metadata: authors: 0: author: Conway,Patrick J.
docna: 0: docna: An atheoretic evaluation of success in
            structural adjustment
docty: Policy Research Working Paper
subtopic: Economic Theory & Research,Economic Conditions and Volatility,Industrial Economics,International Trade and Trade Rules,Economic Growth,Inflation,Macroeconomic Management
teratopic: Poverty Reduction
abstracts: cdata!: The author presents and implements a
            methodology for assessing the success of structural
            adjustment based on a "fixed effect" method. He
            examines data for 75 countries over 11 years. Performance
            indicators include measures of inflation, economic growth,
            external balance, and physical investment. He measures
            government policies in terms of spending, trade regime,
            financial deepening, and real exchange rate policy. The
            empirical estimates he obtains suggest that ranking
            countries by adjusted economic performance yields
            significantly different results than ranking them by
            historical performance. Further, countries following a
            prescription of relatively low government spending, deep
            financial markets, and outward orientation in trade policy
            performed significantly better than those that did not. This
            prescription was correlated significantly with more rapid
            economic growth, current accounts with lower deficits,
            expanded investment, and reduced inflation.
repnme: repnme: An atheoretic evaluation of success in
            structural adjustment
display_title: An atheoretic evaluation of success
            in structural adjustment
listing_relative_url: /research/1991/03/700022/atheoretic-evaluation-success-structural-adjustment
topicv3: Macroeconomic Vulnerability and Debt
            m1326057 1104,Economic Growth m1326241 471,Current Account m1326278 1135,Inflation m1326709 0870F4727ACED1CF8525815C00471347,Trade m1326924 698
publishtoextweb_dt: 2010-07-01T00:00:00Z
historic_topic: Poverty Reduction
origu: Policy, Research & Ect Affairs
no_of_pages: 68
author_keys: 0: author_key: 390741
model_extractions: **Trrade P61i;y WPS 629**

This paper- aproduct of the Trade Policy DivisioQ, C-ountryEconomics Department- ispart of alarger effort in PRE to identify empirical regulaiities in the nexus of economic perfornance and goverment policy 'for deve loping countries. Copies are available fre~irom fth World **Bank,** 1818 H Street **NW,** Washington, D%20433. Please contactDawnBallantyne P room -025,extension37947(63pages,with tables).

Conway presents and implements,a methodology perfoimance yields significantly different results for assessing the -success of stnictural adjustment' than ranking themi by historical perfobnmncebased on a "fixed effect" methodology.

Furfthr, counitries following aprescription of He exaroines data for 75 countries over I11 .~~ ~ ~ ~ ~ - relatively low government spending, deep, years. Perfonmance-' licatDrs include measure's firnancial markets, and outward orientatio'i **n** of inflation, economic grow'th, extemnal balance, trade policy performed.significantly befter than andphyica inesuea.Hemeasures govemnthose that did not. merit policies in terms of spending, trade regimie, financial deepening, and real exchange rate' This prescription was correlated significaiitly policy. **o** with more rapid econominic growth, current -acCounitt with lower deficits, expanded investThe empirical estimates he obtains suggest -ment, and reduced inflation.

that iiinking countries by adjusted e4bonomiicThe empirical estimates he obtains suggest 0~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 'th **PRE Working Paro Series disseminates** the rindings **of work** under **way** in **the Bank's Policy, Resxch,** pan **Exterof** al **Affairs Complex. Anobjectiveof theseriesis to get** th **ridings out quickly even ifpremstions are less than fully polished. The findings, interpretations,** andconclusions **inr ipilab fdonotnecarily. rp.eet officialBank policy18** H Produced by **the** PRE Dissemination Center
# Table ogf Contents

# I. Introduction.

# II. Accounting for the External Environment.

A. Methodology B. Data III. Comparing Historical and Adjusted Economic Policy and Performance.

A. The Normal Response to External Shocks B. Country-specific Patterns: Chi-Square Tests C. Country-specific Patterns: Spearman Correlations

- IV. Conclusions.

Bibliography.

Endnotes.

Appendix.

......,.......................................................................

I have benefited in the research underlylng this paper from the financial support of World Bank Research Grant 675-32 and the hospitality of the External Adjustment Division of the IMF Research Department, although neither is to be implicated in the conclusions reached. Thanks as well to Bela Balassa, Jaime de Melo, Lant Pritchett and Dani Rodrik for their comments, and to participants in seminars at the World Bank, North Carolina State University, the University of Florida and Harvat. University. Jeff Konz provided excellent research assistance.
# I. Introducti2n.

Successful structural adjustment programs are a stated goal<sup>of many</sup> developinv-country governments. International financial institutions such as the Ivzld Bank and International Monetary Fund have<sup>made structural</sup> adjustment a major target of lending policy. The US government<sup>enshrined</sup> structural adjustment as the centerpiece of its recommendations to indebted countries in the Baker and Brady Plans. Despite this importance, however, there is not yet a consensus on a definition of structural adjustment or on an appropriate measure of success in structural adjustment. 1 In this study I propose a definition and measurement of structural adjustment, suggest a methodology for identifying those policies conducive to successful structural adjustment, and implement these measures and methodologies<sup>for a</sup> panel of 75 developing countries over an 11-ysar period.

Structural adjustment is often put forward in the rhetoric of free markets. However, as with its predecessor the stabilization program, its roots are more likely found in the integration of developing countries<sup>in.</sup> the world economy. Stabilization programs arose because of<sup>inconsistency</sup> between internal policies and external ba.lance in developing countries. In external balance, current account deficits are offset by sustainable<sup>private</sup> and official capital flows. As documented in Cline and Weintraub (1983)<sup>and</sup> Williamson (1983), stabilization programs were implemented in countries characterized by non-sustainable capital flows and were designed to reestablish external balance in the short run through demand<sup>management even</sup> at the cost of economic growth. Structural adjustment programs,<sup>by</sup> contrast, are based upon the need in the medium and<sup>long run to maintain</sup> external balance but to sustain positive economic growth<sup>and development.</sup> 2
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Structural adjustment is thus a reallocation of resources to best compete in .nd take advantage of thc world environment. Such reallocations are necessary because the world economy hias changed greatly for developing countries since the mid-1970s. Prices of crude oil have quadrupled and then halved in real terms; real interest rates have varied from substantially negative values to substantially positive values; international credit availability for many of these countries has gone from ample to nonexistent.

