Tax" and the minimum local content of regional products. All these provisions reflect distinct North American interests and weaken Mexican comparative advantages. It can be concluded that Mexico is paying a relatively high price for its access to US-American and Canadian markets. On the global level, NAFTA has considerably raised fears of increasing regionalism at the expense of the multilateral GATT system. If these fears substantiate, NAFTA may in fact contribute to international disintegration. In this case, a substantial decline in economic welfare and rising political instability are to be expected, and the net economic gain for Mexico from entering NAFTA would certainly become negative, too. This would also mean that the new Mexican economic development strategy, which (after abolishing longlived but misguided import substitution strategies) has started to show success during the second half of the eighties and the early nineties, would again end up in economic stagnation. Judging from the actual situation of the Uruguay Round talks, these fears should not be dismissed easily. Bilateralism and regionalism both contributed to the fragmentation of world markets in the 1930s, and they are accused to have been a major factor in paving the way towards World War II. These are dramatic (if not to say traumatic) scenarios, but they are not too far away in historical terms to have been forgotten. International trade policy, therefore, should be aware of its potentially powerful impact on national and international welfare. The formation of NAFTA, in this context, may become a major threat for the future of the international economic order.

151

References Adams, F. Gerard, Mario Alanis, and Abel Beltran del Rio. 1992. "The Mexico-United States Free Trade and Investment Area Proposal: A Macroeconometric Evaluation of Impacts on Mexico." Journal of Policy Modeling 14 (1) (February): 99-119. Aho, M., and S. Ostry. 1990. 'Trading Blocks: Pragmatic or Problematic Policy?" Economic Impact 1:11-17. Baker, J. 1988. "The Geopolitical Implications of the US-Canada Trade Pact." The International Economy 2:34-41. Bhagwati, Jagdish. 1992. "The Threats to the World Trading System. The World Economy 15 (4) (July): 443-456. Brown, D.K., A.V. Deardorff, and R.H.Stern. 1991. A North American Free Trade Agreement: Analytical Issues and a Computational Assessment. University of Michigan (unpublished). Buelens, Frans. 1992. 'The Creation of Regional Blocks in the World Economy. Intereconomics 27 (May/June): 124-132. Cooper, C.A., and B.F. Massell. 1965. Economic Journal 75 (3): 742-747.

"A New Look at Customs Union Theory.

Corden, W.M. 1988. "On Making Rules for International Trading System." In R.M. Sterm, ed. U.S. Trade Policies in a Changing World Economy. Cambridge, Mass., London. Haberler, S. 1933(1970). Der internationale Handel. Berlin. Hine, Roberte. 1992. "Regionalism-and the Integration of the World Economy." Journal of Common Market Studies. XXX (2) (June): 115-123. Krueger, Anne O. 1992. "Government, Trade, and Economic Integration." The American Economic Review 82 (2) (May): 109-114. Langley, L.D. 1991. Mexico and the United States. The Fragile Relationship. Boston. 1992. Latin American Economy and Business (LAEB-92-09).

(September).

1992. Latin American Special Report, Free Trade and Common Markets, SR 92-03 (June). Lawrence, R.Z. 1991. "Emerging Regional Arrangements: Building Blocks Stumbling Blocks?" In R. O'Brien, ed. Amex Bank Review Prize Essays. Oxford.

or

van Liemt, G. 1989. "Minimum Labour Standards and International Trade: Would a Social Clause Work?" International Labour Review 128 (4): 433-448. Lloyd, Peter. 1992. (Spring): 7-43.

"Regionalism and World Trade." OECD Economic Studies 18

152

Lorenz, D. 1992. "Economic Geography and the Political Economy of Regionalization: The Example of Western Europe." American Economic Review 82 (2) (Papers and Proceedings): 84-87. Nunnenkamp, International

Pomfret,

Unequal Peter. 1992. Trade Policy. Oxford.

Richard. 1986.

Trade:

The Economics

"The Trade-Diverting

Bias of

of

Discriminatory

Preferential

Arrangements." Journal of Common Market Studies XXV (2): 1 0 9 - 1 1 7 .

