metadata: authors: 0: author: Husain, Ishrat
count: East Asia and Pacific,South Asia
docna: 0: docna: How did the Asian countries avoid the debt crisis?
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Industrial Economics,International Trade and Trade Rules,Economic Growth,Inflation,Economic Stabilization,Macroeconomic Management
teratopic: Poverty Reduction
abstracts: cdata!: Economic stability, sound macroeconomic
            policies, and appropriate microeconomic incentives hold down
            a country's external 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. The author contrasts Asian country debt crisis
            behavior with that of 12 highly indebted Latin American and
            African countries.
repnme: repnme: How did the Asian countries avoid the debt crisis?
display_title: How did the Asian countries avoid
            the debt crisis
listing_relative_url: /research/1991/10/699856/asian-countries-avoid-debt-crisis
topicv3: Economic Growth m1326241 471,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Macroeconomic Stability and Growth
            m1326923 1088,Trade m1326924 698,Balance of Payments m1326965 441
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Poverty Reduction
origu: International Economics Department
no_of_pages: 31
model_extractions: **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 gencrally sound and microcconomic diRtortionn minimal, sporadic episodes of ovcrbolITowing or inadequate atteintion to the terms, maturity, **and** curtcnc) composition of external debt will generally **iioi** make a difren-ciice in its decbt picture.

In China, India, ai Kolioma. investment rates **wvere** relativelv hiih, financed mostly from domestic savinos: forcign loans **xxere** use judiciously, as a compllemieint to domcstic savings. Forcign capital accounted for **only** 2 to 3 percent of GDP in thcsc counitrics, although investmcnt ratcs **averaged** _3(0_ percent of GDIP.

But acts of indiscretion in extemal dcht management tend to be magifiiied **when** those basic policies arc inadequate. The reccnl upturin in Latin American economies --- parlicularly in Chiile, Mexico, and Vcnczu.'ia, **xkhich** are now, successfully pursuing maci, ,conomic a(ijusiment -- supports ltlC validity **olf these** f'iiings.

B\ contrast, thle Latin Anmericani **govern-** menis expanded extemnal **borrok inigs** to offset **ihc** effects of exterial shocks. **In** Bra,il, foreign resources **were** substiluted lor domestic sa\ ilgs to support an imporl substitution strategy; in Mexico. fiscal deficits were finaniced by extemal **borr)Wiliw.** l]ow did the Asian countries avoid **the** debt crisis? Husain answers thali question partlk bN contrasting thcir behavior with that of' 12 higlily indcbtcd Latin American and African counities studied by the Bank in the mid- 198(s.

The Asian counitries, itli a fcew exceptions. pursued an outward-oriented stratcg\ and prudenlt imacrocconiomiiic policies [hey inade ing cxpenditures, expanding cxpoinis. and curtailing consumptiol. Mlost horrowed and locally raised funds were invested in productive uses, improving the cconorn\'s abilil\ to rcpay thie debt. 'hese countries relic( heavilx oni doiiestic savinigs aid resources to finance investmenits Thcy did not allow, crises to drift or he aggravated.

At thc samc time. the residents of' these couninies transferred billions ot dollars abrotd. liusaini atitibutes this massive capital 'light to overnalued cxch:tnoc **r'it.- I:i nd -r-n 1i1mi\io** intercst rates. 'hlcsC wcre initcln(ded to curb inflation **htii** instcad cro(ded creditx orthincss because of iteir depressinig effict. oni exports and salvings expericnce(i thc mia,ssive flighlt of private capital while thc\ were stepping up exicnal borrov ing - courtcd trouble %kith debt servicing, because much of the borrowed mioney \Yas not invcs,ted in higih-retuni projects. 'Ihat flight capital has begun to return **to** Mexico and \'Venezula. both of which embarked on successful economlic relorn in 1987.

**-f lie** PRE **Ao,riNign Pqr SCT IIC1,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** 1ih: rc't.'. _.\_ **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

|Introductio|n|1|
|---|---|---|
|Internationa|l Economic Environment|3|
|Domestic P|olicy Environment|4|
|(1 )|Outward Orientation|5|
|_(2)_|Adjustment to External Shocks|6|
|(3)|Macroeconomic Policies|8|
||(a)<br>Price Stability|9|
||<br> <br>(b)<br>Monetary and Credit Policies|9|
||(c)<br>Fiscal Policy|1 0|
||<br> <br>(d)<br>Exchange Rate Policy|11|
||<br> <br>(e)<br>Industrial and Trade Policies|11|
||<br>(f)<br>Policy Stability and Credibility|12|
||(g)<br>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.<sup>2</sup> 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.<sup>3</sup> 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 muchenlarged 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<sup>used for capturing the</sup> influence cl externai envirunilnlit dli **wllAb vAI iLlad** Th. 0 I ' 1 4,,- i -Sf trade of Asian countries declined (0.6 percent per year) during 1973-82 compared to an<sup>increase (3.8 percent) for the</sup> highly indebted countries. The volatility in the termns-of-trade was, however, considerably<sup>higher for the latter</sup> group of countries. Sachs<sup>5</sup> who estimated the real income effect of terms-of-trade change for the<sup>period 1979-85</sup> did not find any significant differences between the two groups of countries. His<sup>broad conclusion based on</sup> calculation of combined effect of the terms-of-trade and interest rate shock was that macroeconomic<sup>performance</sup> and the need to reschedule were not closely tied to the mag niitude of the external shocks as a<sup>proportion of</sup> GDP. Donovan's study<sup>6</sup> of a larger sample of middle-income developing countries also<sup>found that the</sup> magnitude of terms-of-trade movements was not markedly different for groups of reschedulers<sup>and non-</sup> 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<sup>the debt crisis while</sup> the Latin American and African countries have been embroiled in this unfortunate situation<sup>for almost a decade</sup> now. It is not proposed to provide a fully satisfactory or rigorous answer to this question,<sup>but based on a number</sup> 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<sup>analysis presented here</sup> 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<sup>were never able to put</sup> 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<sup>itterplay</sup> of forces and interactions that took place during the course of events in the 1970s<sup>_F_</sup> d 1980s.<sup>The analysis</sup> therefore abstracts from these complex interactions and presents a relatively simplified picture<sup>of the end results.</sup>

