Li4,2t ( 'A Policy, Research, and External Affairs WORKING PAPERS Debt anc 'nternational Finance International Economics Department The World Bank October 1991 WPS 785 How Did the Asian Countries Avoid the Debt Crisis? Ishrat Husain Economic stability, sound macroeconomic policies, and appro- priate microeconomic incentives hold down a country'sexternal debt burden. Most of the Asian countries pursued prudent macroeconomic policies, paid attention to price stability, and minimized price distortions. These countries avoided the overvalued exchange rates and uncompetitive interest rates that caused massive capital flight from Latin American and some African countries. ThePolcy,Research. and l.xtemalAffairs('omplex d,sinbutes l'RI Working Papers todisserunateLhe findingsof work inprogress and to enoourage the exchange of ideas arnong Bank staff and a:l others interested in developmnent issues. These papers carry the names of the authors, rcflect only their views, and should he used and cited accotding;) T'he findngs. interpretations. and conclustons are the authors'oown. They should not be attnbuted to the World Bank, its Board of Directors. its management, or an) of its member counties Policy, Research, and External Affairs Oebt ar,d International Finance WPS 785 This papcr - a product of thie Debt and ltlernatiorial Finance DiviSion, International Ecoinomics Department -is panl of a largcr effort in [IRE to understand thc relationshiip between macroccononlic policies and cxtcrnal indicltcdricss ot'dc\vlopiig countrics. Copies are av'ailable f'rce 'rom the \World BanTk, IXf11fStreetNW,.' WshlingtoniDC20433.. PleaseacontactSheilahilinig}-\ Wa;tson,roomnSX-(4O, extension 31(47 (26 pages). Octobehr 1991. If a country's macroeconomic policies are In China, India, ai Kolioma. investment rates gencrally sound and microcconomic diRtortionn wvere relativelv hiih, financed mostly from minimal, sporadic episodes of ovcrbolITowing or domestic savinos: forcign loans xxere use judi- inadequate atteintion to the terms, maturity, and ciously, as a compllemieint to domcstic savings. curtcnc) composition of external debt will Forcign capital accounted for only 2 to 3 percent generally iioi make a difren-ciice in its decbt of GDP in thcsc counitrics, although investmcnt picture. ratcs averaged 3(0 percent of GDIP. But acts of indiscretion in extemal dcht B\ contrast, thle Latin Anmericani govern- management tend to be magifiiied when those menis expanded extemnal borrok inigs to offset ihc basic policies arc inadequate. The reccnl upturin effects of exterial shocks. In Bra,il, foreign in Latin American economies --- parlicularly in resources were substiluted lor domestic sa\ ilgs Chiile, Mexico, and Vcnczu.'ia, xkhich are now, to support an imporl substitution strategy; in successfully pursuing maci, ,conomic a(ijusi- Mexico. fiscal deficits were finaniced by extemal ment -- supports ltlC validity olf these f'iiings. borr)Wiliw. l]ow did the Asian countries avoid the debt At thc samc time. the residents of' these crisis? Husain answers thali question partlk bN couninies transferred billions ot dollars abrotd. contrasting thcir behavior with that of' 12 higlily liusaini atitibutes this massive capital 'light to indcbtcd Latin American and African counities overnalued cxch:tnoc r'it.- I:i nd -r-n 1i1mi\io studied by the Bank in the mid- 198(s. intercst rates. 'hlcsC wcre initcln(ded to curb inflation htii instcad cro(ded creditx orthincss The Asian counitries, itli a fcew exceptions. because of iteir depressinig effict. oni exports and pursued an outward-oriented stratcg\ and salvings prudenlt imacrocconiomiiic policies [hey inade ing cxpenditures, expanding cxpoinis. and curtail- expericnce(i thc mia,ssive flighlt of private capital ing consumptiol. Mlost horrowed and locally while thc\ were stepping up exicnal borrov ing raised funds were invested in productive uses, - courtcd trouble %kith debt servicing, because improving the cconorn\'s abilil\ to rcpay thie much of the borrowed mioney \Yas not invcs,ted in debt. 'hese countries relic( heavilx oni doiiestic higih-retuni projects. 'Ihat flight capital has savinigs aid resources to finance investmenits begun to return to Mexico and \'Venezula. both Thcy did not allow, crises to drift or he aggra- of which embarked on successful economlic vated. relorn in 1987. -f lie PRE Ao,riNign Pqr SCT II C1,Ws II'mIII) T I111.' II) rlg of %oik 0I 'I A!n Ilk i,Kx t'. . R'coi. !,d l_\!,cnifd T'c- fIr`t:IT1I?. InTirC J.al:Iol;d Li. OT'.Ile III, thC'C 'p)'rT dte iii r.C. >'<.irx rc't.'. 1ih: .\ Ii.tr:k p'l!> P)ro(dtucet hv thc [lRF t)'s'..'nin:iI, ' (cn'ler How Did the Asian Countries Avoid the Debt Crisis? by lshrat Husain Table of Contents Introduction 1 International Economic Environment 3 Domestic Policy Environment 4 (1 ) Outward Orientation 5 (2) Adjustment to External Shocks 6 (3) Macroeconomic Policies 8 (a) Price Stability 9 (b) Monetary and Credit Policies 9 (c) Fiscal Policy 1 0 (d) Exchange Rate Policy 11 (e) Industrial and Trade Policies 11 (f) Policy Stability and Credibility 12 (g) Income Distribution 13 (4) Capital Flows and Portfolio Management 1 4 (5) Domestic Savings 15 Cunciusions 1 6 Tables 18 Ishrat Husain: The World Bank, Washington, D.C. INRODUCTION In the development economics literature, there is a genzral consensus that the less developed countries will normally incur current account dericits and rcmain structural capital importers until they emerge from underdevelopm.