FISCAL DEFICITS AND MACROECONOMIC PERFORMANCE IN DEVELOPING COUNTRIES

Although fiscal adjustment was urged on developing countriesduring the 1980s to lead them out of economic malaise, considerableuncertainty remains about the relations between fiscal policyand macroeconomic performance. To illustrate how financial markets,private spending, and the external sector react to fiscal policies,the behavior of holdings of money and public debt, private consumptionand investment, the trade balance, and the real exchange rateis modeled for a sample of ten developing countries. The studiesfind strong evidence that over the medium term, money financingof the deficit leads to higher inflation, while debt financingleads to higher real interest rates or increased repressionof financial markets, with the fiscal gains coming at increasinglyunfavorable terms. Consumers respond differently to conventionaltaxes, unconventional taxes (through inflation or interest andcredit controls), and debt financing, in ways that make fiscaladjustment the most effective means of increasing national saving.Private investment—but not private consumption—issensitive to the real interest rate, which rises under domesticborrowing to finance the deficit. Contrary to the popular presumption,in some countries private investment increases when public investmentdecreases. There is strong evidence that fiscal deficits spillover into external deficits, leading to appreciation of thereal exchange rate. Fiscal deficits and growth are self-reinforcing:good fiscal management preserves access to foreign lending andavoids the crowding out of private investment, while growthstabilizes the budget and improves the fiscal position. Thevirtuous circle of growth and good fiscal management is oneof the strongest arguments for a policy of low and stable fiscaldeficits.      

FINANCING INFRASTRUCTURE IN DEVELOPING COUNTRIES: LESSONS FROM THE RAILWAY AGE

In recent years suggestions for reforming the provision andfinancing of infrastructure services in developing countrieshave focused on private participation. This alternative to publicfinancing is seen as a way both to minimize the inefficienciesof public administration and to avoid the need for externalborrowing. In fact, for much of the nineteenth century, infrastructureprojects were privately financed and built. This approach, however,did not obviate the need for government intervention and foreigncapital. Because of the difficulties of assessing projects,investors were reluctant to commit their funds, and governmentsturned to subsidies and loan guarantees to encourage investment.Often, however, government intervention only replaced one setof problems with another. Investors with government-guaranteedloans had no incentive to monitor the firm's performance—alimitation that led to the diversion of funds and frustratedthe public interest. This article draws out the implicationsof this experience for policymakers in developing countriestoday.      

Infrastructure Privatization and Regulation: Promises and Perils

Infrastructure is crucial for generating growth, alleviatingpoverty, and increasing international competitiveness. For muchof the twentieth century and in most countries, the networkutilities that delivered infrastructure services—suchas electricity, natural gas, telecommunications, railroads,and water supply—were vertically and horizontally integratedstate monopolies. But this approach often resulted in extremelyweak services, especially in developing and transition economiesand especially for poor people. Common problems included lowproductivity, high costs, bad quality, insufficient revenue,and shortfalls in investment. Over the past two decades manycountries have implemented far-reaching institutional reforms—restructuring,privatizing, and establishing new approaches to regulation.This article identifies the challenges involved in this massivepolicy redirection within the historical, economic, and institutionalcontext of developing and transition economies. It also reviewsthe outcomes of these policy changes, including their distributionalconsequences—especially for poor households and otherdisadvantaged groups. Drawing on a range of international experiencesand empirical studies, it recommends directions for future reformsand research to improve infrastructure performance.      

PRIVATE INVESTMENT AND MACROECONOMIC ADJUSTMENT:A Survey

This article reviews theories of investment behavior and examinesempirical studies of investment in developing countries. Theemphasis is on understanding the interactions among macroeconomicpolicies, structural adjustment, and private investment. Thearticle deals with the effect of exchange rate policy on investment,the relationship between public and private investment, theimportance of market imperfections and financial constraintson capital formation, and the effect of economic instabilityon irreversible investment decisions.      

Developing Countries' Changing Participation in World Trade

Recent years have seen substantial reductions in trade policyand other barriers inhibiting developing country participationin world trade. Lower barriers have contributed to a dramaticshift in the pattern of developing country trade—awayfrom dependence on commodity exports to much greater relianceon manufactures and services. In addition, exports to otherdeveloping countries have become much more important. Thesechanges have profound implications for the role played by developingcountries in the world economy and trade system.      

