WORLD BANK LATIN AM ERICAN f . , t19 Work in progress for public discussion ANNUAL WORLD BANK CONFERENCE ON Development in Latin America and the Caribbean 1995 V. . .1 #%~~~~~~~~~~~~~~~~~~~a Sha/iid. ..,ved B.rkl SCAS1'/41H/(/ A(dw(lrd PROCEEDINGS OF A CONFERENCE HELD IN ____________I WORLD BANK LATIN AMERICAN AND CARIBBEAN STUDIES Proceedings ANNUAL WORLD BANK CONFERENCE ON Development in Latin America and the Caribbean 1995 19: Lu1*IAWJ Proceedings of a Conference held in Rio de Janeiro Edited by Shahid Javed Burki Sebastian Edwards Sri-Ram Aiyer The World Bank Washington, D.C. Copyright © 1997 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing April 1997 The findings, interpretations, and conclusions expressed in this paper are entirely those of the author(s) and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any conse- quence of their use. The boundaries, colors, denominations, and other information shown on any map in this volume do not imply on the part of the World Bank Group any judgment on the legal status of any territory or the endorsement or acceptance of such boundaries. The material in this publication is copyrighted. Requests for permission to reproduce portions of it should be sent to the Office of the Publisher at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduc- tion is for noncommercial purposes, without asking a fee. Permission to copy portions for classroom use is granted through the Copyright Clearance Center, Inc., Suite 910, 222 Rosewood Drive, Danvers, Massachusetts 01923, U.S.A. Cover photo: James L. Stanfield/National Geographic Image Collection. Shahid Javed Burki is vice president of the World Bank's Latin America and the Caribbean Regional Office. Sebastian Edwards is Henry Ford II Professor of International Business Economics, The Anderson School of Management, University of California at Los Angeles. Sri-Ram Aiyer is director of the World Bank's Latin America and the Caribbean Technical Department. ISBN 0-8213-3883-8 Library of Congress Cataloging-in-Publication Data Annual World Bank Conference on Development in Latin America and the Caribbean (lst : 1995 : Rio de Janeiro, Brazil) Annual World Bank Conference on Development in Latin America and the Caribbean : Rio de Janeiro, 1995 / edited by Shahid Javed Burki, Sebastian Edwards and Sri-Ram Aiyer. p. cm. -- (World Bank Latin American and Caribbean studies) Includes bibliographical references. ISBN 0-8213-3883-8 1. Latin America-Economic conditions-1982- -Congresses. 2. Caribbean Area-Economic conditions-1945- -Congresses. I. Burki, Shahid Javed. II. Edwards, Sebastian. III. Aiyer, Sri-Ram, 1939- III. Title. IV. Series. HC125.A55 1995 338.9729--dc2l 97-1539 CIP Contents Introduction .. 1 Shahid Javed Burki and Sri-Ram Aiyer Conference Proceedings: ........................................... 3 The Challenges of Reform Sri-Ram Aiyer and Kin Bing Wu Opening Remarks ................ 9 Pedro Malan Keynote Address The Future of Economic and Social Development in Latin America and the Caribbean .11 Cesar Gaviria Trujillo Latin America after Mexico: Quickening the Pace ................. 15 Shahid Javed Burki and Sebastian Edwards Reform of the State in Latin America ................. 41 Stephan Haggard Comments Edgardo Boeninger ................ 61 Roger Douglas ................................ 63 Stephan Haggard's Response to Roger Douglas ................................ 64 Mario Henrique Simonsen ................................ 65 Why Are Latin America's Savings Rates So Low? An International Comparative Analysis .......................... 67 Sebastian Edwards Comments Carlos Langoni .................................... 88 Yung Chul Park ............................... 90 Floor Discussion .................................................... 91 iii DEVELOPMENT IN LATIN AMERICA ANI) THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Latin America and the Caribbean in the World Economy ................................................ 93 Carlos A. Primo Braga, Julio Nogues, and Sarath Rajapatirana Comments Max Corden .............................................. 120 William Lewis .............................................. 121 Jose Artur Denot Medeiros .............................................. 122 Floor Discussion .............................................. 124 Concluding Remarks ............................................ 126 Sri-Ram Aiyer Poverty, Inequality, and Human Capital Development in Latin America, 1950-2025 .............................................. 129 Juan Luis Londofio Comments Oscar Altimir ...................................................................... 148 Xabier Gorostiaga, SJ .................................... 149 Aspasia Camargo .................................... 150 Oscar Jorge Eduardo Durao ................................... 151 Ruth Cardoso ................................... 152 Floor Discussion .................................. 153 Education Reform in Latin America and the Caribbean: An Agenda for Action .............................................. 155 Ernesto Schiefelbein Comments Roberto Carneiro .............................................. 170 Eduardo Amadeo .............................................. 172 Floor Discussion ............................................ 174 Special Session Capital Markets after the Mexican Peso Crisis .............................................................. 177 William Cline Comments Marcilio Marques Moreira .............................................. 185 Suman Bery ............................................... 186 Floor Discussion .............................................. 187 Roundtable Discussion Latin America and the Caribbean in the Postadjustment Era .............................................. 189 Carlos Langoni .............................................. 189 Marta Mauris Perez .............................................. 190 Brian Stewart .............................................. 191 iv The planning and organization of the first Annual Bank Silvero, and Kok-Tjai Soo of the World Bank, and the staff Conference on Development in Latin America and the of N.C. Eventos of Rio de Janeiro. We also thank Araceli Caribbean (ABCD-LAC) was a joint effort between the staff Barahana, Ana Maria Caetano, Maria Helena Carvalho, of the Getulio Vargas Foundation and the World Bank. Ximena Durand, Sandra Freundt, Zaida Knight, Janice Particular gratitude is due to Marisa Motta and Lilian Molina, and Karen Ravenelle for providing skilled transla- Rebello of the Getulio Vargas Foundation, whose work tion services under extremely tight deadlines, Ana Maria before and during the conference made the event possible, Caetano for transcribing the tapes, Jessica Youniss for tran- and to L. K. Arora of the World Bank, who helped organize scribing and copy-editing, William Mayville for editing, and manage the logistics of the conference with great and Caroline Banton, Lourdes Benzi, Veena Mayani, and resourcefulness. We are grateful to Evelyn De Castro, Jorge Serraino for word processing and proofreading. Finally, Andrea Guedes, and Cecilia Zavaleta of the World Bank, we are highly indebted to Kin Bing Wu for her diligence whose excellent organizational skills kept the conference on and presence in ensuring the success of the conference, and track. We also appreciate the able support for the conference for overseeing the production of this volume. provided by Adriana Costa, Teresalina Marfori, Angelica This publication is part of the World Bank Latin American and Caribbean Studies series. Although these publications do not represent World Bank policy, they are intended to be thought-provoking and worthy of discussion, and they are designed to open a dialogue to explore creative solutions to pressing problems. Comments on this paper are welcome and will be pub- lished on the LAC Home Page, which is part of the World Bank's site on the World Wide Web. Please send comments via e-mail to laffairs@worldbank.org or via post to LAC External Affairs, The World Bank, 1818 H St. N.W., Washington, D.C. 20433, U.S.A. v Introduction S H A H I D J AVE D B URK I A N D S RI - RAM A I Y E R A TRADITIONAL CHINESE CURSE ENDS WITH THE IMPRECATION "MAY YOU LIVE IN INTEREST- ing times." This proceedings volume demonstrates that living in interesting times may not always be a curse. When we at the World Bank first explored the possibility of organizing a conference on development issues along regional lines, we did not anticipate just what inter- esting times these would be for Latin America and the Caribbean. As it turned out, late June of 1995-six months after the onset of the Mexican peso crisis-proved to be an interesting time indeed to analyze the economic and social challenges facing the region. Policymakers and analysts had gained enough distance from the initial shock of that regional "wake-up call" to exchange considered views on the lessons of the crisis. The first Annual Bank Conference on Development in Latin America and the Caribbean took stock of the immediate challenges created by the peso crisis and its aftermath and of the longer-term evi- dence that the region's record in addressing poverty and inequity left much to be desired. Most of the conference's participants agreed that the striking factor to attract attention in the wake of the crisis. Mexican crisis and the longer-term problems of the region Domestic savings are now recognized as crucial not only for were hardly to be viewed as grounds for reversing the eco- their long-term role in supporting investment in physical and nomic reforms pursued in Latin America and the Caribbean human capital, but also for their short-term role in averting in recent years. Rather, they should stimulate a renewed com- the dangers of overreliance on potentially volatile capital mitment to deepening and extension of the reform program. flows. This intensified interest has also focused attention For example, most participants believe that trade reform and throughout the region on reforming contractual savings trade expansion have been critical areas of reform. They also schemes, widely viewed as an important way of allocating believe that both areas need continuing consolidation and domestic savings in the short term, increasing savings in the extension at the national level-by maintaining competitive medium term, and facilitating development of domestic cap- exchange rate regimes and defending open trading arrange- ital markets. ments against pressures for backsliding-and at the levels of Many of the items on the region's agenda that were ana- regional cooperation and international policymaking. lyzed at the conference fall into the category of second-gener- The timing of the conference also helped highlight areas ation reforms. Improving education-its availability, quality, that had been undervalued during the early years of reform. and efficiency-is one of the most important and challenging The significance of domestic savings was perhaps the most of these reforms. Another is reshaping legal and regulatory 1 DEVELOPMEN'T' IN LAI'IN AMERICA AND TIlE CARIBBEAN: RIO DE JANEIRO (CONFERENCE, 1995 frameworks to make them more conducive to productive more solid base of support for economic reforms, and it is investment and employment creation. Such second-genera- in that spirit that the World Bank's Regional Office for tion reforms can require extensive institutional changes that Latin America and the Caribbean and our cosponsors at affect groups at both national and local levels. Generating the the Getulio Vargas Foundation supported this conference. political support needed to launch and carry out transforma- The first conference was a great success, and we intend tions of this kind is one of the most demanding challenges to make these conferences an annual event. The second facing leaders in the region. conference will focus on reducing poverty and improving More generally, the countries in the region face the social conditions-an ultimate goal of economic reform. challenge of building and sustaining consensus on policies We continue to live in interesting and stimulating times. that will contribute to an enduring improvement in the Old economic structures are giving way to new ones as the living standards of the people of the region. Sharing and countries of Latin America and the Caribbean reach out to expanding our understanding of the international experi- take advantage of growing opportunities in the world ence of development economics is one way of building a economy. 2 Conference Proceedings: The Challenges of Reform SRI -RAM A IYER A ND KI N B ING WU T HHE FIRST ANNUAL BANK CONFERENCE ON DEVELOPMENT IN LATIN AMERICA AND THE Caribbean, cosponsored by the World Bank and the Getuijo Vargas Foundation of Brazil, took place in Rio de Janeiro, Brazil, on June 12-13, 1995. Five hundred attendees included policy- makers, public officials, academics, and nongovernmental organizations. The six conference ses- sions focused on reform of the institutions of the state; differences in savings and economic growth in Latin America and the Caribbean and East Asia; Latin America and the Caribbean in a dynamic world economy; poverty, equality, and human capital development; education reform; and capital inflows and the Mexican peso crisis. The opening session economies, growth, poverty reduction, and democratization. Conference participants were welcomed by Marcello Alencar, Trujillo concluded by observing that upcoming elections in governor of the state of Rio de Janeiro. Jorge Oscar De Mello the region will signal either a referendum for reform or a Fl6res, president of the Getulio Vargas Foundation, also return to past policies. extended his welcome and expressed the foundation's desire to Shahid Javed Burki, vice president of the World Bank's broaden the scope of its activities, particularly in Brazil. Regional Office for Latin America and the Caribbean, set the Opening remarks were delivered by Pedro Malan, minis- tone of the conference by identifying the key challenges fac- ter of finance of Brazil. He stressed the importance of ing the region. According to Bank projections, growth must modernizing the state to enable efficient management of a average at least 3.2 percent a year to reduce levels of absolute nation's business. There is a similar need for sustained eco- poverty in the region. Achieving higher growth will require nomic growth and inflation control, in Brazil and elsewhere, increasing domestic savings, infrastructure investment, and to combat social problems. According to Malan, achieving productivity and competitiveness; improving education sys- the necessary growth rate will require strengthening the pri- tems and labor market mobility; and reforming the role of the vate sector, in part by opening domestic markets to external state. Burki cited some principal lessons learned in the competition. region-including those arising from the Mexican peso crisis, Cesar Gaviria Trujillo, secretary general of the Orga- which can be viewed as the region's "wake-up call." The text nization of American States, delivered the keynote address. of his background paper, written with Sebastian Edwards, He emphasized the importance of markets and pricing mech- then chief economist in the World Bank's Latin America and anisms and identified four pillars of regional reform: open the Caribbean Region, appears in this volume. Sri-Ram Aiyer is director of the Latin America and the Caribbean Technical Department at the World Bank. Kin Bing Wu is human resources specialist in the Latin America and the Caribbean Technical Department at the World Bank. 3 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Session 1 Reform of the state region continue delegating authority to autonomous agencies Stephan Haggard, professor at the University of California and regulatory bodies, while avoiding the delegation of dis- San Diego, presented the discussion paper on state reform. He cretionary powers that could result in reckless and ad hoc observed that there are several ways to define state reform- actions. reducing unwanted state intervention, expanding social ser- vices, and developing civil society. State reform in World Session 2 Savings and growth in Latin America and Bank-related efforts usually means reforming central govern- the Caribbean and East Asia ment bureaucracy. Haggard spoke of the need to focus on This session began with a presentation by Sebastian institutional changes in the region's government machinery, Edwards, chief economist in the World Bank's Latin since the policy challenges that accompany rapid change of America and the Caribbean Regional Office, who suggested the kind occurring in Latin America and the Caribbean that differences in savings rates are key to understanding dif- require significant capacity in both public and private insti- ferences in growth between Latin America and the Caribbean tutions. Technocratic solutions to reform the public sector are and East Asia. He showed that East Asia's high aggregate insufficient if they are isolated from social and institutional savings rates of 30-40 percent, compared with 19 percent in inputs. Moreover, changes in government politics are needed Latin America and the Caribbean, are the product of a to counteract undue influence by vested interests and to pro- unique combination of factors involving interest rates, eco- mote government that is responsive to voter expectations, nomic growth, borrowing constraints, taxes, and political taxpayers, and consumers of government services. stability. Latin America and the Caribbean could achieve A number of issues surfaced during the discussion peri- annual growth rates of 6.3 percent if its savings rates were od. Edgardo Boeninger, president of Corporacion Tiempo about 28 percent. And, according to Edwards, public savings Dos Mil and former minister secretary general of the presi- do not symmetrically crowd out private savings. Recent dency of Chile, emphasized the importance of stable and studies indicate that a 1 percent increase in government sav- effective state institutions that can provide needed infra- ings will generate a 0.5 percent increase in aggregate domes- structure and guide the direction of change. Some of the tic savings. Public savings can be increased through higher required changes are constitutional, such as the develop- tax revenues, lower expenditures, or a combination of the ment of a stronger legislature and an independent judiciary, two. although the executive branch should maintain sufficient The first discussant, Carlos Langoni, director of the control over essential functions such as monetary policy and Getulio Vargas Foundation and former president of the public safety. Further changes are needed to enable respon- Central Bank of Brazil, identified a number of reasons for the sible government leadership. Boeninger suggested that sta- variations in economic performance between Latin America ble governments will emerge only in political systems that and the Caribbean and East Asia. In Latin America and the are internally cohesive and disciplined, and he proposed Caribbean, for example, growth has always been accompanied electoral reforms to promote proportional representation. by inflation; in East Asia it has not. Another important dif- The need for strong and unwavering political leadership ference, according to Yung Chul Park from the University of was stressed by Roger Douglas, former finance minister of Korea, is the extent of outward-looking development strate- New Zealand. Strong presidentialism was viewed as an essen- gies. Export industries have not done well in Latin America tial ingredient for state reform by Mario Henrique Simonsen, and the Caribbean but have expanded strongly in East Asia. vice president of the Getulio Vargas Foundation and former Also, growth in Latin America and the Caribbean increased minister of finance and planning of Brazil. inequality in income distribution, which contributed to Reducing the opposition to reform was a third topic of dis- social tension. In East Asia growth did not adversely affect cussion. Discussants agreed that simultaneous presidential income distribution. and congressional elections would reduce the likelihood of During the discussion an audience member suggested divided governments and encourage congressional candidates that greater emphasis be placed on increasing private sav- who were tied to cohesive presidential platforms and nation- ings over public savings. Concern was expressed that high al policies. It was also recommended that politicians in the rates of public savings would increase investments in ineffi- 4 CONFERENCE PROCEEDINGS: THE CHALLENGES OF REFORM cient public enterprises. Thus it was recommended that example, the private sector is as much as 50 percent more governments in Latin America and the Caribbean focus on productive than the public sector in some functions. reducing fiscal deficits instead of saving more. Participants Improvements in productivity of this magnitude can also suggested that the East Asian experience is not suffi- increase employment opportunities. Lewis argued that, ciently comparable to provide lessons for Latin America and although labor market reforms