# DOMESTIC Pt)LICY ENVIRONMENT

The differences in economnic and market structure do persist between the countries in the<sup>three regions</sup> and so do levels of institutional development. They may also, in part, explain for the differentiated<sup>economic</sup> performance. Other variables such as human resource development and skill mix of the labor<sup>torcewhuch attect</sup> the growth in a longer time horizon may also be equally important. The "new"growth theorists<sup>have provided</sup> evidence that increasing returns or positive externalities from such factors as knowledge<sup>and human capital can</sup> explain the divergence in growth rates among developing countries. It is also becoming<sup>clear that the impact</sup> on growth of better economic policies and more education, together is greater than the<sup>sum of each separately.</sup> A comparison of the human development indicators of the Asian countries in this sample<sup>with those of the most</sup> severely indebted countries in Latin America, do not bring out any significant difference<sup>in this aspect (see Table</sup> 4). Eight out of ten Asian countries in the sample are classified as having medium or low<sup>human development</sup> 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<sup>Africa are quite low.</sup> S Sachs,<sup>ibid.</sup>

> 6 Doral 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

> 7 Vorld Development Report, 1991 (forthcoming).

SD. Dollar (1990), 'Outward-oriented Developing Economies Really Do Grow More Rapidly: Evidence for 95 LDCr, 197685." 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.

9 Edwards, 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 shortlived 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 1<sup>3</sup> World Development Report 1985, Box. 4.2 1<sup>4</sup> Edwards, S. 'Structural Adjustment Policies in Highly Indebted Countries.' (UCLA Working Paper 453,September 1987).

**1**<sup>**5**</sup> **The** 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) '<sup>6</sup> has 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

> 16 aassa **B.** 'Economic reform in China,' Banca Nazionale del Lavoro, September 1982.

> 1<sup>7</sup> Ariff, 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).

'<sup>9</sup> McKinnon, 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<duction and external competitiveness. The cornerstone of the exchange rate policy in Korea, Thailand, Malavsia and Indlonesia, on the other hand, has been to maintain external competitiveness.

Since 1980, Korea has followed a system of gradual adjustments to the nomir,al exchange rate. determined with respect to a basket of countries. Aftcr periods of real appreciation or extemal difficulties, a one shot devaluation **has** hben used to restore competitiveness of exports. In Thailand, the exchanige rate has been pegged to the dollar for three decades, with two devaluations: 10% in 1981 and 14% in 1984. There was also a period of floating rates between 1979 and 1981. In general, low inflation has allowed the preservation of a relatively high real exchange rate, and after periods of mild appreciation, devaluationc have been used to restore competitiveness.

Real exchange rate depreciation in Indonesia in 1983 (28'%) and 1986 (31 97), and the flexibilityachieved through an actively managed float subsequently have played a key role in boosting non-oil exports and reducing the current ac_ount deficit.

Malaysia has kept a stable and convertible currency. The real exchange rate has remained very stable over the last two decades. Only in recent years has the currency appreciated by a significant amount. Large inflows of foreign investment, which have pushed up intemational reserves, are mostly responsible for this appreciation of the ringitt.

# _(e) Industrial and Trade Policies_

The thrust of the trade and industrial policies in the ASEAN-4 and NIEs has centered around enhancement of domestic competition and promilotion of exportables through the maintenance of realistic exchange rates, enhancement of import competition through lower tariffs and the reduction of non-tariff barriers, removin. msArket-(liqlorting rectrictions like nrice controls **:nd -,qcino vmr1imm ki.n,d** **_of_ rpmdatinnc Ae 2a 1f** manufacturing value added, on average, grew inore than four times as fast in the NIEs and ASEAN4 (over 10 percent) as in Latin America, andr more than three times as fast as in Africa between 1973 and s988. Manufactured exports led the high growth of the industrial sectors in these countries.

In general, industrial policies in NIEs and ASEAN-4 have placed greater reliance on the private sector **nhe,** n-icr **-- ir.'-,** ff n.iw fived inve,tmnent The **r.ile** of the g... ! **I 1:,'F I** ee ra-ua!red.cedI,hrough privatization of existing state enterprises. Many **kinds** of investment incentives have been used in this attempt.

