IV Why Are Some Developing Countries Failing to Catch Up?

International Monetary Fund. Research Dept.
Published Date:
February 1995
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There have been large differences in growth among developing countries over the past decade. Many countries that pursued macroeconomic stability, liberalized trade, and implemented market-based reforms in the early to mid-1980s are now well-established as the high performers in the developing world. Their policies have enabled them to better withstand adverse external developments. More recently, many other developing countries have adopted similar policy frameworks and have made substantial progress in fostering macroeconomic stability. For many of these countries growth has exceeded expectations, and their prospects are better than they have been for some time. Recent issues of the World Economic Outlook have focused on the experience of the successfully adjusting countries and on their resilience to the recent economic slowdown in the industrial countries.

Growth in a number of other developing countries remains weak, however, and there are at present relatively few indications of improvement. Longer-term growth prospects depend on well-known factors—including accumulation of physical and human capital and improvements in the efficiency of production. Many of the factors that promote growth are, in turn, significantly affected by economic policies. Although policy differences do not fully explain the growth experiences among developing countries or within countries over time, lack of economic stability, inadequate and distorted financial markets, unproductive state intrusion, and inward-oriented trade policies have all acted to restrain growth in many cases. The effects of these factors have, moreover, discouraged needed inflows of official financial assistance as well as of private capital and have tended to aggravate the impact of external developments. Although simple comparisons with the strong performers point to relatively straightforward explanations for the difficulties of low-growth countries, a closer look at their experiences suggests that their failure to grow at more satisfactory rates is attributable to a complex set of interactions among policy failures, poor governance, lack of incentives for reform, and adverse external developments.

Economic Instability

A comparison of developing countries distinguished by their longer-term growth performance is provided in Table 6. During the decade 1984-93, the group of low-growth countries experienced real GDP growth of only 1.4 percent a year, implying declines in per capita real output, whereas the high-growth countries grew by 7.4 percent a year. About three-quarters of this difference is accounted for by total factor productivity growth, which was -1.1 percent a year for the low-growth countries compared with 3.4 percent a year for the high-growth countries.33 Growth rates vary across time, as well as among countries. The low-growth countries had a better record in 1971–83 than in 1984-93, reflecting in part external factors. In particular, their terms of trade improved in the 1970s and then deteriorated significantly in 1984-93, whereas those of the high-growth countries were broadly stable, reflecting less dependence on exports of primary products.

Table 6.Developing Countries: Growth and Other Indicators of Economic Performance(Annual percent change unless otherwise noted)
126 developing countries1
GDP growth5.15.1
Consumer prices20.243.5
Consumer prices (median)10.98.8
Consumer price variability20.70.8
Fiscal deficit (percent of GDP)-3.8-4.3
Investment (percent of GDP)25.425.6
Savings (percent of GDP)24.124.3
Export volume2.27.6
Terms of trade3.1-1.1
External debt (percent of GDP)23.339.6
Real effective exchange rate30.1-3.1
Total factor productivity0.91.7
42 high-growth countries4
GDP growth5.87.4
Consumer prices12.011.5
Consumer prices (median)10.66.7
Consumer price variability20.80.5
Fiscal deficit (percent of GDP)-2.8-3.2
Investment (percent of GDP)25.830.1
Savings (percent of GDP)24.529.3
Export volume8.610.4
Terms of trade0.40.1
External debt (percent of GDP)19.229.4
Real effective exchange rate3-1.0-5.9
Total factor productivity1.93.4
42 low-growth countries5
GDP growth4.01.4
Consumer prices26.453.5
Consumer prices (median)10.810.7
Consumer price variability20.70.8
Fiscal deficit (percent of GDP)-4.1-5.3
Investment (percent of GDP)26.320.9
Savings (percent of GDP)24.118.8
Export volume-0.53.4
Terms of trade4.7-3.0
External debt (percent of GDP)26.951.2
Real effective exchange rate3-1.91.6
Total factor productivity0.2-1.1

The data comprise 126 developing countries, except the figures for total factor productivity, are based on the 84 countries for which data were available. For total factor productivity, the figures in the second column refer to 1984-91.

Equal to the absolute value of the ratio of the standard deviation of price inflation to its mean over the specified period.

Because of data limitations, figures in the first column refer to 1981-83.

The 42 (of 126) countries with the highest GDP growth in 1984-93.

The 42 (of 126) countries with the lowest GDP growth in 1984-93.

The data comprise 126 developing countries, except the figures for total factor productivity, are based on the 84 countries for which data were available. For total factor productivity, the figures in the second column refer to 1984-91.

Equal to the absolute value of the ratio of the standard deviation of price inflation to its mean over the specified period.

Because of data limitations, figures in the first column refer to 1981-83.

The 42 (of 126) countries with the highest GDP growth in 1984-93.

The 42 (of 126) countries with the lowest GDP growth in 1984-93.

Most countries in sub-Saharan Africa have had weak growth performances. In countries such as Cote d’Ivoire, Liberia, and Zaire, average GDP growth over the past decade has been negative. In many others, including Ethiopia, Rwanda, Somalia, and Zambia, growth over the past decade, at less than 1 percent a year, has been only marginally higher. The problem of low growth is not, however, confined to Africa. Myanmar and the Philippines in Asia, and a number of countries in Latin America, have also experienced prolonged periods of very weak growth.