Despite the stated importance of structural adjustment, there is little agreement on how best to measure it. One method is to examine the policies undertaken by the developing-country governments. If these policies accord with the observer's theory for how structural adjustment is to be fostered, then there is a presumption of structural adjustment. This is most clearly the case in the examples of trade liberalization policies: since trade barriers serve to protect the initial economic structure, their removal will lead to structural adjustment impelled by market forces. In this instance, the implementation of the policies is viewed as the indicator of successful structural adjustment. A second method uses actual economic performance as a gauge for the success of structural adjustment. This method is atheoretical and teleological: if a country performs well in the transition from one world ",onomic environment to another, then it exhibits successful structural adjustment. In the example above, the trade liberalization would not be the evidence of structural adjustment: rather, the improvement of the current account would be.

I define and implement the second methodology in this paper. As measures of economic performance I consider the growth rate in real gross
**-4-**

domestic product (GDP), the domestic consumer inflation rate, the ratio of the current account balance to gross national product (GNP) and e ratlo of domestic investment to GNP. The first two provide an indication of the internal balance of the economy, while the remaining are Indicators of external balance and intertemporal balance, respectively. "Performing well" is defined in relative terms in the context of a cross-country comparison of performance. The few studies implemented using this method<sup>3</sup> have neglected an important feature: they have implicitly assumed that all developing countries faced the same world economic environment. This leads to a biased measure of "performing well"; for example, some countri9s may have been favored by terms-of-trade movements wh'le others were penalized. An unbiased measure will control for these differences in external environment. Performance is also measured as an average across the ten-year period 197786. A country experiencing.a mixture of high growth and deep recession during the period (e.g., Turkey or Chile) will thus have both episodes factored into its measure of performance. A "fixed-effect" methodology is adapted to deal with the econometric problems particular to this type of time-series cross-sectional analysis.

The empirical estimates obtained from implementing this techn:que suggest the following conclusions: (1) Ranking countries by historical economic performance (e.g., economic growth, current account behavior, investment behavior) does not incorporate the differing exigencies of external environment facing the different countries. Once performance is adjusted for external factors, the rankings of relative success are altered dramatically.

(2) Hypothesis testing reveals a clear distinction between countries following a prescriptiou of relatively low government expenditure, deep financial markets and outward-orientation in trade policy and those that do not. This "Classical" prescription
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was correlated in our samples to greater success in economic growth, current account improvement, investment expansion and inflation reduction as well as in measures of income distribution.

Thea conclusions are amplified and exterded in the following sections of the text. In the second section I describe the technique for adjusting economic performance to reflect the external environment and discuss the available data. The third section presents in summary fashion tOA statistical results. The final section presents conclusions and suggestions for extending the analysis.

II. Accounting for the External Environment.

Measures of economic performance will respond systematically to four sets of determinants: external incentives, ticular economic development trends, economic policy choices and country-specific structural factors. The observed historical performance will be attributable to all of these factors, and thus observed success could be due either to stimulative economic po:.icy choices or to the serendipity of a favorable external environment. From the country's point of view, of courae, either is welcome. However, for purposes of identifying economic policies successful in structural adjustment it is important to decompose performance into that part attributable to policy and structure and that part due to external incentives or secular trends. The former will provide a useful crosscountry measure of successful structural adjustment. In the following parts I discuss the methodology and the data used in this analysis.
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Methodology.

The systematic relationship between performance and environment can be represented in reduced form for country i in period t (t - 1,2,...,T) as: ai* is a measure of systematic country-specific contribution to economic performance. The three data matrices -- Xit, Sit and Pit -- include time series of variables measuring incentives (and disincentives) to economic performance. The external incentives in Xt can be either price-based (e.g., terms of trade, real interest rate) or macroeconomic (e.g., world demand, debt burden) in nature. The columns of Sit ar.d Pit measure secular economic trends and policy choice respectively. c it is the random component and is assumed independently distributed across time periods. b2 ci and gi are conformable vectors measuring country-specific responses to these incentives.

There are three important elements of country-specific behavior that can be decomposed in this analysis. First, a large ai in comparison with other countries indicates country-specific suc,...s given a stable international environment. Second, the country's economic structure as captured in tbi,ci,gi) can be relatively more or less successful in responding to changes in the environment. Third, government policy (Pit) can be more or less flexible in responding to changes in the environment. I illustrate the first two elements by transforming equation (1) to introduce a "normal" structural response to changes in the environment denoted by the vectors b, c and g for T periods. 4
-7

(2) Yit - ai + Xitb + Sitc + Pitg 4 ,it

***** ~ with ai - as + [Xi(bi-b) + SL(c.-c) + Pj(gj-g))]

fit **e *it** + (Xit.Xi)(bi-b) + (Sit-Si)(ci-c) + (Pit Pi)(gi 8) and Wi (Et Wit]/T for all variables Wit.

The intercept ai includes two effects. The first, given by ai*, represents idiosyncratic country performance abilities. The second, given by the terms in Xi. Si and Pi, indicates the country's structural flexibility in adjustment to secular evolution or external and policy shocks compared with the "normal" response. The terms in b, c and g are the "normal" responses to country i's economic environment. The error term Cit incorporates the random error and the cross-period variability in cour .ryspecific response. Given the definitions of the time-series means the error term ,it has an expected value of zero; however, it may exhibit cross-period autocorrelation.