Korea haz widely uised import restrict'lnv. rarticulan -:!ng the industrialization stage of the 1970s. Although tariffs have not heen high,:' quantitative tradc **rs:li** .:nons have implied a high degree of protection frd lorne.qjz in.dtntrie. The idTea hac hben to} nurtire somill infant indoUtries, so that they can eventually grow **tipl and** be(ome competitive in xworld markets. Thiis trIatey, whichi worked so badly in Latin America, has

> 21F.r _oxamn, t,_ **_tl,,c_ :mirl -** **_1,_** _sesr,jr t,wlr_ r.!c fI _* IQ 9_ **_\k;<'_** _.3_ 23. i,van, . 11 47. p 3?, ji' id)
12 prodi. cd positive rezuhs in sp. CiI' imsitin.<sup>s</sup> su.-' - ,t **ni-** ,b;?.- and **'c.- !** _-i_ Ni -take, hoe% **i,** h.vc also Ih.el. IliadeL. wh1i0lh th iiuthoritics **1** 'ov,-,' **e** ; 0 **:ui.t .'an** .l **.heu** 0il,', 'dhand id t', **Pip P** aiqh di;ti osh Export _suisLdive_ lsavc bt)eei u ed, m;ainly .tu,in,1 preil d .'f p..! lp ci;at **'o** .Jlch as in th: **!.3t,** 1970' In **tet ,** of industrial **poh** iy, **tln** f, **v** e year mac; n oc **r plans** targcted certain industt i **exw** hiTh **have** been helped through easy credit, i..v in..nti\oc', **:UbhcZidit-,** etc. Ffticten.y, howe-X. had beenl Cnkour.gted and many of these industries now export their- **own** production .uccessfully<sup>to the rest of the world. The experience</sup> of lTyundai in automrobiles has heon a<sup>L</sup><sup>**c-**</sup> in p. ,nt, al!houL1h lal- l it h2s nrn into **soime** difficulties in the UT.S. niarket.

Thailand followed an impoit substitution strategy until<sup>1976, with high tariffs and other import</sup> restrictions so as to promote domestic industries. However, through the<sup>Investwment Promotion Act it exempted</sup> taxes on imported capital machinery. This encouraged investment<sup>and the use of modem technologies. The</sup> strategy shifted towards export prom-notion firct in 1972 and then<sup>more strongly in 1976, and tariffs were reduced</sup> substantially. Some non-tariff barriers are still significant, however.

Malaysia has kept an opcn trade regime with very few non-tariff<sup>restrictions and a low average tariff rate</sup> (9.5 percent) though with a relatively highi disp2rsion. According<sup>to some authors, this low protectionism is</sup> related to the belief of the authorities that thc herteficiaties<sup>of piotectionism would be Chinese-run business.'3</sup> Malaysia has made the most significant progress in privatization<sup>with some of the country's best known state</sup> enterprises being listed on the local stock exchange. Plans<sup>have been draw.n to fiurther reduce government</sup> ownership of enterprises.

Industrial policies in Malaysia hav'e been an essential<sup>ingredient of the modernization plans of the</sup> country since its independence. Fiscal and other broad incentives to industrial investment have<sup>been provided</sup> throughout. As a result, the manufacturing sector has led growth<sup>in M,alaysia during the last two decades, going</sup> from 8.5% of GDP in 1961 to more than 20 %c m I he i980s.

The Indonesian Government initiated a series of trade<sup>reforms by reducing nominal tariffs in 1985 and</sup> trade deregulation measures in 1985 by reducing the burden<sup>of import licensing. The proportion of domestic</sup> production protected by import licensing restrictions was reduccd<sup>from 41 % to 29% and the value of imports</sup> subject to controls declined to 21 % from 43 %.

**TI,p hi;c noAinst** foreipn investment was curtailed and the role of<sup>the local contentprogram was reduced.</sup> In 1989 the Government converted the Investment Priority<sup>list to a short negative list and removed virtually all</sup> regulatory constraints. Private firms have been allowed to establish export processing<sup>zones in authorized</sup> industrial estates.

# _(fl Poliay Stability and Credibilib_

The role of uncertainty in investment has been emphasized<sup>by several authors and is generally associated</sup> with the irreversibility of investment. The basic argument goes as follows: if macroeconomic conditions<sup>are</sup> uncertain, and given that once investment is in place **it** is impossible to undo it, it may<sup>pay to wait. The greater</sup> the uncertainty and macroeconomic instability, the lower the investment.

22Collins and Park (1989), 'External **Debt** and Nlacro-conomic<sup>Performance in South Korea,' in</sup><sup>_Developing_</sup><sup>**_Countr)_**</sup><sup>_Debt_</sup><sup>**_and_**</sup> _Economic Performance._ **edited** by Jeffrey **D.** Sachs and Susan **Ni**<sup>Collins</sup>

