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Shared Experience: What Reforming Economies Have in Common
Good afternoon, and thank you for that kind introduction, N.K. I am delighted to be here today and to have the opportunity to talk about the economic reform process and what countries can learn from each other's experience.
But I first want to say something about the tragic events of the past few weeks. We are still trying to assess the scale of the destruction left by the tsunami that struck many parts of Asia on December 26th. Tens of thousands lost their lives, including many here in India; many more lost loved ones, their homes, their places of work and their livelihoods. Millions of people across the region have been directly affected in one way or another.
But many millions more around the world have been touched by these terrible events. The response, at official and, perhaps more strikingly, at the individual level, has been unprecedented. An enormous relief effort is underway across the region. It needs to be enormous because of the scale of the damage. It needs, too, to be sustained over a long period even when, dare I say it, the catastrophe that has affected so many ceases to be front-page news.
The IMF, like the other international agencies, has from the start stood ready to help; in our case by assisting with macroeconomic assessments of the impact and by helping to maintain macroeconomic stability where appropriate. The Fund is not a frontline relief agency: but we do have a lending facility for countries affected by natural disasters. Last week, Rodrigo de Rato, the Fund's Managing Director, was in Indonesia to attend the donors' meeting held in Jakarta and to visit some of the affected areas. When I leave India next week, I will be going on to Sri Lanka and then the Maldives, to assess the scale of the challenges these countries face and the hardships they will now have to overcome.
In one sense the challenge for all the affected countries is one for the global community as a whole. The survivors in the affected areas need help in re-building their lives: material help, yes, but at such a devastating moment, they also need to know that they will not be ignored by the rest of the world, that concern for their future will not quickly fade.
The extraordinary response to this terrible crisis has, I believe, been an unexpectedly eloquent answer to the critics of globalization. Modern communications technology has ensured that virtually all the world's citizens were quickly able to sense that this was a major disaster. It has been possible to marshal funds and resources quickly and then, in most cases, get them to the areas of greatest need. There has been a widespread recognition that this was a global disaster and needed a global response. The aid effort has genuinely been a collective one; and the longer-term reconstruction effort needs similarly to be global in scale.
I think one of the factors determining this response has been a clear sense of vulnerability that we all share. We are all potentially exposed to the risk of natural disaster. It is true that some countries are, for geographical reasons, more susceptible than others. It is also true that some among those at greatest risk are better able to protect themselves. In this age of mass travel, we can all find ourselves in the wrong place at the wrong time, no matter how secure our home environment might appear to be. But it will always be the poor who are worst affected. They are the ones living in the most vulnerable sites, in the poorest quality buildings that have least chance of withstanding the damage that natural disasters can inflict.
And so there is now a greater sense of mutual responsibility. We all have a duty to help others help themselves and this is increasingly recognized. That is part of the bargain associated with globalization's benefits.
The role of economic reform
Am I straying too far from my chosen topic, you ask? No. We cannot entirely protect ourselves from nature, but there are things we can do to reduce its occasionally adverse impact. In the case of tsunamis, it has already been agreed that an early warning system should be established as rapidly as possible, to help limit the damage from future incidents.
And the economic reform process can similarly help governments and their citizens cope more successfully with exogenous shocks. Economic reforms enable countries to achieve higher growth rates than would otherwise be possible. This reduces poverty and so reduces the number of those most vulnerable to natural disasters. Economic growth also increases the resources available to countries to cope with the aftermath of natural disasters as well as reducing vulnerability to the economic or financial turbulence that can follow such events or that inevitably occurs from time to time.
The recent events have also served as a more general reminder that we cannot know what the future holds. This is as true in economic policy as it is for all other aspects of life. So it is important to seize opportunities for locking in progress, pressing ahead with economic reforms when there is a chance, and increasing the flexibility—and thus the adaptability—of economies when sharp changes do occur. Where economic reforms have been undertaken, economic growth has been more rapid; and rapid growth is the only effective way to enable countries to adapt better in the face of unexpected and unpredictable shocks.