-nt. It is also true that the bulk of the financing of these deficits would be provided by net capital inflows that give rise to external indebtedness. After all, that is how most of the developed countries of today achieved their growth. So, there is nothing intrinsically wrong with external borrowing per se. The crucial question is how best should developing countries manage external debt without plunging themselves into a crisis.2 This is by no means an easy task as it involves some important trade-offs that balance the positive effect of external borrowing with its adverse affect on debt accumulation. The link between borrowing and growth is quite complex On the one hand, external financing enables the borrowing country to achieve higher levels of imports and investment than can be warranted by domestic savings alone. On the other hand, to be able to fully service the debt when it falls due, the borrowing countries should have generated reasonably high growth and in turn trade and saving surpluses. If this link between higher levels of imports and investment does not transmit itself into high growth in income and exports then the borrowing countries face serious difficulties. Most of the academic and popular discussion in recent years has exclusively focussed on the origin and factors contributing to the debt crisis, the behavior and responses of highly indebted countries in Latin America and Africa, the bargaining between these countries and their creditors and the impact of debt overhang on the economic conditions of these countries. Very little has been said about the 60 countries or so that were able to avoid plunging into this crisis and able to strike the trade-offs required. This paper attempts to fill this gap in the literature and reviews the experience of external debt management of Asian developing countries during the past twenly years, compares this with the highly indebted countries and draws some lessons for enhancing our understanding of the management of external debt.3 As the region contains a variety of countries with different characteristics, endowments, and economic structures, it is useful to provide a typology of Asian developing countries on the basis of their income and debt burden. The World Bank classifies countries in three categories: high income (more than $6,000 per capita income), middle income ($581 - $5,999) and low income (less than $580). Hong Kong, Singapore, and Taiwan 1 The author is Chief, Debt and Intemational Finance Division, World Bank. The views expressed in this paper are those of the author's and should not be attributed to the World Bank, its Board of Directors, its management or any of its member countries. The author has drawn freely from a number of intemal Bank studies in the preparation of this paper and he wishes to thank Mr. Ning Zhu for his assistance in preparing the statistical tables. 2For a survey of the literature on the relationship between external debt and growth in developing countries, see McDonald, D.C. (1982), 'Debt capacity and Developing Country Borrowing,' sIF Staff Papers 29 (4). 31he other study which attempts to make a comparative analysis of extemal debt and macroeconomic performance is Jeffrey Sachs, External Debt and Macroeconomic performance in Latin America and East Asia,' Brookings Paper on Economic Activity 2. (1985). That study covered six Latin Amencan and four East Asian countries and was limited up to the period 1983. The analysis was a very useful exposition of the political economy of Expon-led and Import-substitution strategies and an cxplanation of the differing exchange and trade regimes in Latin Amenca and Asia 2 income), middle income ($581 - $5,999) and low income (less than $580). Hong Kong, Singapore, and Taiwan fall in the high income country and are excluded from the 'developing country' group as the term is applied 3nly to low and middle income countries. This paper focusses on four sub-groups of Asian developing countries: (a) the ASEAN-4(lndonesia, Malaysia, Philippines and Thailand); (b) South Asia (c) China and (d) Korea. The ASEAN-4 and Korea are middle income countries while South Asia and China belong to the low income category. The data for Asia shown in this paper therefore refer to this sample of ten countries, which accounts for 98% of the GNP and 97% of total debt, and 94% of the popullation of the region.Lack of reliable data on Afghanistan, Myanmar, Kampuchea, Lao P.D.R.,and Vietnam forced the exclusion of these countries from the present study. Nepal, Bhutan, Maldives and the Pacific Island economies are relatively free from pressures of a debt burden and have also been excluded. An objective measurement of the severity of debt burden when applied to developing countries in Asia, indicates that the Philippines and Myanmar are the only two countries in Asia which are severely indebted (out of 46 developing countries) while Indonesia, Bangladesh, Sri Lanka and Pakistan are moderately indebted 4. How has the debt burden evolved in the Asian countries in comparison with that of Latin America? The total external debt of these ten Asian countries in 1990 was $307 billion. India and Indonesia were the largest debtors owing debt in excess of $50 billion each, followed by China, the Philippines, Thailand and Pakistan. Debt service ratios of only three countries--Indonesia, India and Philippines--exceeded 30 percent. Latin American debt outstanding in 1990 was $429 billion. Brazil, Mexico, Argentina and Venezuela were the largest debtors and twelve out of twenty severely indebted middle income countries belonged to this region. It is interesting to note that the average annual growth rate in debt of East Asian countries during the sub-periods 1973-80 and 1980-87 has been higher than that of Latin America (see Table 1). Despite the more rapid accumulation of debt, all other key debt indicators except Debt/GNP remained stable or declined for Asia, while those in Latin America worserted despite repeated reschedulings and arrears accumulation (see Table 2). The improved debt indicators of Asia in fact reflect the underlying strong economic performance of the countries in this region. How has the economic performance of the two groups of countries varied? Table 3 presents the comparative picture for three sub-periods 1965-73, 1973-80, and 1980-87. The first sub-period which is rhrarntpri7PA hv qtpssdv snd stable economic conditions showq thst th 1 diffprinrq-e in thb nerfennA nee of the two groups were not that large. The second sub-period captures the effects of the exogenous shocks and turbulence suffered by the developing countries, while the third sub-period depicts the differentiated response and adjustment to these shocks. In the 1980s, Asian incomes grew more than twice as fast as in the rest of the world, and exports expanded at about twice the rate of North America and Europe. Management of external debt can be influenced by the international economic environment, domestic economic policies and portfolio management decisions. It would be useful to recapitulate, as a backdrop, the intemational economic enviroinment in which the developing countries had to manage their external debt. 4World Debt Tables 1989-90presents the classification of the countries and the definitions of the severe and moderate indebtedness. Severely indebted countries are defined as countries in which three of the four key ratios are above critical levels: debt to GNP (50 percent), debt to exports of goods and services (275 perccnt) scheduled debt service to exports (30 percent) and accrued interest to exports (20 percent). 3 INTERNATIONAL ECONOMIIC FNVIRONMENT D;1ring the decades of the 1970s and 1980s, four features of the international economic environment particularly affected the development performance of developing countries. The first of these was relatively slow growth in industrialized countries. The annual growth of real GDP of OECD countries slowed down considerably from 4.1 percent in the 1960s to 2.5 percent in the 1970s. The recovery that was expected for the 1980s failed to materialize. Second, the prices of primary commodities fell sharply; nominal prices were highly volatile during the two decades. Real interest rates are believed to be inversely correlated with prices of non-fuel commodities, and real interest rates, particularly in the 1980s, were relatively high compared to the earlier decades. Third, the movement toward free-trade policies, sustained since the late 1940s by successive rounds of tariff reductions under 'he auspices of the General Agreement on Tariffs and Trade, came under serious threat in the mid-1970s. Successive adjustments in the Multi-Fibre Arrangement, and the proliferation of voluntary export restraints and non-tariff barriers, affected a growing proportion of the trade in manufactured goods between OECD and developing countries. In agricultural trade, already heavily protected, barriers in OECD countries became even more onerous durinm the 1980s. Fourth, the breakdown of the Bretton Woods system of fixed exchange rates in the early 1970s made macroeconomic management much more complex than before for developing countries, which now had to adapt to sharp fluctuations in exchange rates among major currencies. For all these reasons, the global context during the 1970s and 1980s was in sharp contrast to that of the previous 20 year. B3ut a distinction has also to be drawn between the 1970s and the 1980s. The 1970s witnessed oil price hikes, with their profound repercussions throughout the world. Efforts were made to finance the much- enlarged balance of payments cdeficits of oil-importing developing countries including two oil facilities at the IMF. Private commercial bank lending to ceveloping countries expanded phenomenally. In addition, there was a big increase in official development assistance, partly from petroleum exporting countries. In many ways the 1980s had quite a different character, The financial and econoniic turbulence of the decade had a pervasive adverse impact on development generally. For OECD countries experiencing double-digit inflation, containment of price levels in the 1980s became a key aim of economic oolicv. overridin0 the. eArlier emphasi.j on maintairang full employment. The strict monetary policies adopted by industrial countries in the aftermx h of the :.iflationary period of the late 1970s had a noticeable effect on demand and prices for primary commodities from developing countries. Prices of conmmodities other than fuel fell further; their average level for the decade was 35 percent lower than in 1980. Developing countries' exports of manufactured goods volume had sustained very rapid growth of 13.4 percent a year in 1974-80, registered a major setback. Such exports increased by only 9.4 percent a year during 1981-87. In value terms, the growth of these, eAn1tz QlnAxena more markedly - trom 14 percent a year in the earlier period to only 4.7 percent a year in 1981-87. The most dramatic feature of the international economic environment in the 1980s was of course the debt crisis. In international capital markets, real interest rates rose to very high levels. Averaging 5.85 percent during 1980-89, they were twice as high as in the 1960s, and nearly six time as high as in 1974-79. As debt difficulties grew, international commercial lenders stopped most voluntary lending to the highly indebted developing countries. Gross commercial bank lending to all developing countries dropped from $52 billion in 1981 to far short of $10billion a year at the end of the 1980s. The gross flow of private foreign direct investment to developing countries peaked in 1982 and then declined sharply in subsequent years in contrast to high growth recorded in OECD countries throughout the