Trading

Porter, M.E. 1991. The Competitive Advantage of Nations. London and Basingstoke. Preuße, Heinz Gert. 1991. "Voluntary Export Restraints— an Effective Means Against the Spread of Neo-Protectionism?" Journal of World Trade 25 (2) (April): 5-17. 1988. 'The Indirect Approach to Trade Liberalzation: Dynamic Considerations on Liberalization-cum-Stabilization Policy in Latin America." World Development 16 (8 August): 883-897. Sobarzo, H.E. 1992. 'Trade for the Mexican Economy of a North American Free Trade Agreement." The World Economy 15 (1) (January): 83-100. Stoll, J. 1990. "Markteröffnungsstrategie oder Neoprotektionismus?" WiSt (August): 349-350. Ten Kate, A.Y.F. de Mateo Venturini. 1989. "Apertura comercial y estructura de la protección en México: Un análisis de la relación entre ambas." Comercio Exterior 39 (6): 497-511. Ten Kate, Adriaan. 1992. "Trade Liberalization and Economic Stabilization in Mexico: Lessons of Experience." World Development 20 (5) (May): 659-672. Tuchtfeldt, Egon, und Erich Bürkler. 1991. "Der nordamerikanische Freihandelsraum - ein neuer Block im Welthandel?" Jahrbuch für Sozialwissenschaft 42 (3): 290-309. USITC (United States International Trade Commission). 1992. "Rules of Origin Issues Related to NAFTA and the North American Automotive Industry." World Trade Materials 4 (3) (May): 111-173. Viner, J. 1950. The Customs Union Issue. New York.

Whalley, John. 1992. "CUSTA and NAFTA: Can WHFTA be far behind?" Journal of Common Market Studies XXX (2) (June): 125-141.

153

Liberalization in Latin America: The Experience of the 1980s Roberto Guyer *'

Dear ladies and gentlemen, first of all I would like to thank the University of Góttingen and its Ibero-America Institute for Economic Research for giving me the opportunity of commenting on some aspects of economic development in Latin America during the past years. I would like to start off with a short historical reflection on events in Latin America during the years before the turbulent 1980s. This seems expedient in order to understand the following path of economic development in its whole context. The regional integration of Latin American society during recent years is generally due to an economic crisis. This is not a matter of business cycles but a crisis of the economic structure as a whole, or in academic terms: a crisis of the model of development. If we take the last three decades as a time reference, we can say that in the sixties - in Latin America more than elsewhere in the world - a debate had emerged about the theory of development. Its content and result touched a certain state of affairs for which external factors were important. Following the predominant economic model at that time, the state was expected to or had to influence development to a high degree. Industrialization was to be promoted through a maximum of outward protection. Latin American efforts of integration and cooperation were also characterized by the hope of reducing the dependence on industrialized countries. In addition, there was a desire for change in the international economic and financial system. In this context, considerations of a limited isolation policy gained special importance. These were the pillars of economic reflections of a very important and very influencial group in Latin America. The ideas basically evolved at the United Nations Commission for Economic Affairs in Latin America, better known under the acronym of CEPAL or ECLA. The import substitution theory emerged from this institution as well as the dependence theory (^dependencia*).

*)

S.E. Dr. Guyer Is Ambassador of the Republic of Argentina in Bonn.

154

During the period following the isolation policy it was clear that regional integration in form of a limited outward opening would not - because of the political and economic instability of the associated countries - lead to desired results nor to a suitable answer to regional economic problems. When Latin America was confronted with the necessity of a new and different kind of economic model in the mid-1970s, the unexpected inflow of petrodollars began. These exogeneous factors enabled the region to maintain structures which were no longer competitive within the framework of the international economic system. Due to the so-called oil crisis, the oil producing countries - especially the larger ones - benefited from extraordinarily large capital inflows. Part of this capital was passed on by commercial banks in the form of credits and loans. At this time, Latin America's debt burden grew beyond the region's solvency. In some countries positive achievements were made during this time. In Brazil, industrialization and development of the infrastructure were advanced by means of these additional inflows. However, the largest share of this capital was used to cover budget deficits, for the purchase of arms, and for the realization of ambitious projects which were not appropriate to correct our deficient economic structures, let alone to eradicate them. Summing up, at the end of the 1970s we were more indebted than ever before. We had to amortize loans. These were short-term loans for often unproductive investments. In many cases we had weak industries. These were poorly organized and not competitive, and therefore not adequate for an integration into world markets. Next to continuing unforeseeable political alterations, for a majority of the countries the state as such had become the most important economic factor. Only few sectors existed without direct or indirect state intervention. The state became less efficient in accomplishing its main tasks the more it extended its economic involvement. So it happened that in many countries in Latin America, with its deeply rooted centralized tradition, a political system arose with far-reaching powers of economic regulation. Not only the political leaders of the respective countries were responsible for this, but also the socio-economic framework which had developed over time. In fact, among the traditional clientele of the state were enterprises which preferred greater public protection to the extension of the personal freedom of the individual. Assessments of the consequences of such concepts revealed alarming results: Stagnation, hyperinflation, inefficiency, oversized bureaucraties, and overregulation.

