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Chapter 20 Sequencing and Speed of Reforms. © Pierre-Richard Agénor and Peter J. Montiel. Sequencing of Reforms. Uncertainty and Gradualism. Adjustment Costs, Credibility, and the Speed of Reforms. Sequencing of Reforms .

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Chapter 20 Sequencing and Speed of Reforms

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Chapter 20Sequencing and Speed of Reforms

© Pierre-Richard Agénor and Peter J. Montiel

  • Sequencing of Reforms.

  • Uncertainty and Gradualism.

  • Adjustment Costs, Credibility, and the Speed of Reforms.

Sequencing of Reforms

  • Macroeconomic Stabilization, Financial Reform, and the Opening of the Capital Account.

  • Capital and Current Account Liberalization.

  • Macroeconomic Stabilization and Trade Reform.

Macroeconomic Stabilization, Financial Reform, and the Opening of the Capital Account

  • First principle of sequencing: macroeconomic stabilization and fiscal adjustment should precede financial reform.

  • Relationship between stabilization and capital account liberalization:

    • Adequate flexibility of policy instruments is required to counteract effects of capital movements.

  • If fiscal consolidation is not achieved before the capital account is opened, looser fiscal policy may not be adopted in response to contractionary shocks.

  • Domestic financial system must be reformed before opening the capital account of the balance of payments.

    • If real domestic interest rates are much below world levels, the removal of capital controls will lead to capital outflows and balance-of-payments crisis.

    • Avoidance of immiserizing external borrowing.

      • If domestic financial system is repressed, any resulting capital inflows may be misallocated.

      • Social rate of return on the use of these external funds may fall short of the cost of these funds to the domestic economy.

  • Fischer and Reisen (1994):

    • Fiscal control is needed before the capital account is opened up, because without such control financial repression will result in capital outflows or inflation.

    • Possible loss of monetary autonomy with a fully open capital account would leave no instruments for stabilization policy if fiscal policy cannot be used flexibly.

    • Even if opening up financially would leave some domestic monetary autonomy, capital account opening should be delayed, because of the needs to

      • establish and deepen domestic money and securities markets to permit sterilization of capital flows;

      • develop the domestic banking system to ensure that financial opening does not lead to high domestic interest rates and financial overintermediation.

    • Enforcement of competition to foster allocative efficiency in the financial sector.

    • Strengthening of prudential regulation and supervision, establishment of legal and accounting systems to cope with systemic risks.

    • Removal of excessive bad loans to increase the franchise value of banks.

      Proposed sequence of reform:

  • Liberalization of foreign direct investment and trade finance should come first.

  • Fiscal consolidation is the most important next step for two reasons:

    • It is needed to do without revenues from financial repression and to provide a stabilization instrument.

    • Healthy fiscal position is required to cope with potential bad loan problems in the financial sector.

  • Next is the implementation of measures for improved bank regulation and supervision.

  • Domestic interest rates can be freed, after

    • macroeconomic stability is achieved;

    • institutional mechanisms are in place for the domestic financial sector;

    • any bad loan problems are resolved.

  • At the same time the authorities should take steps to foster deepened securities markets.

  • Then it is prudent to liberalize capital outflows and complete domestic financial reform.

    • At this point, the entry of foreign banks into the domestic financial system can be permitted.

    • Liberalization process can be completed by opening up to short-term capital inflows.

    • Under this sequence, interest rate convergence will be achieved, new external resources will be allocated efficiently, and crises will be less likely.

    Capital and Current Account Liberalization

    • Appropriate sequencing of trade and capital account liberalization: experiences of

      • Asian countries in the 1960s,

      • Southern Cone countries of Latin America in the late 1970s.

    • Argentina and Uruguay opened their capital account before removing impediments to trade transactions.

    • Chile reduced barriers to international trade before lifting capital controls.

    • Korea opened its trade account before relaxing controls on capital movements.

    • Indonesia reduced trade barriers and simultaneously eliminated most controls on capital movements.

    • Opening the capital account prior to liberalizing the external trade regime is not a desirable reform strategy.

    • If the domestic financial system is liberalized prior to the removal of capital controls, massive capital inflows occur, leading

      • to buildup of reserves;

      • if not sterilized, to monetary expansion, domestic inflation, and appreciation of real exchange rate.

    • Successful liberalization of the trade account requires real depreciation of the domestic currency to

      • offset the adverse effect of cuts in tariff protection;

      • stimulate exports and dampen imports.

    • On the contrary, real appreciation associated with removal of capital controls

      • reduce profitability in export industries;

      • have adverse effect on reallocation of resources,

      • lengthen the adjustment process.

    • Opening the current account first is desirable, followed by gradual opening of the capital account.

    • Reason: if trade and capital account reforms are implemented simultaneously, net outcome can be an appreciation of real exchange rate due to

      • slow response of real sector to changes in relative prices in the short run;

      • relatively faster response of capital flows.

    • Edwards (1984) and McKinnon (1973, 1993): tariffs should be reduced prior to lifting capital controls.

    • Rodrik (1987):

      • Trade liberalization may have a contractionary effect in the short run if it is preceded or accompanied by capital account liberalization.