**23 Sec** James Ct al, (1987), ibid.
1 3 Korea, i .Thailand.!, zmj MaI;', ; xanlti. l tl'n tTlIc . ;,. .. !,,' _d'_ **_,_** o0 **.,uoi!** itx. 1e.2 ha **bck. ii IO** i.tOli. **,** h.ii It:s. :. t)'I . i **.'** sfti,ric' .!In;. the _III;, 0C'10). lerhap._ thl' Inc **IriI()O jia I** a. 'Fl l **aInI id, 'A** _iI_ to) .II. **.I** rtrid gJ x' th si fratceg In t<sup>t</sup> mi-n'id - OfK **_0l'_** . "Big Pusli" nhap. **wa;** an ti'4 - l''i-. , *.-#1 **-i ?r,t,'If5'.i fli. , IJ** -l **fi** **_--_** aind MalaY 11;a s libelalization p)s-. x , thL I tl,- I I tie rr'ihi taiun of a rc tht vasii 'sy incieeangIljg intervenltioiiist These!. r1c !lnnoi 'anjd lclati\cl ) fco' ) chongve wh. n ouiepircJ **%withi** thoe--. '.i other regions of the wotId. Latin American countries, for instarnIe, hax **c** suffered wide policvy Xhanges o\ er the last 310 years. **la** addition to struttuial adl u'ptrnmiit s.,l'ili 'liol proeranim have bevn the notn **i** n ltn ATI!erili throughout the I980s,\i%th their s;quel vl ecooI nnic cesin and relative price volatility Man) countries have undergone several stabilization etfort'. in the ;hort p,-vil of a fexk years, av in Argentin., Brazi! and Peru to name the most promilient. Stabilization progran)ms ht\i e **1I.n** few in the su.ccssful .ases of Tast Acia. because they have rarely been necessar).

The Ioo- x'ailability of the real exchange rate in East Asia can bte observed in Table 8. The average coefficient of variation of the real exchange iate for the period 1975-88in the four East Asian countries is 0.097; the same figure for a sample of 7 Latii .Arneri,.an countries is more than twice this, at 0.201. Mioreover, the tigtire foi Thailand. tl-hc East Asian countr\ x\th hi he't coctffictt of variation (0.106), is lower than the figure for any of the seven Latin Amierican countries in the tabic.

Government policies in East Asia have by and large been credible and consistent with emphasis on promoting exports, savings and investment, and on the mindatrialization of the economr.. Investors inside and outside these countnies have perceived thcse goals as pvrmanent and government behavior hab validated these expectations. This has produced an extraordinarily good environment for investment, vwitnessed b)' ver) high private investment rates. The absence of major pol;cy changes over the last three decades, as mentioned above, has no doubt enhanced credibility.

# _(g) Income Dist-ibution_

It has been argued that one of the reasonis that latin American governments have been so erratic in their macroeconomic policies _may_ be the big inconie inequality existing in these countries. 24 Income inequality leads to social pressures **that** governments have attempted to relieve through populist policies. After one or two years of economic expansion inflatior, soars, real xvages fall, unemployment starts to increase and output declines. The policies prove to be unsustainable and the goverarnent has to switch to another set of policies. The populist cycle has been suffered by many countries in the region. _s_ **_.o.._** _. ._ **_._** In East Asia the situation is just the opposite. Indeed, macroeconomic stabiliLy is facilitated by equitable income distribution. The inlcome distribution figures for a group of East Asian and Latin American countries (the share in national income of the top and the bottom quantiles of the income distribution), show **the** tatio of top to bottom income is much lower for East Asian countries than for Latin American ones. In East _A-''--+ **.-** A"AIb"'-A+ **.** JIA' ' .u"m' t "''"" on **a.C** ;.W **U. l** vi **01as, j)UOi** poul **C.i; IO 11CiCiwIL.** In Iatin America, the ratio is 18.6 times (see Tahle 9). Moreover, with the exception of Malaysia, the distribution of income in East Asia is within the range shown by developed economies. Furthermore, even in Malaysia the progress has been impressive. The incideince of poverty in Malaysia has declined by 34.4percentage points between 1973 and 1987. The income difterential between the Chinese and Malays has been greatly reduced. In 1973,a Chinese had a 26 percent less chance of being poorer than a Malay, holding other variables constant. By 1987, the differential had been reduced to 7 percent.

**La4Iz"iii and** Vcrgara, ibid.
14 Recent work has suggeNted that incomn inequality provokes **aI** negativc effect **ofn** econonhjic growth7(Vtn It has betn postulated that a key channel tor thi rviatiuoi hip iv investmernt. More eAluitable **inconle** diqtribution leads to less social conflict, which reduces uncertainty and creates a more stable econornic environment for investment.

# (4) Capital Flows and Portfolio Management

Fourth, the Asian countries made productive use of borrowed external funds, eased infrastructure bottlenecks, inivested in human resources, expanded productive base, and did not allow public sector enterprises to run nmassive deficits. They ensuied that the growth of exports and income exceed the growth of debt and the interest rate. It is only when the interest rate exceeds the growth rate of both GDP and exports, debt and debt ratios grow on an explosive and unsustainable path. The external capital flows were not very large in relation to debt servicing capacity and were diversified over time, with foreign diret investment becoming a growing vehicle for raising extemal finance. The volumc, terms aind conditions of borrowing from private and commercial sources were also carefully worked out to avoid a mismatch between beniefits stream and the repayment of debt.

lThe success of their external borroswing strategy can be gauged from the fact that four Asian econonies have begun to make large net resource transf'ers abroad. These transfers are different from those made by the highly indebted countries as they were made in the context of high GDP per capita growth, high investment and current account surpluses. Korea has maintained its investment at 30 percent of GDP but also made net resourrce transfers of 8 percent of GDP.

One way of measuring the efficiency of capital invested is examining the incremental capital output ratios. Table 10 presents ICORs for five East Asian countries and reveals that these countries have ueen quite efficient in terms of their investment. ICORs in these economies are within the range shown by the most efficient countries. The sharp and short-lived increase in Mialaysia's figures during the mid-1980s is associated with the 1985-86 recession; iCORs of subsequent years show a marked improvement. This outcome is closely linked to the trade and industry policy stances of these countries which have been discussed earlier.