Choosing a System of Unemployment Income Support: Guidelines for Developing and Transition Countries

Mounting evidence suggests that excessive job protection reducesemployment and labor market flows, hinders technological innovations,pushes workers into the informal sector, and hurts vulnerablegroups by depriving them of job opportunities. Flexible labormarkets stimulate job creation, investment, and growth, butthey create job insecurity and displace some workers. How canthe costs of such insecurity and displacements be minimizedwhile ensuring that the labor market remains flexible? Eachof the main unemployment income support systems (unemploymentinsurance, unemployment assistance, unemployment insurance savingsaccounts, severance pay, and public works) has strengths andweaknesses. Country-specific conditions—chief among themlabor market and other institutions, the capacity to administereach type of system, and the size of the informal sector—determinewhich system is best suited to developing and transition countries.      

MACROECONOMIC ADJUSTMENT TO CAPITAL INFLOWS: LESSONS FROM RECENT LATIN AMERICAN AND EAST ASIAN EXPERIENCE

Capital inflows to some developing countries have increasedsharply in recent years. Impelled by better economic prospectsin those countries, lower international interest rates, anda slowdown of economic activity in the capital-exporting countries,the inflows have furnished financing much needed to increasethe use of existing capacity and to stimulate investment. Butcapital inflows can bring with them their own problems. Typicalmacroeconomic repercussions have been appreciation of the realexchange rate, expansion of nontradables at the expense of tradables,larger trade deficits, and, in regimes with a fixed exchangerate, higher inflation and an accumulation of foreign reserves. Should government intervene to limit some of these side effects—andif so, how? The question is especially pressing in the wakeof the Mexican crisis of December 1994. This article looks foranswers in the experience of four Latin American and five EastAsian countries between 1986 and 1993, examining the effectsof the capital inflows on the economy and comparing the differentways in which these countries responded to the problem of "toomuch" capital.      

New Models for Old-Age Security: Experiments, Evidence, and Unanswered Questions

The escalating costs of traditional social security systemsare forcing countries to reevaluate the formal programs thatprovide income maintenance support to the aging. This articlesuggests a reform strategy built around three systems, or "pillars,"to provide old-age security—a public pillar with mandatoa private, mandatory savings plan, and a voluntary savings system.Three variations of this model are being implemented in differentcountries: the Latin American model, in which individual workerschoose an investment manager for their retirement finds; theOECD model, in which employers, union trustees, or both choosethe investment manager for an entire company or occupation;and the Swedish notional account model, a reformed pay-as-you-gofirst pillar that may be supplemented by a second, funded pillar.Preliminary empirical evidence on the efficiency and growtheffects of pension reform, mostly from Chile, indicates thatthe impact on national saving and financial market developmentand, through these, economic growth, has been positive and possiblylarge. Problems concerning high administrative costs and regulationsthat distort investment decisions remain to be resolved, however.      

THE ECONOMICS OF THE GOVERNMENT BUDGET CONSTRAINT

This article summarizes the simple analytics of the macroeconomiceffects of government budget deficits. The presentation is organizedaround three key relationships: the national income accountsbudget deficit identity, the deficit financing identity, andthe dynamic equation for the evolution of the ratio of publicdebt to gross national product. The national income accountsidentity highlights the effect of the deficit on domestic savingand investment and the current account. Examining the financingof the deficit brings to light the different kinds of macroeconomicimbalance the deficit can cause—as a first approximation,printing money excessively shows up as inflation, excessiveuse of foreign reserves leads to crises in the balance of payments,high foreign borrowing leads to a debt crisis, and too muchdomestic borrowing leads to high real interest rates and crowdingout of private investment. The debt dynamics equation is usedto show the long-run constraints on fiscal policy.      

Corporate Governance and Development

The literature shows that good corporate governance generallypays—for firms, for markets, and for countries. It isassociated with a lower cost of capital, higher returns on equity,greater efficiency, and more favorable treatment of all stakeholders,although the direction of causality is not always clear. Thelaw and finance literature has documented the important roleof institutions aimed at contractual and legal enforcement,including corporate governance, across countries. Using firm-leveldata, researchers have documented relationships between countries’corporate governance frameworks on the one hand and performance,valuation, the cost of capital, and access to external financingon the other. Given the benefits of good corporate governance,firms and countries should voluntarily reform more. Resistanceby entrenched owners and managers at the firm level and politicaleconomy factors at the level of markets and countries partlyexplain why they do not.      