decade. Many developing countries that had received large net resource transfers from abroad in the 1970s now had to pay very high proportions of their export earnings to service debt. 4 The external circumstances facing Asian countries in the 1970s and early 1980s were no different from those faced by the Latin American and African countries. Oil price shocks, low cost of funds, falling commodity prices and recession in the industrial countries stimulated the demand for external borrowing while the excess liquidity of commercial banks pushed the supply of these funds. A proxy variable used for capturing the influence cl externai envirunilnlit dli wllAb vAI iLlad I Th. 0 ' 1 4,,- i -Sf trade of Asian countries declined (0.6 percent per year) during 1973-82 compared to an increase (3.8 percent) for the highly indebted countries. The volatility in the termns-of-trade was, however, considerably higher for the latter group of countries. Sachs 5 who estimated the real income effect of terms-of-trade change for the period 1979-85 did not find any significant differences between the two groups of countries. His broad conclusion based on calculation of combined effect of the terms-of-trade and interest rate shock was that macroeconomic performance and the need to reschedule were not closely tied to the mag niitude of the external shocks as a proportion of GDP. Donovan's study6 of a larger sample of middle-income developing countries also found that the magnitude of terms-of-trade movements was not markedly different for groups of reschedulers and non- reschedulers. The main question explored in this paper is: Given the same international economic environment and no differences in the magnitudes of external shocks, why have the Asian countries avoided the debt crisis while the Latin American and African countries have been embroiled in this unfortunate situation for almost a decade now. It is not proposed to provide a fully satisfactory or rigorous answer to this question, but based on a number of empirical studies carried out within and outside the Bank some plausible hypotheses and supporting evidence are presented to shed some light. It needs to be emphasized at the outset, that the analysis presented here should not be interpreted as if the Asian countries were above comrmiitting mistakes or they did everything right all the time. Alternatively, it would be unfair to characterize that the Latin Americans were never able to put their act together and kept on repeating the same errors of judgement. It is equally plausible that the facts and hypotheses that guided their policy decisions turned out to be quite different in actual implementation of these policies. The actual outcomes examined over an extended period of time tend t^ mask the complex itterplay of forces and interactions that took place during the course of events in the 1970s F d 1980s. The analysis therefore abstracts from these complex interactions and presents a relatively simplified picture of the end results. DOMESTIC Pt)LICY ENVIRONMENT The differences in economnic and market structure do persist between the countries in the three regions and so do levels of institutional development. They may also, in part, explain for the differentiated economic performance. Other variables such as human resource development and skill mix of the labor torce whuch attect the growth in a longer time horizon may also be equally important. The "new"growth theorists have provided evidence that increasing returns or positive externalities from such factors as knowledge and human capital can explain the divergence in growth rates among developing countries. It is also becoming clear that the impact on growth of better economic policies and more education, together is greater than the sum of each separately. A comparison of the human development indicators of the Asian countries in this sample with those of the most severely indebted countries in Latin America, do not bring out any significant difference in this aspect (see Table 4). Eight out of ten Asian countries in the sample are classified as having medium or low human development indices. On the other hand, five highly indebted countries Chile, Costa Rica, Argentina, Venezuela and Mexico fall under high human development class. Of course, the same indicators for Sub-Saharan Africa are quite low. S Sachs, ibid. 6Doral Donovan, 'The sources of External Debt Difficulties: Some empirical evidence.' tF Discusaion Memorandum 84/15 (1984). 5 The role of the state in Asian countries where partnership between state and private sector and between labor and capital has been a distinctive feature of their development strategy may also be advanced as 'the dominant' factor that impinges on the performance of these countries. Govemnient intervention is essential for development, but what makes the difference in the outcome is whether this intervention is likely to help rather than hinder economic growth. In East Asian countries, these interventions were, by and large, beneficial and conducive ar A took the forrn of simple, transparent rules and policies rather than discretionary controls. The complementarity of a sound policy environment and market-friendly interventions is one of the most encouraging lessons of the development experience that has been amply documented in the forthcoming World Development Report. 