An important policy factor that has held back growth in many countries is the lack of a stable environment for economic decision making. In the low-growth countries, inflation has been relatively high and variable. This has often contributed to overvalued exchange rates and to a decline in competitiveness, and it has discouraged saving in financial assets because unanticipated inflation and low or negative interest rates have threatened to erode the real value of financial assets. Moreover, fiscal deficits often absorb excessive shares of national saving, reducing resources available for investment. Some countries have reacted to macroeconomic imbalances by resorting to import controls and restrictions on foreign exchange. Such policies are unlikely to be sustainable and often exacerbate the problems they were supposed to address. The experience of countries that have successfully adjusted shows that reducing fiscal deficits helps to raise domestic saving, and the introduction of market-determined exchange rates permits the trade sector to expand.34 In contrast, in many low-growth countries state intervention in allocating foreign exchange has resulted in weak supply responses to market signals and in chronic external imbalances.

Some low-growth economies continue to suffer from poor governance and considerable social and political instability, which often exacerbate the effects of economic imbalances. In parts of southern and sub-Saharan Africa, governments’ control of economic and financial policy is tenuous, and countries that have suffered extensive war damage—such as Angola. Ethiopia. Mozambique, and Somalia—face expensive national reconstruction programs. In many low-growth countries, problems in implementing adjustment programs are due in large part to the lack of commitment on the part of governments, to pressures from interest groups, and to a widespread lack of accountability. These factors have undermined the quality of public-sector decision making.35 In many developing economies with large agrarian sectors and highly unequal land distribution, land reform that results in wider ownership can help to alleviate poverty and to improve productivity.36 The provision of well-targeted social safety nets can help to ensure that distributional concerns do not delay necessary reforms.37

Grouping countries according to per capita growth rates provides an indication of the relationship between growth and improvements in living standards, as measured by per capita income (Table 7). Developing countries that are growing faster than industrial countries account for about 68 percent of developing country population; the majority of these countries with high per capita growth are low-income countries, including China and India. A second group of countries, representing 15 percent of developing country population, have per capita income growth that is positive but less than that in industrial countries, implying that they are failing to catch up in terms of average living standards. Of even greater concern is the absolute decline in living standards in countries that have experienced negative per capita income growth. This group represents about 16 percent of the population of developing countries, or over 400 million people, and about half of the countries in this group are low-income countries.

Table 7.Developing Countries: Economic Growth and Population, 1984-93(Annual percent change unless otherwise noted)
Developing countries2
GDP growth5.
Per capita growth3.
Population growth2.
Share in developing country population (in percent of total, 1993)
High per capita growth2
GDP growth7.
Per capita growth5.
Population growth1.
Share in developing country population (in percent of total, 1993)
Low per capita growth2
GDP growth3.
Per capita growth0.
Population growth2.
Share in developing country population (in percent of total, 1993)
Negative per capita growth2
GDP growth1.
Per capita growth-1.2-0.8-1.3-2.3
Population growth2.
Share in developing country population (in percent of total, 1993)

High-, middle-, and low-income countries correspond respectively to high/upper-middle-income, lower-middle-income, and low-income groups in the World Bank’s World Development Report (New York: Oxford University Press).

The sample includes 126 developing countries. Countries with high per capita growth are those with per capita growth above the average of 2.02 percent for industrial countries during 1984-93. Countries with low per capita growth are those with per capita growth that is positive but below the average for industrial countries.

High-, middle-, and low-income countries correspond respectively to high/upper-middle-income, lower-middle-income, and low-income groups in the World Bank’s World Development Report (New York: Oxford University Press).

The sample includes 126 developing countries. Countries with high per capita growth are those with per capita growth above the average of 2.02 percent for industrial countries during 1984-93. Countries with low per capita growth are those with per capita growth that is positive but below the average for industrial countries.

Unsustainable population growth has resulted in enormous strains on the capacity of countries to provide basic services and employment, especially in urban areas. In Africa, poor growth performance and rapidly expanding populations have meant that average per capita incomes have fallen by around 1.4 percent a year since 1989. Even in African countries with relatively strong growth, per capita income growth is only marginally positive. The transition to lower population growth rates, historically associated with higher economic growth and better living standards, can be promoted by policies that reduce the incentives for large families and improve access to family planning and education, especially for women. In many of the poorest countries, if population growth is not controlled, the attainment of higher living standards and poverty reduction will require exceptionally high growth rates of output for an extended period, which may not be realistic.

Insufficient Financial Sector Reforms

The experience of many developing countries, particularly the East Asian countries and also some of the successfully adjusting African countries, suggests that a well-functioning financial sector can help to promote efficiency in real resource allocation.38 In many low-growth countries, however, financial intermediation is not well developed. In sub-Saharan Africa, for example, the ratio of broad money to GDP in the period 1984-92 was about 0.25 compared with over 0.70 in the newly industrializing economies of Asia. In part, this difference reflects varying stages of economic development, but governments have also hindered—often inadvertently—the process of financial development by imposing a variety of restrictions on financial markets. In the majority of low-growth countries, interest rates on bank deposits and loans are controlled, often being held significantly below market interest rates, and credit is often allocated according to nonmarket criteria. The maintenance of artificially low rates of interest is intended to encourage investment by reducing the cost of borrowing. But, with a few exceptions, the results have been the reverse: savings in financial assets have been discouraged, and low interest rates have reduced the efficiency of investment. Real interest rates in the high-growth countries have been positive on average, whereas they have been negative on average in the low-growth countries (Table 8).