What, though, do I mean by economic reform? Too often, we talk about economic reform in vague terms, without specifying what we mean. It is a useful term, since it is all-encompassing. Reform is under way almost everywhere and almost all the time. We talk of social security reform in the United States, of the reform of corporate governance in the US and in Europe, of financial sector reform in Japan, of labor market reform in Germany.
Reform is not a one-off process that governments can undertake and then put behind them. As economies evolve, the economic framework needs constant adjustment, to reflect the changes that are taking place all the time. Economic progress doesn't pause for breath, and nor should the economic reform process.
So by economic reform I am talking about altering the framework for economic activity in ways that significantly improve the prospects for economic growth. Anything that helps remove a distortion or reduce the risk of a future economic crisis is a reform. Thus the corporate governance reforms I mentioned were a response to problems identified in the system in the wake of affairs such as Enron and Parmalat. These were corporate scandals on a grand scale. But they were also crises that involved real losses for large numbers of people and that, in consequence, resulted in lower growth than would otherwise have been the case. The changes put in place were intended to reduce the risk of such corporate crises in the future and so reduce the potential losses.
Similarly the current debate about social security reform in the US reflects concern that without adjustment the public finances will not be able to cope with old age pension commitments at some point in the future. A fiscal crisis in 20, 30 or 40 years time would have serious consequences for America's growth prospects. Heading off such a crisis now would enhance future growth performance. It would also be much cheaper. The longer such problems are postponed, the greater the cost of their eventual resolution. And at some point, problems such as these have to be dealt with. It is not a question of whether but of when—and how painfully.
So economists and policymakers in all economies must constantly monitor developments as they continuously seek to improve present and future economic performance.
Reforms do not have to be wide-ranging in order to have a beneficial impact on growth. But reform programs often do involve sweeping changes across the whole spectrum of economic activity—even when reformers did not set out with such grand ambitions. The reforms introduced in Britain in the late 1970s were broad in scope. But it was only as the initial reform program progressed that those in charge recognized the need, and the opportunity, to extend their scope significantly.
Korea starting in the 1960s; Chile in the 1970s; New Zealand in the 1980s, Brazil and Turkey more recently—all these are examples of countries that have seen large-scale reforms affecting most, if not all, areas of the economy. The ambition and scope of reform, however, does not necessarily tell us very much about the potential for a successful outcome: and I shall return to this shortly.
When countries embark on what we call a reform program, it is usually in response to disappointing economic performance—or a crisis—where this is perceived to reflect shortcomings in the framework of regulations and incentives for economic activity in both the public and the private sector.
The circumstances in which such reform programs are undertaken can nevertheless differ greatly from one country to another.
In some cases, a new program is part of the election platform of a newly-elected government. Often, the new government has won power as a result both of the perceived failures of its predecessors and of the promises it has made to introduce reforms. That was clearly the case, for example, when the Thatcher government won power in Britain in 1979, when the Aznar government took office in Spain in 1996 and when a new government was elected in Turkey in 2002. In other cases, a new government is appointed specifically to oversee a reform program—the new Egyptian government, for example, has embarked on an ambitious program of economic change.
At other times, reforms are introduced because of a broader societal conviction that the current economic framework has failed. This was arguably true in Turkey in 1980, when the longstanding import substitution strategy was abandoned. And it was also the case in Korea in the late 1950s, when there was widespread recognition that without radical change, Korea's economy could never be self-sustaining or even grow by very much.
Yet many reform programs are introduced in response to a crisis: such as those in Latin America in the 1980s and 1990s; India in 1991; Korea, Thailand and Indonesia in 1997-98. Reforms started in crisis circumstances come with advantages and disadvantages.
On the plus side, governments acting in response to a crisis usually get quite a bit of leeway from the electorate, at least in the short-term. It can be possible in such circumstances to go for radical change at a time when opposition will be more muted than usual. And it can be easier to lock in change, at least for long enough to permit the benefits to start showing.