      • Mechanism: effect of trade reform on real interest rate.

      • Without restrictions on capital movements, trade liberalization raises consumption rate of interest if future price of traded goods is expected to fall.

      • Private agents react by switching spending from the present to the future.

      • Result: contraction in activity; increase in unemployment.

    • Krueger (1985):

      • Liberalizing capital movements in a country where capital/labor ratio is low reduces

        • rate of return to capital;

        • rate of accumulation;

        • long-term growth.

      • Opening the current account first may stimulate output to compensate for this negative effect.

    • Edwards (1989), Khan and Zahler (1985), and Edwards and van Wijnbergen (1986): role of intertemporal considerations; effect of distortions prior to reform.

    • Edwards and van Wijnbergen (1986):

      • relaxing capital controls in the presence of tariffs amplifies existing distortions;

    • reverse sequence is neutral or may be positive.

  • Calvo (1987a, 1989):

    • Lack of credibility plays the role of an intertemporal distortion.

    • Capital account should not be liberalized before agents have sufficient degree of confidence in the sustainability of the trade liberalization program.

    • Credibility affects both speed of reform and optimal sequencing strategy.

  • Capital mobility in developing countries may be higher than what is suggested by the intensity of legal restrictions.

    • Reason: agents use alternative, unofficial channels to transfer funds.

    • Result: removing legal restrictions on capital controls may not have much effect on the portfolio structure of private agents.

  • Similarly, if large portion of external trade is unofficial, removal of tariffs affect mostly the distribution of transactions between official and unofficial markets.

  • In these cases, appropriate order of sequencing can be determined by evaluating real efficiency gains of legalizing illegal activities under alternative strategies.

  • Macroeconomic Stabilization and Trade Reform

    • Successful trade reforms must be preceded by depreciation of real exchange rate.

    • Reason: ensure the sustainability of the liberalization process by dampening the excess demand for importables that removal of tariffs induces.

    • Real exchange rate can be influenced by nominal devaluations and restrictive demand policies.

    • Stabilization is precondition for the implementation of full-fledged trade liberalization program:

      • Macroeconomic instability distorts the signals transmitted by changes in relative prices brought by trade reforms.

    • If trade liberalization takes the form of substantial tariff reductions and has an adverse effect on tax revenue, macroeconomic imbalances may constrain

      • scope of measures that can be taken;

      • pace of tariff reductions.

    • Real devaluation is brought about by large nominal devaluations, which may exacerbate inflation if monetary and fiscal policies are not tight enough.

    • Devaluations affect the role of the exchange rate as a nominal anchor and may damage the credibility of the stabilization effort.

  • Disadvantage of reducing taxes on trade

    • In many developing countries these taxes are an important source of government revenue.

    • Reduction in revenue may lead to increased money financing and higher inflation.

  • Advantage of trade liberalization: increase in output and domestic revenue.

    • Increase in imports (tax base) compensates for reduction in tariff rates, bringing an increase in revenue.

    • Reducing tariff rates reduces incentives for smuggling, under-invoicing, and engaging in rent-seeking activities, so tax revenue may rise.

  • Greenaway and Milner (1991): no significant relationship between trade reform and amount of revenue collected from taxes on external trade.

    • When concern over the fiscal impact of trade reform is important, tariff reductions should proceed in steps:

      • gradual reductions in the level and structure of tariffs;

      • progress in expanding the domestic revenue base.

    • Falvey and Kim, (1992):

      • as alternative domestic revenue sources develop, relative importance of the fiscal objective will diminish;

      • this allows an acceleration in pace of trade reform and removal of tariffs.

    • Role of credibility factors: important element in the timing of trade and macroeconomic reforms.

    • Since trade reforms require real exchange-rate depreciation, it is regarded as a source of conflict from credibility point of view.

    • In practice two issues arise:

      • Lack of fiscal reform does not explain liberalization failures in some developing countries.

      • Trade reforms have been implemented in conjunction with macroeconomic stabilization programs rather than after stabilization has been achieved.

    • Supportive macroeconomic environment is required to ensure that real depreciation is not eroded by upward pressure on domestic prices.

    • Consistency between macroeconomic policy measures and trade reforms is essential to foster credibility and ensure success of the overall reform program.

    Uncertainty and Gradualism

    Conley and Maloney (1995):

    • Even under full credibility of policymakers, important source of uncertainty that related to the effect of reform on the economy's structure remains.

    • Changes caused by the reform occur over time and their precise magnitudes are not fully perceived.

    • Implications of them for speed of reform can be investigated using a two-period model.

    • Economy is initially closed financially and government policies are fully credible.

    • Reform program consists of two parts.

      • Part that affects real sector: once-and-for-all increase in the marginal product of capital.

    • Complete freeing of capital account: private agents can smooth intertemporal consumption through lending and borrowing on world capital markets.

  • Magnitude of the rise in the marginal productivity of capital is not known ex ante.

  • Private agents must form a prediction of its size to determine their consumption path.

  • Agents' prior distribution corresponds to the objective distribution of the new marginal product of capital.

  • New marginal product of capital has higher mean and variance.

  • There is a single consumption good available in the economy.