155

The administration of overproportioned states inevitably implied more staff, more administrative errands, and finally a greater dependence of the citizens on the political administration. At the beginning of the 1980s, Latin America was characterized by large public deficits and their sufficiently known consequences: rising inflation and distributional strife owing to diminishing state expenditures. Thus, serious macroeconomic disparities and instabilities emerged as federal budgets had been financed to a considerable degree by foreign divices until then, and exactly these capital inflows were suddenly exhausted. The following basic data appear particularly illustrative of the development of those years: Between 1981 and 1989 economic growth in this region diminished by approximately 8.3% on average. During the same period of time the population of the region rose from 355 to 423 million. The share of investments in GDP accounted for 23% between 1970 and 1979, and fell to 16.5% between 1980 and 1989. These data impressively explain the stagnation of the whole economy, the decline in per capita income, rising unemployment, and the increase in social conflicts. Parallel to domestic developments, the share of the region in world trade and international capital inflows continued to decline. These economic changes had a substantial impact on the living standards of the population, but also on political stability. Latin America, formerly a capital importer, now became a capital exporter due to high net transfer payments mainly as a result of foreign debt servicing. In view of this crisis situation the only solution was seen in fundamental structural adjustment. It was perceived not only as a way out of the prevailing situation but also as a step toward the establishment of conditions conducive to sustained convalescence. It was a matter of internal Latin American determination and reorientation. During this period of time - in the middle of the 1980s - when the seriousness of the state of affairs became apparant, a change occurred with immense importance for international development: With the inauguration of Michael Gorbachov in the former Soviet Union a global process was set off that reached its climax with the end of the Cold War. This constituted a parallel phenomenon, as the Latin American transformation process was initiated irrespective of the changes in Eastern Europe. Still, during the following years Latin America was influenced by the worldwide changes. These

156

new developments proved, inter alia, the worldwide failure of the theories of interventionism and of the model of state socialism. This process encouraged a comprehensive democratization process in Latin America. Latin America has become an integral part in the dominant trends of the modern world. For the subcontinent the 1980s meant a complete integration into the democratic system which nowadays is, apart from some exceptions, dominant in the region. Seen this way, the 1980s meant more than the expression of the so-called "lost decade" indicates: they were the epoch of fundamental change which lead to an integration of Latin America into the democratic process and the rules of a market economy. This process has led to a new orientation of many countries in the region towards the USA and Europe. An example for this, by the way, is the participation of my country in the peace-securing operations of the United Nations during the past Gulf War. The cooperation of Argentina and Brazil in the utilization of nuclear energy for exclusively peaceful means underlines the dimensions of change. In a pure economic sense, many Latin American countries employed alternative options in their efforts to overcome the crisis during the greater part of the last decade. In the second half of the 1980s some Latin American countries achieved real economic growth. The reasons for this were divers: Colombia was not excessively indebted as it pursued a more conservative development strategy. Paraguay represents a similar case even though the reasons should be evaluated differently. Some countries anticipated the liberalization process of the continent: notable examples are Chile, Mexico, Costa Rica and Bolivia. Other countries subdued themselves early to this liberalization process, even if only partly and with different results, for example Uruguay, Ecuador, and Venezuela. Expressed in a simplified way, one can say that the cumbersome experience of the 1980s demonstrates that there are alternative ways out of the crisis. During the late 1980s, the advocates of a new development strategy, a new model, began to win recognition: basically, it was a question of accepting the fact that economic life is determined, so to speak, by its own and objective rules. The idea of a self-regulating economy was increasingly accepted - to the effect that economic rules exist which are not allowed to be distorted by political volition. On the other hand, the old consensus is still being emphasized according to which economic development is to a substantial degree dependent on internal efforts. Backwardness