The term "normal" is used as in the seminal work of Chenery and Syrquin (1975) in a descriptive rather than normative sense. A normal response can be defined as an average structural and policy response to the external environment. Least-squares regression is used to derive this average - response. Suppose that there are M countries (i 1,2,...,M). Stack the vectors Yit into the (MTxl) column vector Yt - (Ylt' Y2t ... YMte] . Stack the vector eit and the matrices Xit, Zit and PLt similarly. Define a blockdiagonal intercept matrix Ai with dimension (VLTxH) and the mth block consisting of a (Txl) vector of am in the mth column. Least-squares
-8-

regression can be used to derive estimates of b, c, g and the countryspecific ai as in equation (3).5 (3) Yt - Ai + Xtb + Stc 4 Ptg + et Although the technique introduces sote econometri **c** omplexities, it allows identification of economic performance by country corrected for the 6 hospitality (or lack thereof) of the external and policy environment. This measure of economic performance will serve as the basis of crosscountry comparisons of success in structural adjustment.

The government policy choice Pit is a third component of countryspecific economic performance. It is also an endogenous decision, and can be representecs by a reaction function. Observed policy dill then have the characteristics in equation (4), with an autonomous (and country-specific) component Gi, a component induced by external and secular variables (Xitpix + Sitpis) and a random component * it.

(4) Pit - _Gi_ + Xitpix + Sitpis + v it This can be rewritten using a decomposition as above to highlight the normal and country-specific aspects olI this policy choice. qi is the countryspecific component of policy choice that is of interest, while Pit is the random component. p5 and Px represent normal policy reactions to external and secular shocks, respectively.

(5) Pit - qi + Xitpx + Sitps + Pit
_-9._ with qi - _Gi_ + Xi(Pix-Px) + Si(ftP-Ps) and Vit W v* it + (Xit-Xi)(Pixapx) **+** (Sit-Si)(pis-ps) When equation (5) is substituted into (1), the fixed-effect estimation equation can be rederived in substantially the same form as in (2).

(6) Yit -Mi + _XitB_ + Sit7 + nit with ai - ai + qig - - b **+** pxg 7 - C + p8g 6 nit * it + pit These matrices can be stacked as in preparation of equation (3) to allow fixed-effect estimation of ai, jO and 7.7 ai will thus capture all three components of country-specific economic performance outlined above. The gist of the method can be presented in Figure 1. Suppose that the economic performance measure of interest is the current account/GNP ratio (C), and that Countries A and B have observed (negative) ratios of CA and CB, respectively, in this period. The two countries have observed terms-oftrade in that period of TA and TB, respectively, and otherwise face an identical external environment. CA is less than CB, so that<sup>an initial</sup> examination of the evidence suggests that B has a more successful externalaccount performance than A. However, there is a normal relationship observed historically between the terms of trade for a country and its current account: as the term of trade improve (T rises) so also will the current account.8 This normal relationship is illustrated in Figure 1 by the slope of the line C(T).
<!-- Start of picture text --> C,~~~T<br>4 \. _ . _' j _ _ Se'<br>C4<br>. C./,C<br>C. C.<br>Figure 1<br>Comparisons of Historical and<br>Adjusted Current-Account Performace<br><!-- End of picture text -->
10 -

-

To adjust for the external environment, both countries' performances should be evaluated as if they faced the<sup>same terms of trade. By doing</sup> this, the comparison is corrected for<sup>external differences and focuses on</sup> policy and structural differences<sup>between the economies. In Figure 1 this</sup> compazi.son is made by projecting points A and B<sup>onto the vertical axis using</sup> the slope of the normal relationship.<sup>This projection could be done to any</sup> common terms of trade -- in i.he empirical section of this study<sup>I derive a</sup> normal value of T for this evaluation.<sup>The adjusted current account</sup> performance for A and B is defined relative<sup>to CO and is given by the</sup> measures<sup>0</sup> A and GB- It should be clear<sup>from the figure that the value of CO</sup> is not of importance in comparisons of<sup>adjusted performance. As the figure</sup> indicates, the rianking of adjusted performance for countries A<sup>and B is</sup> reversed from the historical ranking<sup>-</sup> country A was more successful than the norm in dealing with a deteriorated<sup>terms of trade, while country B was</sup> less successful given its elevated terms<sup>of trade. If third countries were</sup> looking to this pair for guidance on<sup>improving current account performance,</sup> they would do well to choose country A<sup>as the exemplar despite its lower</sup> observed current account ratio.

Thq terms of trade is for most developing<sup>countries a relative price</sup> outside their control. Once determined,<sup>it has a direct effect on economic</sup> performance -- not only on the current account, but for<sup>economic growth,</sup> investment, inflation and other measures. It<sup>and other such variables</sup> define an environment within which the developing<sup>country must operate. The</sup> country's success will be relative to<sup>that constraint. Among the variables</sup> treated as external constraints in the<sup>empirical section are the real</sup> interest rate, the terms of trade, the country's<sup>level of economic</sup>
11 -

-

development (as proxied by the share of agricultural output in total output), and its previous accumulation of external debt.<sup>9</sup> They define the field on which economic policy will play, and thus the economic policy will be judged relative to the condition of the field.<sup>10</sup> Government policy will have direct and indirect ef'ects on country success (or lack thereof) in stabilization and structural adjustment, but will itself be dependent upon the external environment. I focus on three policy instruments often identified with stabilization and structural adjustment programs: the real exchange rate, the ratio of government current spending to GNP and the degree of financial deepening of the economy. Economists since Salter (1959) and Swan (1963) have identified use of the real exchange rate and government spending with attainment of initernal and external balance. Positive domestic real interest rates have been more recently identified as incentives to lncreased domestic investment through the channel of financial deepening as first discussed by McKinnon (1973) and Shaw (1973). More recently, descriptions of structural adjustment as a strategy have noted its reliance on relative price movements to provide appropriate incentives to private actors (see, eS,, Reisen (1985), Conway (1987) and Celasun and Rodrik (1989)). Consideration of the real exchange rate and the degree of financial deepening addresses the fundamental relative prices of foreign to domestic goods and of consumption to saving.<sup>11</sup> Correction for the external environment through regression analysis will leave a country-specific component to policy that can be used to estimate a policy position for each country. This position will be defined relative to a normal policy stance in a manner analogous to that of the performance measures.
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Once the adjusted performance indicators are derived I compare them across countries in two ways. Statistical tests are performed to see what countries stand out as relatively greater or lesser successes in each dimension of economic performance, and then their chosen policies (also adjusted for the economic environment) are examined for similarities. Chisquare statistics from contingency tables and Spearman correlation analysis are also used to identify common rankings of countries by their countryspecific economic performance. These comparisons of rankings are nonparametric but permit an identification of common elements in the policyperformance nexus across countries.

hta.

