Macroeconomic Adjustment and

St
Structural
t l Reform
R f

An Overview

Joshua Greene
Consultant, IMF
January 2015

This training material is the property of the International Monetary Fund (IMF) and is intended for the use in IMF courses. Any reuse requires the permission of the IMF.

Lecture Outline
 I. Macroeconomic Stability and Its Importance
 II.
II Achieving
A hi i St Stability:
bilit Add
Addressing
i
Macroeconomic Imbalances Through Adjustment
(St bili ti M
(Stabilization Measures and d St
Structural
t lR Reform)
f )
 III. Promoting Growth via Structural Reform

 IV.
IV Adjustment and the Financial Sector
 V. Summary

2
 Primary Concerns for
Macroeconomic Performance

 Macroeconomic p performance focuses on

achieving stability and economic growth
 Macroeconomic stability entails
 Internal balance: low inflation, operating near
potential output (low unemployment)
 External
E t lb
balance:
l a sustainable
t i bl external
t l position
iti
(current account in balance or small deficit,
financed with modest debt/GDP ratio
 Stability is important for sustained growth

Another Definition of Stability

“The macroeconomic framework can be
described as stable when inflation is low
and predictable, real interest rates are
appropriate, fiscal policy is stable and
sustainable, the real exchange rate is
competitive and predictable, and the
BOP situation is perceived as viable.”
-- Stanley Fischer (1993)
To the above one could add maintaining a
sound financial system,
y , with well-
capitalized financial institutions and the
avoidance of excessive corporate or
household debt.

4
 Why Stability Matters for
Growth: External Balance
 Growth is hard to
achieve without a Country and Pct. Chg. in
sustainable balance Y
Year R l GDP
Real
of payments.
External crisis usually
y Mexico: ‘95 -6.2
brings disruptions to
imports, capital
Indonesia: ‘98 -13.1
outflows, and Turkey: ‘01
01 -7.5
75
sometimes trade or
payments restrictions. Argentina: ’02 -10.9
 Consider GDP losses
during recent external Iceland ‘09 -6.8
crises (see chart):
Sources: IMF, World Economic Outlook, Sept. 2003, Sep. 2004, Apr.
2005; IMF, Iceland – Staff Report for 2010 Article IV Consultation.
5

Why Stability Matters for

Growth: Price Stability
y
 Growth is also hard to achieve without
price stability (low inflation)
 Why? High inflation discourages saving
and foreign investment, distorts relative
prices,
i promotes wasteful
f l fi
financial
i l
activities, and encourages speculation,
dollarization, and capital flight
 Considerable research supports this view
(see following slides)
 NB: Addressing supply-side inflation can
be tricky when the national economy is
weak (e.g.,
e g mid-1970s,
mid 1970s OECD countries in
2011)
6
 Above a modest level,
inflation hurts growth
g
 There is a kink in the relationship between
inflation and growth:
g
 For inflation rates above the kink, there is a
robust negative
g relationship,
p, p
partly
y because
higher inflation means more variability
 At lower inflation rates,, some inflation may
y
be useful to “grease the wheels” of the
economy, allowing small increases in relative
wages, for example. Beware of demand-
induced deflation!*
 Estimates of the kink point vary (next slide).
*See Kumar and others (2003), Deflation: Determinants, Risks,
and Policy Options, IMF Occasional Paper 221. 7

Inflation and growth: a diagram

Sample: 140 countries, 1960-98
0.050

“kink” at 1-3% for industrial countries

0.045
7-11% for developing countries
(Khan and Senhadji)j
0 040
0.040
GDP growth

0.035

0.030 Other estimates of the “kink”:

2.5% (Ghosh & Phillips, 1998)
8% (Sarel, 1996)
0.025
13%
% (Ch
(Christoffersen
i ff &DDoyle,
l 1998,
8
transition countries)
0.020
1 2 3 4

log (inflation rate)

Source: M. Khan & A. Senhadji (2000), “Threshold Effects in the Relationship
between Inflation and Growth,” IMF WP 00/110. 8
 Key Policies for Macroeconomic
Performance
 Macroeconomic policies
 Fiscal policy (revenue, outlays, and budget
balance as pct. of GDP; financing mix)
 Monetary policy (setting policy interest rate and
other
h keyk policy
l instruments))
 Exchange rate policy (exchange rate regime and
level of the real exchange rate)
 Pricing policies (setting administered prices)
 Structural policies: trade, labor, competition,
pricing, state enterprises, governance, safety
nets, and especially financial sector policies
 Strong and appropriate financial sector
regulation, for a sound financial system 9