are needed, product market the Caribbean. In China, where private savings are high, the reforms ultimately are more important. In European coun- public sector does not save. Park noted that high private tries, for example, product market restrictions in service savings rates in East Asia could be explained by the fact that industries have impeded the incorporation of quality prac- most workers are not covered by a social security or pension tices and limited new employment generation. scheme-contrary to the experience in Latin America and Jose Artur Denot Medeiros, Brazil's permanent repre- the Caribbean. East Asia's high savings rates were also the sentative to the Latin American Integration Association consequence of import restrictions and limits set on bor- in Montevideo, pointed out that any trade regime creates rowing from international sources. In Latin America and the winners and losers and that free trade can have negative Caribbean, where luxury consumer goods can easily be effects on labor and the environment. Moreover, small imported, there are fewer incentives for private saving. countries that are forced to compete under free trade schemes can be at a tremendous disadvantage because Session 3 Latin America and the Caribbean in the they may lack sufficient capacity. Countries in the region world economy also are more vulnerable to the risks that arise from exter- The third session covered trade liberalization in Latin nal instability. If national policies are not well conceived, America and the Caribbean since the mid-1 980s and its effect they will seriously compromise Latin American and on trade flows. The session focused on a paper prepared by Caribbean countries' efforts to participate in the global Carlos A. Primo Braga, senior economist; Julio Nogues, exec- economy. The move to open trade regimes must be close- utive director; and Sarath Rajapatirana, trade and industry ly monitored to ensure that countries do not return to policy adviser for Latin America and the Caribbean, all at the protectionism. World Bank. Their findings suggest that the region has During the floor discussion Nogues noted differences in quickened its pace of integration with the world economy the effects of liberalization in the region. In Argentina trade since the 1990s began. Despite the recent Mexican peso cri- liberalization-in the form of capital goods imports-has sis, it was agreed that a return to earlier policies seemed been a key ingredient in productivity growth. But other unlikely. Still, an unfinished agenda exists-institutional countries are increasingly compromising their liberalization changes are required to support and sustain the benefits of measures, and this should be a concern. In this respect the liberalization. smaller countries in the region should try to convince the The discussants elaborated on issues that need to be three largest economies not only to maintain but also to resolved if the region is to compete effectively in the world increase their openness. economy. The first issue involves the difficulties presented by Sri-Ram Aiyer, director of the Technical Department for a reliance on a fixed nominal exchange rate. Another is the the World Bank's Latin America and the Caribbean Region, need for greater openness in the world economy for free trade concluded the session by noting that trade liberalization in to take root. Max Corden, professor at Johns Hopkins the region had improved competitiveness and increased out- University, commented that protectionist sentiments in some puts and income. The World Bank, he added, is focusing on industrial countries impede free trade. competition policy and reform to improve the environment In the view of William Lewis, director of the McKinsey and potential for foreign direct investment. The regional Global Institute, free trade is important because-in addi- agreements being pursued among Latin American countries tion to changing the structure of the economy and employ- will be important to these efforts by ensuring that trade cre- ment-it can foster competition to stimulate technological ation and harmonization are common goals. The region innovation, new products, and higher productivity. should take seriously the advice to maintain pressure on the Encouraging private activity is also important. In Brazil, for three largest global economies to minimize isolationist ten- 5 DEVELOPMENT IN LA'rlN AMERICA AND TIIF CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 dencies. Only by acting together can the small- and medium- by the end of the decade. In some countries the reduction size countries apply pressure to support liberalization. in rural poverty before 1980 had an important effect on later poverty levels: overall poverty increased considerably Session 4 Poverty, inequality, and human capital during the regional economic crisis, but rural poverty did development not. Altimir suggested the need to create a virtuous circle Juan Luis Londofno, principal human resources economist of growth and equality, with sustained growth based on of the Latin America and the Caribbean Region at the international competitiveness. This, in turn, requires World Bank and former minister of health of Colombia, modernizing technology and educating the workforce over laid the groundwork for a discussion of the inadequacy of the longer term. Achieving this virtuous circle will require human capital formation in Latin America and the economic reforms to increase production and stimulate Caribbean. He identified this shortcoming as a major con- capital investment, accompanied by education reform. tributor to weak economic performance during the past Other discussants said that education alone may not be fifteen years as well as to the lack of sufficient progress sufficient to address the social segmentation that exists. toward poverty reduction, more equitable income distrib- Xabier Gorostiaga, S.J., rector at the Universidad ution, and democratic governance. One of every three Centroamericana in Nicaragua, commented that today pover- Latin Americans lives in poverty, with an income of less ty is urban, not rural as it was in the past, and introduces the than $2 a day. Of these, 86 million people earn less $1 a new factor of "social exclusion." Such exclusion is becoming day and live in extreme poverty. Meanwhile, every minute more pronounced as the globalization of economies moves two more people join the ranks of the poor. Moreover, the forward without employment growth. Latin America will number of people who are functionally illiterate and who need to respond with deep changes in its education systems reach age twenty-five with little or no education is grow- to respond to new inequalities and new poverty and to meet ing at an alarmingly high rate. Londofno recommended the challenge of growth in the absence of employment cre- investments in health and education that would reap high ation. In addressing the link between education and growth, dividends for the region. To further this process, central- Gorostiaga observed that Latin America and the Caribbean ized social sectors need to become more diversified, using has lost competitiveness in the international market despite incentives to improve the efficiency and quality of services an increase in the number of university graduates. Thus mere- rendered. ly increasing the number of postsecondary graduates does not During the discussion it was noted that Londonio's solve the problem of international competitiveness. The most aggregate data on regional income inequality do not important adjustment to be made in the region is in educa- reflect differences among and within countries in the tion-not only in terms of spending but also of quality and region. On this point Oscar Altimir, deputy executive sec- content. What is needed is a symbiosis of the state, the mar- retary of the United Nations Comisi6n Econ6mica para ket, and civil society, with education at its center, that leads America Latina y el Caribe (CEPAL) in Chile, said that to a structural integration based on shared values. In this definitions of inequality vary and that aggregating hetero- sense economic and social development are interdependent- geneous observations raises methodological concerns. one cannot occur without the other. Despite these issues, there was general agreement that the Aspasia Brasileiro Alcantara de Camargo, executive secre- region suffers from an unusually high degree of inequality. tary of Brazil's Ministry of the Environment, pointed out that Altimir believes that inequality evolved in different ways. sustainable development requires that environmental and Until the 1980s Argentina, Chile, and Uruguay-coun- human capital development issues be considered simultane- tries with low and interrupted levels of growth-had high ously. The quality of life must be measured not only by levels of inequality. By contrast, during the same era coun- income or education, but also by the availability of basic san- tries with high growth rates, such as Mexico and itation, housing, water, transportation, and cultural facilities. Colombia, saw levels of inequality fall. During the 1980s Jorge Eduardo Durao, executive director of the FederaWao inequality increased in nearly every country in the region, de Orgaos para Asistencia Social e Educacional (FASE) in stabilizing in the mid-1980s and then dropping slightly Brazil, echoed the view that a more integrated social policy is 6 CONFERENCE PROCEEDINGS: THE CHALLENGES OF REFORM needed to foster broader public participation. He suggested a environment in which teachers and schools have incentives strategy emphasizing investment in human capital based not to improve performance. only on education policies but also on policies for food safety, The discussants agreed that there was insufficient com- generation of new jobs, public health, and the like. At issue mitment to education reform. Eduardo Amadeo, professor is whether Latin American governments will make those at Pontificia Universidade Cat6lica in Rio de Janeiro, said investments and bear the cost of this strategy. Because non- that the reason for this in Brazil was that rich families send governmental organizations are dealing with the reality of their children to private schools and thus lack incentives to poverty in Latin America, they can play a vital role in improve public education. A discussion theme focused on facilitating the dialogue between government and society. reallocating resources and introducing financing reforms in Clearly, Durao said, many types of social organizations will higher education to help pay for the large investments need to be involved in implementing and monitoring required in basic schooling. Roberto Carneiro, president of social policies. the executive board of Televisao Independente, S.A. (TVI) Ruth Cardoso, president of the Conselho do Programa and former minister of education of Portugal, said that edu- Comunidade Solidaria and first lady of Brazil, agreed with cation should be at the top of the social agenda. He empha- the emphasis on education reforms but suggested that atti- sized that reducing social inequality and eliminating the tudes about equality and exclusion also need to change, par- exclusion of the poor increase the demands placed on edu- ticularly in Brazilian schools. New attitudes will be cation and proposed ranking education priorities within a required, for example, to increase the length of teaching long-term strategy, allocating funds accordingly. Carneiro time, since the quality of the teaching-learning environ- also said that education should provide the basis for social ment often determines the achievement levels of the poorest mobility and that there should be more community students. She also said that the climate was favorable for involvement in local schools to promote salutary and cohe- reform efforts because urban populations are highly orga- sive social values, with education at the center of the devel- nized. This organization is reflection in affiliations with for- opment concept. Simon Schwartzman, president of the mal organizations and in numerous community activity Instituto Brasileiro de Geografia e Estatistica (IBGE) in centers. Brazil, agreed with Schiefelbein on the need for more research on the learning process to counter the inadequacies Session 5 Education reform of classroom teaching. A paper on education reform presented by Ernesto Schiefelbein, director of the Oficina Regional de Educaci6n Special session The role of capital flows in the para Am6rica Latina y el Caribe (OREAL) of the United Mexican peso crisis Nations Educational, Scientific and Cultural Organization An overview of capital flows preceding the Mexican peso (UNESCO) and former minister of education of Chile, doc- crisis was provided by William Cline, deputy managing umented the low quality of basic education in the region, director and chief economist at the Institute of International especially for the poor. Signs of low quality include the lack Finance in Washington, D.C. Cline noted that significant of basic learning materials, insufficient teaching time, inad- capital inflows to Latin America took the form of direct equate screening of teachers, and inequitable resource allo- investment, stock purchases, and bond floats. The funds cation that penalizes poor households. Strategies exist to came mainly from capital repatriated by Latin American correct these deficiencies, but additional resources are need- investors and from institutional investors abroad seeking ed to do so. Among the strategies Schiefelbein suggested higher yields. The large capital inflow was countered by were changing teaching methods to promote student par- large current account deficits, however. Mexico's policy mis- ticipation, extending instructional time, rationalizing the take was to adhere to a quasi-fixed exchange rate for too allocation of teachers based on enrollment patterns, revamp- long, leading to overvaluation and high levels of external ing the recruitment and training of teachers, and reorient- imbalance. The government's reliance on short-term paper ing education ministries to be more focused on broad poli- to finance government debt, coupled with the political cy considerations, especially on the creation of an enabling instability resulting from the Chiapas rebellion and the 7 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Colosio assassination, left little margin for policy error. The Roundtable discussion Latin America and the peso was already in crisis when investors realized the extent Caribbean in the postadjustment era of Mexico's debt and its low level of reserves. A key message of the conference, noted Carlos Langoni, A number of options were suggested to prevent anoth- was the strong link between political and economic er crisis: establish mechanisms to provide short-term reforms. Macroeconomic stability is obviously indispens- emergency financing to countries with good policies, able to any reform effort. Marta Mauras Perez, regional reform international institutions and provide an early director of the United Nations Children's Fund (UNICEF) warning by the International Monetary Fund (IMF) to in Colombia, spoke of the importance of reducing poverty, countries whose policies are misaligned, double IMF quo- improving income distribution, and concentrating on tas, and establish an international bankruptcy procedure. human capital investment, since income distribution One discussant, Marcilio Marques Moreira of Merrill remains a source of social tension even in countries with Lynch and former minister of finance of Brazil, spoke of sound economic growth, such as Chile. Brian Stewart, the ways countries sequence economic and political deputy director of the Western Hemisphere Department reforms. For example, Mexico and China initiated eco- at the IMF, noted that Latin American and Caribbean nomic reforms without first introducing political reforms. countries have assigned increasing importance to macro- By contrast, Brazil and Russia embarked on political economic stability but that conditions remain fragile and reform first, followed by economic reforms. Although strategies that involve more public spending should be political turmoil has not been insignificant in either coun- viewed with caution. In a final observation, Stewart noted try, initial political reforms might provide a more solid that the IMF is considering establishing surveillance platform for economic reforms. Another observation was mechanisms to stave off crises such as that in Mexico. that the success of economic reforms depends not just on top-down policies but also on bottom-up changes Closing remarks throughout the economy. In this regard it was mentioned Marcos C. de Paiva, executive director of the World Bank, that economic reforms might be perceived as more legiti- closed the conference by summarizing the challenges facing mate if political reforms led to more popular participation. Latin America and the Caribbean. These challenges-reform- Also during the discussion, Suman Bery, economic ing the state, developing effective social policies, and becom- adviser to the Latin America and the Caribbean Regional ing integrated with the world economy-have as their coun- Office at the World Bank, remarked that the new conven- terpoints three questions for the World Bank. First, how is it tional wisdom of restricting capital flows might not be the going to act as an investment partner in areas where the state best course of action. Some countries that are short on cap- is being replaced by the private sector? Second, how can the ital might choose to liberalize foreign capital inflows. In Bank ensure effective project implementation, particularly in Mexico the ability of the monetary authorities to control the social sectors, where institutional capacity is weak? their current account may have been circumscribed by the Finally, how can Bank activities be linked with local commu- large capital inflows they had to manage. The challenge for nities and nongovernmental organizations? These questions capital importers, Bery said, is to develop policies that should provide the themes for future conferences. encourage optimal use of external savings, instill confi- dence in both domestic and foreign investors, and create a policy climate more conducive to sound investment. 8 Opening Remarks PEDRO MALAN T _ HIS CONFERENCE PROVIDES THE WORLD BANK WITH AN OPPORTUNITY TO EXPRESS ITS commitment to social and economic development in Latin America and to reaffirm its partner- ship with the region's countries. In the same way, it gives Latin American countries the oppor- tunity to commit to the ongoing changes in the region. Despite the success of Brazil's Real Economic Plan, introduced one year ago, much remains to be done to consolidate stability and keep inflation low while pursuing a higher level of social justice. Specific indicators of the Plan's success include lower costs of the basket of basic goods relative to last year, nominal increases in salaries and minimum wages with a corresponding increase in workers' buy- ing power, and control of inflation without recession and without resorting to confiscation, freezing, breaking contracts, or government interference. In 1994 GNP grew by 5.7 percent, industry and agri- the public sector is in no condition to assume that respon- culture increased 7 percent, and the 1994-95 harvest set sibility. Consequently, private sector assistance is essen- a record. Growth has continued in 1995. But as the gov- tial, be it national or international. ernment has said many times, this level of growth is The government should not engage in production activi- unsustainable and incompatible with stabilization since it ties where its presence can no longer be justified. Instead, it will inevitably create expectations for price increases and must assume its indisputable responsibility for investing in lead to an unfavorable balance of payments. Successful basic education, health, and sanitation. The government measures were implemented in March to contain unsus- should also be more effective in managing its policies. This tainable growth, and since then there has been a reversal concept of an efficient government implies the need for mod- in negative expectations about an increase in inflation. ernizing relationships with the private sector. Also, there is no indication that prices will go up again, Inflation is the cruelest taxation that a government can now or later. impose, since its main victims are the poor. The cultural Brazil faces three long-run challenges. The first is effects of inflation and memories of past experiences help modernizing the state to enable the government to effi- keep this problem alive. Properly dealing with these ciently manage national affairs. Again, great improve- problems is essential to ensure social justice. A modern ments have been made in this area-but much remains to Brazilian economy depends on defeating inflation. be done. The current debate on privatization is one exam- The second challenge is achieving sustained growth. A ple. The scope of public services must be broadened, but development boom that melts away with inflation and an Pedro Malan is minister of finance of Brazil. 