157

and underdevelopment can neither be eradicated by loans nor by extension of maturity or moratorium. The conviction of the necessity to provide a stable long-term macroeconomic policy has to be seen in this context. Within this framework the efforts towards a balanced budget gain special importance. A further fundamental feature of the new presently prevailing model is the opening up to world markets. The integration into the world economy does not only constitute an efficient economic strategy in a narrow sense, but also the only realistic option to avoid a detachment from the ever accelerating technical and technological development. In this context, I consider it meaningful to refer to the fact that today in Latin America it is commonly accepted that the attraction of foreign capital inflows is necessary. The inflows not only stimulate the private sector but also, in the long-run, promote the access of our economies to foreign markets and to technologies from industrialized countries. On the other hand, the public sector share in GDP has not only been reduced in many Latin American countries but substantial progress has also been made concerning deregulation. In this context it has to be stressed that the leading role for investments and growth is increasingly attributed to the private sector. This also applies to potential increases in technology transfer. The integration process of Latin America and its major characteristics are subject to thorough analysis by leading economists and political leaders. These analyses provide evidence of the loss of confidence in the development models of the 1960s. Nowadays pragmatic observations enjoy absolute preeminence. One of the major consequences of this new situation are the efforts towards regional integration combined with a gradual reduction of tariff barriers. These new integrated markets are not to represent outward fortresses but instead larger domestic markets with an improved ability of integration into the world economy. Outstanding examples are the

Mercosur, the revitalisation of the Andean Pact and the common market of Central America. The planned participation of Mexico in the North American free-trade area NAFTA has received special attention. In the meanwhile, the liberalization process introduced in the second half of the 1980s has led to a series of concrete results. I would like to illustrate them on the basis of some statistical data: In 1991 and 1992 capital inflows into Latin America amounted to about US$ 40 billion annually - the share of direct investments was US$ 11 billion in

158

1991. Still 1989 it was only 5 billion. The capital inflow in the first half of 1992 already amounted to more than 20 billion dollars. I take this to be a very impressive development. The capital inflows in the past year are projected to lead to an average increase of the region's GDP of about 3.2% which represents a revitalisation of the economy. An increase in per capita income has been achieved for the first time in four years. Even though this increase was below one percent it brought a change in trend. On average, per capita income has reached the level of 1977. In the majority of cases, the stabilizing policies have been successful in achieving a containment of inflation. On average, the annual increase of consumer prices of about 1200% was reduced to about 200%. The present trend projects a further stabilization of inflation rates. Irrespective of the fall in prices and/or the unchanged prices for many of the classic Latin American export products, import capacity rose in the region. In this context, the easements in debt service but mainly the earlier mentioned net capital inflows have been very influential. During the past three years, the majority of Latin American countries have been able to increase their foreign exchange reserves. In 1991 the increase was exceptionally high. Solely in the case of five countries the foreign exchange reserves declined. The increase in net capital inflows was reinforced by a reduction in outward transfer payments from Latin America. Thus, the region was able to register net capital imports for the first time since 1981. With the exception of the English-speaking countries of the Caribbean, the foreign debt stock of Latin America remains unchanged at about 425 billion US dollars. Its overall size did not increase due to stabilization and debt reduction programs in several countries. In some cases, among these Argentina, foreign debt has even been amortized. * *

*

This may suffice for the general spectrum. With your permission, I would now like to turn to the case I am firmest in: Argentina. My country has dealt with very high inflation rates which at some point in time belonged, by far, to the highest on earth. During three five-year-periods the inflation rates varied between 6 and 20% a month, at times reaching 1200% per annum.