Contracts,governance, and country risk in project finance: Theory and evidence

Project finance links financial structure to the operational characteristics of the project to optimize the allocations of various project risks. We develop a model in which concession grants and offtake agreements benefit both public and private sponsors in the presence of political risk. The public can use these contracts to incentivize the private sponsor to undertake an otherwise unacceptable project while benefiting from delegating the process of financing, building, and operating the project to the private sponsor. For the private sponsor, the government concession grant, while improving financial returns, entails political influence. We develop hypotheses connecting these contract choices to the public–private partnership governance structure of project finance and provide supporting evidence. Our findings suggest that a country's political and financial risks have significant impacts on the contract choice as well as the public–private governance structure in project finance. Projects in greater political risk countries tend to be structured with less government involvement in order to avoid political influence of the local government. Projects with the private finance initiative end up with more government involvement and control in order to protect the public interest.     

BEYOND RATE OF RETURN: REORIENTING PROJECT APPRAISAL

Traditional approaches to project appraisal fail in practiceto address two fundamental questions: whether a project belongsin the public or the private sector; and what effect any externalassistance associated with the project has on the country'sdevelopment. The first issue is of general interest to bothnational policymakers and international donors. If the governmentprovides a good or service that would otherwise have been providedby the private sector, the net contribution of the public projectcould be low. The second issue is of particular concern to donors.If financial resources are fungible, the project being appraisedmight well have been undertaken with out external financing.In this case, donor funds are actually financing some other,unappraised project. Both cases argue for a shift in the emphasisof project evaluation away from a concern with precise rate-of-returncalculations and toward broader sectoral analyses and publicexpenditure reviews. In this context, three areas critical forproper project appraisal include a consideration of the rationalefor public intervention, the fiscal impact of the project, andthe fungibility of external assistance.      

Contagion: Understanding How It Spreads

Much of the current debate on reforming the international financialarchitecture is aimed at reducing the risks of contagion—bestdefined as a significant increase in cross-market linkages aftera shock to an individual country (or group of countries). Thisdefinition highlights the importance of other links throughwhich shocks are normally transmitted, including trade and finance.During times of crisis, the ways in which shocks are transmitteddo seem to differ, and these differences appear to be important.Empirical work has helped to identify the types of links andother macroeconomic conditions that can make a country vulnerableto contagion during crisis periods, although less is known aboutthe importance of microeconomic considerations and institutionalfactors in propagating shocks. Empirical research has helpedto identify those countries that are at risk of contagion aswell as some, albeit quite general, policy interventions thatcan reduce risks.      

REFORMING FINANCE IN TRANSITIONAL SOCIALIST ECONOMIES

Financial reforms initiated in most transitional socialist economiesdo not yet adequately provide many of the financial servicesassociated with market-oriented financial systems. Such services—mobilizingresources, selecting firms and allocating capital, monitoringfirm managers, and facilitating the management of transactionsand risk—are a necessary condition for economic reformto improve living standards. This article envisages four central strategies to guide reformof the financial sector: • Building an infrastructure based on clear and enforceableproperty rights, modern accounting and auditing standards, reliablepayments systems, sound prudential and enforcement regulations,and professionals trained in finance • Ending the shell game of trying to hide the losses ofstate-owned enterprises, and separating government decisionsto finance "priority" firms from the allocation decisions ofindependent financial institutions • Privatizing some financial institutions early—althoughnot necessarily precipitously—in concert with the privatizationof firms and supervisory capabilities, meanwhile cleaning upbank loans to maximize the chances that firms and banks willsucceed as private entities • Improving the tax system and stressing a prudent interestrate policy to reduce uncertainty, distortions, and excessiverepression of the financial sector.      

ECONOMIC ANALYSIS FOR HEALTH PROJECTS

This paper applies to the health sector a method of projectanalysis advocated recently by Devarajan, Squire, and Suthiwart-Narueput.A health project evaluation should establish a firm justificationfor public involvement; establish the counterfactual—whatwould happen with and without the project; and determine thefiscal effect of the project and the appropriate levels of feesin conjunction with project evaluation. The evaluation shouldalso acknowledge the fungibility of project resources and examinethe incentives both for high-level public servants to shiftgovernment resources away from project-funded activities tothose that have not been evaluated and for lower-level contractorsand civil servants to provide good or bad service. Market failuresin health services and insurance markets should serve as a startingpoint for economic analysis, not as a reason to ignore economicsin health projects. Project outputs should be predicted aftertaking into account the reaction of consumers and providersin the private sector as well as market structures of supply,demand, and equilibrium for health services.      