Keys for Achieving Stability

 Appropriate macroeconomic policies, to
achieve internal and external balance:
 Monetary policy that delivers low inflation
 Supportive
S ti fiscal
fi l policy
li that
th t limits
li it ddemand
d
for financing and maintains a moderate
public debt/GDP ratio
 Appropriate exchange rate regime that
maintains a competitive real exchange rate
 Supporting structural policies (trade,
llabor,
b competition,
titi fi
financial
i l sector,
t pricing,
i i
state enterprises, governance, safety nets)
10
 Keys for Achieving Growth
 Achieving macroeconomic stability
 Implementing growth
growth-promoting
promoting policies
 Favorable investment climate*
 Good infrastructure (transport, power systems)
 Effective public and private sector institutions
 Rule of law, protection of property rights
 Effective judicial system
 Effective and stable financial system
 Effective education system
 Political stability and good governance
 Ability of government to respond to new issues
 Structural reform is often the key to growth
* See www.doingbusiness.org for World Bank country assessments. 11

Achieving Stability through

Macroeconomic Adjustment
j
 Definition: “Macroeconomic adjustment
involves the development and
implementation of policies to address or
prevent the emergence
p g of imbalances in
an economy.”
 Chief macroeconomic imbalances:
 Internal (inflation, shortfall from potential
GDP; substantial unemployment may signal
the latter)
 External (large current account deficits; major
capital
p outflow signaling
g gp problem with entire
BOP)
12
What Prompts
p Adjustment?
j
 Financial crises, which often reflect
underlying macroeconomic imbalances
 Need to address serious macroeconomic

problems: inflation, slow growth, decreasing

competitiveness
 Limited financial resources: risk of running
g
out of reserves
 Adjustment
j in response
p to external
imbalances involves recognition that external
imbalances often reflect a resource-absorption
or savings-investment imbalance
13

The Rationale for Adjustment:

j
The Resource Absorption or
Savings-Investment
Savings Investment Balance
and the Current Account Balance
 GDP = C + I + X-M
X M
 GNI = GDP + Yf
 GNDI = GDP + Yf + TRf
 = C+I+X-M+Yf+TRf
 = A + X-M
X M + Yf + TRf
 GNDI - A = X-M+Yf+TRf = CAB
 GNDI - C = S
 S-I = CAB 14
 Key Elements of Adjustment:
Stabilization and Structural Reform
 Adjusting demand through stabilization: using
macroeconomic policy tools to bring demand
into balance with supply
 Ensuring
E i th thatt relative
l ti prices
i give
i appropriate
i t
signals, through changes in exchange rate,
i t
interest
t rates,
t and
d other
th administered
d i i t d prices
i
 Adjusting supply through structural reform

(altho gh this ttypically

(although picall req
requires
ires more time)
 Taking sufficiently strong action to establish the

credibility of an adjustment program

15

Key Stabilization Measures

 Expenditure adjusting policies (fiscal and
monetary policy)
 Adjust the level of aggregate demand

 Address sustainability concerns

 Expenditure switching policies (exch. rate policy)

 Shift demand between tradable and non-

tradable (domestically and foreign-produced)

goods and services
g
 Other policies (mainly adjusting key prices)

 Affect demand by changing relative prices

(e.g., petroleum products, producer prices)

16
 Monetary Policy
 Can reduce inflation by slowing
monetary growth,
growth raising interest rates
 Key issues where monetary policy

has scope:
 Which objective? (inflation, growth, exch. rate)
 Which regime? (Inflation targeting or other)
 Ch i off iintermediate
Choice t di t ttargett (interest
(i t t rates,
t
monetary aggregates, or inflation forecast)
 Direct vs. indirect instruments ((e.g.,
g , credit ceilings
g
vs. open market operations)
 Can monetary policy affect more than one target?
 Central bank independence: affects
credibility 17

Fiscal Policy
y
 Policy should aim at sustainability:
moderate public debt/GDP ratio (e
(e.g.,
g 50%
or less for emerging market countries)
 Deficit reduction is important to curb

demand and limit pressure on money

supply
– Key measures include
 Expenditure
p restraint ((mayy also include
expenditure reallocation to raise productivity
of government spending)
 Revenue-raising
R i i iinitiatives
iti ti (t
(tax and
d non-tax)
t )
18
 Exchange
g Rate Policy
y
 Goals of exchange rate policy
Promoting competitiveness and a sustainable current
–
account position
– Achieving and maintaining exchange market
equilibrium and a credible exchange rate system
– Helping equilibrate domestic demand and supply
– NB alternative measures of judging misalignment:
macro economic balance
macro-economic balance, equilibrium real exchange
rate, and external sustainability (“CGER” approach).*
Different measures may yield different assessments!
 When may exchange rate adjustment be needed?
– Noticeable parallel market in foreign exchange
– Large,
Large persistent current account deficit/surplus
– Large, sustained real appreciation/depreciation
19
* Discussed further in external sector accounts, analysis, and forecasting lecture.