9 D)EVELOPMENT IN LATIN AMERICA AND 'I'HE CARIBBEAN: RIO DE JANFIRO CONFERENCE, 1995 unfavorable balance of payments serves little purpose. Brazil the capacity of our industrial parks. The question now is how needs sustained development that allows a solid economy to to reconcile current levels of economic growth with interna- grow, enabling the resolution of immense social problems tional competitiveness as well as the extent of economic cor- while controlling inflation and sustaining growth. rections to be made. The third challenge is to increase private sector efficiency Achieving these goals will require lowering medium- and and competitiveness. This implies increasing domestic com- long-term capital costs; reducing the cost of work and infra- petition, developing markets, exposing domestic products to structure; tax reform; and effective action from different min- external competition, and encouraging production that is istries to eliminate bureaucracy, needless regulations, ineffi- potentially exportable and competitive with imports. ciency, and corruption. It is our firm intention to work on this More than 70 percent of Brazilian exports are capital open economic strategy and toward a significant reduction of and intermediary goods. To compete domestically and the so-called "custo Brasil." internationally, we must consider modernizing and increasing 10 KEYNOTE ADDRESS The Future of Economic and Social Development in Latin America and the Caribbean CE S AR GAV I RI A TRUJ I LLO WANT TO THANK THE WORLD BANK AND THE GETULIO VARGAS FOUNDATION FOR THEIR INVI- tation to reflect on the future of economic and social development in the Americas. No other issue in the hemisphere generates more interest and requires more analysis today than the one that inspires this conference. How are we going to face the future when people have the impression that economic reform has been exhausted? How can we put this continent on a path of sustained and balanced growth? Is there any way to change the fate of the growing number of people living in poverty in our countries? While I can only contribute ideas to the debate of these issues, our collective thinking-stimulated by the solid research and ideas gathered in the papers to be discussed here-can offer new insights. What have we learned? gies. Inflation led poverty to such oppressive levels and made The discussion of development strategies in Latin America economies behave so erratically that along with the return of has changed significantly in recent years. In the past, eco- democracy came a widespread demand for price stability. nomic liberalism and government interventionism were These are trying times for the economies of our hemi- seen as two antagonistic policy options. While we spent a sphere. Because of the cyclical nature of capital markets, lot of energy and paper in that tug-of-war, the realities of excesses of optimism are inevitably followed by surpluses of the debt crisis forced the region to understand that mar- pessimism. What happened in Mexico shook the faith of the kets are essential and that bureaucracies make too many international financial community and scattered doubts costly mistakes. around the globe about the future of emerging markets. An important economic lesson of the 1980s was to recov- Enormous change was witnessed in Latin America er the status and role of markets and price mechanisms. throughout the 1980s and the 1990s. Profound structural Behind us are the times when it was sacrilegious to advocate reform took place and, almost without being noticed, the free markets as effective and socially convenient organizing level of integration among the Latin American countries and economic principles. with global capital markets grew significantly. Financial and This recognition was accompanied by an enlightening capital markets in Latin America opened their doors enthusi- rediscovery about economic policy. The region learned that astically to foreign investors, attracting billions of dollars in tackling fiscal imbalances, defeating politically induced mon- direct and portfolio investments. etary expansion, and creating a stable macroeconomic envi- In the process, the nature of hemispheric economic ronment were at the core of successful development strate- relations changed dramatically. Governments and institu- Cesar Gaviria is secretary general of the Organization of American States and former president of Colombia. 11 DEVELOPMENT IN LATIN AMERICA AND TIIl CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 tions lost their predominance as the main financial actors for President Cardoso, a symbol of economic stability. The in the region and were effectively replaced by entrepre- recent approval of constitutional reform ending governmen- neurs and private investors. The quantum leap in the tal monopolies in mining activities is an example of the magnitude of cross-border, market-induced trade and momentum that reform is gathering in this country. financial flows created a new reality for both internation- This widespread and renewed political mandate reinvigo- al financial actors and Latin American economic authori- rates the region's economic reform agenda. We should take ties. Open economies led to more efficient yet less man- advantage of the fact that committed governments with pop- ageable and less predictable markets. Implementation of ular support are devoted to guiding their societies toward development policies in market-oriented economies is prosperity using the right policies. We have a second chance much more complex than in the centralized, bureaucratic, to move forward. and regulated environments of the past. But first we have to acknowledge what we have learned in We should not be surprised when, under this new set of the recent past. There seems to be consensus that expansion- rules, policies and decisions are influenced by global market ary credit policies and diminishing external reserves can breed dynamics. We should recognize that markets, more often disaster. Also, disregarding chronic current account deficits than not, are brutal and unforgiving when imposing disci- can be devastating when relying on short-term debt to pline. The countries willing to play by these tough rules- finance both public expenditures and cover current account despite the pain and the cost of the adjustments-are cer- deficits. When the international capital markets react tainly the best candidates for dynamic economies of the adversely, economic authorities are sometimes left with very future. little room to maneuver. Using inflexible exchange rates to In fact, when adjustment processes respond to market stabilize the economy without a strong commitment to pari- conditions and are designed to preserve market-oriented ty, and the sacrifices it entails, can be unsustainable. On the macroeconomic environments they usually result in more institutional level, inadequate supervision of financial agents stable structural reforms. Mexico is a case in point. The and lack of effective accountability of public finances can turn recent crisis sparked a new round of reforms and spurred off the early-warning system of the economy. private initiative, thus guaranteeing the long-term health The nature and focus of the economic reform process has and prosperity of the Mexican economy. Sometimes coun- to be adapted to overcome the frustrations and encourage the tries have to be dragged, kicking and screaming, into successes of the last decade. As Shahid Burki and Sebastian prosperity. Edwards advocated in their recent work, we need to enter into With the shock of the Mexican crisis behind us we should a phase of consolidation. now address long-term issues surrounding the Latin The reforms implemented by Latin America and the American and Caribbean economies. We should ask whether Caribbean during the 1 980s were designed under the need to the political tendencies in Latin America favor the breakdown respond to severe external sector and public financial imbal- of market-driven economies and macroeconomic stability. ances. The resulting "shock therapy" addressed the most The recent and upcoming elections in Latin America can obvious distortions and urgent macroeconomic disequilibri- be interpreted as a referendum for reform, not as a return to ums. The policies were aimed at avoiding the collapse of the the past. Voters have already cast their ballots in favor of economy and set the general ground rules for long-term macroeconomic stability and economic reform. President change. Although some economies require further progress Zedillo of Mexico, for example, was elected on a platform that on that front, for many others it is time to move on to a new strongly favors modernization of the economy and, above all, stage. Without forgetting the macroeconomic objective of monetary and fiscal stability. The Argentine people chose the stability, the goal of the "second wave" of reforms should be stable and market-oriented economy built by President to reduce poverty and achieve effective and democratic states. Menem instead of the old regime of hyperinflation. President Let me comment on some of those challenges. Fujimori was reelected due to his successful program to recov- Stephan Haggard's paper identifies institutional and er institutional and economic stability. Look around and you governmental transformation as the core of the reform will see the millions of Brazilians who enthusiastically voted process. Probably the most critical question for the "sec- 12 THE FUTURE OF ECONOMIC AND SOCIAL DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN ond generation of reforms" is how we deal with the state. lization, corporatism, and concentration of ownership of pro- In fact, the papers prepared for this conference all refer to ductive assets create barriers to entry to new firms. They dis- major institutional change as the critical variable to accel- courage the enthusiasm of many entrepreneurs and potential erate economic growth and to promote equality and social investors. justice. Without doubt, political and institutional reform The access to competitive markets is not only denied by should be placed at the core of our new development governments. Private actors can become serious obstacles to strategies. the dynamic entrepreneurial process. We should therefore include reform of the private sector as part of the develop- What else must be done? ment agenda. We need a revolution of entrepreneurship; we Mois6s Nafm offers a good description of the size of the job need to unleash the growth potential of private initiative in front of us. He argues that "in this new stage govern- often tamed by the absence of competitive environments. ments will have to do much more than maintain macro- Deliberate and strong antitrust efforts combined with economic stability. The pending agenda of Latin America measures to encourage broader access to asset ownership can is overwhelming; the list of tasks is long and the necessary have a significant impact on the investment potential of Latin changes are technically, politically, and administratively American economies. This aspect has received less attention complicated." in the reform process and could emerge as a critical obstacle Each country and each circumstance will demand different for translating structural adjustments into long term growth. policy mixes. However, in all cases we will need less of what However, the fundamental vulnerability of the economies makes the state an obstacle and more of what makes service- in Latin America is a level of domestic savings and invest- providing institutions efficient, focused, and specialized. We ment that cannot support a growth rate congruent with the need a state that is firm and stringent in its regulatory people's expectations. The dramatic boom and bust nature of responsibilities. economic cycles in Latin America has a lot to do with inade- But there is another side to the debate of state reform that quate savings rates. The inability to finance capital forma- goes beyond the concern for fiscal prudence. I am referring to tion-both physical and human-with internal resources the need to construct stable, efficient, and legitimate democ- leads to a dependency on external finance. However, since ratic states. The task of the coming years does not only resources eventually have to be paid back we have a tendency require fine-tuning specific reforms, improving the trans- toward over-indebtedness. And since the flows can unexpect- parency of markets, or achieving appropriate legal frame- edly be reversed by uncontrollable international capital mar- works for private investment. Those things are very impor- kets, these exogenous capital movements usually are not tant and we must defend them. But it is equally important to sustained. foster the legitimacy and institutional strength of the demo- Hear me correctly. I believe in the advantages that accom- cratic state. If we do not consolidate democracy throughout pany open economies, foreign investment, and international the hemisphere, our efforts on the economic front will be financial flows. However, they will never be a substitute for meaningless. This is an area in which the World Bank, the the positive effect of strong domestically generated savings. Inter-American Development Bank, and the Organization of If we want to see a successful Latin America we need to the American States-which have mandates and capabilities develop a strategy that creates a permanent and structural to participate in the promotion of democratic institutional increase in savings. Although no one knows exactly how to development in the Americas-could craft innovative increase the propensity to save, the paper by Sebastian approaches. Edwards presented in this volume is a starting point and pro- We used to blame governments, with good reason, for the vides useful insights into this issue. The experiences of Chile difficulties that have accompanied our development efforts. and Colombia suggest that increasing the efficiency and cov- But I am increasingly convinced that in our eagerness to pro- erage of private social security systems stimulates capital mote private initiative we have overlooked the development accumulation. Also, a more efficient and reliable financial sec- of a sound and dynamic entrepreneurial spirit in the tor capable of protecting and better remunerating individual Americas. In our region, relatively high degrees of monopo- savings efforts acts as an incentive. 13 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Latin America and the Caribbean urgently need a revo- most basic problems affecting the lives of the poorest of their lution in education and social services. In Juan Luis countrymen. Londofno's and Ernesto Schiefelbein's papers it is evident Education is the topic with the most profound implica- that these problems are becoming crises. Inequality and tions for development. It has decisive effects on all the key poverty have not been alleviated and the situation seems to variables related to economic growth, poverty, and political be getting worse. participation. Despite its importance, Latin America is doing In the context of social development we have to address poorly in comparison with other regions. As Londofio sug- structural problems as well as the quality of policy formula- gests, we are rapidly losing ground. The region has left seg- tion. Despite the increasing resource allocations to social ments of its population without the necessary skills to expenditures in Latin America and the Caribbean, the target improve their income and to contribute to economic growth. population-the poorest sectors-have not seen substantial If Latin America wants to experience growth rates as high as improvement. other parts of the world, a dramatic transformation of the The lack of effectiveness of our systems suggests a better education sector must take place. way of doing things. As the World Bank has advocated, Dear friends, to consolidate economic reform in Latin instead of subsidizing the supply of services and creating America, to sustain structural reforms, and to guarantee huge governmental bureaucracies to provide them, countries development and growth we need to enhance and enrich the should directly subsidize the demand for these services. This political life of the people of the Americas. We need to pro- will allow the poor to exercise greater discretion when select- mote participation, local democracy, and involvement of the ing goods and services and allow them to have their needs people in the policymaking process. Economic growth, no more closely met. matter how fast or slow, will mean nothing if it does not pro- For decades we left social policymaking in the hands of mote more freedom, more democracy, and better living con- weak institutions, disinterested bureaucrats, and inadequate- ditions for the poorest of the hemisphere. I am sure that this ly prepared professionals. That must change. We have to be conference will contribute to the region's quest for develop- able to devote the best and the brightest to think about the ment and social justice. 14 Latin America after Mexico: Quickening the Pace SHAHI D JAVED BURKI AND S EBASTIAN EDWARDS O NN DECEMBER 20, 1994, A FEW DAYS AFTER THE CONCLUSION OF THE SUMMIT OF THE Americas, Mexico devalued its currency, triggering a major crisis that threatened to engulf the Latin America and the Caribbean (LAC) region. International investors reacted with panic and began to withdraw funds throughout the area. Countries that as recently as 1993-94 had been favored by international investors suddenly were considered high risks, as fear of a repetition of the debt crisis of 1982 grew. Fueled by the difficulties faced in the initial rescue attempts by the U.S. government, bearish expectations on LAC were the rule at the beginning of 1995. Analysts throughout the world wondered whether the look at their economic performance and prospects only a Mexican events indicated a systemic failure of the new LAC few months ago have given way to a sense of urgency. paradigm of market-oriented reforms or just an episode of Events in Mexico also made it clear to the region's lead- the transitory turbulence characteristic of growing ers that reform is an unending, continuous process and that economies in transition. Some argued that mismanagement they must be permanently alert to changes in the envi- of the Mexican economy during 1994-the acute overval- ronment in which they operate. The global economy of the uation of the currency, rapid credit expansion, and the pil- late 20th century is a bit like Alice, Through the Looking ing up of short-term debt-provided an indication that the Glass: it takes all the running you can do to keep in the LAC countries were not yet ready for the rigors of a mar- same place; if you want to go somewhere else, you must run ket-based system. Others pointed out that disappointment at least twice as fast. Leaders from a growing number of and nostalgia could bring back populism, statism, and countries in the region have concluded that deepening control. reforms-and doing so more rapidly-is the only way to These reactions have proven groundless. In fact, the counter the skepticism that emerged among international Mexican crisis has turned out to be a wake-up call not only financial analysts and, more importantly, to move firmly for Mexico but for all of Latin America and the Caribbean. toward prosperity and social harmony. The crisis has made it clear to policymakers, intellectuals, The Mexican crisis crystallized the need to move into a and the public that there are urgent unfinished tasks. The second phase in the reform process and clarified its agenda. complacency, self-congratulation, and sense of triumph Rebuilding the state and reducing poverty and inequality with which policymakers in some countries had begun to are critical for the consolidation of the reforms that have Shahid Javed Burki is vice president of the Latin America and the Caribbean Regional Office at the World Bank. Sebastian Edwards was chief economist of the Latin America and the Caribbean Regional Office at the World Bank at the time of the conference. The authors acknowledge the collaboration of Roberto Steiner and Fernando Losada, and thank Judith Evans for her excellent editing work. 15 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 already been advanced as well as for future growth. More taken and inflation declined in the early 1990s, the world specifically, Mexican events turned caution lights on a financial community wanted to take part in the rebirth of number of the region's problems. Raising domestic savings Mexico's economy. They did so by moving funds-mostly rates, encouraging private investment in infrastructure, short run, portfolio capital-into the country. This was fur- reforming the labor codes and education systems, and ther facilitated by the decline in U.S. interest rates during deregulating and debureaucratizing lower levels of govern- 1993. The inflow of capital helped finance a tremendous ment now top the list of reform priorities. private sector consumption boom and, in 1994, an expan- More important, a growing number of leaders in the sion in public sector expenditures. Figure 1 shows the region see the pressing need to rebuild the state. New insti- marked decrease in Mexican private savings during recent tutions must be created to efficiently perform those tasks years. that the private sector cannot undertake-the maintenance Before the December crisis, most analysts of the of law and order, the provision of basic social services to the Mexican situation acknowledged the need to implement poor, the establishment of modern, independent, profes- some type of adjustment. The question was: when? sional regulatory bodies, and the provision of basic infra- Mexican policymakers favored a gradual rather than an structure, among others. immediate response. In September 1994 the World Bank Because the Mexican crisis drove home the need to take argued in a public document that the excessive reliance on rapid action, it induced the implementation of policies capital inflows had made Mexico vulnerable, citing the fall with unavoidable short-term recessionary effects. Although in savings rates and the link to higher consumption levels these policy decisions made the first quarter of 1995 diffi- (World Bank 1994b, p. 331). The Bank also mentioned cult for some countries in the region, long-term growth that "productivity growth has so far been insufficient to off- prospects have been enhanced. Deepening the reform set the loss of external competitiveness implied by the peso process is the surest route to accelerating the region's aver- appreciation." age rate of growth in the medium and long run: we expect Mexican authorities recognized that the current account that if a set of plausible conditions is met, the region will gap could not be maintained at the 1993-94 level in the grow, on average, at rates in excess of 6 percent a year longer run, and planned to deal with the problem gradually. between 1998 and 2005. This view was based on two key assumptions. First, improvements in productivity would increase export com- The Mexican crisis and short-term petitiveness, helping close the trade gap; and second, the contagion effects approval of the North American Free Trade Agreement Recent events in Mexico raised questions regarding the (NAFTA) would entice additional capital to move into sustainability of the market-oriented reform process in LAC. As we will argue, a detailed review of the Mexican FIGURE 1 episode reveals that the reform process is indeed sustain- Private domestic savings in Mexico, 1989-94 able, even more so now that the crisis produced a loud and P-rce.t.ofGDP clear message throughout the region in favor of strength- 25 ening and deepening existing policies and stepping up the 20 effort to improve social conditions. 