Table 8.Developing Countries: Real Interest Rates, 1984-93(In percent; median)
Developing countries0.02
High-growth countries2.89
Low-growth countries-2.81
Note: The countries included are a subset of those in Table 6 for which data were available. The real interest rate is defined as the short-term nominal interest rate minus the rate of inflation. The median for each group is used in order to reduce distortion caused by a few high-inflation countries.
Note: The countries included are a subset of those in Table 6 for which data were available. The real interest rate is defined as the short-term nominal interest rate minus the rate of inflation. The median for each group is used in order to reduce distortion caused by a few high-inflation countries.

All the countries that borrowed from the IMF under its structural adjustment facility (SAF) had previously used nonmarket mechanisms to allocate credit and, consequently, had suffered from inadequate saving. Correcting this problem became a key objective in the adjustment programs of these countries.39 In countries with high and volatile inflation rates, administered interest rates have resulted in negative and volatile real interest rates, further discouraging saving. In Mozambique and Uganda, for example, real interest rates on bank deposits in the late 1980s were between –40 percent and -50 percent. Even where governments have adjusted administered rates frequently, it has been difficult to maintain stable positive real rates in the face of high and unstable inflation.

The relationship between growth and the degree of intervention in financial markets is not clear-cut, in part because of the diversity of experience between countries that have maintained relatively free financial markets, those that have imposed mild controls, and those with underdeveloped financial sectors. Policies pursued in some of the successful East Asian economies are often cited as demonstrating the advantages of nonliberalized financial markets. In Korea and Taiwan Province of China, interest rates were controlled throughout the 1970s and 1980s; foreign portfolio investment in listed Korean firms is still limited to 10 percent.40 In these economies, however, subsidized credit was largely allocated on the basis of economic criteria. In Korea, for example, firms were rewarded with subsidized credit on the basis of export performance.41 Moreover, in Korea and Taiwan Province of China, interest rates were only moderately repressed and were positive on average during 1971-91. Real interest rates in the successful East Asian economies were also considerably less volatile than in many other developing economies because macroeconomic conditions were relatively stable: fiscal deficits were controlled, and corrective measures were rapidly undertaken when public sector demands on credit exerted upward pressure on inflation and interest rates.42 Although there have been many successful examples of selective government intervention in the allocation of credit in these countries, there were also many failures and examples of overinvestment and misallocation. Whatever the contribution of selective credit policies in Southeast Asia, the experience of most other countries suggests that it is extremely difficult to administer such policies in an evenhanded way. In any case, the growing integration of the world economy is undermining the viability of highly regulated financial markets and controlled credit allocation.

To successfully liberalize the financial sector, it is imperative that public sector demands on credit do not exert excessive strains on financial institutions, which in many low-growth economies are insolvent or undercapitalized. Nonperforming loans of banks are often accounted for by public sector or quasi-public enterprises. Banks that have been recapitalized, at significant public expense in many instances, have been in difficulty subsequently. The need for better supervision and prudential regulation is recognized in countries that are engaged in financial sector reforms, but implementation has been slow, primarily because of the continued demands to finance government deficits or weak public sector enterprises. Implicit taxation in the form of unremunerated reserve requirements is pervasive in many developing countries, and in part explains the reluctance of governments to implement market-based reforms that are necessary to ensure that public sector credit demands are evaluated at their true opportunity costs.

Role of the State

Growth prospects for many of the low-growth countries depend critically on how successfully they restructure the role of the state away from direct intervention in product and factor markets toward the provision of infrastructure, basic services, and investment in human capital. In many of these countries, government intervention extends well beyond areas of genuine market failure. Although there is broad consensus on the policy measures required—privatization of state-owned enterprises, elimination of price controls (especially on agricultural products), and liberalization of trade and commerce—state involvement in economic activity is still extensive. In some countries, such as Korea, for example, interventionist policies have had some success, largely because they focused on fostering the right fundamentals, particularly macroeconomic stability. In most developing countries, however, interventionist policies failed badly because they caused large price distortions, discouraged investment, and resulted in inefficient resource allocation.

In the group of high-growth countries, central government current expenditure accounts for around 16 percent of GDP compared with almost 20 percent in the low-growth group (Table 9). Capital expenditure ratios are about the same for both groups. These figures may be somewhat misleading, however, because the productivity of public expenditure is different across countries43 and also because they do not distinguish between countries that are at different stages of development. Some countries may need to assign greater priority to provision of basic services. For example, although expenditure on health as a percent of GDP in many African countries is similar to that in countries in Latin America and East Asia, in some sub-Saharan African countries, such as Mozambique, Sierra Leone, and Zaire, total health expenditure per capita is less than $10 a year, compared with over $100 a year in Argentina, Brazil, and Mexico, and over $300 in Korea.

Table 9.Developing Countries: Central Government Expenditures, 1984-93(In percent of GDP)
116 Developing Countries39 High-Growth Countries38 Low-Growth Countries
Total expenditure24.222.325.5
Current expenditure18.016.519.6
Capital expenditure6.15.85.9
Note: The countries included are the subset of those in Table 6 for which data were available.
Note: The countries included are the subset of those in Table 6 for which data were available.