There is a minus side to crisis-driven reform programs, though. Too often, governments have undertaken the minimum necessary to get through the crisis and, where necessary, to secure outside help—whether this be from the international organizations, or creditors, or both. In many such cases, though, the commitment to reform has been at best weak; reforms may have been introduced because of necessity rather than conviction. The consequence of this is that such policy shifts are unlikely to survive beyond the immediate crisis. Backsliding occurs quickly before the long-term benefits of change have become apparent.
Reforms introduced in response to a crisis can also be too narrow in focus. By that I mean that the government draws up a reform program that is only intended to remedy the immediate source of trouble. Such a short-term approach can only be a short-term solution. Unless the underlying causes of the crisis are confronted, problems soon recur. This was arguably the case in Turkey during the 1990s, when repeated crises reflected the fact that very little had been done to confront serious structural problems, despite the abandonment of import substitution and other reforms that had enabled almost a decade of significant growth. Eventually, as we know, the crisis of 2000 forced the then Turkish government to tackle the remaining underlying problems.
The context matters
The context in which reforms are undertaken differs widely over time and from country to country. Priorities change according to specific circumstances. Sometimes bringing down high rates of inflation is the most urgent challenge facing policymakers. In closed economies, trade liberalization takes centre stage. In yet other cases, regaining control over the public finances is the highest priority.
So the exact nature of the reforms introduced depends on the specific problems they are intended to remedy. But reforms such as trade liberalization; greater labor market flexibility; control of the public finances; a reduction of public debt; reform of the financial sector: all contribute to greatly improved economic performance. They strengthen economic resilience and they reduce vulnerability to outside shocks.
Successful reform programs share factors that cut across national boundaries. Experience over a long period and across many countries tells us that the most effective and durable reforms have usually, though not always, had certain important characteristics in common. I want to address these in turn. But first let me say something about the reform process. As I noted, reforms are introduced in response to perceived failures in the economy. Aspects of macroeconomic performance are judged to be weak, even when there is not a full-blown crisis; and growth is below potential.
What those undertaking reforms cannot know with certainty, however, is how, and how quickly, economic actors will respond to the changed behavioral incentives that reforms bring. They do not know how strong the opposition will be. They do not know how long it will take for actors to be convinced that reforms represent a permanent shift in the economic framework and will not be reversed in the face of opposition. Nor do policymakers know how quickly speculative pressures resulting from a crisis will subside once reforms have been introduced.
Economic actors face similarly difficult challenges in deciding how to respond to reforms. They, too, have an interest in the degree of opposition, since they need to make a judgment about whether reforms are likely to be enduring before they alter their behavior in potentially costly ways. Some actors will themselves be the opponents of reform, usually because they believe their interests to be threatened.
The more energy expended on opposing reforms instead of adapting to them the more the payoffs from reforms will be delayed for the economy as a whole; indeed, the reforms might be fatally undermined if opposition is sufficiently strong.
And efforts to oppose reforms can make it more difficult for opponents to share in those payoffs. One study of Chilean business responses to the reform program there found that many opponents had gone out of business: they had not succeeded in halting change but their attempts to do so had undermined their ability to adapt to the changed business environment. Those who believed that reforms would endure had been much more likely to survive.
The reform process is thus fraught with difficulties. All the more reason, then, for those undertaking reforms to benefit from what we already know about the best means to ensure their success. And we do know a surprising amount about what can give reform programs the greatest prospect of lasting success.
We know, for a start, that speed is important. The architect of the ambitious reform program begun in New Zealand in 1984, Roger Douglas, is convinced that it is essential to move swiftly. Reflecting on that heady period, Douglas argues that policymakers have the best chance of success by moving as rapidly as possible with the reform program, and taking it as far as is feasible:
"When an economy has been driven down a blind alley and ends up facing a brick wall, what matters is to back it out as soon as possible and get it back onto the high road to a better future".
Not all reform programs have been quite so ambitious in scope, but most successful reformers argue that swift action to introduce and implement reforms is essential. India's reform efforts have tended to be an important exception to this rule: here, gradualism has generally been favored by those undertaking economic reforms.
