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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 20Sequencing and Speed of Reforms

© Pierre-Richard Agénor and Peter J. Montiel

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

  • 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): account is opened, looser fiscal policy may not be adopted in response to contractionary shocks.

    • 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.

  • 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 financial system can be permitted.

    • 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 financial system can be permitted. 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): reduced prior to lifting capital controls.

      • 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;

  • 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.

  • 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 not have much effect on the portfolio structure of private agents.

    • 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.

  • 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: important, tariff reductions should proceed in steps:

      • 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

    Uncertainty and Gradualism important, tariff reductions should proceed in steps:

    Conley and Maloney (1995): important, tariff reductions should proceed in steps:

    • 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.

  • 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: smooth intertemporal consumption through lending and borrowing on world capital markets.

      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: smooth intertemporal consumption through lending and borrowing on world capital markets.

      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 smooth intertemporal consumption through lending and borrowing on world capital markets.

      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.

    • c smooth intertemporal consumption through lending and borrowing on world capital markets. 1 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.


    -1 smooth intertemporal consumption through lending and borrowing on world capital markets.


    = 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).

    -1 smooth intertemporal consumption through lending and borrowing on world capital markets.


    = 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 +  smooth intertemporal consumption through lending and borrowing on world capital markets. 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 + smooth intertemporal consumption through lending and borrowing on world capital markets. 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:






    1 program:

    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


    (1-)U(c1, c2) if c2 > c1,

    W(c1, c2) =

    (1-)U(c1, c2) -  if c2c1.

    Conley and Maloney’s simulation results: takes into account both

    • 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.

    Adjustment costs credibility and the speed of reform

    Adjustment Costs, Credibility, reform, it may be optimal to liberalize gradually.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.