Recent empirical work on the sources of growth of income carried out by the Bank provides further corroborative evidence for efficiency of resource use, going beyond capital alone. 2' Table 11 decomposes the source of GDP growth by the relative contributions of capital, labor and total factor productivit) (TFP). TFP captures the efficiency with which inputs are used. For the period 1960 -73, the differences in the relative cointributions ot capitai aind **i0** [oJi **jUL** E.h . , **nt** d L;.. ' A.... **"qi' lr hitt** **_b,,_** for the subsequent period 1973-87,TFP accounted for one-fitth of the growth in East Asia while its contribution in both Africa and Latin America was strongl) ne-ative. This study also found a strong and positive association between productivity growth and aggregate growth. The decline in Latin America GDP growth in 1973-87 relative to the earlier period is closely matched with the decline in TFP.

Asian countries not only invested the horro.xncd resources productively but had a balanced portfolio of **foreign** capital flows. ASEAN-4 and China relied heavily on Foreign Direct Investment flows in addition to horrowing from commercial sources, bilateral and multilateral inctitutions at competitive rates. ASEAN-4 and China made sensible decisions in rclation to external borrowvinv about (a) the terms of foreign borrowing - **interest,** maturity and cash flow profiles (h) the currencis in \xhich liabilities a.-, determined (c) the balance betwcen fixed rate and floating- rate intrunments: (d) Xays of sharing risk between lenders and borrowe;rs, including the balanLe betwcen debt anjd equity and (e) the **IL%-** and comnpo.sit;n of a country's reser\es. The Alksina **L,nd** Rodrk (1991), "Diqifibt;t:\ **PlRi.- and E,onmIk, Gio,\kh,** NBER %orkini pzpdr **'** 3668

**(Th,; W\uld i** anik. **\NoiIJ** D;7l-p'n;i:X! R; 'tr. I-: **\x *,iygi,r** _DC)_ X
15 maturity structure, interest rate and currency composition were compatible with the repayment capacity of the projects or investments for which the funds were borrowed. The level and composition of the reserves were both adequate. Of course, there were exceptions to these generalizations in individual country cases at certain points of time. Indonesia's growing exposure in yen was a source of concern in 1987 and 1988 while the size of Korea's debt stock in 1982 had created some questions in the minds of the creditors.

South Asian countries received substantially large proportions of capital flows in the form of concessional assistance. It is only in the late 1980s that India became a significant borrower in the international capital markets. Finally, the share of variable interest rates in total debt wab *.omparaiiveiy lower than the Latm American countries and thus the rise in interest rates did not result in immediate servicing difficulties.

FDI has contributed to growth both by augmenting resources available for capital formation and by improving the efficiency of investment. The rate of approval of FDI in ASEAN countries during the period 198689 is impressive. According to some estimates, the total approvals escalated to $16.7 billion in 1989 compared to $2.5 billion in 1986. FDI flows account for more than 50% of all types of capital flows to these countries. In China, the pledged value of foreign direct investment amounted to $34 billion at the end of 1989, of which $15.4billion had actually been disbursed. Disbursements have risen to $3.3 billion annually and foreign investors have made a major contribution to the development of services, oil exploration and export-oriented manufacturing industries. As a result, these countries do not face difficulty in attracting foreign savings at relatively lower cost.

# _(5)_ Domestic Savings

Finally the domestic savings rates and domestic resource mobilization efforts in these countries were intense which enabled them to finance a large proportion of their overall investment without resorting to excessive external borrowing.

For the period 1973-80, Asia's domestic savings rate was 25.3 % while investment ratio was 26.1 %. In the subsequent period 1980-87 these ratios were 26.7% and 28.1 % respectively. Foreign resources inflows were thus modest despite the two oil shocks and other adverse external circumstances. Empirical studies have also shown a stronger correlation between growth rates in GDP and domestic savings ratios than between growth rates and investment rates. Thus the policy relevance of stronger domestic saving effort becomes more pronounced.

When domestic savings decline in relation to national income while external indebtedness increases, the substitution of external borrowing for domestic savings implies a rise of funds borrowed from abroad to finance consumption. The evidence for Asia shows that this has not happened. The saving rates of China and Malaysia exceeded 35 % while those of Indonesia, Malaysia, Thailand, and MrD a, 30_ ZOV. '-dia saves aboui 21 _%o_ of its income. In thalland, significant increases in **government** savings have taken place. The Philippines, Pakistan and Sri Lanka have lower domestic savings rates in the range of 10 to 15 percent while Bangladesh has barely positive rates. The savings GDP ratio in Latin America was 20% and Sub-Saharan Africa about 13%.