I have assembled data for 75 countries from the 1989 World Tables and World Debt Tables of the World Bank; the characteristics and precise definitions of these data and countries are given in the appendix. The measures of economic performance examined in this study include the growth rate in real output (YGR), the inflation rate (DINF), the current account/GNP ratio (CAR) and the domestic investment/GNP ratio (IR). These are not exhaustive, but reflect performance along a number of dimensions important to the developing country. YGR and DINF are indicators of internal balance: success in structural adjustment occurs when resources are being allocated efficiently and with little excess demand. CAR measures performance in attaining external balance; structural adjustment has most recently required adjustment to limited access to international credit, and this variable measures relative success in that. IR is a measure of intertemporal balance: even though policies and external events may
13 stimulate growth and adjustment, this will not be sustainable without a concomitant expansion in productive capacity.

I have collected as well comparable data on economic policy choices in these countries. The ratio of government current expenditure to GNP (GOVGNP) is a measure of fiscal policy stance. The ratio of money, broadly defined, to nominal GNP (MON) is an indicator of the monetization and financial deepening of the economy. The normalized real exchange rate index (RERA, RERB) illustrates government's efforts to maintain competitiveness in international trade. The trade regime index (TRAREG) is drawn from rankings provided in World DeveloDment Report 1987 and measures the overall outward orientation of the economy.

The environment within which structural adjustment policies are made and economic performance is attained is characterized by the countryspecific realizations of the external variables cited above. The real international interest rate (RR) is defined ex Rost by subtracting the US inflation rate from the country's average nominal rate on international borrowing. International debt is total debt, including private, public and publicly guaranteed, deflated to billions of 1980 US dollars. It is stated in ger ca2ita form, and is divided into a longer-term component (LTDPC) and a short-term component (STDPC).12 The terms of trade (TOTA, TOTB) is the ratio of average export to average import prices normalized as described in the appendix. It is likely that there are other common international influences on economic performance in these countries as well, and to measure the influence of these I introduce a series of year-specific dummy variables (D7 for 1977 through D5 for 1985) as explanatory variables. These will register, for example, the growth in world real demand for imports or
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the impact of restrictions on international credit that as Sachs (1989b) documents were imposed in the post-1982 period.<sup>13</sup> The share of total output produced in the agricultural sector (YASHR) is a proxy variable inversely related to the country's secular stage of economic development.

Least-squares estimation is used to calculate the normal response of performance ard policy measures to the external environment and to derive the appropriate country-specific adjusted measures. The intercept is set so that at panel averages of the external factors the equation generates the average, or norm, of the dependent variable. The other fixed-effect coefficients in the regression results represent the deviation of countryspecific performance from that normal performance.

Given the cross-country and time-series nature of the panel data, it is reasonable to expect e'lements of both heteroskedasticity and countryspecific serial correlation in the errors. Use of least-squares estimation techniques will assure unbiased estimates of the parameters even in the presence of these elements. However, the variance-covariance matrix of coefficient estimates must be corrected to test hypotheses about these estimates. The results presented below incorporate these corrections, and the correction methodology is presented in detail in the appendix.

III. Comparing Historical and Adiusted Economic Policy and Performance. There are two important sets of statistics that result from of the "fixed-effect" regression analysis. The first are the coefficients of the external-environment variables: these indicate the extent of commonality of developing-country response to external shocks. The second are the
- 15 -

coefficients of the country-specific dummy variables: these "fixed effects" are the adjusted measures of country-specific performance and policy. The latter are amenable to two different methodologies for correlating performance measures with one another and with the policy measures undertaken. The first method takes a country perspective, and compares those countries that had performance significantly different from the norm to identify any common characteristics of that performance. The second examines correlations of policy position and structural adjustment performance across countries. Chi-square statistics from contingency tables and Spearman rank correlation coefficients are used to identify statistically significant groupings of countries within the sample. In this second methodology it is also possible to introduce country performance for areas in which annual data are not available. It is useful to define a specific policy strategy including deep financial markets, outward orientation, a depreciated real exchange rate and relatively low current expenditure ratio as a Classical prescription. The results that follow will provide evidence of a link between successful structural adjustment and the Classical prescription.

# The Normal Resgonse to External Shocks.

Table 1 presents the results of the five generalized least squares (GLS) regressions of structural performance variables on external variables and "fixed effect" terms.14 These provide strong intuicive support to the notion of a normal response to the external environment.

The explanatory equation for economic growth illustrates quite plausible normal relations between the external environment and growth performance. Each standard-deviation improvement in the terms of trade is
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associated with an additional .88 percentage points in growth, while each percentage point increase in the real interest rate facing a country is correlated with a .2 percentage point fall in economic growth. Both longand short-term debt burdens reduce economic growth significantly; each $1 increase in gar caRita debt is associated with a fall on average of 2.4 and 8.0 percentage points in the growth rate. All of these effects except that of long-term debt are significantly different from zero at the 95 percent level of confidence, and that coefficient is significant at the 90 percent level. Year-specific dummy variables were not jointiy significant in this regression at the 90 percent level.