15 Why did the Mexican crisis happen? The main reason for the Mexican peso crisis was an unsus- 10 tainable current account deficit, financed by large capital inflows.' How did the current account deficit get to this 5 level? This was partially the result of Mexico's "success," 0 partially the result of political developments, and partially 1 99 1990 1991 1992 1993 1994 the consequence of overconfidence. As reforms were under- SoFrce: World Bank data. 16 LATIN AMERICA AFTER MEXICO: QUICKENING THE PACE Mexico, providing space and time for the adjustment to markets in mid-January. Soon, however, it became clear work. that the rescue package would not be approved by the U.S. A number of developments, however, frustrated this Conigress, and the peso came under renewed pressure. By plan. First, political events in 1994 frightened foreign that time it was obvious that Mexico faced a major crisis investors, who became particularly leery about currency and that it would require a major adjustment, including a risk.2 In an effort to avoid rising peso interest rates, the drastic turnaround in the current account, high unemploy- Mexican authorities issued increasing amounts of peso ment, and a substantial decline in the level of economic denominated but dollar indexed, short maturity notes- activity. It was not until April, after the announcement of the infamous tesobonos. Second, higher interest rates in the an extremely strict adjustment program on March 9, that United States during 1994 further reduced capital flows the financial markets began to settle. into Mexico. And third, although productivity began to improve in 1993-94, it was not enough to generate the Mexico's policy response expected boom in exports so as to compensate for the After the failure of early attempts at restoring market con- increase in imports. fidence, the Mexican government finally unveiled a tight As a result of these factors, and in spite of the rapid macro program on March 9, backed by a major IMF stand- increase in outstanding tesobonos, capital inflows declined by agreement signed in January. Its main objective is the markedly during 1994. The current account deficit was restoration of stability and the rebuilding of international financed largely through a reduction in international confidence. The plan also calls for aggressive moves on reserves, which dropped from approximately $30 billion in infrastructure privatization, decentralization, reforms in February 1994 to $5 billion by December 22. With presi- the legal and judicial system, and improvement in the dential elections looming, authorities ruled out imple- effectiveness of social programs. menting contractionary credit and fiscal policies during the The main elements of the program announced March 9 first half of 1994. Despite the decline in international liq- are: uidity, the central bank decided to maintain its overall * The fiscal measures include an adjustment in prices of monetary program, sterilizing the reduction in interna- public sector goods, an increase of the value added tax from tional reserves. During 1993 and 1994 the fiscal stance also 10 percent to 15 percent on most goods, and a reduction became somewhat loose. The overall fiscal balance deterio- in the real level of public expenditure. In 1995, tighter fis- rated by 2 percent of GDP, while the primary balance dete- cal policy is expected to produce a primary budget surplus riorated by almost 3 percent of GDP. Furthermore, the tri- of 4.4 percent, twice as large as the one originally envi- partite agreement with business and unions-the so-called sioned in January 1995. pacto-led the government to rule out an early currency * The authorities committed themselves to a floating depreciation to correct the accumulated overvaluation. exchange rate regime, with monetary policy designed to Wage increases had generally been set above the rate of help stabilize prices. To achieve an inflation target of 42 nominal depreciation, an excess that was not compensated percent in 1995, the Bank of Mexico would restrict the by productivity gains. After the presidential elections were expansion of net domestic assets to 23 percent. won by the PRI candidate Ernesto Zedillo, authorities still * With the assistance of a major World Bank operation, resisted putting in place a contractionary adjustment Mexico designed a program to strengthen the banking program. sector through intensive supervision and regulation. It The circumstances that led to the rapid unraveling of increased capital requirements and loan loss reserves, and Mexico's economy are now well known. The exchange rate removed the ceiling for foreign ownership of Mexican band, broadened on December 20, was too little too late. banks. A foreign currency line of credit was established to The international financial community reacted in disbelief, enable domestic banks to meet their international com- and generated a chain-reaction financial panic. The mitments and created a subordinated convertible debt announcement by the Clinton administration of the provi- program to help banks experiencing a temporary fall in sion of massive loan guarantees temporarily calmed the their capital requirements. It gave FOBAPROA (Fondo 17 I)EVELOPMENT IN LA'IIN AMERICA AND TIIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Bancario de Protecci6n al Ahorro) the right to convert the generally require higher public sector savings. subordinated debt of banks into capital and to take them * The composition of capital inflows is very important. over. Short-term flows are very sensitive to changes in interest * Notwithstanding the severe fiscal contraction, real expen- rates and to political events. Keeping speculative capital diture for social and rural programs in 1995 is expected to under control, while encouraging long-term investment- increase by 2 percent, while other non-interest expenditure is as Chile has done-makes eminent sense. Increasing the expected to fall by almost 20 percent. An effort is being made share of long-term investment funds, however, will not be to fortify the social safety net through an expansion of the easy. Investors are looking at the analyses of investment rat- negative income tax, an extension of public health insurance ing agencies before committing large volumes of funds. for the unemployed, the initiation of a program of public Until now only two LAC countries-Chile and Colombia- works targeted to the poorest of the unemployed and the have attained investment grade ratings. Achieving this sta- expansion of the labor retraining program. tus will require other countries to pursue their reform pro- The March 9 program broke some new ground in grams vigorously. Also, the characteristics-and especially Mexico's effort to stabilize and restructure its economy. the strengthening of the domestic financial system-will Given the magnitude of the adjustment effort that was determine the way in which capital inflows are intermediat- called for, the administration of President Ernesto Zedillo ed and channeled throughout the economy. did not attempt to reach advance consensus with labor and * Productivity gains are a fundamental element in the the business community, as had been done since 1987. By economy. They are at the heart of export expansion and, giving up the pacto President Zedillo took upon himself the thus, contribute to keeping the current account in balance. responsibility for engineering economic change. Second, by Productivity increases, in turn, depend critically upon the abandoning the fixed exchange rate regime, the administra- amount of effort the government is prepared to make in tion shifted the burden of adjustment onto fiscal discipline. developing human resources and improving physical The fact that the exchange rate has stabilized and that infrastructure. the stock market has regained part of the lost ground indi- * There is an inherent danger in using fixed exchange cates that the adjustment program put in place is adequate. rates as a stabilization device. Experience has shown that Despite the increase in inflation, there has been a major they tend to generate real exchange rate overvaluation and correction in the level of the real exchange rate, which is loss in external competitiveness. This is particularly the producing the much-needed adjustment in the trade bal- case in countries where contracts are subject to some iner- ance. Once stabilization is completely established, growth tia. Moreover, fixed nominal exchange rates tend to distract will be restored on a much firmer basis. policymakers and the public from the need to implement policies to put in place-and, as important, maintain-a Some lessons fiscal anchor. Fixed exchange rates are particularly difficult The Mexican crisis offers-or more accurately, reaffirms- to preserve in situations of high capital mobility. If, how- several fundamental lessons regarding the economic reform ever, a country decides to adopt an exchange-rate based sta- process: bilization program, it is essential that the authorities The current account is a key variable that should not get implement the policies that assure that fixed parity will be "out of line." The magnitude of the current account deficit maintained. This means that the fiscal situation has to be sustainable in the medium and long term will depend on a under control and that the monetary authorities do not number of variables, including the demand for the coun- sterilize changes in international reserves. Maintaining this try's securities and the rate of growth of GDP. Under most type of policy is not easy politically, since nonsterilized circumstances, a sustainable deficit would rarely exceed declines in reserves are translated into high real interest 3 percent of GDP. Since successful stabilization pro- rates, reduced economic activity, and high unemployment. grams-and especially those based on a fixed nominal * Particular attention should be given to the size, term exchange rate-generate a private sector consumption structure, and currency denomination of public debt. The boom, maintaining the current account under control will accumulation of short-term maturity debt is a signal of 18 LATIN AMERICA AFTER MEXICO: QUICKENING THE PACE underlying fiscal problems and inconsistent macroeconomic nomic leadership, its level of international reserves policies. remained high, public debt maturities were not concen- * In redefining the role of the state-as is being done both trated in the short term, many of its structural reforms implicitly and explicitly in most of Latin America and the were deeper, and its inflation rate was extremely low and Caribbean-it is important not to forget that a strong state was expected to remain so. is a prerequisite for a robust economy. The state should Argentina's financial sector, however, is particularly vul- draw its strength not by owning industrial assets, manag- nerable to negative external shocks, given the nature of the ing public institutions and conducting commerce. Rather, Convertibility Plan under which high-powered money has it should do so by building powerful institutions-legal to be fully backed by international reserves. Thus, the systems, regulatory agencies, and the like-that help pro- Central Bank has very limited resources to confront a run mote competition, protect the consumer, and provide a against bank deposits. After December 1994 the general- framework within which the response of all economic ized "flight for quality" affected liquidity across many LAC agents can be predicted with reasonable accuracy. economies. In the case of Argentina, a few banks had to sus- * Improving income distribution and alleviating poverty pend temporarily the convertibility of deposits in order to cannot be left to trickle-down consequences of economic avoid selling their assets at distress prices following the growth. Government policies-in particular fiscal pro- withdrawal of funds. With assistance from the World Bank grams and tax administration efficiency and fairness-are and the 1DB the government is engineering a far-reaching critical for improving the distribution of income and reform of the financial sector, facilitating the merging of reducing poverty. As Mexico is discovering, stabilization institutions, the streamlining of provincial banks, the programs have a better chance of succeeding if political strengthening of supervision and the implementation of a peace can be secured with the help of social safety nets. broad deposit insurance system.3 Contagion effects Under crisis conditions a change in the Convertibility Law in an increasingly dollarized economy could add to economic p t f t t instability. The only internal response to the recent test of the reactions that will bear fruit in the long run, it has generat- ed sorttermturulene i theregon. ati Ameicaand program was fiscal tightening and the further strengthening ed short-term turbulence in the region. Latin America and the Caribbean is a highly diverse region, where countries of the adjustment process. In a display of vision and with the face very different conditions and where economies have dif- exercise of strong leadership, the government reacted force- ferent strengths and weaknesses. For this reason any serious fully to the crisis. It took courageous measures to reestablish analysis of the impact of the crisis should, ultimately, focus a fiscal surplus by cutting expenditures on, among others, on individual countries. Having already discussed the situ- exports subsidies, public sector wages and social security, ation in Mexico, we now proceed to analyze the economic while raising VAT rates and other taxes. circumstances in five of the large countries of the region, Argentine GDP will not grow in 1995 but will increase three of which-Argentina, Brazil and Venezuela-have at the rate of 2 percent in 1996 (regional forecasts of the been mentioned in the media as facing particular difficulties main macro variables appear in the appendix). This is sig- following events in Mexico, and two that provide strong nificantly less than in 1994, but is still a favorable outcome evidence that the best insurance against systemic risk is given the magnitude of the Mexican crisis and the rigidi- good economic policy-Chile and Colombia. Some of the ties of the exchange rate system. If anything, this modest remarkable recent achievements of Peru are highlighted in growth shows that convertibility withstood a major crisis; the appendix. but, if rapid growth is to be resumed, major structural reforms are imperative. The current account deficit should Argentina not pose any financing problem (2.3 percent in 1995 and In late 1994 Argentina enjoyed several advantages com- 2.2 percent in 1996). As expectations stabilize in the com- pared to Mexico: its current account deficit was less than ing months and the modernization process continues, half that of Mexico's, it enjoyed a credible political and eco- Argentina is anticipated to resume vigorous growth. 19 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Brazil in real interest rates from early March 1995 will exacerbate The country's stock market was the most severely affected the interest payments burden on the Central Bank and the in the postcrisis days, losing one-third of its dollar value federal and state governments. between December 20, 1994 and March 1995. Investors' Inflation can be reduced in a sustainable manner only if nervousness translated into a loss of international reserves. fundamental structural reforms are implemented in support There are, however, a number of factors that strongly indi- of macroeconomic policies. Above all, reforms to elicit a sup- cate that Brazil is in a more solid position than Mexico. ply response under the newly established stability, to promote First, the maturity of Brazilian debt is more favorable. investment and the flexible use of savings, and to ensure effi- Second, when the real plan was launched the currency was cient use of capital are necessary. Thus a redefinition of the clearly undervalued, providing room for appreciation. role of the state within the economy, encompassing policies Third, substantial productivity gains took place up front. for deregulation, privatization, and fiscal, financial, and social Fourth, the consumption boom that accompanies success- security reforms are central to the overall effort. On several ful stabilization is only beginning, and the authorities are fronts the reform process is already under way. Since 1990 for- aware of the need to keep it under control. Fifth, interna- eign exchange controls and the list of prohibited imports have tional reserves are high; and sixth, the current account been eliminated, fiscal incentives for exports and external deficit forecast for 1995 is modest. However, the much financing requirements for imports abolished, granting of larger than expected trade deficit in December 1994 and in import licenses made automatic, and a multi-year tariff the first quarter of 1995 suggests that before the eruption reduction program implemented. Further trade reforms will of the Mexican crisis, the external situation in Brazil was be conducted under the aegis of the MERCOSUR agreement beginning to deteriorate. with Argentina, Paraguay, and Uruguay. On the negative In contrast to markets elsewhere in LAC (particularly side, recently some protectionist policies have been estab- Argentina and Mexico), Brazil's exchange rate has not been lished in which tariffs on cars and durable goods have been under protracted pressure and capital flows have not been increased and broad ranging anti-dumping powers intro- as capricious. Interest rates have been rather stable (but duced. Fortunately, steps have been taken to reduce the par- high); a policy-induced rise in interest rates was ultimate- ticipation of the state in various sectors of the economy and to ly effected in the wake of the widening of the exchange rate encourage competition and reduce regulation of economic band in March. Such relatively stable economic and finan- activity. The privatization program initiated in 1991 has thus cial developments in Brazil can be explained by a variety of far resulted in sales of 30 federal government-owned enter- factors such as confidence in the stabilization plan and in prises, realizing revenue of $8.6 billion. The need to strength- low inflation; a modest current account deficit partly en and deepen this reform process has become more pressing, financed through autonomous capital inflows; and large following