Key Issues for

Exchange Rate Policy
 Type of exchange rate regime:
“h d” fi
“hard” fixed
d ((with
ith currency b
boardd or in
i
currency union), floating (“free” or
managed), d) intermediate
i t di t positions
iti ((e.g.,
managed crawl, floating within bands,
adjustable peg)
 Inflation targeters usually use floating

 The real level of the exchange rate, rate

especially for fixed rate systems: critical
to establish and keep the real rate at an
equilibrium level 20
 Price Adjustment
j Issues
 Administered prices: Keeping prices
below market levels may inhibit
production, encourage smuggling and
imports and/or impose subsidy costs
imports,
 Interest rates: Avoid negative real

rates
 Real exchange rate is also a key price

in the economy. Overvaluation

discourages exports, promotes imports.
Undervaluation ((a “super-competitive”
p p
exchange rate) may accelerate inflation.
21

Choice of Stabilization Measures

 Depends on nature, size, and likely duration of
the imbalance
imbalance. Programs must be tailored to a
country’s specific problems and institutions.
 Monetary,
Monetary fiscal,
fiscal and exchange rate policy all
affect both internal and external balance. Thus,
programs often involve combinations of these
policies and structural reforms.
 Policies differ in their ease of implementation,

speed of impact, and issues for which they are

particularly
p y effective ((see next slide).
)
22
 Choosing Among Policies
Implement- Impact
Implement- Especially
ation Speed
p Speed good
g for
Monetary Very fast Often Reducing
Policy
o y long
o g lag
ag inflation
a o
Fiscal Less rapid; Some lag Sustain.;
Policy
y depends*
p growth
g
Exch. Rate Fast Faster for External
Policy imports
p balance
Structural Slow to very Slow Growth
Reforms slow
* Slower in countries with separate executive and legislative branches.
23

The Limits of Stabilization and

the Need for Structural Reform
 Macroeconomic stabilization can achieve low
inflation and external sustainabilityy – but mayy be
unable to achieve rapid growth and higher real
incomes by itself
 Structural reform, which improves market

mechanisms and how macroeconomic policies

f
function,
ti can raise
i potential
t ti l output
t t
 Structural reform may also be needed to underpin

the success of an adjustment program

 (e.g., price changes may be needed for cutting

inefficient subsidies,
subsidies to strengthen fiscal
outcome) 24
 Structural
St uctu a Reforms:
e o s Rationale
at o a e
 Address institutional rigidities that
create imbalances and slow growth
 Improve resource allocation

 Allow
All stabilization
t bili ti att a hi
higher
h llevell
of real income (e.g., by improving
i
investment climate)
li )
 Can raise the credibility of

stabilization programs or ensure

their sustainability
25

Key structural reforms

 Price liberalization; making subsidies more efficient
 Policies to promote competition

 State
S enterprise
i reform,
f i l di
including privatization
i i i and
d
enterprise restructuring
 Strengthening
g g tax and expenditure
p administration
 Financial sector reforms, incl. development of broader

capital markets, related legal reforms

 External sector reforms: trade liberalization and,
and
where appropriate, capital account liberalization
 Budgetary reforms (structure, institutions)

 More
M transparency
t and
d better
b tt governance, including
i l di
judicial reform, stronger auditing, improved data
 Strengthening
g g corporate
p governance,
g , invest. climate
 Measures to combat money laundering, terrorist fin’g.

 Anti-corruption activities
26
 IV. Macroeconomic Adjustment
and the Financial Sector
 Adjustment inevitably affects the
financial sector
 Policy tightening affects the demand for
lending and the ability of firms and
households to service existing loans
loans, via
 Changes in interest rates
 Changes in aggregate demand, affecting
sales, employment, and household income
 Where firms have assets in local currency
but many foreign currency liabilities,
liabilities
exchange rate depreciation can affect firm
balance sheets and the ability of firms and
fi
financial
i l iinstitutions
tit ti tto service
i fforeign
i d
debt
bt
27

Financial Sector Weakness Can

Affect Adjustment
j Policy
y
 Widespread loan losses may make
authorities reluctant to tighten monetary or
fi
fiscal
l policy,
li since
i thi
this could
ld iincrease NPL
NPLs
 Substantial foreign indebtedness among
banks and firms may discourage exchange
rate depreciation, which could worsen firm
and bank balance sheets
 Financial sector
secto weakness
eakness also lessens the
effectiveness of policy tools, by
 Disrupting
p g transmission links between monetary
y
policy and operating targets
 Weakening supply response to exch. rate change
 Financial sector weakness can also trigger a
crisis, even if macro indicators look sound 28
The Financial Sector, Adjustment,
and Structural Reform
 Addressing banking crisis affects fiscal policy
 Bank recapitalization has budgetary
implications. Costs include any debt issued to
finance asset management institutions to
purchase non-performing
non performing loans (NPLs)
 Addressing a financial crisis usually also
requires structural reforms for the financial
sector, such as
 Restructuring, and possibly recapitalizing, financial
i tit ti
institutions
 Strengthening bank regulation and supervision
 Introducing an appropriate deposit insurance
system or reforming an existing one
29

Summary
 Sustainable growth requires stability,
including low inflation and a sustainable BOP.
 Adjustment is usually needed to address
macroeconomic imbalances
 Domestic policy (stabilization) can address
both external and internal imbalances
 Structural reform is often key for growth
 Together, stabilization and structural reform
can foster
f adjustment
d and
d higher
h h growth. h
 Note implications of financial sector concerns
f adjustment
for dj t t and
d structural
t t l reform.
f
30