The domestic inflation regression picks up a number of interesting cross-country characteristics of inflation generation. First, there is no evidence of transmission of inflation from developed to developing countries, even controlling for other external factors. The US inflation rate, as a proxy for world inflation, has a negative coefficient in the equation -- during this period as the US inflation rate came down the domestic inflation rates rose on average. Ceteris 2aribus, the leastdeveloped countries have significantly higher inflation rates. Increases in real interest rates on external borrowing are associated with significantly lower inflation, while increased debt burdens are associated with significantly higher inflation. Terms of trade improvements are correlated with higher inflation, but only insignificantly so.

The CAR regression results do not accord well with the predictions of the balance of payments constraint. As expected, an improvement in the terms of trade is correlated with a significant improvement in the current account. However, the real interest rate and real ger capita debt variables
- 17. -

Table 1 <!-- Start of picture text --> Impact of Environment on Adjustment Performmnee<br><!-- End of picture text --> <!-- Start of picture text --> YGR DINF CAR IR<br>Intercept# 4.070 -1.62 -8.60 28.00<br>USINF -0.561*<br>YASHR 0.037 0.755** 0.082 -0.225**<br>TOTB 0.881** 1.015 1.645** 0.385**<br>RR -O.180** -0.845** 0.061 -0.102*<br>LTDPC -2.402* 18.567** 8.393** -8.473**<br>STDPC -8.015** 3.916 2.708 -3.599<br>D7 -0.581 1.345**<br>D8 -0.979 2.048**<br>D9 -0.524 1.877**<br>DO -1.803** 2.189**<br>Dl -2.149** 2.319**<br>D2 -2.421** 1.367**<br>D3 -0.498 -0.233<br>D4 -0.308 -0.070<br>D5 0.099 -0.505<br><!-- End of picture text --> <!-- Start of picture text --> Summary statistics:<br>R2 - 0.46 0.64 0.63 0.90<br>F value 7.12** 14.25** 12.09** 63.47**<br><!-- End of picture text -->

-

- Intercept was not estimated. It was chosen to center fixed-effect terms around a median of zero.

- ** - Significant at 95 percent level of confidence.

- - Significant at 90 percent level of confidence.
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have positive coefficients; the balance of payments identity suggests that these should be negative. The only one of the three significantly different from zero is that associated with long-term debt, and that may be due to the investment uses of that debt generating exporc.,Ae or import-competing product.15 The year-specific dummy variables indicate a sample-wide ability to sustain larger negative current-account ratios in years previous to 1986 than in 1986 itself. This ability was most pronounced in the period 1980-1982; in that year the sample average current-account ratio was ceteris 2aXLbus 2.4 percentage points more negative than in 1986.

The investment ratio regression accords well with economic intuition. A more industrial economy (as indicated by a decline in agricultures share in output) is significantly correlated with a larger investment ratio; so also is an improved terms of trade. Higher real interest rates, short-term and long-term debt burdens are all associated with reduced investment ratios. An increase of one percentage point in the real interest rate is correlated with a fall of .1 percentage points in the investment ratio, while $1 increases in geX caRita debt are associated with reductions of the investment ratio of 3.6 to 8.5 percentage points. The year-specific dummy variables indicate a sample-wide tendency toward higher investment ratios during the pre-debt crisis period. In 1981 the average investment ratio was ceteris R over 2 percentage p ints higher than in 1986, while in the 1983-1985 period investment ratios were on average only slightly above that of 1986.

These regressions indicate the importance of the external environment to the adjustment performance of the sample countries. Improved terms of trade are significantly associated with improved economic growth, investment
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and the current account. Further, an increased burden of international debt contribute **s** ignit1cantly to slower economic growth, higher inflation and lower investment ratios. Higher real interest rates on international borrowing are also associated with lower economic growth and the investment ratio. The significant coefficients on country-specific dummy variables suggest that other external factors not explicitly accounted for in the regression are important in understanding external and intertemporal imbalances.

There is as well a normal impact of the external environment on the policy structure of economies. Table 2 examines these common impacts for current government expenditure (GOV), the index of financial deepening and a normalized real exchange rate index (RERA).

MON, money broadly defined, is. an indicator of financial deepening in the economy.16 As McKinnon (1973) suggested, non-inflationary monetization of the economy may increase efficiency in allocation of goods while increased use of other financial instruments may improve efficiency in allocation of saving. This ratio will register both, but will exclude monetizat: n leading only to inflation. The regression results suggest that financial deepening is associated with higher world real interest rates and with higher Rer capita international debt. There has been as well a samplewide tendency toward financial deepening, with ratios in 1986 being on average over 3 percentage points higher on average than in 1977.

Government current expenditure as a share of GNP is rising with level of development. It is falling with improvements in terms of trade, perhaps because social expenditures need increase less rapidly than GNP as the terms
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................

Table Impact of Environment on Adjustment Policy <!-- Start of picture text --> MON GOV RERA<br>Intercept# 38.20 19.10 21.40<br>YASHR 0.041 -0.150** 0.844**<br>TOTB -0.332* -0.382** -1.554**<br>RR 0.329** 0.058** 0.155<br>LTDPC 8.871** -0.544 -4.407<br>STDPC 8.896** 0.927 15.433*<br>D7 -3.070** 2.318<br>D8 -3.030** 0.399<br>D9 -2.695** 1.648<br>DO -2.266** 0.718<br>Dl -2.027** 3.988**<br>D2 -1.788** 4.339**<br>D3 -1.477** 4.006**<br>D4 -0.738 4.055**<br>D5 -0.422 4.306**<br>Summary statistics:<br>R2 0.91 0.97 0.82<br>F value 76.52** 232.18** 31.88**<br>...................................... ..............................................................................<br><!-- End of picture text -->

- The intercept was not estimated, but was chosen to center the fixedeffect terms around a median of zero;.

- ** - Significant at 95 percent level of confidence.

- - Significant at 90 percent level of confidence.
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of trade improve. Higher real interest rates and increased short-term international debt are associated with an increase in GOV, while higher long-term debt is negatively correlated. The non-debt coefficients are significant at the 95 percent level of confidence.