Progress toward privatization, particularly in Africa, has been slow. In Zambia, even after price controls on government-owned enterprises were abolished in 1989, the state did not give up ownership. Countries that have privatized faster, such as Argentina and Malaysia, have managed to attract significant foreign investment, in part into rapidly growing equity markets (sec Box 4 in Chapter II). Countries that instituted privatization programs earlier, such as Chile and Mexico, generally have experienced faster growth. Because private investment is generally more productive than public sector investment, except perhaps in infrastructure projects, further progress on privatization should improve prospects.44

In the 1970s and 1980s, one of the most distortionary aspects of economic policy in many developing countries was the widespread resort to price controls. Allocation inefficiencies that arise from such policies are well known.45 Discrepancies between official and market prices typically lead to shortages, unproductive rent-seeking activities, and reduced tax bases through the diversion of economic activity to informal sectors. In Myanmar, where controls have until recently been extensive, most economic activity is not taxed at all. Moreover, allocation of inputs and distribution of final goods may be determined by noneconomic criteria. In low-income countries with IMF-supported structural adjustment programs, there has been substantial progress in decontrolling prices, and this has had a positive impact on economic incentives and growth. In Mozambique, for example, general controls on goods prices and profit margins have been replaced by selective controls, and growth has increased.

The motivation for certain forms of government intervention is well founded. Apart from investment in infrastructure and human capital, governments are rightly concerned about poverty alleviation and income distribution, and in some cases they seek to protect poorer groups from increases in the prices of staple foods. Although these are legitimate concerns, it is in general more efficient to address such issues through the tax and transfer system rather than through direct intervention in product and factor markets, where policy-induced distortions often result in perverse outcomes. This has been particularly true in agricultural markets in many developing countries.

Inefficiency of agricultural production, in large part the result of excessive controls and misguided government policies, has held back development significantly in low-income economies. To finance rapid industrialization, governments have often taxed agriculture excessively. The share of agriculture in total output in sub-Saharan Africa was 43 percent in 1965, similar to the 41 percent share in the East Asian economies. But by 1988, the share of agriculture in total output in East Asia had fallen to 22 percent, as productivity increases of more than 2 percent a year in the agricultural sector freed resources for use in other sectors. By contrast, in Africa agricultural productivity grew by only of ½ of 1 percent a year, and the share of agriculture in total output had fallen to only 36 percent. Countries that have neglected agricultural infrastructure investment have benefited little from the “green revolution.” In India, for instance, two-thirds of the work force is employed in agriculture, but the sector accounts for only one-third of total output.

As a result of price controls and export restrictions on agricultural output, returns to producers do not rise with increased productivity. In Myanmar, for example, farmers are required to sell some proportion of their output to the state for export at well below world market prices. This implicit tax creates incentives to underreport output, discourages production, and diverts land use to crops not subject to restrictions. In Zambia, before reform in 1989, prices for maize were fixed by the government, and government-run marketing boards were responsible for distribution. Consequently, there was no regional variation in prices, and production moved away from urban areas, thus raising costs of distribution substantially. In general, reducing government intervention would help countries to diversify the agricultural export base as relative price distortions are removed.

Inward-Oriented Trade Policies

Inadequate exposure to international competition has contributed to low growth in many of the poorly performing countries.46 Import restrictions designed to promote infant industries have effectively offered permanent protection, increasing the cost of imported intermediate and capital goods and sustaining overvalued currencies. As a result, growth and diversification of the export sector have been limited. Because production of exports in most developing countries is more labor-intensive than the production of import substitutes, these restrictions often result in underutilized labor.

Empirical evidence suggests that output and productivity growth and the share of investment in output are positively associated with growth in exports and with the degree of outward orientation and the elimination of trade impediments.47 The failure of protectionist policies—for example, in many Latin American countries during most of the postwar period until the mid-1980s—contrasts sharply with rapid growth in those South and East Asian countries with a longer tradition of outward-oriented policies. Trade reforms can also allow countries to industrialize faster. In Turkey, for example, as a result of trade and foreign exchange reforms in the early 1980s, exports grew nearly twice as fast as imports during 1979-89, and the share of manufacturing in GDP increased from 22 percent to 27 percent.48 Liberalization programs may of course entail some short-run costs. Imports may rise, drawing down foreign reserves and putting downward pressure on the exchange rate, with possible adverse distributional effects on poorer groups in the economy. This underscores the need for safety nets to protect the poor while the economy adjusts. In addition, excessive import growth and exchange rate depreciation may be avoided through appropriate domestic demand management policies.

The recent shift in the orientation of trade policies has been most striking in the case of Latin America, where almost all countries are now significantly more open to trade than in the early 1980s. Nontariff barriers, which covered over 50 percent of imported goods in Colombia, Mexico, and Peru in the mid-1980s, have been substantially reduced or eliminated altogether; and the dispersion of import tariffs—the highest in the world in the 1960s in Brazil, Chile, and Colombia—has been drastically reduced. In Africa, although it is recognized that trade is a necessary ingredient of revival, progress on trade liberalization has been slow. The possibility and benefits of successful liberalization, however, have been demonstrated by countries such as Ghana, where import licensing has been substantially liberalized and a uniform tariff introduced for most imports, and in Morocco, where significant reductions in protection have taken place since 1983 through the elimination of quantitative restrictions and the reduction of tariff rates, with the maximum rate reduced from 400 percent to 35 percent.