recent events in Mexico. international reserve holdings. Furthermore, domestic debt In all, it is expected that in 1995-96 the Brazilian econ- is low and is largely denominated in domestic currency. omy will grow at a rate of 4.5 percent, with a current External short-term debt is also modest. account deficit of modest magnitude in both years (1.9 and However, sustaining the present program will require a 1.7 percent of GDP in 1995 and 1996 respectively). On the substantial tightening of fiscal policy to assure that the negative side, inflation-though significantly lower than cyclically adjusted operational balance of the public sector in the recent past-will still remain on the high side in is in surplus. Fiscal accounts have been in balance thus far 1995, when it is expected to be around 35 percent. only as a result of the strong boom in consumption since the introduction of the real; this indicates the presence of a Venezuela significant underlying fiscal gap that has to be addressed The country entered a deep crisis even before the recent through both tax and expenditure policies. In addition, a Mexican developments. By isolating itself from internation- large quasi-fiscal deficit is projected to emerge in 1995, al capital markets-by introducing stern controls on capital given that the Central Bank has extended support to sever- flows-Venezuela has not been severely affected by the al state banks to cover operating losses. Also, the sharp rise Mexican crisis. In fact, the economic situation was already 20 LATIN AMERICA AFTER MEXICO: QUICKENING THE PACE under such strain that events in Mexico could not make it bright. Growth is expected to remain at around 6 percent (5.9 much worse. The prospect of smaller capital inflows to the in 1995 and 6.5 in 1996), inflation should continue its grad- region only make Venezuela's prospects dimmer. ual decline (8.2 percent in 1995 and 6.8 percent in 1996) and Of the major LAC economies, Venezuela is the only one the current account deficit should remain well under control in which the fiscal situation is out of hand. The fiscal deficit (with a temporarily high level of 3.1 percent in 1996), posing is almost 9 percent of GDP. There has been a dramatic con- no threat to the balance of payments position. traction of private investment, which helps explain why output growth was negative both in 1993 and 1994. The Colombia situation is not expected to improve significantly any time Colombia was the only major country in the region in soon. In addition, there is a generalized banking crisis, cap- which the stock market rose at the same time that the sit- ital controls, high inflation (71 percent), and a real uation was unraveling in Mexico. Even though Colombia exchange rate estimated to be overvalued by 17-25 per- has been running current account deficits that are on the cent, with a fixed nominal exchange rate. high side, foreign investment in the oil sector has been Short-term prospects are poor, with GDP expected to dynamic enough to produce an increase in international decline 1.5 percent in 1995 and to increase only 1 percent reserves. The current account deficit is partially explained in 1996. Inflation is projected to be around 70 percent in by an important recovery both in private and public invest- 1995 and 100 percent in 1996. As a result of the severe ment. There has been, however, a decline in national sav- recession, significant current account surpluses are expect- ings calling for an important tightening of fiscal policy to ed for the near future. increase savings and for the deepening of some structural reforms-particularly in the financial system and capital Chile markets-in order to mobilize them more effectively. The example of Chile is particularly important because it Even though macroeconomic stability is not immediate- represents a case in which a stable macroeconomic envi- ly threatened, Colombia still shows relatively high rates of ronment has been the norm for several years and one in inflation. The new administration of President Samper is which most structural reforms have been in place for quite relying quite heavily on an income policy based on the a long period of time. Chile is the only country in the Mexican pacto. Whether these policies will have the region in which capital inflows have been dominated by desired results will largely depend on the accompanying direct foreign investment. Gross foreign investment fiscal and monetary stance. increased from 1 percent of GDP in 1986 to 9 percent in In addition, and notwithstanding a tradition of macro- 1994, making the overall balance of payments much less economic discipline, Colombia's structural reform program sensitive to short-term changes in interest rates and in is recent and, in some sense, not extremely ambitious. financial market perceptions. Recent events in Mexico have spurred protectionist pres- In addition, the depth and strength of Chile's reform pro- sures by several interest groups, to which the government gram have brought about a continuous increase in productiv- should respond with firmness. Deepening and strengthen- ity. That made it possible to maintain export-led growth in ing of reforms is required to complement a good macro- spite of real exchange rate appreciation. While the peso economic record with a more sustainable growth prospect. appreciated 25 percent in real terms between 1990 and 1994, We expect that Colombia will continue to grow at a brisk productivity has increased by an average of 3.8 percent per pace (5 percent in 1995 and 5.5 percent in 1996), with infla- year. Chile's economic fundamentals and quality management tion only gradually declining (to around 20 percent in 1995 suggest that they can deal well with potential risks. If a and 16 percent in 1996) and a current account deficit that, regional effect were to produce a temporary reduction in the though on the high side, should be financed with large for- rate of capital inflows, Chile could sustain this reduction eign investment and medium- and long-term debt. given its small current account deficit, high savings ratio, and comfortable international reserve position. Challenges The most recent estimates suggest that prospects are In order for the region to consolidate its growth prospects 21 DEVELOPMENT IN LATIN AMERICA AND THE (.ARIBBEAN: RIO DE JANEIRO CONFERFNCE, 1995 in such a way that the benefits accrue to the population at actually achieved during 1991-93. This means that after large, macroeconomic stability and the removal of alloca- all the reforms, the efforts, and the accolades from the tion distortions will be necessary, but not sufficient. Recent financial media, the region as a whole is making little and ongoing reforms will have to be complemented with progress toward breaking out of the quagmire of poverty. policies that address education, poverty, and the distribu- Accelerating growth to higher levels will require policy tion of wealth. reform in, at least, the following six areas: competitive- During the past few years LAC countries have instituted ness, domestic savings, infrastructure, rebuilding the major economic reforms which have begun to generate state, labor market reform, and educational reform. results as exports expanded, inflation declined, productivity grew, and personal income increased. In spite of this Competitiveness progress, the LAC region still faces key challenges which Exports are at the center of the new LAC development strat- became more evident following recent events in Mexico. egy, and are becoming the "engine of growth." Until now, The most important of these challenges is the need to con- this approach has worked rather successfully. Between 1987 solidate the reforms by expanding the political coalition and 1994 regional exports grew at around 10 percent per that supports the modernization process. This, in turn, will annum in real dollar terms and 6 percent in volume (table 1). require two fundamental developments. First, the rate of Moreover, during this period they have become more diver- growth has to accelerate significantly; second, the fruits of sified, reducing the region's vulnerability to external shocks. the reform should be distributed in a way that reduces the Increases in productivity induced by opening the economies region's legendary degrees of inequality and poverty (Burki and, until recently, competitive real exchange rates in most and Edwards 1995). countries, have been behind this positive record. Accelerating growth while reducing poverty and inequal- In the years to come exports will have to further accel- ity will require intensifying some reforms already in place as erate if economic growth is to increase. Historical data sug- well as implementing a series of "second generation" efforts. gest that rapidly growing countries in different parts of the The new reforms will have to change microeconomic and world have experienced, for long periods of time, a rate of political incentives; they will have to strengthen institutions, export expansion that exceeds income growth by a factor of rebuild the state, thoroughly reform civil administration and around two. For exports to grow rapidly in a sustained fash- modernize the judiciary. In short, they will have to create the ion, it will be necessary for the region to increase its inter- framework that will allow investors and workers to operate national competitiveness through continuous productivity efficiently and harmoniously, while permitting them to com- improvements, which will depend on two basic develop- pete successfully in the world economy. What is encouraging ments. First, deregulation and privatization will have to be is that regional leaders and the population at large-as evi- furthered and deepened. In particular, these reforms will denced by the results of the last seven national elections in have to be broadened to reach the sub-national level. which pro-reform candidates, many of them incumbents, Second, labor markets and the educational system will have won by wide margins-are aware of the need to move expe- to be reformed (see discussion below). Certainly, a trade ditiously in implementing the next rounds of reforms. regime characterized by openness to the rest of the world must be kept in place. The need to enhance growth In the aftermath of the Mexican crisis, most countries in The recovery in the first half of the 1990s made LAC one the region have continued to move briskly towards reduc- of the most dynamic parts of the global economy. In spite ing resource misallocation. For instance, in April 1995 of this, and even before the Mexico-induced slowdown of Mexico approved legislation to open transportation, stor- 1995, its rate of growth was not sufficiently high. A age, and distribution of natural gas to foreign investors. recent World Bank study estimated that a minimum aver- The deregulation of telecommunications markets has age growth rate of 3.2 percent per annum is required to already been approved by the Mexican Congress. In reduce the absolute levels of poverty in the region (World Venezuela, the opening of the state-owned oil holding Bank 1993). This has been the approximate rate of growth PDVSA to foreign investors is under consideration in 22 LATIN AMERICA AFTER MEXICO: QUICKENING THE PACE TABLE I respect. First, the implementation of a hemispheric trading Growth in export volume, Latin America and East Asia system based on a high degree of openness to the rest of the (annual percentage rates) world-what has been called open regionalism-is likely REGION/COUNTRY 1982-87 EARLY 1990S to help expand exports significantly. Intraregional trade has Latin America 1.8 6.0 increased greatly in recent years, but its level is still below Argentina 0.8 12.8 that of other regions (table 2). Even though Chile was Bolivia -5.3 4.5 Brazil 8.0 1.5 invited to join NAFTA during the Summit of the Chile 7.6 7.4 Americas, the Mexican crisis has created doubts that a free Ecuador 2.4 9.6 market zone in the Americas will be established any time Guyana 1.5 0.4 Honduras 1.8 -3.8 soon. This is unfortunate because no action could do more Jamaica -2.0 8.5 to stimulate intraregional trade than NAFTA's expansion. Paraguay 9.2 17.2 Peru -4.0 1.3 Second, it is important that industrial countries reduce Uruguay -0.5 4.8 their level of protectionism. Some industrial nations' threat Venezuela 2.1 7.5 of using new "standards"-on labor and the environ- East Asia 9.9 10.t ment-in trade policy is likely to jeopardize not only the Hong Kong 17.6 16.4 region's growth, but the world trading system. Indonesia 7.0 4.2 Korea 15.0 7.6 The volume of intraregional trade in LAC has exploded Malaysia 5.8 1.5 since the beginning of the 1990s. Intraregional exports rose Philippines 2.4 8.4 from $16 billion in 1990 to more than $32 billion in 1994, Singapore 11.2 14.5 Thailand 10.7 18.1 or from 3 percent of total exports to almost 22 percent.4 ______________________________________ MERCOSUR is the most dynamic group, with a total Source: ECLAC, Statistical Yearbook for Latin America; IMF, Inrernarional Financial Statistics. $11.4 billion in intraregional exports in 1994. This repre- sents a threefold increase in five years, a performance that is Congress. If approved, the legislation will allow foreignl enhanced by the simultaneous boost of 28 percent in companies to hold up to 65 percent of joint ventures. In exports to the rest of the world. Trade within the Andean Peru, Petroperu was sold to private (both local and foreign) Pact countries also increased in an impressive way, with investors during 1993-94, and the country's two main exports reaching $3.5 billion in 1994. Bolivia, Colombia, refineries are expected to be privatized during 1995. In Ecuador, and Venezuela have already formed a customs Brazil, although President Cardoso has ruled out the priva- union, and Peru is expected to join toward the end of 1995. tization of the oil company Petrobras, electricity-generat- In November 1994, all five countries reached agreement on ing industries are expected to be sold to the private sector a common external tariff, to be implemented later this year. within one year. In May 1995, a congressional committee Intraregional trade doubled from 1990 to 1994 in the voted to open the telecommunications sector to competi- Central American Common Market, recovering from the tion, allowing private local and foreign companies to com- meager levels of the 1980s. In the case of CARICOM, pete with the state-owned Telebras. In Bolivia a privatiza- implementation problems and the more heterogeneous tion scheme has been established in which a significant composition of the group resulted in the virtual stagnation portion of any divested company is given to its workers and of regional trade at the low levels of the late 1980s. the rest sold to investors. The proceeds obtained from the The new wave of trade integration strategies contrasts latter are immediately capitalized in the same firm, with sharply with the early attempts of the 1960s. LAC countries the end result that assets are more evenly distributed and have now embraced an open regionalism approach in which firms have a much more sound balance sheet. the increase in intraregional trade is encouraged without Improving domestic competitive conditions, however, is imposing additional barriers on countries outside the area only one of the factors that will affect export performance. (CEPAL 1994). As a result LAC economies have become At least as important will be the evolution of the world more interdependent at the regional level, without slowing trading system. Two factors are particularly relevant in this the drive for increased involvement with the rest of the 23 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 TABLE 2 Intraregional exports in Latin America and the Caribbean, 1980-93 (percentage of total exports) AVERAGE AVERAGE COUNTRY 1980-85 1985-90 1990) 1991 1992 1993 Argentina 19.0 22.7 26.1 29.3 32.9 41.4 Bolivia 49.1 52.9 44.8 48.4 38.7 37.3 Btazil na 12.5 11.6 16.7 22.0 25.2 Chile na 14.6 12.6 14.8 17.0 20.0 Colombia 15.7 14.2 16.1 21.6 23.8 25.3 Ecuador 17.0 13.6 17.7 17.1 17.9 21.0 Mexico na 6.7 6.0 6.7 5.0 4.9 Nicaragua na 14.8 21.9 26.2 28.5 27.3 Paraguay na 49.3 52.4 46.7 50.2 49.0 Peru 15.8 14.9 14.6 18.5 18.0 18.7 Uruguay na 33.5 39.5 40.7 41.8 51.2 Venezuela 11.4 10.0 11.9 12.6 17.1 20.0 na is not available. Source: ComTrade, United Nations International 'rrade Database. world. In addition, the recent approval of GATT and the rate of capital accumulation requires, in turn, an increase in subsequent creation of the World Trade Organization have domestic savings. The LAC region has traditionally had low been important elements in assuring that regional trade saving rates: in 1980 the region saved on average 19 percent growth will not clash with a multilateral trade strategy. of its GDP; by 1994 this ratio was basically unaltered. This The integrationist boom has given rise to the establish- contrasts with fast growing regions, that save up to 35 per- ment of several overlapping pacts. About 30 of these cent of GDP (table 3). Low saving rates are, in fact, one of second-generation agreements are in place, seeking the the most serious constraints faced by the region's countries effective liberalization of trade in the area within increas- in their effort to accelerate growth.5 Recent events in ingly shorter schedules. The first sign of this trend was the Mexico triggered a significant slowdown in capital inflows, bilateral pact between Argentina and Brazil, signed in proving that foreign savings are not a long-term reliable 1986, which led to the formation of MERCOSUR in 1991. source of funds, nor a substitute for domestic savings as a Its member countries formed a customs union that has been means for financing investment. operating, with predictable imperfections, since January The most effective way to raise domestic savings is 1995. A common external tariff schedule was introduced, through higher public savings. This will have to be achieved though with a short but important list of exceptions. through further improvements in fiscal positions. Recent The impressive list of bilateral and trilateral agree- studies suggest that increasing government savings by 1 per- ments, often overlapping, will require careful coordination cent will generate an increase in aggregate domestic savings to achieve the desired level of integration and avoid peri- of around 0.5 percent. The specific circumstances of individ- odic conflicts of interest. Thus this initial outburst of ual countries will dictate whether public savings should bilateral pacts should be followed by a process of orderly increase through higher tax revenues, reduced expenditures, convergence. or a combination of both. Under most circumstances some reduction in expenditure is likely to be optimal. In most Domestic savings countries it seems feasible to reduce military budgets as a The accumulation of capital-both physical and human- way to generate somewhat higher public savings. Argentina plays a fundamental role in the growth process. Countries has provided a pioneering example in that regard. Of course, that grow faster devote a higher proportion of their GDP to that is not the case in some other countries, where narcotraf- investment and have developed a capital market that helps ficking and insurgency movements pose a threat to the sus- channel these funds towards high return projects. A faster tainability of democratic institutions. 