The real exchange rate has a sensible relation to the external environment. 17 RERA is defined to be appreciating as it rises. It is increasing in YASHR, indicating that the least-developed countries are those with the more appreciated real exchange rates, ceteris Raribus.

Improvements in the terms of trade are associated with depreciation of the real exchange rate; this suggests that nominal exchange rate choice is not the dominant determinant of the real exchange rate, since real depreciation due to nominal depreciation should also be correlated with terms-of-trade deterioration. Short-term debt is also significantly associated with real appreciation, as countries have been able to finance current account deficits and maintain real appreciation. There is evidence of sample-wide real appreciation during the period 1981-1985 after other factors have been controlled for, with a sharp average real depreciation in 1986.

The evidence of Table 2 suggests that adjustment policy in the period under consideration was quite responsive on average to the external environment. Financial deepening was clearly associated with greater reliance on international debt and with higher world real interest rates. Government current expenditure appeared to move counter-cyclically with terms of trade improvements while of necessity rising with real interest charges. The real exchange rate demonstrated the financing-adjustment tradeoff by maintaining a greater appreciation for countries and periods with greater short-term international debt.
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Country-speciRic patterns: chi-square tests.

The fixed-effect regressions underlying Tables 1 and 2 not only define the normal response to the external environment but also provide countryspecific measures a. Analysis of the ai permits identification of patterns in the cross-country incidence of success at structural adjustment and policy implementation. I consider two non-parametric statistical. tests for patterns: chi-square statistics from contingency tables and Spearman rank correlation coefficients.

The most general use of the information embodied in the Oi is possible through examining their values relative to the normal value of zero. It will be evidence of a significant linkage between policy and successful performance if positive ai in investment performance, for example, is disproportionately correlated with positive oML in financial deepening. The significance of such a relation is measured through the contingency table: each cell corresponds to the number of times possible combinations of aIi and aMi occur in the estimation results. For example, the vi observed in estimation had the pattern given in Table 3: this pattern is sufficiently disproportionate that a chi-square test rejects the null that no pattern is present in the underlying population at the 95 percent level of confidence. The pattern evident in the data is that positive aML occur disproportionately often with positive ali, and similarly for negative values: this is evidence of the importance of financial deepening to investment success.

Similar chi-square statistics can be calculated for each pair of performance and policy variables, and a summary of these results is reported in Table 4. These indicate a number of intriguing policy/performance
- 23 .

Table 3 <!-- Start of picture text --> Contingency Table and Chi-Square Statistic<br>IR Performance by MON<br>Contingency Table<br>I SNi<br>FREQUENCY I<br>PERCENT I <c0 > 0 TOTAL<br>. -......-..-...- +*------+<br>< 01 251 131 38<br>I 33.33 I 17.33 I 50.67<br>aIi ''''- '+--'''+---''+<br>> 0 141 231 37<br>I 18.67 I 30.67 I 49.33<br>.................. +. +.. +.<br>TOTAL 39 36 75<br>52.00 48.00 100.00<br>Chi-Square Statistic<br>Value 5.868<br>Degree of Freedom 1<br>Probability of Random<br>Underlying Distribution 0.015<br>Sample Size 75<br><!-- End of picture text -->
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Table 4 Summary of Results: Chi-square statistics from contingency tables

|Variables<br>..................................................|x2<br>......................|Prob value|Direction of<br>correlation|
|---|---|---|---|
|YGR by MON|2.962|0.085|positive|
|by GOV|3.099|0.078|negative|
|by RERA|0.013|0.909||
|by COMP|6.676|0.463||
|DINF by MON|0.111|0.739||
|by GOV|4.945|0.026|negative|
|by RERA|3.448|0.063|positive|
|by COMP|9.403|0.225||
|CAR by MON|0.017|0.897||
|by GOV|13.058|0.000|negative|
|by RERA|2.595|0.107||
|by COMP|21.458|0.003||
|IR by MON|5.868|0.015|positive|
|by GOV|2.987|0.084|positive|
|by RERA|0.013|0.909||
|by COMP|5.243|0.630||

The statistic reported is the chi-square value calculated by forming the contingency table of positive and negative ai for the two variables named. The final column is the direction of disproportionate correlation if significant: for example, in the correlation of ayi from the YGR equation and aMi from the financial deepening equation positive values occurred disproportionately with posit. e values and similarly for negative.

Each statistic has 1 degree of freedom, except those of variables with COMP; thcse have 7 degrees of freedom. There are 75 observat.ons for all variables except GOV (74 observations) and RERA (65 observations).

COMP is a variable with eight values; each one corresponds to a different permutation of policy realization relative to the norm (example: COMP-1 implies above-normal financial deepening, above-normal current expenditures and a real appreciation relative to the norm). A significant chi-square value indicates that the policy mix realized significantly affected the performance realized.
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# Table 5

<!-- Start of picture text --> Summary of Results: Chi-square 3tatisti¢s from contingency tables<br>Significant ai only<br><!-- End of picture text --> <!-- Start of picture text --> Variables x2 Observations Direction of<br>correlation<br>......... ......................... .. ... ..................................... __. . ........._ ... ......................<br>YGR by MON 13.80 14 Positive<br>by GOV 1.78 15<br>by RERA 0.25 4<br>CAR by MON 0.16 10<br>by GOV 4.94 9 Negative<br>by RERA 1.07 3<br>IR by MON 64.00 22 Positive<br>by GOV 13.44 23 Positive<br>by RERA 2.04 7<br>DINF by MON 0.00 5<br>by GOV 0.00 6<br>by RERA 0.00 3<br><!-- End of picture text --> Critical values for chi-square with one degree of freedom: 2.71 at 90 percent level of confidence 3.84 at 95 percent level of confidence There were no measures of domestic inflation performance significantly less than the norm of 20.00 chosen; as a result, these chi-square values were necessarily zero.
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interrelations. Using the 90 percent level of significance, there is a significant correlation between above-normal economic growth performance and above-normal financial deepening, and also between b2low-normal economic growth and above-normal current government expenditures. Above-normal current-account performance is negatively correlated with government current expenditure. Above-normal domestic inflation is significantly associated with real appreciation, as expected; and also with above-normal current government expenditures. The positive correlation between investment performance and financial deepening was remarked upon earlier; also evident is a positive correlation between investment and government current expenditure performance. There is a significant difference among policy mixes in achieving above-normal performance only in the case of the current account.