THE COMMON AGRICULTURAL POLICY: A Review of Its Operation and Effects on Developing Countries

Policy changes in the European Community (EC)—the world'slargest importer and, since 1986, exporter of agricultural commodities—mayhave significant effects on world markets and developing countries.This article investigates the EC's Common Agricultural Policy(CAP), its history, mode of operation, and the prospects andpossibilities for change, to bring out the implications of thepolicy for developing country exporters and importers. The hypothesisthat evolves differs from that of many studies in proposingthat an agricultural liberalization in the EC is unlikely toeffect any great change in world market prices over the firstfew years. Developing countries' principal gain from a liberalizationof the CAP would derive from increased stability of world marketprices, improved access to export markets, and a reduction inthe uncertainty currently caused by discretionary measures inthe EC.      

CASH FLOW OR INCOME?: The Choice of Base for Company Taxation

Cash flow and equity income (or income) are two alternativebases advocated for taxes on businesses throughout the world.Although in practice most tax systems are hybrids with elementsof both types of taxes, recent literature has stressed the meritsof the cash flow tax because it is simple in concept and itdoes not distort decisions about capital expenditures and financing.But international issues and administrative complexities—particularlytax evasion—present problems that must be sorted out beforea cash flow tax can be implemented.      

Weak Links in the Chain: A Diagnosis of Health Policy in Poor Countries

Recent empirical and theoretical literature sheds light on thedisappointing experience with implementation of primary healthcare programs in developing countries. This article focuseson the evidence showing two weak links in the chain betweengovernment spending for services to improve health and actualimprovements in health status. First, institutional capacityis a vital ingredient in providing effective services. Whenthis capacity is inadequate, health spending, even on the rightservices, may lead to little actual provision of services. Second,the net effect of government health services depends on theseverity of market failures—the more severe the marketfailures, the greater the potential for government servicesto have an impact. Evidence suggests that market failures arethe least severe for relatively inexpensive curative services,which often absorb the bulk of primary health care budgets.A companion paper, available from the authors (seep. 219), offersa perspective on how government funds can best be used to improvehealth and well-being in developing countries. It gives an alternativeview of appropriate public health policy, one that focuses onmitigating the characteristic market failures of the sectorand tailoring public health activities to the government's abilityto deliver various services.      

THE ECONOMICS OF NATURAL RESOURCE EXTRACTION: A PRIMER FOR DEVELOPMENT ECONOMISTS

As developing countries become major consumers of the globalsupply of commercial energy, it is essential to understand thedeterminants of future energy prices. At the same time, manydeveloping countries are relying on exports of their own naturalresources—tropical hardwoods, oil, tin, gold, and otherminerals—to generate badly needed foreign exchange. Governmentpolicies influence how much of a resource is extracted todayand how much is saved for the future. Flawed policies needlesslywaste precious national wealth.      

EDUCATION VOUCHERS IN PRINCIPLE AND PRACTICE: A SURVEY

An education voucher system exists when governments make paymentsto families that enable their children to enter public or privateschools of their choice. The tax-funded payments can be madedirectly to parents or indirectly to the selected schools; theirpurpose is to increase parental choice, to promote school competition,and to allow low-income families access to private schools.Some opponents predict that vouchers will destroy the publicsystem, aggravate poverty, and foster segregation. Others fearthat voucher-receiving independent schools will be regulatedout of recognition. The main purpose of this article is to examine the recent emergenceof voucher systems as an interesting phenomenon in its own right.The evidence summarized relates to voucher systems operatingin twenty countries, provinces, and states. The typical "funds-follow-the-child"voucher system, in which governments subsidize "schools of choice"in strict proportion to enrollment, appears to be the favoriteform. This type of voucher has been adopted by developing countries—notablyBangladesh, Belize, Chile, Colombia, Guatemala, and Lesotho—aswell as by industrial countries such as Poland, Sweden, theUnited Kingdom, and the United States. Much of the recordedexperience with such programs is pertinent to the longstandingtheoretical debates on the desirability of voucher systems.