Reforming policymakers more commonly see important advantages in moving as quickly as possible. First, the more rapidly reforms are introduced, the more rapidly the benefits start to become apparent. And second, the speedy introduction of sweeping reforms can be an effective way of convincing private decision-makers that reforms represent a permanent change, thus inducing them to respond rapidly.
It is not just a question of speed. Roger Douglas makes no bones about it—reformers, in his view, need to be ambitious. Experience bears this out. Look at Brazil and Turkey, currently two of the largest users of IMF resources. Both have stuck with tight fiscal policies: Turkey's primary surplus is running at more than 6 percent of GDP a year—it was 6.9 percent in 2004, Brazil's is 4.5 percent. And both are reaping the rewards of fiscal prudence. Far from constraining growth, reducing fiscal deficits has freed up resources in the economy. Turkey's growth rate was 8.7 percent last year; and growth has accelerated in Brazil, to 5.2 percent in 2004, as the effects of strong policies work through the economy.
South Africa, too, has also benefited from fiscal reforms undertaken between 1993 and 2001. The tax base was broadened; income tax rates were cut, revenue administration was reformed and a medium-term budget framework was put in place, with improved expenditure planning and management, better accounting and reporting, and strengthened oversight. The overall deficit was reduced by 6½ percent of GDP over the ten years to 2002/03. Declining debt service costs have provided room for more social and capital spending.
This is not just anecdotal evidence. A recent IMF Working Paper supports the case that large fiscal adjustments have a better prospect of success than smaller ones. Likewise, back-loaded adjustment programs tend to be more successful than front-loaded ones.
Large adjustments signal the authorities' intention to put fiscal policy on a sound footing and achieve large reductions in the stock of public debt, while back-loaded adjustments provide the opportunity to phase-in adjustment over a longer period of time. This permits the introduction of higher quality, more durable reforms, including measures to limit unproductive spending, expand the tax base, and improve tax administration. And more gradual fiscal consolidations can generate consensus and act as a signal to markets that fiscal discipline will be maintained over the longer term. But it is important that back-loading not be an excuse for postponing change; enough has to be done at the beginning to make clear the extent of the commitment involved.
Fiscal consolidations undertaken under IMF-supported programs also have a higher probability of success, as they may reflect the fact that countries with such programs are more committed to adjustment than those without.
Ambition in other policy areas is equally important. Korea's spectacular growth performance over many decades owed much to the ambitious policy of trade liberalization pursued from the late 1950s. Trade and labor market liberalization in Australia in the 1980s resulted in significant and lasting improvements in economic performance. Wide-ranging labor market reforms in Britain in the 1980s helped make more rapid growth possible over a sustained period.
So speed, ambition and long-term commitment are all vital ingredients of successful reform.
Assess what is practicable
Given the benefits to be had from moving quickly, successful reformers start by tackling those policy areas where they have most direct control. These tend to be where changes can be implemented without legislative backing. Administrative changes are an obvious example. Removing unnecessary regulations that hamper business, or setting up administrative arrangements, such as one-stop shops, that encourage business start-ups can all usually be introduced without having to pilot legislative change through Parliament.
Take the licensing regime that plagued Indian business for so long. I and some colleagues in the audience here this evening visited Infosys in Bangalore earlier this week. We heard how in the 1980s, it took that company 25 visits to Delhi over a period of two and a half years to secure permission to import a computer worth around $20,000 at that time. The burden thus imposed on the company represented a tariff of something between 200 and 300 percent. Since 1991, when the licensing regime was largely dismantled, Infosys has not once had to go to Delhi to secure an import license. Most license requirements have been removed and in those cases where one is still required, it is possible to go to the nearest office—there is now one in most Indian cities.
Recent surveys of the time taken in different countries to set up a new company suggest that there are plenty of opportunities for governments to introduce simple changes that would streamline procedures and encourage enterprise. Some work done by the World Bank suggests that many governments having been making progress in this area.
Between 2003 and 2004, for example, Jordan cut the time it takes to start a new business by 62 days (it still takes 36 days though); France cut the time by 45 days and is now among the countries where it takes least time to start a new business—only 8 days. In Australia, though, it takes only two days. Here in India it still takes 89 days.