The chi-square statistics can be recomputed using only those ai significantly different from zero in the underlying regressions. These are less reliable statistics because of the lower number of observations, but they reinforce the conclusions of the complete sample.18 Table 5 reports these results. Above-normal economic growth is positively and significantly associated with financial deepening. Current-account performance is negatively associated with high current government expenditures. Abovenormal investment performance is correlated with above-normal financial depth and with above-normal government current expenditure.

The associations of these two tables suggest an assignment of policy to performance targets. Financial deepening is positively correlated with real investment and with economic growth. Real current government expenditures
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do best by doing least as evidenced by their negative correlations with economic growth, current account performance and inflation. Countrv-specific Ratterns: Spearman correlations.

The second non-parametric methodology for analysis of the fixed-effect results is through Spearman rank correlation statistics. The contingency tables use relatively little of the information irnherent in the ai. The Spearman rank correlation coefficient measures the correlation in the ranks **(ii..,** position among the 75 countries) of countries' adjusted policy and structural adjustment performance. It is a nonparametric technique that places weight not on the absolute values of estimated coefficients but on their relative sizes.

Spearman rank correlation coefficients are presented in Table 6 for the adjusted performance measures derived from fixed-effect estimation. The patterns uncovered in the contingency tables remain, while others less visible there emerge. For example, relative success in economic growth as measured by adjusted rankings is positively and significantly related to financial deepening, to below-normal government current expenditure and to above-normal investment performance. Rather than having growth fueled on average by large current account deficits or large current government expenditures during this period, there was on average a tendency to greater adjusted economic growth from those with more balanced adjusted current accounts and limited current expenditure ratios.

Success on the adjusted current account is negatively and significantly correlated with the two adjusted absorption measures aned positively correlated with the measure of output, reflecting the income-absorption interpretation of the current account. Current-account performance has a
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Table 6

|||SPEARHA<br>(|N CORRELA<br>75-country|TION COEF<br> <br>sample)|FICIENTS||
|---|---|---|---|---|---|---|
||YGR<br>................|CAR<br>....................|IR<br>................|HON|GOV|DINF|
|YGR|1.0000|00.11963|0. i,3852|0.23829|-0.24052|0.15397|
||0.0000|0.3066|0.0001|0.0395|0.0390|0.1872|
|CAR|0.11963<br>|1.00000<br>|-0.29869<br>|-0.02088<br>|-0.30053<br>|0.29690<br>|
||0.3066|0.0000|0.0092|0.8589|0.0093|0.0097|
|IR|0.4385<br>|2 -0.2986<br>|9 1.0000<br>|0 0.3386<br>|1 0.1163<br>|6 -0.06842<br>|
||0.0001|0.0092|0.0000|0.0030|0.3235|0.5597|
|NON|0.2382|9 -0.0208|8 0.3386|1 1.0000|0 0.2556|2 -0.14882|
||0.039|5 0.858|9 0.003|0 0.000|0 0.027|9 0.2026|
|_.Gy_|0.2405|2 -0.3005|3 0.1163|6 0.2556|2 1.0000|0<br>-0.26285|
||0.039|0 0.009|3 0.323|5 0.027|9 0.000|0 0.0237|
|DINF|.0.153|97<br>0.2969|0 -0.0684|2<br>-0.1488|2<br>-0.2628|5 1.00000|
||0.187|2 0.009|7 0.559|7 0.202|6 0.023|7 0.0000|

The first statistic in each pair is the Spearman rank correlation coefficient. The second is the probability that the absolute value of the observed correlation will occur for null hypothesis of zero correlation. There are 75 observations for each correlation with the exception of GOV; those have 74 observations.
- 29 -

near-zero correlation with financial deepening, but is positively related to inflationary performance.

The investment ratio performance rankings are negatively correlated with the current account rankings -- the trade-off mentioned in the preceding section -- and correlated significantly and positively with output growth. Inflation is in orthodox theory seen as a spur to physical investment; in this sample of countries, even after adjusting for external conditions, there is some indication that the opposite occurs. The positive linkage between financial deepening and the investment ratio is both significant and large.

Domestic inflation in this sample is significantly and positively correlated with ui-ccess on the current account, and negatively correlated with current government expenditures.

These correlations provide additional advice on assignment of policy to performance; the relevant Spearman correlations are provided in Table 7. There is a clear preference in the data for financial deepening and for reduced current government expenditure in achieving faster economic growth. Financial deepening is positively correlated with investment success and correlated as well (though not significantly) with reduced inflation. Reduced government current expenditure works to reduce inflation and current account deficits as well. It is surprisingly the case that real adjusted depreciation plays no role in the policy mix: there are only insignificant correlations between real exchange rate regime and performance ranking. To further investigate the importance of external policy in structural adjustment I consider the correlation of adjusted performance measures with an index of the openness of their trade regime (TRAREG) as assessed by the
- 30 -

Table 7

# Spearman Correlations: the Policy Mix

||YGR<br>. .........................|CAR|IR<br>.....<br>.....|DINF<br>.....<br>...<br>...**.**....|
|---|---|---|---|---|
|_GOV_|-0.24052|-0.30053|0.11636|-0.26285|
||0.0390|<br>0.0093|<br>0.3235|0.0237|
|_MON_|0.23829|-0.02088|0.33861|-0.14882|
||0.0395|<br>0.8589|<br>0.0030|0.2026|
|RERA|-0.09952|0.08951|0.02212|<br>0.23999|
||0.4303|<br>0.4783|<br>0.8612|0.0542|

The first statistic in each pair is the Spearman rank correlation coefficient. The second is the probability that the absolute value of the observed correlation will occur for null hypothesis of zero correlation. There are 75 observations for each correlation with the exception of GOV (74 observations) and RERA (66 observations).
- 31 -

World Bank in its World DeveloDment Regort 1987, p. 83. In the World Bank rankings, countries were classified in one of four categories: strongly outward oriented, moderately outward oriented, moderately inward oriented and strongly inward oriented. This ranking, with strongly outward oriented the top rank, was used in the Spearman correlations of Table 8.