159

The underlying cause of the fiscal and monetary policy-induced inflation was a model of development which aimed at keeping salaries low, capital expensive, and the exchange rate high. By doing so, naturally, no economic growth was to be achieved. Capital costs being high, enterprises could not afford the devices needed for their expansion. With low salaries, it was not possible to retain qualified staff, and even less to encourage effective performance. Unstable exchange rates, in turn, stimulated foreign exchange controls, flight of capital and taxes, and hereby also the investment of profits abroad. These developments led the government to the consideration of a fundamental liberalization. This above all applies to our present government, but also to some extent to the preceding. Possibly, the facts were stronger than the conviction, reality stronger than theoretical analysis. The reform of the public sector was and is seen as essential. Public enterprises, to a large extent, have caused the fiscal deficits with which the Argentinian state had to live for years. They were also an essential reason for the inflation spiral which, like everywhere on earth, imposes a tax on investments and growth. For matter-of-factness it cannot remain unmentioned that the private sector also contributed to this scenario. Among Argentinian private enterprises there were strong sectoral interests through which the crisis was aggravated. Examples for this behaviour can be given by suppliers of public contracts, as well as by the beneficiaries of laws or enactments for the promotion of industry, who to a high degree enjoy the advantage of legal tax privileges. One of the cornerstones of present Argentinian policies is the fundamental reform of the public sector. The privatization program initiated two years ago is one of the most extensive programs of this kind ever, and has made a considerable contribution to the consolidation of public finance. The privatization program is being accompanied by extensive deregulations of the economy. These deregulations have not only led to more transparency and a reduction of administrative rigidities, but they also enable what long since was a taboo: The participation not only of national but especially foreign capital in numerous enterprises many of which were formerly public. Among the most important results of this policy of opening, deregulation and privatization is the elimination of the fiscal deficit, and with this, the undoubtedly increased stability in the economic framework which forms the basis for the economy's planning of investments. In 1988 the fiscal deficit amounted to more than

160

US$ 10 billion. In 1991, a balanced budget was already registered, and a slight fiscal surplus is expected in 1992. The developments, in combination with other measures, not only made possible a reattainment of monetary stability but also a reattainment of credibility abroad, and in the country itself. Today Argentina again has a stable currency. The monetary emission is covered to 100% by gold or foreign exchange. We have also, under the Brady-Plan, regulated our relationship to foreign creditors. By doing so, our already reduced foreign debts were restructured, and today Argentina is in a position to service its liability without delay, without needing to expend more than 2% of its gross domestic product. The present recovery of my country can be underlined by some basic statistics: The monthly rate of inflation fell from about 200% in the middle of 1989 to around 1% in 1991/92. At the same time, the unemployment rate fell from 7% in October 1989 to 5.3% today. Since the beginning of 1990 our foreign exchange reserves have been multiplied by four. In a nutshell: Argentina has restructured its economy by introducing transparent and stable rules. The objective of this policy is the establishment of a true market economy. * *

*

If you permit, I would finally like to comment upon the analysis of the present situation of the subcontinent as a whole. The question with respect to future development prospects is answered by leading international economists to the effect that for the coming years a general economic revival is expected. According to projections an average annual growth rate of 4.7% is estimated for Argentina for the years 1991- 1996 after 0.6% in the period of 1985 - 1990. The outlook for growth in Mexico is expected to be 4.2% annually. Chile will presumably register an average growth rate of 6.4%, more even than the average 5% of the past years. These are only some examples. Of course, I do not want to suggest that Latin America has turned into a paradise. Great achievements in some parts are opposed by, now as before, substantial need for action in others. Although studies confirm differences in development in the various countries, the overall regional performance is testimony to the existence of complex and sustaining

161

liberalization processes on the whole subcontinent. Their introduction and continuation need a remarkable amount of political determination, social sacrifices, and comprehensive external cooperation. It is certainly correct to say that the economic situation of some Latin American countries is not recovering rapidly, and that some have not yet carried out the necessary adjustments to their economic policies. Characteristically, this is predominantly the case of those countries which have not yet opened their economies to world trade. Here, inflation and macroeconomic instability is comparatively higher. Irrespective of the progress in foreign debt reduction, the servicing of it, now as before, constitutes a large share of the export receipts of many countries. More than ever before Latin America needs free trade to secure its development. Regretfully, the opening of our economies has not always led to an equal response by the industrialized countries. A successful completion of the current Uruguay-Round of the GATT is indispensable in this context. As the Argentinian President recently stated: thousands of jobs in Latin America and even in Germany are dependent upon the success of these negotiations. The importance of the GATT negotiations cannot be sufficiently stressed. In these days we are experiencing the tensions these negotiations have caused between the USA and the EC, as also within the EC itself. The importance of the successful completion of the current Uruguay-round was again referred to, a few days ago, by the German Minister for Economic Affairs. From the Latin American viewpoint these problems are of greatest importance, and in such a way that, a year and a half ago the Uruguayan State President declared the Uruguay Round to be more important than the Gulf War. The Latin American efforts toward the stabilization of their economies will achieve relatively little as long as they take place in an environment which prevents free world trade. Seen this way, the subsidized agrarian exports of the European Community also represent a drag whose dimensions can endanger the success of the reform efforts in Latin America. The region has commenced a new and promising period in its history, a phase of progress and stability which, with some exceptions, is consolidated daily. This process is not without problems, but it has a clear target. The so-called "lost decade" has made room for the "decade of structural changes".