Box 8.Striving for Stability: Realignment of the CFA Franc

Since its creation almost fifty years ago, the African franc zone—usually referred to as the CFA zone—has served its members well.1 The common currency, the CFA franc, has been freely convertible into French francs at a fixed rate and has provided an anchor for the economic and financial policies of the 14 African member countries.2 These countries benefited from a long period of remarkably low inflation and—until the mid-1980s—sustained economic growth. The discipline imposed on monetary policy ensured that appreciations of real effective exchange rates arising from inflationary finance were avoided.

The CFA zone does not, however, satisfy all of the conditions for an optimal currency area. Despite the zone’s arrangements and the activities of West and Central African trade organizations, formal trade in goods within the zone represents less than 15 percent of total trade. Trade tends to be mainly with the industrial countries of Europe, with total imports and exports of goods to Europe representing more than 40 percent of GDP of CFA zone countries. In addition, regional labor markets are not integrated, with different employment regulations and practices applying in each country.

Since 1985, the economic and financial situation of the zone has deteriorated as a consequence of two major shocks (see chart). First, the zone’s terms of trade deteriorated by about 50 percent during the second half of the 1980s, owing mainly to a sharp drop in world market prices for its major exports of cocoa, coffee, cotton, and petroleum. Second, the external competitiveness of the zone weakened further as a result of the marked appreciation of the French franc against the currencies of the zone’s other major trading partners. At the same time, the zone was handicapped by a number of structural and sectoral problems, particularly relatively high wages.

Despite repeated attempts at internal adjustment—especially, to control wage costs and restructure the banking system and public enterprises—per capita incomes fell steadily, and the economic and financial situation continued to worsen. Given the size of the shocks, reliance on internal adjustment alone would have resulted in increased tax rates being imposed on a shrinking tax base and in large cuts in current and capital expenditures—particularly in education, health, and infrastructure—thereby jeopardizing the basis for sustainable growth. With governments’ wage expenditures taking up an increasing share of government revenues, and with transfers to public enterprises rising, the public sector financing requirement expanded significantly, crowding out the private sector. Considerable domestic and external payments arrears were accumulated, creating serious distortions for the productive sector and weakening the banking system. Under these circumstances, the zone’s attractiveness to foreign investors diminished substantially—despite the advantage of stable prices and exchange rates—and capital flight increased appreciably.

CFA Zone Countries: Real Effective Exchange Rate and Terms of Trade1

(Index, 1985 = 100)

1 An upward movement of the real effective exchange rate represents an appreciation of the CFA franc, and a downward movement of the terms of trade represents lower export prices relative to import prices. All aggregates are constructed using 1985 GDP weights.

These differences were reflected in a sharp worsening in economic performance. Before 1985, growth in the CFA area was generally better sustained than in the rest of Africa (see table). Since 1986, however, output has remained flat on average in the CFA zone, whereas output expanded by an average of 2½ percent a year in the other sub-Saharan African countries; the contrast in terms of per capita incomes is even starker. The overall budget and external deficits were much larger in the CFA countries, and external debt increased by nearly 40 percentage points relative to GDP compared with 14 percentage points in other sub-Saharan African countries. By the early 1990s it had become increasingly clear that a new growth-oriented strategy was needed.

On January 11, 1994, the member countries of the CFA zone decided collectively to adopt a broadly based strategy consisting of a large change in the parity of their currencies, effective January 12, 1994, coupled with a coherent set of macroeconomic and structural policies tailored to the circumstances of each country. The member countries also agreed to strengthen their economic integration through twice-yearly meetings to coordinate policies and monitor the implementation of adjustment programs. In addition, the member countries of the West African Monetary Union (the members of the BCEAO) adopted a treaty establishing the West African Economic and Monetary Union.

The CFA franc was devalued by 50 percent in foreign currency terms, from CFAF 50 to CFAF 100 per French franc, and the Comorian franc was devalued by 33 percent, from CF 50 to CF 75 per French franc. The size of the parity change was based on several indicators of the extent of the overvaluation of the CFA franc and the Comorian franc, including the evolution of the real effective exchange rate and the deterioration of the terms of trade since the mid-1980s. To reap the full benefits of the devaluation, all of the CFA countries will have to implement fiscal adjustment programs, adopt prudent monetary policies, control wage costs, and accelerate structural reforms to foster recovery of supply. To implement these adjustment programs successfully, well-targeted social safety nets, perhaps supplemented by limited and temporary price subsidies, will have to be established.

These policies should allow the needed correction in relative prices of traded and nontraded goods, while ensuring that inflation returns rapidly to its predevaluation level. It should be possible to achieve sustained real growth in the range of 4 to 6 percent and external viability. Indeed, the realignment should lead to a shift in resources from low-growth sectors, which are often artificially protected, to more dynamic and competitive sectors. The agricultural sector—which employs most of the population—might be the first to benefit from these policies, in part because of higher domestic prices for export crops, as well as effectively targeted public investments. Similarly, increasing production of non-traditional exports and substitutes for imports should allow existing capacities to be utilized more effectively. Inflows of private capital can be expected to resume and to be invested in the tradable goods sectors, where the productivity gains and profitability are likely to be most pronounced, thus reviving growth and creating employment.