Fry' has analyzed determinants of savings ratios in Asian developing economies and found that these ratios are increased by income growth. National savings ratios are also raised by a higher overall governnent budget balance aid by higher real deposit rates of interest. On the other hand, higher population dependency 27Fry, M.J., Domestic Resource Mobilization in Developing **Asia:** Four Policy Issues.' Asian Development Review 1991, Vol. 9, No. I.
16 ratios, expansionary monetary policy and<sup>higher foreign deb. reduce savings. As pointed out earlier, East Asian</sup> countries had higher real rates of<sup>interest, relatively lower budgetary deficits and tight monetary policies</sup> throughout this period with some<sup>exceptions and interruptions.</sup> In recent years, however, the growing<sup>government hudgetary deficits in India and Pakistan have created</sup> pressures on the sustainability of their<sup>creditworthiness. Interest payments on internal and external borrowing</sup> are growing rapidly and accounted<sup>for 30 % of current expenditure in Pakistan and 25 % in India. The domestic</sup> resource gap is bigger than the current account<sup>deficit as rernittances from workers abroad are substantial. But</sup> the recent Gulf Crisis exposed the vulnerability<sup>of these countries to reliance on this source of foreign exchange.</sup> The heavily indebted countries of Latin<sup>America got into trouble precisely because of large public sector deficits</sup> which were financed through monetary expansion<sup>and large borrowing. The South Asian countries should learn</sup> from the lessons of the HICs and take<sup>steps to contain their fiscal imbalances. But they must also ensure that</sup> fiscal contraction does not reduce investment<sup>in social sectors and that demand management is accompanied by</sup> structural reforms, particularly in incentive<sup>policies.</sup>

# CONCLUSIONS

The case of Asian developing countries<sup>in managing their foreign debt burden presents a contrast to</sup> Latin American and African countries.<sup>' For the latter group, the combination of inward-oriented strategy, poor</sup> quality of macroeconomic policies and investment<sup>in unproductive ventures contributed a great deal towards the</sup> final outcome. A study of the twelve<sup>highly indebted countries carried out by the World Bank in the mid-1980s,</sup> concluded that the quality of economic<sup>management in these countries themselves was the decisive determinant</sup> leading them towards the path of<sup>debt crisis.</sup> The Asian countries, with a<sup>few exceptions, pursued an outward-oriented strategy, and prudent</sup> macroeconomic policies. They made quick<sup>adjustment to external shocks by expenditure switching, expanding</sup> exports and curtail;ng consumption.<sup>Most of the borrowed and locally raised funds were invested in productive</sup> uses that raised the capacity of the<sup>economy to repay the debt. These countries relied heavily on domestic</sup> savings and domestic resources for financing<sup>investment.</sup> It would be misleading to suggest that<sup>the Asian countries did not have their crisis periods -either</sup> induced by domestic policy slippages<sup>or extemal shocks. Korea met a serious crisis in 1980. Indonesia faced</sup> difficult problems when oil prices fell<sup>in 1983. Malaysia was confronted with a current account deficit of 14</sup> percent of GNP in 1982. But the important<sup>point to note is that in each case adequate, strong, and timely policy</sup> 1CGFV1v,0 **tV"Z4,,IJ** _LiC_ **The.a:c. ..** cr.ise's otr A t. ***** 4 r g agra _-iSA_ At " v a whole period of two decades is examined,<sup>the end-results appear impressive as presented in this paper.</sup> In the Latin American countries,<sup>the governments expanded external borrowing to offset the effects of</sup> extemal shocks. In Brazil, it led<sup>to substitution for domestic savings by foreign resources to support import</sup> substitution strategy and in Mexico fiscal<sup>deficits were financed by external borrowing.</sup> At the same time, the domestic residents<sup>of these countries transferred billions of dollars abroad. Why</sup> did capital flight occur on such a massive<sup>scale? The answer has much to do with fiscal, monetary and balance</sup> of payments management, and in particular<sup>with the maintenance of overvalued exchanee rates and unattractive</sup> interest rates intended to curb inflation.<sup>Overvalued exchange rates and uncompetitive interest rates have clearly</sup> been shown to encourage capital<sup>flight.</sup> Tn the longer run, distorted exchange<sup>and interest rates erode</sup> 2sThe references in Latin American<sup>and African countries in this study pertain to the period prior to 1987. Since 1987,Chile,</sup> Mexico and Venezuela have undertaken<sup>successful economic reforms and achieved significant progress. Argentina, Peru and Brazil</sup> have also initiated some reforms, but<sup>it is too early to judge the resulu</sup> Similarly, more than twenty African<sup>countries are currently</sup> pursuing structural adjustment programs<sup>and the preliminary results are encouraging</sup>
17

# creditworthiness because of their depressing effect on exports and savings.

Again, in countries where funds were borrowed specifically for investment purposes and in fact invested rather than consumed, much of the investment yielded low or negative economic returns. These poor investments, however attractive the termsq of borrow.ing, b a.m a ,jor probLkri as they failed to geneiate an income stream to service debt and depressed the efficiency of the economy as a whole.

Countries such as Argentina, Mexico and Venezuela which experienced massive private capital flight while they were stepping up external borrowing courted servicing trouble, since much of the borrowed money was clearly not invested in high return projects. As a result, these countries were faced with debt payment obligations, the income counterpart of which was out of the governments' reach. The return of flight capital has started in Mexico and Venezuela - both of which have embarked on successful economic reforms since 1987.

In the ASEAN-4, China, India and Korea, the investment rates were relatively high, financed mostly out of domestic savings and the foreign borrowing was used judiciously and widely as a complement to domestic savings. Foreign capital did not account for more than 2 to 3 percent of GDP in these countries while the investment rates were on an average 30 percent of GDP.

Particular attention was paid to price stability which reduced the uncertainty and strengthened investor confidence. Tight monetary and fiscal policies along with flexible exchange rate management maintained external competitiveness. Industrial and trade policies induced private investment, promoted manufacturing sector and manufactured exports and reduced price distortions. Policy continuity helped to strengthen credibility and Rtability ..hile equitab'e ixz,or,e Iitz ibLuiuii xiciiuicd c.redibiiity by minimizing social and political tensions.