24 LATIN AMERICA AFTER MEXICO: QUICKENING THE PACE TABLE 3 Private, government, and national savings rates, various regions, 1970-93 197()-82 1983-93 FIRST QUARTILE MEDIAN THIRD QUARTILE AVERAGE FIRST QUARTILE MEDIAN THIRD QUARTILE AVERAGE Private savings Latin America 13.1 13.2 21.7 16.1 10.9 14.7 17.9 13.8 Asia na na na na 17.4 19.1 22.9 20.2 Africa 11.4 14.4 18.9 15.2 10.7 16.7 19.5 15.6 Industrial countries 18.0 21.6 23.4 21.3 18.3 21.3 23.4 21.3 Government savings Latin America -0.7 1.7 6.6 3.3 -1.3 2.4 5.5 2.2 Asia 0.0 2.7 8.8 4.4 0.0 1.6 9.0 3.9 Africa -1.6 0.9 2.1 0.6 -1.3 1.0 4.5 0.9 Industrial countries -0.5 2.0 3.8 1.8 -3.6 -0.1 1.3 -0.8 National savings Latin America 14.5 19.4 27.7 19.8 14.0 17.8 19.1 15.3 Asia 4.9 24.8 26.7 18.8 18.8 23.8 28.5 24.5 Africa 10.8 15.5 18.7 16.4 10.6 17.5 22.1 16.8 Industrial countries 19.6 22.8 25.8 23.1 17.5 19.1 23.4 20.4 na is not available. Source; International Monetary Fund data. Efforts to raise public savings should be supplemented by private savings. Higher growth increases disposable income, policies aimed at encouraging private savings. Improving and encourages savings. Higher savings, in turn, permits a the efficiency of domestic financial markets will go a long higher level of capital accumulation, and thus, reinforces way toward achieving this goal.6 Comparative studies have growth. A strategy that combines an increase in public sav- suggested that an improvement in the provision of financial ings with reforms geared at improving the mobilization of services, including increased confidence in financial institu- private savings will provide an effective way of taking tions, are at the heart of higher household savings. advantage of this virtuous circle. The reform of the region's social security systems pro- vides a second and fundamental vehicle for raising private Infrastructure savings. Analyses have shown that private savings are affect- During most of the 1980s and the first half of the 1990s ed by the extent and coverage of government-run social investment in infrastructure was seriously neglected in security systems. If individuals perceive that when they LAC. As a result, the region faces a serious deficit in power retire they will receive high benefits from the government, generation, roads, water supply, and telecommunications. they will tend to reduce the amount saved during their The World Bank has calculated that to make up for these active days.7 This forcefully indicates that social security deficiencies and provide the region with the infrastructure reform that replaces a government-funded with a privately stock consistent with an export-led growth strategy, invest- administered system tends to increase private savings. ment in infrastructure will have to amount to approximate- Recent findings suggest that while long-term foreign ly $60 billion a year until 2005 (table 4). Moreover, detailed investment enhances growth, short-term foreign financing analyses in the Bank's World Development Report 1994 show may stimulate consumption, thereby substituting domes- that the quality of the services provided by LAC's existing tic savings. It is therefore desirable to implement policies infrastructure leaves much to be desired. A region that turns that favor direct foreign investment over short-term spec- toward the external sector to drive growth cannot afford to ulative flows. have third-class infrastructure. Perhaps the most important finding of recent work on The volume of infrastructure investment required for savings is that there is a virtuous circle between growth and the next decade is substantial-representing approximate- 25 DEVELOPMENT IN LATIN AMERICA AND TIlE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 ly 4.5 percent of regional GDP-and much larger than the in their infancy, with funds for longer maturities general- combined commitments of the World Bank and the IDB. ly unavailable. Memories of inflationary years and banking The bulk of the increase will have to come from private scandals, untested legal structures, and young regulatory sector investment. International experience indicates that frameworks still stand in the way of truly modern financial an efficient and credible regulatory framework overseen by markets. Moving swiftly toward their reform will help fully independent and professional regulatory bodies and increase domestic savings and facilitate investment in commissions is a fundamental requirement for getting a infrastructure. substantial private sector involvement in infrastructure Recent calculations prepared for the World Development investment. This is an area, however, where even the most Report 1995 (using a worldwide general equilibrium model) advanced reformers are lagging behind and where signifi- suggest that if the type of policies advocated in this cant effort will have to be made in the next few years. The report-enhanced private savings, and competitiveness and World Bank is leading a drive for increases in infrastruc- adequate provision of infrastructure-are indeed undertak- ture development to help countries mobilize, from private en, LAC is very likely to grow strongly in the medium and sources, the large volume of funds necessary while also longer terms. As is discussed below, our own projections providing financing. Its main contribution will come suggest that the improvement in fundamentals generated through analytical support for private participation, by these policies are likely to result in an average rate of already proceeding rapidly in the power sector.8 growth for the region of 6.3 percent a year for 1998-2002. Reducing perceived country risk is a fundamental requirement for inducing foreigners to invest in domestic Poverty, inequality, and "second generation" reforms infrastructure projects. Perhaps the most important step in Poverty and inequality have long been salient features of that regard is for the LAC countries to be granted invest- LAC. The inability to deal effectively with these issues is, ment grade ratings by international agencies. In deter- perhaps, the saddest illustration of the traditional policies mining the degree of risk involved in doing business in a of government intervention. Income inequality precedes particular country, rating agencies focus on its ability to the debt crisis and the adjustment programs of the 1980s; generate, in a timely fashion, the foreign exchange in the late 1970s the percentage of income received by the required to meet contractual payments to investors. In poorest 20 percent was lower in LAC than in any other part determining whether this requirement is met, these agen- of the developing world.9 The debt crisis negatively affect- cies consider the nature of capital and exchange controls, ed an already battered social picture. Although a number of the quality of local regulatory laws, and the impartiality countries reacted to the crisis by implementing emergency and effectiveness of the judiciary. Making major improve- social programs, the overall level of poverty and inequality ments in all three areas is an urgent task for the countries increased in many countries. in the region. A dozen years after the debt crisis, one of the main-if Infrastructure investments require long-term financing. not the main-challenges in LAC is to reduce poverty and In most LAC countries, however, capital markets are still reverse decades of inequalities. Addressing the needs of the poorest strata of society is both a social and political issue. TABLE 4 This has been made even more evident by the Mexican cri- Annual infrastructure investment needs sis. In Mexico, social tensions generated uncertainty that in Latin America rocked the financial markets and, as argued in the second $ BILLION, SHARE OF REGIONAL part of this report, contributed to the unleashing of the cri- SECTOR 1993 PRICES GDP (PERCENT) sis. Only to the extent that poverty is reduced and income Power 24 1.8 distribution becomes more equal, can the structural Transport 14 1.0 reforms become sustainable. Moreover, attending to the Telecommunications 10 0.7 needs of the poor for education, nutrition, and health will Water and sanitation 12 0.9 Total 60 4.4 have direct effects on economic growth. Source: World Bank I994a. During 1994-95 the World Bank undertook several 26 LATIN AMERICA AFTER MEXICO: QUICKENING THE PACE country studies on the social conditions and the extent of provides important information for the design of successful poverty in the region. Although methodologies are social programs (Fizsbein and Psacharopoulos 1992). It was country-specific, table 5 clearly shows that the Mexican found that four fundamental factors determine the proba- situation is by no means unique. Both poverty and bility of being at the bottom of the distributional scale: extreme poverty are widely spread across the region. As education, gender, ethnicity, and regional issues. Education expected, poverty is more significant in rural areas, appears to be the single most important determinant of though in some cases even the urban indicators are dis- inequality. This study, as well as others, also found that, turbingly high (table 6).1l In the next few months addi- other factors being equal, the probability of being at the tional case studies will be completed, providing a rela- bottom of the distributional scale is higher for females. tively complete regional diagnosis. Moreover, poor women tend to be older, and have fewer For many years, acceleration in growth was considered opportunities to improve their skills through additional the main prescription for reducing inequalities and pover- training and education. In many countries, ethnicity is ty. Increasingly, however, empirical evidence indicates that, directly related to poverty and inequality. For example, in although very important, higher growth is not enough. In 1989 only 40 percent of Guatemala's indigenous popula- general, it takes time for the fruits of faster growth to tion had more than 5 years of education, compared to 76 spread over the most vulnerable and poorest segments of percent of the non-indigenous population. Countrywide society. A number of authors and institutions, including aggregate data tend to hide significant regional variations the World Bank, strongly argue that there is a need to within countries. Brazil provides the starkest example of implement a two-prong approach toward poverty and intracountry differences in development. Rio Grande do inequality where faster growth is supplemented with social Sul has social indicators comparable to those of Portugal programs targeted at providing services to the neediest. and Korea, while the region of Paraiba is not significantly A recent World Bank study on several LAC countries different from East Africa. TABLE 5 Poverty in Latin America and the Caribbean (percentage of population living in poverty) POVERTY EXTREME POVERTY EARLY MID- TO LATE EARLY MID- TO LATE COUNTRY 1980S 1980S 19905 1980S 198()S 1990S Argentina (1980, 1986, 1993)Y 16.2 51.1 17.6 3.3 21.1 3.4 Bolivia (1992) na na 72.0 na na na Brazil (1980, 1986, 1990) 39.0 40.0 43.0 na na na Chile (1987, 1992) na 28.0 24.0 na 17.0 9.0 Colombia (1988, 1992) na 33.8 32.7 na 18.7 17.7 El Salvador (1992) na na 38.3 na na 9.9 Guatemala (1989) na 75.2 na na 57.9 na Guyana (1992) na na 43.2 na na 27.7 Honduras (1989, 1993) na 55.0 53.0 na 36.0 32.0 Jamaica (1989, 1992) na 26.9 34.2 na na na Mexico (1984, 1989, 1992) 24.8 27.5 25.9 6.1 7.7 8.2 Nicaragua (1993) na na 50.3 na na 19.4 Paraguay (1990) na na 20.5 na na 3.5 Peru (1982, 1989, 1992) 46.0 52.0 53.7 21.0 25.0 21.2 Trinidad and Tobago (1992) na na 21.0 na na 11.0 Uruguay (1980, 1986) 11.0 15.0 na na na na Venezuela (1982, 1989) 22.3 31.4 na 10.3 22.3 na na is not available. Note: Poverty is defined as the headcount index, the proporrion of people who are deemed to be poor (or extremely poor). Although the poverty line (or the indigent line) is country- specific, in all cases it is defined on the basis of the cost of a basic basket of goods. a. Refers to metropolitan Buenos Aires. The significant increase in the mid- to late 1980s is, to a great extent, the result of very high inflation. Source: World Bank data and ECLAC, Statistical Yaerbook for Latin America. 27 DEVELOPMEN'I' IN LATIN AMERICA AND TIIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 TABLE 6 firms that were formerly financially weak. The latter Urban and rural poverty in selected implies that the benefits of the scheme are widely spread Latin American countries in the community. (percentage of population living in poverty) COUNTRY TOTAL URBAN RURAL Rebuilding the state Colombia (1992) 32.7 19.8 50.5 Designing and implementing effective programs to tackle El Salvador (1992) 38.3 36.2 41.4 poverty and inequality will require resources and, perhaps Guatemala (1989) 75.2 57.2 85.7 Mexico (1992) 25.9 22.4 31.0 more importantly, a thorough rethinking of the mecha- Nicaragua(1993) 50.3 31.9 76.1 nisms through which social services are delivered. In many Paraguay (1990) 20.5 19.7 28.5 LAC countries-Venezuela being, perhaps, the best exam- Souwrce:World Bank data. ple-the main issue is the inefficiency with which pro- grams are run, not a lack of funds. The lack of administra- Both from the point of view of equity as well as a mat- tive capacity, the reluctance of government employees' ter of good economics, the region should play close atten- unions to modernize themselves, and the absence of tion to the redistribution of assets. Policies that, in the accountability mechanisms have tended to create a situa- name of fairness, created a hostile environment for both tion of grave mismanagement and inefficiency. domestic and foreign private sector initiative are a thing The extent to which these issues are addressed through of the past. However, in the search for a more efficient major administrative reforms-which implies no less than and productive economic environment, actions that rebuilding the state-will the determine the level of imply a more equitable redistribution of certain assets improvement of the provisions of the social sector. The might be an integral part of a successful economic acceleration of growth and the reduction of poverty and strategy. inequality will require implementing a series of "second At least two issues are worth mentioning in this regard. generation" reforms. In contrast with most of the policies In some countries the land tenure system is a major cause undertaken in the last few years, which were addressed at of macroeconomic inefficiency and stagnation in produc- correcting gross inefficiencies and macroeconomic disequi- tivity. When unnecessarily large plots of land are left idle libria, the new reforms will have to deal with more subtle or are devoted to grossly inefficient land-intensive activi- issues, including the strengthening of institutions, the ties, policies that strive for the redistribution of land make reform of civil administration, and the modernization of great sense. Of course, redistribution should be carried out the judiciary. Perhaps the most difficult aspect of this new in consultation with the markets. On the supply side, cur- phase is that relatively little is known about creating the rent landowners have to be compensated at market prices; type of institutions required to move forward on the path on the demand side, specific care should be given to ensure toward modernization. that recipients of land will be those who would be willing Because of its nature, the initial stage of the reform to use it in the more efficient and productive manner. In process was, to a certain extent, rather simple. After all, any event the common practice of bailing out large farm- many of the policies were designed and implemented ers when land prices fall significantly should be directly by governments, with little or no need for con- discontinued. gressional approval. They were administratively simple, In many cases public sector divestiture also creates with ample theoretical support and with several prior prac- room for asset redistribution. An interesting case already tical experiences from which to benefit. Rather than the mentioned is that of Bolivia, where privatization has creation of new institutions, they implied the downsizing been carried out through a mechanism that implies cap- of the government (see Naim 1994). The challenge that lies italization of divested firms and partial ownership by ahead is formidable. Fortunately, recent events in Mexico employees. The former ensures that revenue from priva- have reminded technocrats, politicians, and the general tization is not devoted to finance current government public that the deepening and broadening of the reform expenditure, but rather to enhance the capital base of process has to be performed, and soon. Decrees that reduced 28 LATIN AMERICA AFTER MEXICO: QUICKENING THE PACE tariffs or liberalized interest rates were the typical instru- discouraging employment creation. Second, because of the ment of the initial stages of reform; in what lies ahead, new specific way in which the legislation was put into effect, the institutions will have to be created and existing ones will policies strongly discouraged training activities and the have to be reformed. And it will no longer be the case that acquisition of new skills. What makes existing severance changes will be "evenly" distributed among members of payment schemes particularly inefficient is that they are society, as was the case, for example, with tight monetary related to the worker's tenure in the firm. This introduces policies to reduce inflation. In what follows, specific groups some serious and arbitrary distortions, as firms will tend to will win at the cost of others. The implementation of these retain older workers, even if they are less productive than changes will be costly in political terms, and much more others. Relating severance payments to years of service also complicated than before. reduces the employers incentive to invest in human capital formation, especially if skills are not firm-specific. Labor market reform Transforming severance payments into a deferred compen- The delivery of social services lies at the center of poverty sation scheme or replacing them by unemployment insur- and equity and is a pillar toward achieving a more produc- ance systems would greatly increase the degree of efficien- tive work force. Labor issues are also at the heart of any cy of labor markets. This has been partially done in some attempt to enhance competitiveness. For decades LAC countries. countries used labor legislation as a tool for achieving social Existing labor legislation in most of LAC pre-dates recent goals. Minimum wages, job protection, and related mea- market-oriented reforms and encourages confrontational, sures were thought to be an efficient way of transferring long, and costly bargaining processes. With the exception of income and protecting the poor. Although these policies Chile, the process is similar across countries. Unions with were well intentioned, they ended up creating overly rigid legal representation propose a collective contract, and labor markets that were unable to respond to the changing employers must respond. The state becomes part of the conditions of the world economy. However, the market- negotiations from the beginning, and the final agreement oriented reforms implemented in LAC since the 1980s applies to all workers. Strikes have been one important have barely touched labor market legislation. mechanism used to resolve disputes. The most important In most LAC countries social security contributions are cost to firms is the prohibition on hiring temporary replace- seen as pure taxes, not as a component of total compensa- ments. All of this encourages confrontational relations that tion package." As a result, they introduce serious distor- hinder an efficient use of resources and tend to reduce the tions that increase the cost of labor and reduce its mobili- private sector's ability to compete internationally. ty. Moreover, in most countries the social security system is But perhaps the most serious aspect of labor relations is financially insolvent, imposing additional costs by con- that in many countries public sector unions-and especial- tributing to the fiscal deficit. Replacing the region's pay-as- ly those in the health and education sectors-exercise a you-go pension regimes, where there is no link between tremendous political influence at the same time that they contributions and benefits, by a combination of individual obstruct any attempt to introduce accountability, reform capitalization accounts and minimum services assured by their operations, and improve the delivery of public ser- the government would go a long way toward reducing the vices. Reforming labor legislation and "reinventing" the current degree of distortions. This system reduces the cost labor movement to be truly democratic, inclusive, and non- of labor, encourages savings, and provides a boost to capi- confrontational is one of the most difficult challenges that tal markets by developing institutional investors. LAC will face in the future. This will not be an easy task. The region's labor legislation has a long tradition of try- But if it is not attempted and, moreover, if results are not ing to protect employment stability. This has been done obtained, the economic and social future of the region will through a series of measures, including limitations on tem- be clouded. porary hiring and imposing substantial costs-in the form of severance payments-on dismissals. These policies had Education reform two consequences. First, they increased the cost of labor, There is now abundant evidence from the rapidly growing 29 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DO JANEIRO CONFERENCE, 1995 nations of East Asia proving that successful competition in ies has strongly supported this view, indicating that the che international marketplace demands flexibility. Firms existence of a highly educated labor force, whose skills must be allowed to readjust their production mix accord- improve rapidly year after year, has been partially behind ing to rapidly shifting comparative advantages and workers the tremendous economic success in Korea, Hong Kong, have to be appropriately educated. The limited coverage of Singapore, Taiwan (China), and other East Asian the Latin American educational system, its lack of sci- economies. Table 7 presents data on recent education ence/technology emphasis, and its generally low quality attainment for a group of Latin American countries. stand in the way of improved productivity. Only to the Information on three of the East Asian miracle coun- extent that the dual objectives of a flexible labor market tries-Hong Kong, Korea, and Singapore-is also pro- and an improved education system are achieved will the vided for comparative purposes. This table shows that Latin American countries be in a position to systematically while there are significant