7 The role of the State cannot, however, be separated from the strategy and the policies they pursue or the response they make to the external shocks or the way the external poitfolio i uimuiageu. Our hypothesis is that even after taking account of the differences in the structure and institutions, the most dominant factors in explaining Asia's impressive growth performance in the 1970s and 1980s, have been the orientation of the development strategy, mode of adjustment to external shocks, the nature of macroeconomic policies, the efficiency of investment and portfolio management and finally the domestic saving efforts. (1) Outward Orientation First, the Asian countries were generally less affected from recession in part due to the outwsrd-oriented policies that they pursued. When the global recovery began in 1982, they were able to take advantage of the rapid expansion of manufactured goods exports, raising export earnings sufficiently rapidly to reduce their debt/export ratios and escape the debt crisis. By outward orientation it is generally meant a combination of two factors: first, that the level of protection, especially for inputs into the production process, was relatively low (resulting in a sustainable level of a real exchange rate favorable to exporters); and second, that there is relatively little variability in the real exchange rates, so that incentives are stable over time. The evidence regarding the differences in econornic performance arising out of outward or inward orientation of the developing economies has recently been presented in a major study of 95 LDCs for the period 1976-85! The study uses an index of outward orientation on the basis of real exchange rate distortion and variability. This measure was tound to be highly correlated with per capita GDP growth in this large sample. The most open quantile of countries which included twelve out of sixteen Asian countries had a per capita growth rate of 2.9%; the next quantile which included the remaining four Asian countries, 0.9%; the third quantile, 0.2% and the most closed quantile, 1.3%. These results strongly imply that trade liberalization, devaluation of the real exchange rate, and maintenan^e of a 'ompetitive real exchange rate could dramatically improve growth performance in many poor countries. The study estimates that the gains from shifting to an 'Asian level" of cutwaid ouieniation ai.d real exchange rate stability are increases of 1.5 percentage points per year in Latin America's per capita growth and 2.1 percentage points per year in Africa's. The outward orientation of Asian countries can be clearly discerned by examining trade openness and price distortion measures in Table 5. Edwards (1990) has used a modified neoclassical growth model to test the same proposition. Using cross section data from 30 coumtries, he found strong support for the hypotheses that there exists a negative aliaiituuship boiweun the degree of restriction on internationai trade and econormc pertormance In the developing countries. After taking into account the roles of capital accumulation, growth in the labor force and technological gap, countries with higher degrees of trade intervention tend to grow, on average, slower than 7Vorld Development Report, 1991 (forthcoming). SD. Dollar (1990), 'Outward-oriented Developing Economies Really Do Grow More Rapidly: Evidence for 95 LDCr, 1976- 85." Economic Development and Cultural Change (forthcoming). 6 countries with lower trade restrictions. There are a number of reasons why the difference in orientation could affect growth, both in the short and long run. Outward orientation generally results in a more rapid growth of exports. Competition with foreign producers raises efficiency and there mav be externalities associated with exporting that cause open economies to grow more rapidly over long periods of time. There is considerable evidence that the process of exporting, combined with easy availability of imported inputs and machinery, accelerates technological advance in developing economies. '° Outward orientation also leads to diversification of imports. High level of exports create an equally high level of demand for imports of various capital and intermediate goods. At the same time, higher income leve!s associated with higher exports induce demand for additional consumer goods imports that were either previously restricted or faced stiff tariff barriers. Under the new liberalized regime, no single import item (for example, oil) constitutes a large share of the total irnports. Thus, just as export diversification leads to relatively stable export price index so does import diversification impart sonie stability to the aggregate import price index. Outward orientation therefore makes it possible to use external capital for development, without encountering serious problems in servicing the corresponding debt. Inward orientation of production is considered one of the reasons why Latin American and African economies have experienced "debt crises' that have inhibited growth in the 1980ss (2) Adjustment to External Shocks Second, the successful countries treated adverse exogenous shocks as permanent and promptly undertook adjustment, thereby avoiding recourse to borrowing in excess of their capacity to repay. By contrast, those that considered these shocks to W-e temporary aberrations and postponed adjustment - continuing with normal levels of expenditure financed by ex.ernal borrowing - now face severe payment difficulties as the borrowed resources were used mainly for consumption. Clearly, countries must be prepared to react rapidly and sharply to negative shocks. Furthermore, being less dependent on commodity exports, Asian countries were able to better withstand the decline in commodity prices. The timeliness with which countries are able to react to these shocks and the strength and adequacy of the adjustment seem to be a moot point. Those countries which take early remedial action are eventually better 6JA'i th4U tl i A 90 W --;104 :AJ't-6 :1- lproractcd isnacto,,.. and 11vv ;iJi: W;b;3L' Ul 'tAlt 0 gOt; kgglaVatou. Malaysia recognized the gravity of the international economic environment early on in the 1981-1982 period and took corrective measures to turn around both the fiscal deficit and the current account deficits very significantly. Indonesia, becoming aware of the softening in oil markets, started the process of drastic adjustment in 1983 to help restore the competitiveness of non-oil exports. Korea decided to retrench its ambitious heavy ilUusLIy CApalIbiUll plUgrani WeCn it lealiia; that ihe economy was in serious troubie. 