The lessons that can be drawn from this comparative study of highly indebted countries and Asian countries are (a) that success in managing debt is closely related to macroeconomic management as such and (b) that macroeconomic stability and prudent economiic policies - both macro and micro- stand out at the top of the pyramid of the factors that influence external debt outcomes of developing countries. If these policies are generally sound, sporadic episodes of overborrowing or inadequate attention to the terms, maturity and currency composition of external debt would tend not to make a large difference. But if the basic policies are inadequate then such acts of indiscretion in external debt management tend to get magnified and create serious difficulties for the debtor countries. The recent upturn in Latin American countries, particularly in Chile, Mexico and Venezuela, which are now pursuing successful macroeconomic adjustment, tends to provide support for the validity of these lessons.
18 Table 1. Average Annual Growth Rate of Long-Term Debt

||1973-80|1980-87|
|---|---|---|
|East Asia|22.7|12.7|
|South Asia|11.2|13.4|
|Latin America|21.6|9.1|

Sources: World Bank, World Debt Tables,1990.

Table 2. Comparative Debt Indicators 1980-90

||As|ia|Latin|America|
|---|---|---|---|---|
||1980|1990|1980|1990|
|Debt/GNP|19|25|35|48|
|Debt/Exports|108|108|197|261|
|Debt Service/Exports|<br>15|15|37|33|
|Interest/Exports|9|7|20|17|

Source: World Bank data.
19 Table 3. Economic Performance Indicators

||1965|-73|1973|-80|198|0-87|
|---|---|---|---|---|---|---|
||Asia|LAC|Asia|[AC|Asia|<br>LAC|
|Growth of GDP|5.3|5.8|5.6|5.0|6.8|<br>1.5|
|GDP output deflator|1.8|3.5|6.8|15.9|6.1|<br>39.8|
|Growth of Merchandise Export|7.1|-0.4|<br>8.5|2.2|9.0|<br>3.4|
|Growth of Investment|7.8|7.1|8.7|5.4|7.9|<br>-4.0|
|Growth of Per Capita Consumption|<br>2.1|2.9|3.2|2.9|3.8|<br>-0.7|
|Current Account Balance/GDP|-2.0|-2.6|-6.3|<br>-3.1|-2.0|<br>-2.7|
|Share of Manufacturing<br>in Exports|29.4|10.9|37.5|17.7|50.2|<br>23.8|

Source: World Bank data.
20 Table 4: Human Development Indicators for Asia and Latin America

|||1990<br>HDI Rank|199C<br>HDI Value|
|---|---|---|---|
|High Human Development|Korea|35|0.884|
||Chile|38|0.878|
||Costa Rica|<br>40|0.876|
||Argentina|43|0.854|
||Venezuela|44|0.848|
||Mexico|45|0.838|
||Malaysia|52|0.802|
|Medium Human Development|Panama|54|0.796|
||Jamaica|59|0.761|
||Brazil|60|0.761|
||Colombia|61|0.757|
||Thailand|66|0.713|
||Sri Lanka|75|0.665|
||Ecuador|77|0.655|
||Peru|78|0.644|
||China|82|0.614|
||Philipvine|s<br>84|0.613|
||Nicaragua|85|0.612|
||Guyana|89|0.589|
|Low Human DeveloRment|Indonesia|98|0.499|
||Honduras|100|0.492|
||Bolivia|110|0.416|
||Pakistan|120|0.311|
||India|123|0.308|
||Bangladesh|<br>136|0.186|

Source: UNDP, Human Development Report 1991. (New York, Oxford University Press, 1991)
21 Table 5: Trade Regime and Price Distortion Ranking Measures

|Trade Openness<br>(most open t|Measure, 1988<br>o least open)|Price Distortion Measure, 1990<br>(least distorted to most distorted)|
|---|---|---|
|Singapore|1|12|
|HongKong|2|2|
|Malaysia|3|13|
|Thailand|9|6|
|Sri Lanka|10|1|
|Indonesia|11|23|
|Pakistan|13|7|
|Philippines|15|15|
|Bangladesh|19|3|
|Nepal|na|5|
|India|na|20|
|Fiji|na|19|

Source: Leamer, Edward (1988), "Measures of Openness" in Robert Baldwin, ed. Trade Policy Issues and Empirical Analysis, Chicago: University of Chicago Press, and Dollar, David, "Outward-Oriented Developing Economies Really do Grow more Rapidly: Evidence from 95 LDCs 1976-85." mimeo.

Table 6: Domestic Saving, Investment and GDP: 1980-90 Average Annual Percentages

||Low Inflation<br>Countries<br>4|<br>Moderate Inflation<br>Countriesb|High Inflation<br>Countries'|
|---|---|---|---|
|Domestic Saving|Rate<br>33.0|21.8|5.7|
|Investment Rate|<br>30.8|25.5|18.4|
|GDP Growth Rate|<br>7.2|5.1|2.7|

Notes: a - Average annual inflation rate of 6 percent or less; b - Average annual inflation rate between 6 and 10 percent; c - Average annual inflation rate greater than 10 percent.