differences in education cover- grasp new export opportunities. If these reforms are not age across Latin America, in every category with available undertaken, new export markets will be captured by other data, educational coverage in the East Asian "tigers" sig- nations and the Latin American countries will be left (once nificantly exceeds the LAC average. again) on the sidelines. Incomplete coverage is not, however, the only problem The accumulation of human capital through increases with the Latin American education system. A recent World in the coverage and quality of education constitutes one of Bank study has found that the average quality of Latin the fundamental pillars of successful development strate- America's primary education is dismal. For example, an gies. 2 For instance, it has been argued that the Korean international comparative study on reading abilities of 9- "miracle" since the mid-1960s-where living standards year-old children found that Venezuelan students ranked have doubled every eleven years-has been largely pro- last out of 27 countries; students in Trinidad and Tobago pelled by increases in productivity fueled by the accumu- did better, but still significantly below the average. A 1992 lation of human capital. A series of recent empirical stud- study on science and mathematics achievement for 13-year- olds found that Brazilian students from Sao Paulo and TABLE 7 Fortaleza were outscored by students from Korea, Taiwan, Educational attainment in Latin America Israel, Jordan, and China as well as by students from every and East Asia, 1991 developed country in the sample. The only country Brazil PRIMARY outscored was Mozambique. Finally, a 1992 study on PRIMARY NET SECONDARY TERTIARY PUPIL/TEACHER mathematics and science for 13-year-old students in five COUNTRY ENROLLMENT ENROLLMENT' ENROLLMENT' RATIO Latin American countries-Argentina, Colombia, Costa Latin America and Rica, the Dominican Republic, and Venezuela-found the Caribbean 87 47 18 26 Argentinia na na 43 18 that, with the exception of elite schools, in most cases test Brazil 88 39 12 23 performance was significantly below that of "average" Chile 86 72 23 25 countries, such as Thailand and the United States.'3 Colombia 73 55 14 30 Costa Rica 87 43 28 32 The low quality of the region's education system is par- Guatemala na 28 na 34 tially reflected by very high repetition rates, which rank El Salvador 70 25 16 44 Jamaica 99 62 6 37 among the highest in the developing world. In Bolivia the Mexico 98 55 15 30 repetition rate goes from 16 percent in Beni to more than Peru na 70 36 28 35 percent in Chuquisaca. It is estimated that in 1990 the Trinidad and Tobago 91 81 7 26 Hong Kong na na 18 27 cost of repetition exceeded $4 billion for the region as a Korea, Rep. of 100 88 40 34 whole. The Eastern Caribbean, where a UK-based system Singapore 100 70 na 26 operates, is the region's exception. The rate of repetition in na is nor available. those countries is significantly lower than in the rest of the a. As a percentage of the eligible population. Soarce: World Bank 1994c. region (World Bank 1993).1 Upgrading the quality of education is an urgent task. 30 LATIN AMERICA AFTER MEXICO QUICKENING THE PACE Currently, low-quality public schools coexist with first-rate forecast will be important increases in investment and private schools, creating a dual educational system that advances in factor productivity. tends to perpetuate inequalities and undermine the bases of According to an IMF study, average annual GDP democracy. Improving the quality of education will require growth for the 12 largest LAC economies during the fif- strengthening management, reallocating resources, increas- teen years between 1970 and 1985 was 2.9 percent. This ing funding, making teachers accountable, and imple- poor performance was explained primarily by low capital menting fundamental changes that enhance competition. accumulation (1.5 percent) and a very small increase in Teachers should be trained using modern techniques, their productivity (0.3 percent). Another World Bank study skills should be periodically renewed, and their salaries set recently reached the conclusion that between 1960 and according to performance and not on the bases of some 1987 productivity increased at an annual rate of only 0.9 bureaucratic formula-the best teachers should get salaries percent. In addition, physical capital increased by 6 per- similar to those of relevant comparison groups. Parents cent, the labor force by 2.9 percent, and human capital by should get more involved in the educational system 4.1 percent, combining for an average GDP growth rate of through an increased role in the decisionmaking process. If 4.8 percent. This picture contrasts sharply with that in Latin America maintains its traditional neglect for educa- countries in the East Asia and the Pacific region, which tion and fails to take measures that will greatly improve the exhibited similar increases in physical capital (6.4 percent) quality and coverage of the system, the likelihood of the and in the labor force (2.5 percent) but much higher structural reforms being sustained in the long run will be advances in productivity (1.5 percent). As a result, the greatly reduced. As the experience of the East Asia miracle East Asian and Pacific region grew at an annual average countries has shown, a solid educational base is required for rate of 6.1 percent, or close to a full point and a half more increasing productivity and successfully competing inter- than the LAC countries (DeGregorio 1991; World Bank nationally. Moreover, a broad and high-quality educational 1995c). system usually provides a ticket for social peace, harmony, As we mentioned in the previous section, if LAC is to and generalized prosperity. achieve higher rates of growth and if growth is to be sus- tainable, the accumulation of capital and labor has to be O * * complemented by several other factors. Of particular importance are the development of infrastructure, the edu- None of the benefits of all the above reforms will be sus- cation of the labor force, the reduction of policy-induced tainable in the long run and several of the incentives distortions, the enhancement of international competitive- implicit in recent reforms will be unsuccessful in stimulat- ing private sector participation if the judicial system is TABLE8 ineffective. The rights and responsibilities of labor unions Some key determinants of growth and of privately owned "natural monopolies"; the effective (percent) rules of the game governing foreign investment and land EARLY PROJECTIONS tenure; and the threat posed by drug mafias and guerrilla 1990S 1998-2003 movements require a new approach to governance in which Savings 19.9 28.0 the role of the state is no longer one of producing goods and Private 13.8 19.5 Public 2.2 6.0 providing employment. Foreign 3.9 2.5 Investment 19.9 28.0 prospects ~~~~~~~~~~infrastructure 3.0 4.5 Long-term growth prospects Schooling 4.9 6.2 A recent projection exercise performed at the World Bank TFP growth 0.0' 1.5 indicates that by the end of the century-only five years GDP growth 3.4 6.3 Note: Savings and investment are percentages of GDP. Schooling is in average years. from now-LAC could be growing at an annual rate of 6.3 Total may not add to 100 percent due to rounding. percent (table 8). Broadly speaking, this doubling in the a. Average for 1960-87. TFP increased by 1.3 percent a year in 1960-73 and decreased by 1.1I percene a yeae in 1973-87 region's average rate of growth is explained by what we Source: World Bank 1995b. 31 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 ness, and an overall reduction in the size of the public sector. results in the region approach those observed in the coun- It is worth emphasizing that these elements for growth tries that pioneered market-oriented reforms, total factor must be complemented by a stable political environment. productivity growth could add 1.5 percentage points to There is ample evidence that political conflicts deter GDP, compared to a negligible contribution throughout growth. The targeting of social expenditure, the reduction the 1980s. in poverty, the redistribution of assets, and complementary By increasing domestic savings while maintaining for- policies that reduce social conflict are, therefore, not just eign savings at a reasonable and sustainable level, and by desirable in and of themselves but are vital components for staying the course on policies that facilitate a more efficient high and sustainable growth. In that regard, LAC offers use of resources, LAC would be able to boost its annual some impressive grounds for confidence. Between 1993, growth rates from 3 percent to 6 percent. This is a prelim- when Chile held a presidential and congressional election, inary estimate that is likely to be affected by several factors *and May 14 of this year, when Argentina did the same, over that are very difficult to forecast, such as changes in the 85 percent of the region's population voted in nationwide terms of trade. Regardless of the preliminary nature of the elections. In most of them, presidential candidates sup- forecast, it is worth mentioning that early reformers, both porting economic reform were elected or re-elected. This is in LAC and in other regions, have experienced such GDP significant evidence that in the LAC societies there is an increases. The attainment of such rates of growth is not increasing agreement on reform and that there will be a heavily dependent on the ability to attract large amounts of high and unprecedented degree of policy continuity in the foreign savings. In fact, the above estimates assume a region looking out and beyond the end of the century. regional current account deficit that is actually smaller Returning to the economic elements, many of the deter- than the one we have seen in recent years. minants of private savings are expected to evolve in a posi- tive direction. On the one hand, demographic tendencies Conclusion suggest that age dependency will decline, implying an The countries of Latin America and the Caribbean have the increase in the population that will be working and saving. potential to double their average growth rate to 6 percent Recent World Bank estimates show that age dependency in a year over the next decade. In our view, the response of LAC is 66 percent, as compared to 62 percent in the upper- policymakers in the region to the crisis that began in middle income countries. Moreover, as the LAC countries Mexico in December 1994 is a very significant indication continue to redefine the role of the state the private provi- that this result can be expected. Faced with a forceful neg- sion of certain elements of social security is expected to ative market reaction to the region as a whole following increase. This will have an additional positive effect on sav- Mexico's currency devaluation, political authorities, eco- ings. All things considered, private savings as a percentage nomic officials and-more importantly-citizens in the of GDP could reach close to 20 percent, compared to the country most affected by the crisis, Argentina, reaffirmed single digit range in a number of LAC countries today. their commitment to continue and to deepen economic Public and foreign savings are also expected to develop reform. Mexico's difficulties were a costly but important favorably. reminder of the need for urgency in moving to what we Under favorable circumstances, overall savings should have called the second generation of reforms. approach 28 percent of GDP, with private savings This urgency is a consequence of two important figures complemented by foreign savings of around 2.5 percent and revealed by recent World Bank studies. The first is that in public savings on the order of 6 percent. This would allow spite of the economic achievements registered in the last for a level of gross investment near 28 percent. In terms of few years, LAC's poverty rates have not budged and growth, the impact of enhancing savings and investment by income distribution, for which we have no conclusive 8 percentage points of GDP is significant. It would raise data, may have improved only slightly. LAC's record is the annual growth figure by around 2 percentage points. now unbroken: since the 1950s-for four and a half Factor productivity is also predicted to increase as a con- decades-the number of people living in poverty has not sequence of education, deregulation, and openness. If fallen. The impressive growth rates reached in some coun- 32 LATIN AMERICA AFTER MEXICO: QUICKENING THE PACE tries have barely pushed the region's average annual recent past, but no significant downturn. In fact, it is wide- growth rate to the 3.2 percent that the World Bank con- ly expected that in most countries matters will start siders the minimum for producing an actual reduction in improving as early as 1996. Under positive conditions the poverty levels. region's average annual growth rate would be 5.1 percent Moreover, for the reforms that have produced higher for 1995-2010, with total factor productivity increasing growth rates, a staggering amount of investment is by 1.6 percent a year and investment reaching 25 percent required. The World Bank's estimate that $60 billion in of GDP (World Bank 1995c). Our own projections, dis- infrastructure investment is needed every year between cussed above, indicate that under a "best case" scenario we now and the year 2005 is an indication of the order of mag- can expect an average rate of growth for LAC of 6.3 percent nitude. For that investment to materialize-whether pri- for 1998-2003. vate in the case of infrastructure or public in the case of During 1994 inflation rates continued to fall across the some social services-the second generation of reforms region (table A2). The average, excluding Brazil, was 20.3 must be incorporated into the continuing macroeconomic percent. When Brazil is included, it increases to 61.6 per- policymaking agenda. cent. This falling trend is expected to continue over the rest When implemented and supported by the international of the decade, including a further reduction in Brazilian financial community, including multilateral organizations inflation, following the introduction of the real stabiliza- like our own, the reforms of this second phase should reach tion plan. The pace at which Brazil's inflation will decline into the daily lives of citizens throughout the region. is, to some extent, an open question. The acceleration of Better educated, more secure, both personally and econom- industrial activity since mid-1994, and the 43 percent ically, citizens with more efficient systems of environmen- increase in the minimum wage in May 1995 covering more tal and consumer protection, health, and justice, and with than 15 million workers have put pressures on the wage fewer fellow citizens living below the poverty line, will bill and thus on aggregate demand. In Mexico, the depre- strengthen the medium- and long-term prospects for sus- ciation will be partially reflected in inflation, which is tained economic growth. Mexico's difficulties sent a mes- expected to increase fourfold from 1994 to 1995 to around sage; it has been heard. 46 percent for the year as a whole. Information on current account balances and inflows Appendix of funds is displayed in tables A3 and A4. During 1991, Recent evolution of Latin American 1992, and 1993, the region enjoyed abundant foreign and Caribbean economies financing due to bullish expectations of institutional During 1994, and up to the eruption of the Mexican cri- investors following the process of far reaching reforms, sis, LAC continued to evolve in a positive way, following and to significant reductions in U.S. interest rates. That the trend observed since the late 1980s for most of the situation began to change in 1994. As should have been reforming countries (Edwards 1993). GDP growth for expected, large external deficits became harder to finance the region as a whole was 4.4 percent, almost one per- calling for more aggressive export strategies and policies centage point above the average from 1990 to 1993. to enhance domestic savings. The conditions that reigned While this regional average hides diverse performance through early 1994 were totally reversed when the crisis across countries, it is worth underscoring that the growth broke in Mexico. Curtailed foreign financing is expected rate in most countries was clustered around the aver- to last through most of 1995. However, once the markets age-Peru grew at a remarkable rate during 1994 (12 see the emerging economies of LAC moving successfully percent); Argentina (7.1 percent), El Salvador (5.8), with the second phase of reforms, foreign capital will Colombia (5.3) and Brazil (5.7) also performed well on return, and this time around direct investment will play the growth front. Haiti, Venezuela, and Honduras, how- a more important role.'5 ever, did poorly (table Al). Figure Al shows the evolution of real exchange rates For the region as a whole, the prospects for 1995 and in the region. It is clear that the generalized process of 1996 show a slowdown in growth as compared to the appreciation observed at the beginning of the 1990s has 33 DEVELOPMENT IN LATIN AMERICA AND THE (CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 TABLE Al GDP growth in Latin America and the Caribbean, 1991-96 (annual percentage rates, constant prices) AVERAGE COUNTRY 1991-93 1991 1992 1993 1994 1995 1996 Argentina 7.9 8.9 8.7 6.0 7.1 0.0 2.0 Bolivia 3.8 4.6 2.8 4.1 4.2 4.5 4.7 Brazil 1.7 1.1 -0.9 5.0 5.7 4.5 4.5 Chile 8,2 7.3 11.0 6.3 4.5 5.9 6.5 Colombia 3.7 2.1 3.8 5.3 5.3 5.0 5.5 Costa Rica 5.5 2.3 7.7 6.4 3.5 1.5 3.5 Dominican Republic 3.9 0.7 7.9 3.0 4.0 2.5 3.5 Ecuador 3.5 5.0 3.6 2.0 4.1 4.2 4.6 El Salvador 4.6 3.5 5.3 5.1 5.8 6.5 6.5 Guatemala 4.1 3.7 4.8 3.9 4.0 3.0 4.0 Guyana 7.4 6.0 7.8 8.3 5.0 5.0 5.0 Haiti -6.8 -3.0 -14.8 -2.6 -10.6 4.5 5.0 Honduras 5.0 3.3 5.6 6.1 -1.5 2.5 4.0 Jamaica 1.5 0.8 1.8 2.0 2.0 3.0 3.5 Mexico 2.3 3.6 2.8 0.4 3.8 -4.8 2.0 Nicaragua -0.2 -0.2 0.4 -0.9 3.0 3.0 4.5 Panama 7.8 9.6 8.5 5.4 4.0 3.5 3.0 Paraguay 2.7 2.5 1.8 3.7 3.5 4.8 5.2 Peru 2.1 2.3 -2.4 6.5 12.0 6.0 6.0 Trinidad and Tobago -0.2 2.7 -1.7 -1.7 4.0 2.0 2.5 Uruguay 4.1 3.2 7.7 1.5 4.2 2.8 3.2 Venezuela 5.1 10.4 5.4 -0.4 -3.3 -1.5 1.0 Source: World Bank data. TABLE A2 Inflation in Latin America and the Caribbean, 1991-96 (annual percentage rates) AVERAGE COUNTRY 1991-93 1991 1992 1993 1994 1995 1996 Argentina 36.9 84.0 18.6 8.0 3.5 4.0 3.0 Bolivia 14.0 21.4 12.1 8.5 8.3 6.9 6.1 Brazil 1,368.9 475.1 1,131.5 2,541.0 929.0 35.0 25.0 Chile 16.6 21.8 15.4 12.7 11.4 8.2 6.8 Colombia 26.7 30.4 27.0 22.6 22.0 20.0 16.0 Costa Rica 20.1 28.7 21.8 9.8 19.6 20.0 15.0 Dominican Republic 21.1 53.9 4.6 4.8 9.3 7.0 15.0 Ecuador 46.7 49.0 60.2 31.0 20.0 15.0 10.0 El Salvador 13.9 9.8 19.9 12.1 8.9 8.5 5.9 Guatemala 19.6 35.1 10.2 13.4 12.6 10.0 10.0 Guyana 73.1 102.3 104.9 12.0 12.0 6.0 4.0 Haiti 17.0 6.6 17.5 26.9 52.1 20.0 15.0 Honduras 13.7 21.5 6.5 13.0 30.0 12.0 6.5 Jamaica 50.2 68.6 57.5 24.5 32.0 13.6 7.4 Mexico 12.9 18.7 11.9 8.0 7.1 45.7 18.3 Nicaragua 926.9 2,740.0 20.3 20.4 7.2 8.4 6.8 Panama 1.2 1.3 1.8 0.5 1.0 1.3 1.3 Paraguay 19.2 24.3 15.1 18.3 20.7 11.0 9.0 Peru 173.0 409.5 73.5 48.5 23.7 12.0 10.0 Trinidad and Tobago 7.0 3.8 6.5 10.8 8.3 4.4 3.4 Uruguay 74.9 102.0 68.5 54.1 45.0 41.9 34.7 Venezuela 36.3 31.0 31.9 45.9 70.8 70.0 100.0 Source: World Bank data. 34 LATIN AMERICA AFTER MEXICO: QUICKENING THE PACE TABLE A3 Current account balances in Latin America and the Caribbean, 1991-96 (percentage of GDP) AVERAGE COUNTRY 1991-93 1991 1992 1993 1994 1995 1996 Argentina -3.1 -1.5 -3.7 -4.1 -2.8 -2.3 -2.2 Bolivia -8.4 -6.3 -10.1 -8.8 -5.8 -6.6 -8.5 Brazil 0.3 -0.3 1.5 -0.2 -1.1 -1.9 -1.7 Chile -2.1 0.4 -1.8 -4.8 -0.9 -1.4 -3.1 Colombia -5.9 -4.8 -5.5 -7.4 -5.2 -4.5 -4.0 Costa Rica 0.9 5.4 1.5 -4.2 -4.2 -3.7 -3.0 Dominican Republic -3.5 -2.1 -6.8 -1.5 -1.8 -1.3 -2.0 Ecuador -3.0 -5.0 -0.7 -3.2 -3.1 -3.8 -3.7 El Salvador -4.9 -5.0 -5.8 -3.9 -2.9 -1.8 -2.0 Guatemala -5.6 -2.7 -7.6 -6.6 -6.0 -3.3 -3.3 Guyana' -23.7 -13.1 -26.3 -31.6 -22.0 -22.8 -22.2 Haiti -10.4 -12.9 -6.9 -11.4 -6.9 -20.6 -17.5 Honduras -6.9 -5.0 -6.6 -9.2 -8.1 -3.7 -3.5 Jamaica -3.1 -4.9 -0.1 -4.3 -1.0 -2.3 -0.4 Mexico -6.3 -5.1 -7.4 -6.4 -7.7 -0.3 -0.1 Nicaraguae -50.8 -48.9 -54.6 -48.9 -48.0 -32.0 -34.0 Panama -4.7 -1.9 -5.7 -6.6 -5.6 -5.6 -5.5 Paraguay -9.2 -8.1 -12.4 -7.2 -5.4 -5.2 -5.2 Peru -5.6 -6.4 -4.6 -5.9 -3.1 -3.2 -3.9 Trinidad and Tobago 0.8 -0.9 1.7 1.6 2.1 1.9 1.1 Uruguay -1.7 -1.8 -1.0 -2.4 -2.7 -0.9 -1.1 Venezuela -2.4 2.8 -6.2 -3.7 6.8 5.7 5.5 a. These large figures are heavily affected by the existence of foreign aid. Source: World Bank data. subsided. The exception is the Brazilian real, which, ing in 1991, reaching an $18 billion deficit. Commodities introduced at a highly depreciated level, has risen by prices have been evolving favorably in the last couple of about 30 percent against the U.S. dollar since the plan's years, in sharp contrast with events in the latter part of the inception. The external environment, in which the region's access to foreign financing has been temporarily TABLE A4 decreased, requires a renewed attempt at enhancing Net capital flows into Latin America and the Caribbean, external competitiveness. Increases in productivity and 1991 96 .. . . . ~~~~~~~~~~~~~(billions of U.S. dollars) more competitive real exchange rates will be essential in this respect. However, productivity gains are long-term COUNTRY 1990 1991 1992 1993 1994 in nature; no short-term relief from this should be Argentina -1.9 3.6 11.2 10.0 10.5 in nature; no short-term relief from this should be Brazil 5.3 0.8 8.8 9.0 13.1 expected. Chile 3.0 0.8 3.5 2.8 3.1 Regarding international trade, exports have continued Colombia 0.0 -0.8 0.2 2.2 3.1 Mexico 8.2 24.9 26.5 30.9 11.5 to perform quite well, with an increase in 1994 of 14.3 per- Peru 0.9 0.5 2.7 2.7 6.0 cent. Imports however grew even faster (14.7 percent), con- Venezuela -6.0 1.2 2.5 1.7 -5.2 tributing to the development of large current account Regional total 14.6 33.8 61.7 65.1 56.6 deficits. The trade balance followed its negative trend start- Sources: IMF for 1990 and 1991, CEPAL for 1992-94. 