9Edwards, S. (1990) 'Operness, Outward Orientation, Trade Liberalization and Econonmic Performance in developing countries.' (World Bank PRE Working Paper 191;. l°Mieko Nishimizu and Sherman Robinson, 'Trade Policies and Productivity Change in semi-industrialized countries.' Joumal of Development Economics, (September - October 1984) 7 Seiji Nayu," a former Cliief Economist of ADB has made a quantitative estimate of the balance of payments effects of external shocks and the policy response of 12 Asian developing countries in making adjustment to these shocks. He estimated that the ten net oil importers had adverse effects averaging 17.5 percent of GNP between 1974 and 1982. The more open economies are more vulnerable to open shocks and thici the effet!r !z"2 ger in iiw s*;en i'us the more open countnes and smaller for larger or relatively closed economies. Indonesia and Malaysia had favorable effects. The balance of payments effects can arise either due to terms of trade losses which reflect in part the large increases in oil prices and the export volume effects which reflect the impact of the various recessions. In this study, three-fourths to four-fifths of the effects was due to terms of trade losses. Adjustments are usually analyzed in terms of expenditure reduction, expenditure switching or financing. Naya argues that adjustments to these external shocks can take place through four different mechanisms: (a) increase in export market share (b) import substitution (c) import savings via lower economic growth (d) net external borrowing. He uses this typology to analyze the outcome. It was found that the newly industrialized ec.l-oiiies (NIEs) relied mainly on increased export market penetration and secondarily on import savings and import substitution. The Southeast Asian oil importers increased their export market shares but also relied on recourse to net external finance. The South Asian countries and the Philippines overwhelmingly opted for external borrowing while the South Asian countries took measures to reduce spending initially, but later expanded external borrowing. The nature of thle policy responses has important implications for the problems of extemal debt, particularly in the Philippines. It may be useful to recount the experience of the Philippines here - one of the two severely indebted countries in Asia. 12 'The Philippine crisis resulted from both exttrnal and internal causes. External conditions created a difficult situation but inappropria:e government domestic and macroeconomic policies turned difficulty into crisis. After a decade of rapid growth, the Philippines faced problems of long-term structural adjustment and short-term stabilization. The long-tern problem was to shift the economy to a more open outward-looking stance. The old import substitution could no longer be paid for by taxing exports of primary products; the Philippines needed to promote exports of labor-intensive manufactured goods to achieve sustained economic development. This, in turn, required liberalization of foreign trade, including relaxation of trade restrictions and lessening of tariff rates and their dispersion. However, before structural changes could take place, the external environment 4Cuue wurbc. Tne government began relying more and more on capital market borrowings to cover the saving and foreign exchange gaps. Fiscal deficits mounted and the current account deficit rose in the late 1970s. Rather than cutting expenditures and thus sacrificing some growth in order to stabilize the economy, the government in the early 1980s gambled that export growth would pick up. Between 1980 and 1982, the budget deficit in the Philippines rose from 1.3% of GDP to 4.2%; the current account deficit rose from 5.8% to 8%. Expansionary fiscal policies were financed by extemal borrowing. The Philippine peso anpreciated in re-Al tprme Qtvaint th currencies of major trading partners, lessening the competitiveness of exports and increasing the incentives to import. The government increased investment in poorly managed state enterprises. In the meantime, capital flight reachec alarming proportions; domestic savings was discouraged by low real interest rates and the overvalued peso. 11 S. Naya. 'Effects of Extemal Shocks on the Balance of Payments Policy responses and debt problens of Asian Developing Countries." (ADB Economics Office Repot No. 22, December 1983). 12The following account is reproduced from James et al (1987), Asian Development, (San Francisco, International Center for Econornic Growth). 