    • Representative agent's utility function:

      U(c1, c2) = c1/2 + c2,

      c1 (c2): consumption in period 1 (2);

       > 0: discount factor.

    • Agent is endowed with  in the first period.

    • It can either consume  entirely or invest for c2.

    • Budget constraints:

      c1 =  - s, c2 = F(s),

      s: saving;

      F(s): production function, (F ` > 0, F `` < 0).


    • Production function:

      F(s) = s1/2.

    • Government introduces a two-part reform program.

    • First part: distortion that leads to a positive increase, z, in the marginal productivity of capital is removed.

    • z is assumed to be a random variable uniformly distributed over the interval [0, zm].

    • First part of the reform converts production function to

      F(s) = (1+z)s1/2.


    • Agent's second-period budget constraint becomes

      c2 = (1+z)s1/2.

    • Second “leg” of liberalization program: government opens the capital account.

    • This enables private agents to borrow abroad and to increase their resources by, b in the first period.

    • Loans must be repaid in the second period with r denoting the world interest rate.

    • Using (4):

      c1 =  - s + b, c2 = (1+z)s1/2 - (1+r)b.

    • c1 and c2 are both assumed nonnegative, and agents are able to repay their debts in an expected sense:

      (1 + Ez)s1/2 - (1+r)b 0,

      Ez: mean value of z.

    • Three alternative scenarios: no reform, “real” sector liberalization only, “financial” sector liberalization only, and full liberalization.

      No reform:

    • Agent's optimization problem is to choose s so that

      max ( - s)1/2 + s1/2.




    = 0,

    2( - s)1/2


    • First-order condition is given by

      from which the optimal level of first-period saving can be written as

      s = 2/(1+2).



    = 0,

    2( - s + b)1/2



    - (1+r) = 0.

    2( - s)1/2

    Open access to world capital markets only:

    • Representative agent's optimization problem becomes that of determining s and b so that

      max ( - s + b)1/2 + [s1/2 - (1+r)b].

    • First-order conditions:


    1 + 2

    - .


    • Solutions:

      s = 1/4(1+r)2, b =

      Liberalize only the “real” sector:

    • Agent's optimization problem:

      max ( - s)1/2 +  (1 + zg(z))s1/2dz,

      g(z): distribution function of z.

    • z is taken to be uniformly distributed over [0, zm]; its mean value is thus Ez = zm/2.




    (1 + zm/2)



    = 0.

    2( - s)1/2


    2(1 + zm/2)2

    s =

    1 + 2(1 + zm/2)2

    • After integration, optimization problem:

      max ( - s)1/2 +  (1 + zm/2)s1/2.

    • First-order condition:

    • Optimal value of s:


    • If the government proceeds with the second part of its program:

    • Agent's problem:

      max ( - s + b)1/2 +  [(1 + zg(z))s1/2 -(1+r)b]dz.

    • After integrating:

      max ( - s + b)1/2 +  (1 + zm/2)s1/2 -  (1+r)b.






    1 + zm/2

    - (1+r) = 0.

    1 + 2(1 + zm/2)2

    - .

    2( - s)1/2

    s =

    b =



    • First-order optimality conditions:

    • Solutions:

    (1 + zm/2)



    = 0,

    2( - s + b)1/2


    • Suppose that the government's expected welfare function takes into account both

      • agent's utility and

      • whether the economy's standard of living increases or not.

    • Formally,

    • 0 <  < 1: reduction in welfare when consumption does not grow between the two periods (c2c1).

    (1-)U(c1, c2) if c2 > c1,

    W(c1, c2) =

    (1-)U(c1, c2) -  if c2c1.

    Conley and Maloney’s simulation results:

    • There are cases in which welfare is maximized by liberalizing only the “real” sector.

    • This result depends on the fact that there is uncertainty about the realization of z.

    • There is a range of realizations of z for which the ex post consumption path is decreasing when both sectors are liberalized.

    • If the mean increase were realized with certainty, consumption would not fall, and expected welfare would be EW(c1, c2) = EU(c1, Ec2).

    • In this case, agent's expected utility would be the sole determinant of the government's action, and it would choose to liberalize both sectors simultaneously.

    • When there is a cost associated with the downside risk of reform, it may be optimal to liberalize gradually.

    • Government that cares about a fall in living standards may find it optimal to liberalize the real sector first.

    Adjustment Costs, Credibility, and the Speed of Reform

    • Trade liberalization has strong effects on income distribution, because it affects industries differentially.

    • Social conflicts can be exacerbated if there are more “losers” than “winners,” depending on

      • power structure;

      • relative strength of sectoral lobbies.

    • Reform may have a large output cost in the short run because reallocation of resources across sectors

      • takes time;

      • is limited by the degree of intersectoral labor mobility.

    • Large increase in unemployment may affect endogenously the credibility of reform and weaken political support.

    • Gradual liberalization program may be the optimal response when policymakers aim at

      • minimizing adjustment costs;

      • maximizing the probability of sustaining the reform effort.

    • But doubts will be created about the commitment to reform if the adjustment process is too slow.

    • Providing sustained external assistance may be crucial in such circumstances.

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