Source: ADB, Asian Development Outlook 1991.
22

# Table 7: Real Interest Rate (in X)

|1970-80|1981-88|
|---|---|
|Bangladesh<br>-5.7|<br>0.1|
|India<br>-0.9|<br>1.1|
|Pakistan<br>-3.3|<br>1.7<br>|
|Sri Lanka<br>0.6|7.8|
|Thailand<br>-0.8|<br>7.4|
|Malaysia<br>1.3|<br>5.0<br>|
|Indonesia<br>-0.1|<br>6.4|
|Philippines<br>-3.0|<br>-1.5|
|China<br>3.3|<br>0.3|
|Korea<br>0.2|5.3|
|Average of the above<br>-0.8|<br>3.4<br>|
|Average of the HICs<br>-2.9|<br>-89.9|

Note: HICs are 17 highly indebted countries<sup>as defined in the World Debt</sup> Tables 1988-89.

Source: World Bank data.
23 Table 8: Volatility of the Real Exchange Rate: 1975-1988

# Coefficient of Variation

|East Asia||
|---|---|
|Korea|0.095|
|Singapore|0.091|
|Thailand|0.106|
|Malaysia|0.094|
|Average|0.097|
|Latin America||
|Argentina|0.247|
|Brazil|0.114|
|Chile|0.274|
|Colombia|0.230|
|Mexico|0.210|
|Peru|0.154|
|Uruguay|0.181|
|Average|0.201|

Source: World Bank data.
24 Table 9. Income Distribution: an International<sup>Comparison</sup>

||Percent of<br>bottom 20%<br>(1)|National I<br>top 20%<br>(2)|ncome<br>ratio<br>(2)/(l)|Per-Capita Income (US$)<br>(3)|
|---|---|---|---|---|
|Asia|||||
|Hong Kong|5.4|47.0|8.70|9220|
|<br>Indonesia|8.8|41.3|4.69|440|
|Korea|5.7|45.3|7.95|3600|
|Malaysia|4.6|51.2|11.13|1940|
|Singapore|5.1|48.9|9.59|9070|
|Taiwan|8.8|37.2|4.23|2530|
|Thailand|5.6|49.8|8.89|1000|
|Average|6.3|45.8|7.27|3971|
|Latin America|||||
|Argentina|4.4|50.3|11.43|2520|
|<br>Brazil|2.4|62.6|26.08|2160|
|Chile|4.2|60.4|14.28|1510|
|Mexico|2.9|57.7|19.90|1760|
|Peru|1.9|61.0|32.11|1285|
|Venezuela|3.0|54.0|18.00|3250|
|Average|3.1|57.7|18.61|2080|
|Industrialized|Countries||||
|France|6.3|40.8|6.48|16090|
|England|5.8|39.5|6.81|12810|
|<br>Italy|6.8|41.0|6.03|13330|
|<br>Japan|8.7|37.5|4.31|21020|
|<br>United States|4.7|41.9|8.91|19840|
|West Germany|6.8|38.7|5.69|18480|
|Average|6.5|39.9|6.14|16928|

Sources: World Bank, World Development Report<sup>(1989, 1990), Washington,</sup> D.C., and country-specific sources. For Chile,<sup>Instituto Nacional de</sup> Estadisticas, September 1989.
25 Table 10 Incremental Capital Output Ratio

|Year|Korea|Thailand|Malaysia|China|Indonesia|
|---|---|---|---|---|---|
|1971|1.47|2.25|1.78|1.97|0.96|
|1972|1.83|2.39|1.48|2.44|1.12|
|1973|1.23|1.61|1.37|1.92|1.05|
|1974|1.63|2.21|1.85|3.42|1.23|
|1975|1.80|2.04|3.14|2.01|1.59|
|1976|1.42|1.56|1.39|16.12|1.39|
|1977|1.86|1.78|1.82|2.05|1.31|
|1978|2.18|1.69|1.93|1.90|1.50|
|1979|2.65|2.23|1.69|2.63|1.72|
|1980|7.77|2.26|2.33|2.52|1.45|
|1981|2.03|2.06|2.65|2.54|2.54|
|1982|2.39|2.24|2.89|2.08|4.86|
|1983|1.84|1.88|2.80|1.96|2.11|
|1984|2.07|2.00|2.49|1.79|2.28|
|1985|2.33|2.39|5.21|2.22|3.52|
|1986|1.72|2.00|3.10|2.84|2.73|
|1987|1.85|1.61|1.96|2.53|2.77|
|1988|1.92|1.50|1.68|2.56|2.34|
|1971-88|2.22|1.98|2.31|3.08|2.03|
|1971-75|1.59|2.10|1.92|2.35|1.19|
|1976-80|3.18|1.90|1.83|5.05|1.47|
|1981-88|2.02|1.96|2.85|2.32|2.89|

Notes: (1) ICOR Investment(t) / [GDP(t) - (1-d)GDP(t-l)J; (2) d - depreciation = 0.07.

Source: World Bank data.
26

# Table 11: Sources of Growth

(Percentage share of output growth accounted for by factor gro'wth and total factor productivity)

||19|60-197|3|197|3-1987||1960-|1987||
|---|---|---|---|---|---|---|---|---|---|
||Capital|Labor|TFP*|Capital|Labor|TFP|Capital|Labor|TFP|
|Africa|59|22|17|92|37|-27|73|28|0|
|East Asia|50|16|35|62|17|20|57|16|28|
|South Asia|81|20|0|55|19|24|67|20|14|
|Latin America|55|20|25|94|51|-47|67|30|0|

Source: World Bank Development Report 1991 ( Table 2.3) * TFP: Total Factor Productivity
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