162

All the more important is the assistance we require for the necessary consolidation. The deregulation and the privatization lead nowhere in the long run if the international capital markets do not actively flank and support this revitalization of our economies. For this reason, I would like to conclude my exposé in the hope that we shall, in a time where the walls seperating nations are falling, jointly contribute to establishing a wealthier and more integrated world. Thank you.

163

Text Tables

Reform Steps in Selected Latin American Countries 1990 and 1991

32

Guatemala Development of poverty Years 1980 - 1989

61

Guatemala Gross Domestic Product, Population and Foreign Debt 1981 - 1991

67

Guatemala Per Capita Debt, Per Capita Income, and Balance of Trade 1981 - 1991

68

Gross Domestic Product in Market Prices, Budget Deficit, and Tax Revenues [Guatemala] 1981 - 1991

69

Money Supply and Central Bank Credits [Guatemala] 1981 - 1991

70

Inflation, Interest Rates, Exchange Rates, and Net Credits to the Public Sector [Guatemala] 1981 - 1991

71

Major Elements of the "Attractiveness Portfolio" of Latin American Debtor Countries, 1983 - 1991

84

Net Resource Flows to Major Latin American Debtor Countries, 1983 - 1991

90

Offer Price Indications for Value Impaired Debt in the Secondary Market at 24th September 1992

101

The Bolivian Buyback from 1988

106

Real Interest Rates In Four HICs and Real LIBOR, 1988

116

Indicators of Protection in Mexico (1982 - 1989)

134

Foreign Investment Flows to Mexico 1980 - 1991

136

Real Exchange Rate Indices of Mexico 1980 - 1991

138

165

Figures

Growth of GNP per Capita in Latin America, 1984 - 1992

18

Foreign Direct Investment in Latin America, 1970 - 1991

19

Expected Repayments and Indebtedness

104

167

Abbreviations

Al

Amnesty International

APEC

Asian Pacific Economic Council

CARICOM

Caribbean Community

CEPAL (ECLAC) Comisión Económica para América Latina y el Caribe CU DES EIU FDI FTA GATT GCT GDP

(U.N. Economic Commission for Latin America and the Caribbean) customs union debt equity swap Economic Intelligence Unit foreign direct investment free trade area General Agreement on Tariffs and Trade General Consumption Tax Gross Domestic Product

GNP

Gross National Product

HIC

highly indebted country

IDA

International Development Association

IDB

Inter-American Development Bank

IMF

International Monetary Fund

MERCOSUR

Southern Cone Common Market

NAFTA

North American Free Trade Area

NATO

North Atlantic Treaty Organization

NZZ

Neue Zürcher Zeitung

OMA

orderly marketing agreement

OPEC

Organization of Petroleum Exporting Countries

SEGEPLAN

Secretaría General de Planificación Económica [Guatemala]

SELA

Secretariat of the Latin American Economic System

TRIM

trade related investment measure

U.S.

United States

UNCTC

United Nations Centre of Transnational Corporations

VER

voluntary export restraints

YPF

Argentinian state-owned oil company

169

The authors

S.E. Dr. Roberto

Guyer

Ambassador of the Republic of Argentina, Bonn.

Lie. Lizardo Sosa

Lopez

Director of the Central Bank of Guatemala, Guatemala City.

Prof. Dr. Manfred Mols Johannes-Gutenberg-Universität Mainz, Institut für Politikwissenschaft, Mainz. Prof. Dr. Peter Nunnenkamp Kiel Institute of World Economics, Kiel.

PD Dr. Heinz Gert Visiting

Professor,

Preuße Institute for Trade

and

Development

Economics,

Johann-

Wolfgang-Goethe-Universität, Frankfurt (Main).

Prof. Dr. Hermann

Sautter

Director of the Ibero-America

Institute for Economic Research,

Georg-August-

Universität Göttingen.

Dr. Rolf

Schinke

Academic Director of the Ibero-America Institute for Economic Research, GeorgAugust-Universität Göttingen.