The IMF has assisted each CFA zone country in formulating comprehensive adjustment programs. For 11 of the 14 countries, arrangements had already been approved by the IMF’s Executive Board at end-March 1994. To put IMF assistance in place as rapidly as possible, a number of programs are being supported first with stand-by arrangements, which are expected to be replaced by annual arrangements under the enhanced structural adjustment facility (ESAF). At present, 12 of the 14 African countries of the CFA zone are eligible for the ESAF (Congo and Gabon are not eligible because their per capita incomes exceed the level that defines low-income countries). The World Bank has also closely collaborated in the design of the programs and has already assisted with mobilizing financial support. Shortly after the adjustment programs were approved by the IMF’s Executive Board, the respective countries benefited from rescheduling arrangements with private and bilateral creditors, the latter under the aegis of the Paris Club.

Sub-Saharan Africa: Selected Economic and Financial Indicators for CFA and Non-CFA Countries1
Real GDP growth-Annual percent change
Real per capita GDP growth
Overall fiscal balanceIn percent of GDP
External current account (including grants)
External debt

Compared with the definition used in the Statistical Appendix, sub-Saharan Africa is defined here to include Nigeria and South Africa and to exclude Djibouti, Liberia, Mauritania, Somalia, and Sudan.

Based on the consumer price index.

Compared with the definition used in the Statistical Appendix, sub-Saharan Africa is defined here to include Nigeria and South Africa and to exclude Djibouti, Liberia, Mauritania, Somalia, and Sudan.

Based on the consumer price index.

1 The CFA is commonly understood to refer to both the Communauté financière de I’Afrique de I’Ouest and the Communauté financière de I’Afrique Centrale.2 See Jean A.P. Clément, “Rationale for the CFA Franc Realignment,” IMF Survey (February 7, 1994), pp. 33-36, and the IMF Survey Special Supplement on the CFAF realignment (March 21, 1994). The fixed parity with the French franc has been supported by the operations accounts with the French Treasury of the zone’s three central banks; the Banque Centrale des Etats de 1’Afrique de I’Ouest (BCEAO), whose members are Benin, Burkina Faso, Côte d’Ivoire, Mali, Niger, Senegal, and Togo; Banque des Etats de l’Afrique Centrale (BEAC), whose members are Cameroon, the Central African Republic, Chad, the Congo, Equatorial Guinea, and Gabon; and, since 1979, the Central Bank of the Comoros, which issues its own currency, the Comorian franc.

Differences in both macroeconomic and structural policies, including trade regimes, show up in sharp divergences in export performance. Exports of high-growth developing countries grew at an average annual rate of over 10 percent between 1984 and 1993, compared with a rate of increase of only around 3½ percent for low-growth countries (see Table 6). To some extent this positive correlation between growth and exports reflects movements in the terms of trade, but countries faced with a deterioration in the terms of trade have not always responded with appropriate policies. For example, countries such as Algeria, Egypt, Myanmar, Zambia, and the CFA countries maintained overvalued exchange rates for long periods, implicitly taxing exporters (Box 8).49

For the developing countries as a group, exports grew by nearly 8 percent a year between 1984 and 1993, almost twice as fast as in the industrial countries. The industrial countries have also benefited. According to one estimate, trade liberalization efforts since 1985 in developing countries could raise the demand for industrial countries’ exports in the developing countries by about 20 percent over the medium term.50 In the longer run, the benefits will be even more substantial as liberalization leads to a more efficient pattern of global production and trade.

Financial Flows and Resource Transfers

Trends in the pattern of financial flows to developing countries are dominated by the increase in private capital flows, especially during the past five years (Table 10). In contrast to the early 1980s, most of the recipients are private businesses, and there has been a significant shift from commercial bank lending to direct investment. The latter accounts for over one-third of all net flows to developing countries. Low-growth countries, however, continue to rely on official financing to supplement domestic saving. Over the past decade these countries received gross external financing of over 5 percent of GDP a year, about the same as the high-growth countries, although net resource transfers were marginally higher. In most African countries, foreign direct investment has been limited and has been largely offset by disinvestments by commercial banks. Countries that have liberalized capital controls and pursued privatization programs, such as India, Indonesia, and Pakistan, have benefited the most from private capital inflows, as have countries with strong growth prospects. China, for example, is currently the largest recipient of foreign direct investment.

Table 10.Developing Countries; Resource Transfers(In percent of GDP)
126 developing countries
Gross external financing15.35.2
Official financing2.12.0
Private financing3.13.2
Net resource transfers20.20.6
42 high-growth countries3
Gross external financing15.05.1
Official financing1.71.6
Private financing3.33.5
Net resource transfers20.40.7
42 low-growth countries4
Gross external financing15.35.4
Official financing2.12.2
Private financing3.133
Net resource transfers20.10.9

Gross external financing comprises official and private financing, including amortization due on external debt (see the Statistical Appendix, Table A32).

This is defined as the balance of goods and nonfactor services, with the opposite sign.

The 42 (of 126) countries with the highest GDP growth in 1984-93.

The 42 (of 126) countries with the lowest GDP growth in 1984-93.

Gross external financing comprises official and private financing, including amortization due on external debt (see the Statistical Appendix, Table A32).

This is defined as the balance of goods and nonfactor services, with the opposite sign.