8 In response to the worsening externat and internal deficits, the Philippine government reversed trade liberalization policies and restricted imports rather than abandoning its i..appropriate speniing and exchange rate policies. Subsequently, witb exports falling and access to additional external finance dwindling, the government was forced to seek a rescheAduling of its huge external debt in 1983. The growth rate o' the Philippine economy declined steadily after i978 despite the government's efforts to prop it up. The growth thti was attained under the mlismanaged macroecono-ic policies proved to be short- lived and expensive. Real GNP declined by over 5 % in 1986 and 3 % in 1985,and per capita income in 1990was still below the 1980 level." A contrasting example is that of India during the same period. '3 The oil price increases worsened India's vulnerable external accounts and exacerbated inflation. Although the economy was already in recession, the govemment decided against borrowing abroad to absorb this new shock. Instead, domestic savings were boosted from 14 percent of GDP in 1965-72 to 19 percent in 1973-78 by raising taxes and interest rates, reducing public spending, and tightening monetary policy. Domestic energy prices were also raised quickly to the new international levels. By 1978, India had a small trade and current account surplus, a comparatively low debt to GDP ratio and large foreign reserves. Despite the second oil price increase, India's growth rate during 1979-84 averaged 5.1 percent a year, compared with 3.6 percent a year in 1950-79. India, however, expanded its borrowing abroad - both commercial and short term- in the later half of the 1980s to finance its growing budgetary deficits. The nature of the adjustment prices followed by the highly indebted countries in Latin America has been documented elsewhere. '4 Tn Brazil, the import substitution policy was supplemented with a heavy relia -e on foreign borrowing to finance major investment projects. In Mexico, the populist policies that led to spectacular growth in the public sector and in the fiscal deficits lay behind the crisis. In Chile, the opening up of the Chilean economy allowed the private sector to finance huge increases in consumption - especially durables - with borrowing from abroad. (3) Macroeconomic Policies" Third, the countries in the Asia region, by and large followed relatively cautious macroeconomic policies in the 1970s and 1980s, thereby avoiding inflation. The kind of policies that were pursued by the successful East Asian countries present a sharp contrast to those followed by the Latin American countries. South Asian countries had, until recently, followed prudent macroeconomic policies but their recent policy performance has raised senous questions. I he aifference in the case of South Asian countries iies more in ineir inward-oriente regime rather than the set of macroeconomic policies in the later half of the 1970s and early 1980s. The Chinese case is quite different and mixed. External borrowing has not been a major issue so far. The development performance has been impressive, but the unfinished reform agenda is long. Over the last decade, China's GDP growth has averaged 9.5 percent per annum. Investment was high throughout and was matched by a strong savings performance, which contained the need for external borrowtng. Industrnal modernization increased the competitiveness of China's manufactures in the international market and merchandise exports grew from $18.3billion in 1980 to $52.5billion in 1989. China's share of international trade rose from 0.97 percent to 1.7 percent during the same period. The average incomes of the 800 million rural 13World Development Report 1985, Box. 4.2 14Edwards, S. 'Structural Adjustment Policies in Highly Indebted Countries.' (UCLA Working Paper 453,September 1987). 15The discussion in the following paragraphs on the macroeconomic policies of East Asian countries draws heavily upon F. Larrain and R. Vergara (1991), 'Investment and Macroeconomic Adjustment: The case of Asia. (mimeo, The World Bank). 9 population more than doubled and absolute poverty receded nationwide. Thie most significant issue in China, however, is the alleged conf'ct between reform and macroeconomic stability. The decentralization of decision making and reliance on market mechanisms for price formation and allocation of resources are believed to thwart the attempts to eliminate the macroeconomic disequilibria that generate inflationary pressures. Balassa (1982) '6has argued, however, that readjustment and reform are not necessarily in conflict and may even complement each other, It has been postulated that important complementarities exist between reform and macroeconomic stability. On the one hand, macroeconomic stabilization and improvement of structural balance would greatly facilitate the smooth implementation of reform; on the othe. hand, the increases in efficiency to be expected from refortn could ease some of the difficult medium-term trade-offs and choices. China's debt burden is relatively low at present and the cautious attitude towards external borrowing showed in the last few years augers well. (a) Price Stabilitv In East Asia, low inflation and financial r -udence have been the policy objectives that were given priority over other objectives in the belief that higher rates of inflation were associated with weaker economic performance. That there was some validity in this proposition can be gauged from Table 6 which shows that low inflation conwtries in Asia had high domestic saving rates, high investment rate and rapid growth in output while the reverse was tru in the car, of high-inflation countries. Even in Indonesia which witnessed high and increasing rates of inflation in the first half of the 1960s tlv- new govemment made a strong commitment to p..ce and lower rate of inflation compared to resouice transfers through the inflation tax. Whether this objective conflicts with ernployment objectives is not obvious. In the case of Malaysia, M. Ariff (1983)'7 has investigated the possibility of trade off between inflation and unemployment and finds weak support for a traditional, negatively sloped Phillips curve. He therefore concludes that the existence of the trade-off between inflation and unemploymen. is not bome out by the empirical evidence. For other countries, the evidence is mixed and ambiguous. The variability of inflation is also greater in countries with high