And the World Bank reports that governments have also been reducing the number of hoops through which those starting new business have to jump. Morocco reduced the number of procedures by 6, and Colombia and Spain each reduced it by 5. But again, Australia tops the list of best performers. There, as in Canada and New Zealand, only two procedures are needed to set up a new business. India has a way to go—here 11 procedures are involved.
Business regulation is only one example of reforms that can be introduced speedily and to good effect. In Britain, exchange controls were abolished in a matter of months in 1979: after officials told the newly-elected Thatcher government—probably to its surprise—that phasing out controls gradually would be difficult and made no sense.
None of this obviates the need to secure legislative backing for reforms. But as the German government has recently discovered with the labor reforms currently being introduced, getting parliamentary endorsement can be time-consuming. Reforms that can be introduced quickly permit government to show that they are making a start—and advance the time at which the payoffs become apparent.
Identify those who will gain
Speed helps steal a march on opponents of reform. So do reform measures that bring important payoffs for key groups. In Chile in the early 1980s, opening up the import regime for consumer goods brought significant benefits for consumers in the form both of extended choice and of lower prices. This made it more difficult for opponents to marshal opposition and increased support for reforms.
Identifying particular groups of beneficiaries can be even more effective if at the same time the social safety net is widened to compensate genuine losers from rapid economic adjustment. When the first phase of Chilean macroeconomic reforms was introduced in the mid-1970s, the employment scheme that guaranteed public works jobs for those who would otherwise have become unemployed was widely seen as an effective way of heading off opposition at a critical stage.
It is not easy to identify all those who will gain from reforms. In part this is because those who think they will lose overestimate the likely cost to them of change; in part it is because losers are more easily identifiable than those who might gain new business opportunities or the new jobs resulting from those opportunities—but who cannot know who they are before those jobs are created.
Some producers might conclude that they are vulnerable—protected domestic industries facing the prospect of greater foreign competition might have good reason to worry. But they might be mistaken. Here I cannot resist recounting the tale of the Mexican refrigerator manufacturer. This gentleman, who was head of the Mexican businessmen's association at the time, was strongly opposed to NAFTA because he reckoned that opening up trade would enable American manufacturers to make significant inroads into the Mexican refrigerator market.
This turned out to be a serious misjudgment. A big weakness with Mexican-made refrigerators had been the poor quality of compressors previously available to them. So bad were these that Mexican-made refrigerators had a terrible reputation among consumers. NAFTA made it possible to import and use higher quality US-made compressors in Mexican fridges and so enabled the manufacturer in question to become a leading player in the American refrigerator market for smaller models, as well as faring better in his own home market.
Patience and perseverance
Some reforms take time both to implement and to show significant results: policymakers need to be prepared for that and be committed to the long haul. But some reforms can have a rapid impact on the behavior of economic actors. Exports picked up rapidly in Turkey following the devaluation in 1958; and in 1980, following another shift in exchange rate policy, Turkey saw exports expand rapidly in the middle of a global recession. The British economy quickly strengthened when Britain abandoned the exchange rate mechanism in 1992, and Brazil's devaluation in 1999 resulted in a sharp pick-up in exports. Once exports become competitive, manufacturers are quick to exploit the opportunities afforded them. Even within existing capacity they reorient production lines, hire more workers and shift to round-the-clock operations.
The exchange rate isn't the only policy arena where swift payoffs are possible. An effective monetary policy can bring swift results on the inflation front. From a peak of 23,000 percent in September 1985, Bolivia cut its inflation rate dramatically, to 100 percent in the space of a year. By staying the course, the government brought the rate down further, to 18 percent by 1990. The payoff in terms of economic stability and more rapid growth was seen very quickly. Growth accelerated to almost 5 percent by 1990.
Experience in Latin America and elsewhere has shown that reducing inflation brings substantial political gains for reformers because it helps marshal support for other structural reforms. The sharp reduction in inflation in Argentina in the early 1990s was an important factor in generating popular support for the Convertibility Plan, for example.