The 42 (of 126) countries with the highest GDP growth in 1984-93.

The 42 (of 126) countries with the lowest GDP growth in 1984-93.

For many low-growth countries, especially the low-income countries, greater flows of concessional assistance are called for on social and humanitarian grounds. It is important, however, that additional concessional assistance does not impede future growth prospects in these countries. To avoid the risk that increased financial assistance could exacerbate the dependence of these countries on external assistance while failing to promote needed adjustment, it would be helpful to link such assistance more closely to reform efforts and to improvements in governance. Where economic management does improve substantially, sustained inflows of external assistance will be important to help put these countries on a stronger growth path. For countries with unsustainable debt burdens, timely and realistic debt-reduction agreements are also essential.

During the 1980s, the high cost of servicing unsustainable debt burdens led to a number of initiatives to reduce and restructure the debt of the most heavily indebted countries. Although the high debt burdens had become critical obstacles to growth, they were closely linked to underlying macroeconomic imbalances and distortions affecting resource allocation. These interrelationships have been analyzed extensively in previous issues of the World Economic Outlook. For a discussion of the experience of Latin American countries, many of which have successfully overcome earlier debt-related difficulties and have reformed their economies, see Annex III.

Vulnerability to the External Environment

The external economic environment facing developing countries has varied substantially in recent years. Fluctuations in world interest rates have been particularly large, although the interest payments of highly indebted countries have recently fallen.51 However, the most important adverse effects have come from changes in the terms of trade. Two major recessions in the industrial countries since 1980 depressed demand for developing country output and put downward pressure on commodity prices and, hence, on the export prices of many developing countries. These developments have had important adverse effects, since these countries have only a limited ability to hedge commodity price risks in world financial markets. Negative terms of trade movements also reduce output by increasing the cost of imported intermediate and capital goods.52

To gauge the importance of changes in the external environment for different groups of countries, the staff has constructed a composite “external conditions index” based on a weighted average of world interest rates, industrial country growth, and the terms of trade. A rise in the index indicates that changes in the external environment have contributed positively to growth. The weights for the index are based on the long-run elasticities of output growth in the developing countries to each of the three factors, using the IMF’s developing country model.53 Specifically, they are the long-run response of developing countries’ growth rate to a sustained increase of: 1 percentage point in the U.S. dollar London interbank offered rate (LIBOR); 1 percentage point in the industrial country growth rate; and 1 percent in the terms of trade.54

The developing country model suggests that changes in the terms of trade have the greatest impact on developing country output growth, with long-run elasticities of about 0.5 for both low- and high-growth countries. The sensitivity of developing country growth to industrial country growth is 0.4 for high-growth countries, four times as large as that for low-growth countries. The impact of the world interest rate is small for all groups, although it is large for some individual countries. The small long-run impact of the interest rate reflects the fact that the effects of changes in world real interest rates are partly captured through the terms of trade.

The fluctuations in the external conditions index in the early 1980s were largely the result of sharp variations in the terms of trade experienced by most developing countries (Chart 22). The external environment deteriorated in the second half of the 1980s because of the continued decline in nonfuel commodity prices. The weakness of nonfuel commodity prices over the past decade can be explained in part by an expansion of world supply, owing to higher productivity and structural reform policies and increased commodity exports in developing countries of Asia and the Western Hemisphere. World supply has also increased as a result of the agricultural policies of industrial countries, such as explicit and implicit price support programs.55 Low-growth countries have been exposed to a particularly unfavorable external environment, both because their terms of trade have fallen more than those of the other countries and because their economic structures are more vulnerable to terms of trade changes.

Chart 22.Developing Countries: External Conditions Index1

(Index, average 1981-85 = 100)

1 The sample includes 118 countries and excludes major Middle East and North African oil exporters, for which the index is dominated by oil price movements. Blue shaded area indicates IMF staff projections.

Using the elasticities underlying the external conditions index, the total effect of changes in the terms of trade, industrial country growth, and world interest rates on developing country growth can be estimated. The analysis suggests that the external environment reduced the average growth rate of low-growth countries by ¾ of 1 percentage point during 1984-93, while the average growth rate of high-growth countries was boosted by about 1 percentage point (Table 11). Although these estimates illustrate the relatively important role of the external environment, they also confirm that domestic factors and sound economic management are critical. Clearly, good policies cannot fully neutralize the effects of external shocks on the domestic economy, but they can reduce a country’s vulnerability and give it the ability to ride out such shocks.

Table 11.Developing Countries: Impact of the External Environment(In percent)
Growth, 1984-93
Output growth (annual percent change)7.41.4
Total external contribution1.0-0.7
Variations in output growth1.72.0
Total external contribution0.20.8

The same model can be used to assess the contribution of variations in external conditions to variations in output growth (see Table 11). A relatively small contribution would indicate greater resilience to external shocks. High-growth countries generally have less output variance overall, but the fraction of that variance accounted for by external conditions is only 12 percent, compared with 40 percent for low-growth countries. High-growth countries such as Colombia, Chile, Malaysia, and Sri Lanka have been able to diversify their export base, making them less vulnerable to price variations.56 Moreover, export diversification has not been accomplished at the expense of the production of commodities; these countries are also among those that have increased the volume of commodity exports most.