inflation rates. Most countries in Asia recorded low variability except the Philippines where both the variability and the average inflation rate have been high during the 1980-90 period. Malaysia, Thailand, China, Pakistan, India, Korea and Indonesia recorded average annual inflation rates in einole digite dfiri-g the period and also showed low variability. Banglades.h ar.d Sti LAinka 'Had inflation rates exceedir7 10 percent with low and moderate variability respectively. In contrast GDP output deflator in Brazil record,d an annual average increase of 165 percent, Argentina 298 percent and Mexico 68 percent d4ring the 1980-87perio.. The variability was also quite high in these countries. (b) Monetary and Credit Policies There exists persuasive evidence to support the proposition that positive real rate of interest encourages allocation of resources to their best and highest return use under a comnparative financial market structure. In the absence of positive real rates, credit has to be rationed by factors other than price. Under these conditions it has been suggested that somewhere between one thitd and two-thirds of total investment will be wasted, in 16aassa B. 'Economic reform in China,' Banca Nazionale del Lavoro, September 1982. 17Ariff, M. (1983), 'Inflation in Malaysia - an empirical enquiry,' in Proceeding to a Conference on Inflation in East Asian Countries, Chung-Ha Institute for Econom;c Research, Taipei. 10 the sense of yielding less than its potential. 18 In the East Asian countries, real interest rates were positive and moderately high in the 1980s. (See Table 7) Thus, although investment was not strictly allocated by the market in many instances, private companies using the funds had to pay positive real rates. Credit was not flagrantly subsidized, but it was directed. To some extent, demand for credit had been limited by price, but still credit availability increased s:gnificantly, e.g. from 10.7% of GDP in 1965 to 56.1% in 1987 in Korea, from 14% to 46 % in Thailand and from 13% to 62% in Malaysia. In Indonesia, domestic credit grew at an average 21 % per year between 1973-81, but the inflation trend was much subdued. The growth of the formal financial sector in these economies is reflae-ed in the extent of "financial deepening' defined as the growth in the share of financial assets in the economy. The ratio of M2 to GDP ( a measure of financial deepening) has risen in all these countries. In Korea it has gone from 11.7% in 1962-65 to 39% in 1985-88; in Thailand from 23.9% to 62.9% and in Malaysia from 27.3% to almost 70% over the same period and in Indonesia from 12.9% to 35% in 1989. Indeed, maintaining moderately high real interest rates appears to be closely associated with economic performance and financial deepening at the intemational level. Empirical evidence indicates that countries that have maintained relatively high real interest rates have performed better by a considerable margin than those who have favored negative red interest rates. 19 (c) Fiscal Policy Expansionary fiscal policies have been the bane of the debt problem in many developing countries. Ninety percent of long term debt of developing countries has either been directly contracted by the Government or guaranteed by it. Therefore, the Government's debt servicing capacity and thus its fiscal position assumes a critical role. The ratio of Government debt to GNP will fall if the non-interest government surplus, as a percent of the debt, exceeds the difference between the interest rate and the growth rate of real GNP. X Since many of the highly indebted countries were unable to meet this condition, they had difficulties in making their debt service obligations. On the other hand, NIEs and Asian countries have had, in general, very responsible fiscal policies (except the Philippines). Public savings have been positive every single year since 1970, and the budget deficit, which includes public investment as an outlay, has never reached worrisome proportions. A moderate fiscal expansion has been used only for very short periods of time, to produce a reactivation when internal and external conditions were not favorable. Moreover, when budget deficits have increased, governments have shown a remarkable ability to bring them down quickly, so that they do not jeopardize macroeconomic stability. In Thailand, fiscal deficits have been around 4% of GDP for several years during the 1980s. The Bank of Thailand, thjugh, has been careful to avoid monetary financing as much as possible. Malaysia has experienced even higher public deficits but the Government has carefully avoided resorting to monetary financing and deficits have been reduced significantly since 1987. Indonesia has averaged deficits up to 5% of GDP but has contained them to 2% in recent years. The deficits were financed mainly through counterpart funds generated by foreign aid and external project assistance. le Polak, J. J., Financial Policies and Develooment (Paris: OECD, 1989). '9McKinnon, R. (1989), "Financial Liberalization and Economic Develooment: A Reassessment of Interest Rate Policies in Asia and Latin .metica." International Center for Economic Growth, ICS Press, San Francisco. ) Blanchard et al, The Sustainability of Fiscal Policy: New Answers to Old Questions,' Economic Studies. Vol. 15 (Paris, OECD). 1] It noeod to he stressed thlat in cotintriic \A,lbh rolalivl) high doniesiic rates of savings, public sector deficits of the nmagnitude Jisplay ed in Thailainld ant] NMfal.tsia lealve enoutghl space for the private sector withouit creating inflationary pressures. (d) Exchange Rate Policy Overvalued exclhange rates have been a common occurrence in a majority of Latin American and African countries rcsulting in losses in pr