The World Bank ranking by trade regime presumably took into consideration the real exchange rate policy of each country; there should thus be a negative correlation between trade regime and adjusted real exchange rate ranking. This correlation exists, but is rather small. Rankings by trade orientation are positively correlated with rankings by economic growth, reduced domestic inflation and current account success. The policies of financial deepening, low government expenditure ratio and outward trade orientation are significantly combined in countries experiencing above-average economic results on external and internal balance.

Contingency tables and correlation analysis provide no testing of causal relationships. In the present analysis, it is impossible to choose from among those positive policy influences to identify which (if not all) caused the relative success in structural adjustment. These results do establish, however, some stylized facts about the structural adjustment process that will be useful in future theoretical research and policy planning in this area.

These conclusions are based upon a complicated statistical technique. It is useful to compare the results with those of unadjusted (j,e, historical) rankings in terms of performance and policy. Spearman correlations based on such rankings are presented in Table 9.
- 32 -

Table 8 Spearman Correlations using the Trade Regime Index

||YGR|CAR|IR|DINF|RERA|HON|GOV|
|---|---|---|---|---|---|---|---|
|TRAREG|0.748|0.010|0.352|0.095|<br>-0.315|0.331|<br>-0.247|
||0.00|0.95|0.03|0.57|<br>0.06|0.04|0.14|

Table 9

# Spearman Correlations: Unadjusted Performance and Policy Rankings (75-country sample)

|||HYG|R<br>HCAR|HIR<br>HDINF||
|---|---|---|---|---|---|
||HYGR|1.00000|0.05587|0.40828<br>-0.39024||
|||0.0000|0.6340|0.0003<br>0.0005||
||HCAR|0.05587|1.00000|0.08817<br>0.12728||
|||0.6340|0.0000|0.4519<br>0.2765||
||HIR|0.40828|0.08817|1.00000 -0.27957||
|||0.0003|0.4519|0.0000<br>0.0151||
||HMON|0.22421|0.02191|0.54996 -0.17642||
|||0.0531|0.8520|0.0001<br>0.1300||
||HGOV|-0.1073|5 -0.27390|0.29676 -0.26264||
|||0.3626|0.0182|0.0102<br>0.0238||
||HDINF|-0.3902|4 0.12728|-0.27951<br>1.00000||
|||0.0005|0.2765|0.0151<br>0.0000||
||HRERA|-0.35280|-0.01651|-0.31957<br>0.28790||
|||0.0037|0.8953|0.0089<br>0.0150||
||HYGR<br>|HCAR|HIR<br>|HDINF<br>HRERA<br>HMON<br>;<br>|HGOV|
||.**....**..................<br>||... ............<br> <br>|.._................<br>................<br> <br> <br>||
|RANKTRA|0.559|0.074|0.458<br>|-0.129<br>-0.454<br>0.415|0.045|
||0.00|0.66|0.00|0.44<br>0.00<br>0.01|0.78|
- 33 -

These results are quite comparable to those using adjusted performance measures as reported in Tables 6 through 8. Here as well is evidence of the importance of financial deepening to internal and intertemporal balance, and of lower government current expenditure to external balance. There are a number of important differences as well. The historical (unadjusted) measures indicate a significant impact of real devaluation on economic growth and the investment ratio; these correlations lose their significance in the adjusted measure. The historical measures as well indicate a growthinflation tradeoff as well as an investment-inflation tradeoff that are insignificant in the adjusted measures. In addition, analysis using the adjusted measures suggests tha. reduced government current expenditure is significantly associated with increased economic growth: that correlation is there, but insignificantly so, in the historical analysis. The final section of Table 9 demonstrates the power of the index of trade regime in historical data as well.

# IV. Gonclusions.

Structural adjustment policies can be -.cliated in an atheoretical manner by examination of observed economic performance. However, doing so requires both correction of historical performance for the hospitality of the external environment and definition of a benchmark against which individual country performances can be compared. The body of this paper presents the econometric methodology and estimation results that make that correction and definition.

Measures of structural performance measures are altered significantly by the adjustment for the hospitality of the external environment. Rankings
- 34 .

of countries based upon observed economic growth, current account or investment ratio performance are quite different from those that control appropriately for events beyond the country's control. Analysis of these adjusted rankings provides systematic evidence for three of the anecdotal conclusions of the structural-adjustment debate. First, there is an important negative linkage between current account improvement and reductions in investment ratios. Second, an outward trade orientation is strongly correlated. with success in achieving both internal and external balance. Third, there is a presumption in favor of deep financial markets and lower current government expenditure for more successful structural adjustment.

The results raise some puzzles as well. Real exchange rate depreciation is not so strongly correlated with successful structural adjustment as is supposed in most of the literature (and as is true in the unadjusted data). There does not seem to be a trade-off across countries between high economic growth and current-account deficits: those countries successful at one are more often successful at the other on average.

This research can be carried in two directions from this point. First, these issues can be examined for a larger number of policy and performance measures, and for more countries -- conceivably the analysis can be undertaken for the entire population of developing countries. This increased coverage would improve the precision of the lessons to be learned. Second, the rankings and correlations that emerge from section III can be used as "stylized facts" to inform a new generation of theorizing about the process of structural adjustment. Rather than beginning from theoretical
- 35 -

first principles, we can begin from the observed behavioral patterns to assemble a more complete theory of this adjustment process.