Impact of the Uruguay Round on Low-Growth Developing Countries

Growth prospects for the developing countries, particularly those with outward-oriented trade policies, will be further enhanced as a result of the successful completion of the Uruguay Round. Uncertainty about the future of the multilateral trading system has been reduced, and the Uruguay Round has expanded the scope of the multilateral trading system by including agriculture, textiles, and services and by clarifying the rules on intellectual property (see Annex I). The benefits for developing countries include increased efficiency in the use of domestic resources as tariffs and nontariff barriers are reduced or removed, economies of scale in production are realized, and technology transfers resulting from increased openness and global cooperation are increased. In addition, higher growth in the world economy and increased access to industrial country markets for developing countries will improve the external environment for developing countries. In principle, these benefits should also help to improve the performance of the low-growth countries, although the effects will depend critically on the success of domestic adjustments to make these economies more responsive to the potential new trading opportunities that will open up.

Two important components of the agreement are the planned cutback in agricultural subsidies and the tariffication of nontariff measures, including, notably, protection of agricultural sectors. Developing countries are provided more leeway in phasing in the required changes, and the poorest countries are generally exempted. Although agricultural products constitute only 13 percent of the nonfuel merchandise exports of all developing countries, many individual countries have substantial agricultural exports; for half of the developing countries, tropical agricultural products account for over 50 percent of export earnings.57 The impact of the Uruguay Round on the prices of these commodities will be significant for many developing countries.

With the exception of some large food exporters, particularly in Latin America, there is very little protection for agriculture in developing countries. In contrast, developing countries have only limited access to most industrial country markets, and domestic price supports in industrial countries have promoted overproduction, lowered world market prices, and reduced the share of developing countries in world agricultural output and trade.58 Within developing countries, lower agricultural output has resulted in increased migration from rural to urban areas, adding to the demand for basic social provisions and contributing to economic imbalances. The reduction or elimination of protection and price support schemes in industrial countries is likely to stimulate food production in the developing countries, many of which have a comparative advantage in agricultural production. The developing countries are, therefore, likely on average to benefit from liberalization in agricultural trade, although countries that receive subsidized food as a result of over-production in industrial countries are likely to lose in the short run. Many countries will also benefit from the removal of the extensive import quota systems and trade discrimination in textiles and clothing, their principal industrial exports.

The net benefits for individual developing countries will depend on greater access to industrial country markets, the erosion of trade preferences, and the efficiency and distributional responses within their own economies to changes in relative prices, especially in agriculture, as subsidies and other market interventions are reduced gradually over a five- to twenty-year period. World prices for food products such as wheat, grains, sugar, vegetable oils, and dairy products—whose production is at present heavily protected in the industrial countries—will probably rise, because the multisectoral liberalization envisaged in the agreement will likely result in a fall in production in industrial countries. As a result, the anticipated effect of the Round on the net exporters of food products among developing countries is positive. Some developing countries may be adversely affected by the erosion of some trade preferences, adverse terms of trade effects, and increased intellectual property rights. These negative effects are likely to be outweighted in the medium to longer run as access to industrial country markets increases and efficiency gains are realized. Relative incomes in rural and urban areas will also be affected, with the consequences for urban unemployment depending on the prior degree of protection in manufacturing and on the response of wages to changes in agricultural prices.

The ultimate impact of the Uruguay Round will depend on productivity gains in various sectors that result from the realization of economies of scale, technological transfers as global interaction increases, and the impact of increased trade on investment as markets expand. Confidence is also likely to be boosted, which would increase foreign investment in the developing countries that have participated in the agreement. It is difficult to estimate the overall effects of these factors. As noted in Annex I, the studies undertaken to measure the impact of the Uruguay Round have generally focused on the static gains of the agreement and therefore probably underestimate its full impact. The only study that provides separate estimates for developing countries suggests that full implementation of the Round’s Final Act could increase the incomes of developing countries by over $70 billion, measured in 1992 dollars, by the year 2002.59 This study emphasizes the distributional effects of price changes across different regions, which are expected to result in most of the benefits accruing to middle income countries, with the gains to Africa and Latin America, where some countries that are net food importers may face terms of trade losses, being relatively small. The developing countries of Asia, in particular the high-growth export-oriented economies, are likely to gain substantially from higher growth elsewhere in the world.

* * *

The experience of developing countries that have fostered macroeconomic stability and implemented structural reforms shows the way forward for the low-growth countries, many of which are already embarking on similar programs. Provided that there is broad consensus in favor of such reforms, which can be enhanced by addressing potential short-run adverse effects on poorer groups in the economy, countries can improve their economic performance in a relatively short period. Indeed, many of the countries that were identified as successful adjusters in the October 1992 World Economic Outlook, including some that had implemented reform programs in the late 1980s, were among the weakest performers less than a decade ago.

For low-growth economies, substantial further progress will be required in liberalizing trade regimes and improving the efficiency of agricultural sectors. As the process of further integration of the world economy gathers pace, spurred by the completion of the Uruguay Round, countries will need to adopt outward-oriented policies to share in global efficiency gains and to reduce their vulnerability to adverse external developments. For countries that continue to suffer from excessive debt burdens—particularly in sub-Saharan Africa, where debt-service payments in excess of 200 percent of export earnings are not uncommon—the international community will need to ensure that debt relief and other forms of financial assistance are made available to support policies that contribute to the goal of sustained economic growth.

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