A cumulative process
There will always be opponents of reforms programs. But as the momentum of reform builds up, the benefits start to show and growth accelerates, the opposition tends to diminish in power and size. Moreover, the payoffs of reforms increase because of earlier reforms. For example, labor market liberalization brings far greater benefits if it is accompanied or preceded by trade liberalization. Exporters are more confident that they can go ahead and hire more workers because it is profitable for them to do so. And, as we saw in the aftermath of the Asian crisis, reforms in the financial sector strengthen the economy as a whole by making credit allocation more efficient, improving the return on capital, and making possible more rapid growth.
Nothing succeeds like success and success in reform efforts greatly strengthens the credibility of policymakers. It is important to establish credibility as rapidly as possible because the more credible the reform program the more rapidly actors respond to reforms and the more rapidly the results become evident.
Half-hearted or failed reforms damage credibility. Not sticking with a reform program makes it far more difficult to persuade firms and individuals that any subsequent reform effort is serious. There were repeated but narrowly-focused reform efforts in Turkey in the 1990s: these failed to confront underlying problems and eventually brought an economic crisis which forced the government into more radical action—and a political upheaval which transformed the political landscape in 2002.
Argentina is another example of how much progress can be made with a comprehensive reform effort—and how far this can be undermined by ultimately ducking difficult but vital reforms. In the 1990s, Argentina's reform program, with the Convertibility Plan as its centerpiece, was, initially, seen as a successful model, but failure to address fiscal indiscipline resulting from weak fiscal constraints on the states ultimately brought on the crisis of 2000-2001.
Effective and sustained implementation of fiscal, labor market and structural reforms could have meant that the Argentine economy was robust and flexible enough to cope with unanticipated shocks and thus could have avoided the economic collapse that resulted from the abandonment of the Convertibility Plan.
Reforms breed reforms
As I noted, there will always be opponents of reform programs: policymakers need to ensure that opposition does not succeed and diminishes over time. As reforms take hold and the payoff in terms of more rapid growth and, in turn, poverty reduction, becomes evident, opponents are fewer and less strident.
But successful reforms also breed recognition that yet more reforms are needed. Korea began by reforming its trade regime in 1958-1960; moved on to tax reforms in 1963; on to fiscal reforms in 1964; tariff structure in 1967; and arguably continued reforming right up until the financial sector reforms that followed from the Asian crisis of the late 1990s.
Likewise, Chile started with fiscal and exchange rate reforms in the 1970s, but went on to introduce reforms in the labor market, the agricultural sector, the pension system and much more.
Reforms are always country-specific because they respond to national or global problems that have specific repercussions. The priorities for national reform programs are determined by the nature of the problems they are intended to address. Labor market reform, while always important, is less pressing in a country with hyperinflation. Trade might not be the most important reform in a country where even more could be gained from swift reform of the public finances.
But we know a lot about what makes for successful reforms: and these factors are, in general, not country-specific.
Successful reformers, by and large, move as rapidly as possible. They are ambitious. But they tailor their ambitions so that they first tackle issues that are urgent and that can have an immediate impact: this helps build support for and reduce opposition to reforms.
Identifying those who have most to gain from reform and enlisting their support for future reforms is an effective way of moderating opposition from vested interests that are often misguided.
Successful reformers recognize that reform is a cumulative process. That means maintaining the momentum for reform so that the payoffs increase; and extending the scope of reforms so that the payoffs to any one reform are greater than if it were implemented in isolation.
Credibility is something successful reformers all share. Economic actors will not alter their behavior to enable reforms to succeed if they believe that governments will abandon changes or reverse them.
Finally, significantly accelerated growth follows successful, persistent reforms. Whether in the UK, whose per capita income rose from being 2 percent below that of Italy in 1991 to 9 percent above it in 2004; or Korea, which rose from being the third poorest country in Asia to one of the richest; reduced poverty and higher living standards are the ultimate result.
IMF EXTERNAL RELATIONS DEPARTMENT