35 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 FIGURE Al Real exchange rates in Latin America E--ha-tate i,dcaquaaary 1990 =100) Argentina Brazil 200 110 180 2()0 I l ~~~~~~~~~~~~~~~~~~~~~~~~~10 160 140 go 120 40 100 70 80 60 60 40 51) 20 40 Jan July Jan July Jan July Jan July Jan July Jan Jan July Jan July Jan July Jan July Jan July Jan 1990 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 1990 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 Chile Colombia 100 10 105 95 90 9 85 85 Jun July Jan July Jan July Jan July Jan July Jan Jan July Jan July Jan July Jan July Jan July Jan 1990 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 1991) 1991 1991 1991 1992 1992 1993 1993 1994 1994 1995 P i rh lcalconumr piceinexCohsta Ricras intecuexrprsnsador ppeiain 75~~~~~~~~~~~~~~~~~~~~~9 16 100 85~~~~~~~~~~~~~~~~~~~0 95~~~~~~~~~~~~~~~~~~~~~9 105~~~~~~~~~~~~~~~~~~~7 90~~~~~~~~~~~~~~~~~~~9 65 85 60 Jan July Jan July Jan July Jan July Jan July Jan Jan July Jan July Jan July Jan July Jan July Jan 1990) 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 1991) 1990 1991 1991 1992 1992 1995 1993 1994 1994 1995 Note.; The indices were computed as RER = EP*/P, where E stands fur the tiominal exchange rute in local currency units per US dollar, P* represenits the US whsolesale price index, and P is the loacl consumer price index. Thus a decrease in the index represents a teal appretiatiun. Soares: IMr, Intetw,ational Finatncial Statistics, 36 LATIN AMERICA AFTER MEXICO: QUICKENING THE PACE FIGURE Al, continued El Salvador Guatemala 160 120 115 150 110 140 o10 130 100 95 120 90 110 85 80 100 75 90 70 Jan July Jan July Jan July Jan July Jan July Jan Jan July Jan July Jan July Jan July Jan July Jan 1990 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 1990 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 Mexico Peru 115 180 110 170 105 160 100 150 95 \< 140 90 130 85 80 120 75 110 70 100 65 95 Jan July Jan July Jan July Jan July Jan July Jan Jan July Jan July Jan July Jan July Jan July Jan 1990 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 1990 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 Uruguay Venezuela 95 110 90 ~~~~~~~~~~~~~~~~~~~105 85 100 80 ~~~~~~~~~~~~~~~~~~~95 75 90 70 ~~~~~~~~~~~~~~~~~~~85 65 80 60 75 55 70 50 65 Jan July Jan July Jan July Jan July Jan July Jan Jan July Jan July Jan July Jan July Jan July Jan 1990 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 1990 1990 1991 1991 1992 1992 1993 1993 1994 1994 1995 37 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 1980s. According to the World Bank's Global Economic 13. Costa Rica was the exception, where second tier schools had Prospects, this trend is expected to continue during 1995 very strong test scores. and 1996. 14. It should be noted that high repetition rates reflect a myriad of factors. It is not necessarily true that a low level of repetition reflects Notes high educational standards. In fact the ideal situation is one where rates of repetition are low, and standardized results are high. 1. While large, and even very large, current account deficits 15. In 1995 the region's current account deficit is expected to be can take place for a limited period of time, they cannot be main- close to 1.8 percent of GDP, down from about 3 percent in 1993-94 tained in the longer run. This is a matter of arithmetics. A current (see World Bank 1995a). account deficit of the magnitude of Mexico's would eventually require that the country devote 100 percent of its GNP to pay interest (and dividends) to foreign holders of Mexican securities. References 2. Mexico was subjected to a number of serious political shocks Burki, Shahid J., and Sebastian Edwards. 1995. "Consolidating in 1994, starting with the Zapatista uprising on January 1; the assas- Economic Reforms in Latin America and the Caribbean." Finance sination of Donaldo Colosio, the PRI presidential candidate, on andDevelopment 32: 6-10 March 23; the shaky start of Ernesto Zedillo, the new presidential CEPAL (Comisi6n Econ6mica Para America Latina y el Caribe). candidate, in the presidential campaign; and the assassination of 1994. "El Regionalismo Abierto en America Latina y el Caribe." Francisco Ruiz Massieu in September. Santiago. 3. The World Bank has recently committed two loans to the De Gregorio,Jose. 1991. "Economic Growth in Latin America." IMF Argentine Republic for a total of $1.0 billion to help privatize Working Paper 91/71. International Monetary Fund, provincial banks and restructure the banking system. In addition, it Washington, D.C. has committed two loans for $300 million to help strengthen the Edwards, Sebastian. 1993. "Latin America a Decade After the Debt provision of social services (health insurance and a social safety net) Crisis." World Bank, Office of the Vice President, Latin America during the adjustment process. and the Caribbean Region. Washington, D.C. 4. See CEPAL News, "The Progress of Latin American and - . 1995. "Why Are Latin America's Saving Rates so Low? An Caribbean Integration," April 1995. International Comparative Analysis." NBER Working Paper 5097. 5. For a thorough analysis of savings in developing countries, see National Bureau of Economic Research, Cambridge, MA. Edwards (1995). Fiszbein, Ariel, and George Psacharapoulos. 1992. "Income 6. It is interesting to notice that during the second half of the Inequality Trends in Latin America in the 1980s: A 1980s the level of financial depth in the region-measured by the Decomposition Analysis." Paper presented at the Conference on ratio of money to GDP-was almost one half of what it was in the Poverty and Inequality in Latin America, Brookings Institution, rest of the world. Washington, D.C. 7. Strictly speaking, what matters is the relation between contri- Harberger, Arnold. 1959. "Using the Resources at Hand More butions and expected benefits. If the retirement system is benefit- Efficiently." American Economic Review 49. defined-as many Latin American systems are-it will tend to dis- Naim, Moises. 1994. "Latin America's Journey to the Market: From courage private savings. Macroeconomic Shocks to Institutional Therapy." Occasional 8. See the forthcoming World Bank document Meeting the Paper 62. International Center for Economic Growth, San Infrastructure Challenge in Latin America and the Caribbean. Francisco. 9. Latin America is the only region where the share of income Psacharapoulos, George. 1992. "Poverty and Income Distribution in going to the poorest 20 percent consistently declined between 1950 Latin America and the Caribbean." World Bank, Latin America and the late 1970s. See Sheahan (1987). and the Caribbean Region, Washington, D.C. 10. Even though the incidence of poverty-measured as the pro- Schultz, Theodore W. 1961. "Investment in Human Capital." portion of poor in the overall population-is generally higher in American Economic Review 51. rural areas, the fact that population expansion is heavily concentrat- . 1978. "Nobel Prize Address."Journal of Political Economy 86. ed in urban areas implies that the increase in the number of poor peo- Sheahan, John. 1987. Patterns of Development in Latin America: Poverty, ple is, essentially, an urban phenomenon. Repression, and Economic Strategy. Princeton, N.J.: Princeton 11. This is mostly because retirement schemes are based on a University Press. defined benefit approach, where there is very.litrle connection (if any) World Bank. 1993. Implementing the World Bank Strategy to Reduce between workers' contributions and the benefits they obtain from the Poverty: Progress and Challenges. Washington, D.C. system. . 1994a. An Infrastructure Initiative for Latin America and the 12. T.W. Schultz (1961, 1978) has been the indisputable modern Caribbean. A Directions in Development Book. Washington, D.C. pioneer of this view in economics. See also Harberger (1959) and . 1994b. Trends in Developing Economies. Washington, D.C. Psacharopoulos (1992). . 1994c. World Development Report 1994: Infrastructure for 38 LATIN AMERICA AFTER MEXICO: QUICKENING THE PACE Development. New York: Oxford University Press. Possible." Latin America and the Caribbean Regional Office, - 1995a. Global Economic Prospects and the Developing Countries Office of the Chief Economist, Washington, D.C. 1995. Washington, D.C. . 1995c. World Development Report 1995: Workers in an - . 1995b. "Long-Run Prospects for LAC: Rapid Growth Is Integrating World, New York: Oxford University Press. 39 Reform of the State in Latin America STE P H A N H A G G A RD LA ATIN AMERICAN GOVERNMENTS HAVE GONE A LONG WAY IN THE DIRECTION OF POLICY reform (Williamson 1990; World Bank 1993). Yet the first round of crisis-driven policy change concentrated on macroeconomic and balance of payments adjustment and the restructuring of incentives and relative prices. With the exception of privatization, these early reforms did not typically address institutional issues (Haggard and Kaufman 1992; Nafm 1994). Moreover, many of the reforms were administratively, though not politically, easy. Stabilization and structural adjust- ment could be initiated by a relatively small number of policymakers, often working as teams organized outside of routine bureaucratic channels. These reforms did not require a high level of sustained, large-scale organizational capacity to implement.' The next stage of reform is proving quite different conservative idea that the state's role should be sharply cir- (Evans 1992; World Bank 1993; Streeten 1993; Naim cumscribed. 1994; Grindle 1994). Institutions are being reformed, A second conception of "reforming the state" implies a built or rebuilt, in part because the current policy chal- selective expansion of government activities (Bradford lenges are much more intensive in the use of administra- 1994). The crises of the 1980s created a backlog in provid- tive resources, in part to consolidate those policy changes ing public goods as well as new distributive problems: that have been made. infrastructure; maintenance; provision of basic services; To some, the reform of the state is synonymous with the improving the quality and coverage of education and reduction of unwanted government intrusion in markets health care; and addressing continuing problems of unem- and an increase in bureaucratic efficiency: privatizing; ployment, income distribution, and poverty (Grosh 1990). reducing unnecessary regulation; reorienting spending pri- The move to the market has also created demand for new orities around core government functions; improving the regulatory capabilities, including overseeing financial mar- delivery of services through greater contracting out; and kets, industrial relations, newly-privatized utilities, and eliminating waste, fraud, and abuse through reforms of the the environment. This second vision includes a more system of financial management. This strand of thinking activist state and looks to the European social democracies was born of profound fiscal crises. Politically, it reflects the and East Asian newly industrializing countries for models. Stephan Haggard is professor of international relations and Pacific studies at the University of California at San Diego. The author thanks Robert Ayres, Tim Campbell, Roger Douglas, Paul Drake, Sebastian Edwards, Chris Garman, Merilee Grindle, Robert Kaufman, Phil Keefer, Gary Reid, Matthew Shugart, Roberto Simonsen, Eliza Willis, and Kin Bing Wu for helpful comments. Particular thanks are due to Edgardo Boeninger for his encouragement and wisdom. 41 DEVELOPMEN'I' IN LATIN AMERICA AND 'ITHE CARIBBEAN: RIO DE JANEIRO) CONFERENCE, 1995 Finally, there is a third, more overtly political, conception emphasis on the elected officials who control-or seek to of state reform (O'Donnell 1991, 1994; Bresser Pereira, control-the bureaucracy: presidents, their ministers, leg- Maravall, and Przeworski 1993). The political circumstances islators, governors, mayors, and local council members. surrounding the first phase of economic reform were quite These political actors, and the parties they represent, con- particular. Chile and Mexico launched reforms under the stitute a major channel through which interest group pres- auspices of a military and dominant-party system respective- sures are translated into policy and institutional reform. ly. In the remainder of the continent, reform was in the The political incentives they face will influence the shape of hands of democratic governments, many of them quite new. administrative reform in the region. Partly because of the nature of the reforms, partly because of I concentrate on two issues. First, how do governments crisis circumstances, presidents often initiated policy change build central ministries and agencies that are differentiated without extensive consultation either with legislatures or in their functions, autonomous, and at least partly insulat- interest groups. The transition to democracy is naturally giv- ed from short-term electoral and interest-group pressures? ing rise to efforts to reassert control over the government Part of the answer resides in restructuring internal organi- through the expansion of legislative control and preroga- zational incentives, including the civil service. However, tives; strengthening judicial oversight; making government the problem is broader. How can effective and efficient del- responsive to a wider array of interest groups and citizens; egation be achieved? Delegation requires both coherent and the reinvigoration of provincial and local governments. legislative support and appeal to, and participation of, Reforming the state is therefore not simply an issue of effi- interested social groups. ciency, but of accountability and participation as well. Second, under what conditions and with what effect will These three approaches are not necessarily mutually politicians operating at different levels of the political sys- exclusive; a government can shrink in one area and expand tem agree to decentralize the organization of government, in others, while also increasing its political accountability. within central government ministries, to lower levels of Yet all three of these strands of thinking share one common government, or to private agents? Again, the analysis of feature: they are fundamentally normative. The analysis decentralization requires an examination not only of the begins by positing certain substantive goals (efficiency, incentive structure within bureaucracies, but between levels equity, accountability), outlining the administrative of government. Effective decentralization rests on the politi- reforms required to achieve them, and then calling for cal relationships that exist between the central government political leaders to develop the "will" or "commitment" to and local politicians and interest groups. initiate the favored plan. No theory is provided as to why The central message of this paper is a simple one: gov- politicians would, in fact, choose one set of institutional ernment institutions are designed and reformed to serve arrangements over another. political ends. It may be possible to initiate reform through A further problem is that the reform of the state is typi- the exercise of concentrated executive or technocratic cally taken to mean the reform of the government bureau- authority; this has been a common route to policy change cracy. However, a central insight of contemporary democra- in Latin America (Bresser Pereira, Maravall and Przeworski tic theory is that the bureaucracy is nested in a longer chain 1992; O'Donnell 1991, 1993; Haggard and Kaufman of principal-agent or delegation relationships, from interest 1995, ch. 5). Consolidating policy and institutional change groups and voters to politicians; from politicians to the requires constructing bases of political and social support. heads of bureaucratic agencies; and from agency heads down Understanding how this occurs in different systems through the organizational chain of command (for example, demands an examination of the central institutional fea- Moe 1990). Given the backdrop of democratization in Latin tures of contemporary Latin American democracy.2 America, institutional reform cannot be viewed simply as a question of getting internal bureaucratic incentives right; Democracy in Latin America: Constitutional design, rather, it is an inherently political process. political incentives, and the organization of the state In analyzing this political process, I depart from the Institutional changes are ultimately initiated by politicians well-known focus on interest groups to place greater who have an interest in serving their constituents.3 How 42 REFORM OF THE STATE IN LATIN AMERICA politicians perform this task is a function of the preferences Caldwell 1994). Presidents have a wider national con- of interest groups and electorates, but also of the institu- stituency than legislators, and thus have a greater interest tional setting in which they operate. In Latin America, this in administrative structures that can serve as effective-if setting includes a presidential form of democratic rule not necessarily efficient-instruments for implementing coupled with party systems that vary in important ways their programmatic and political agendas.7 In a presiden- across countries. These institutions structure the incentives tial system legislators are not necessarily in the business of not only to executives, ministers and legislators, but to creating effective government; they are in the business of salient interest groups as well; as a result, they shape the making themselves popular and their jobs secure (Moe and efficiency of the political process. Caldwell 1994, p. 175). Depending on the nature of the electoral system, they may only be able to accomplish this Some features of presidential rule objective by courting interest group backing and pursuing The debate over the relative merits of presidentialism and particular concerns. parliamentarism has been intense in Latin America, but In a presidential system with competing and overlap- presidentialism remains-and is likely to remain-the ping centers of power, it is possible for legislators to pro- dominant constitutional form in the region (see Linz tect their policies against future reversal by designing com- 1993a, 1993b; Linz and Valenzuela 1994; Horowitz 1993; plicated rules that reduce the discretion of bureaucrats: Lijphart 1993) There are reasons to be skeptical of some decision criteria, procedures, timetables, personnel rules, claims of the "parliamentistas"; in particular, I will and so forth (McCubbins, Noll and Weingast 1987, 1989). emphasize that some of the supposed problems with pres- Given the independent institutional and electoral interests identialism can be traced to features of the party system of legislators, the multiple veto points built into a division (Shugart and Carey 1992, pp. 28-54; Mainwaring and of powers system, and the interest groups that crystallize Shugart 1994; Shugart 1995; Haggard and Kaufman around them, these structures become extremely difficult 1995, ch. 10).4 Nonetheless, the separate and independent to change once in place. election of the executive and legislature that is a core fea- The potential for stalemate in presidential systems is ture of presidential rule does generate coordination prob- partly offset by the powers of the president; these include lems that are important for understanding administrative veto and override provisions, decree powers, and broader design.5 legislative powers, for example, with respect to the budget. Divided political authority provides checks and balances In Chile, the president has the power to submit the budget, that are lacking in a parliamentary system and also opens and taxes and spending cannot be raised by the Congress the possibility of stalemates between branches. Because nor expenditures shifted between categories. The president presidents are elected independently of the legislature, they in Uruguay also enjoys substantial budgetary authority. do not necessarily come from the majority party in the leg- However, these powers are exceptional in Latin America islature, assuming one exists. While outright divided gov- (Shugart and Carey 1992, p. 155). As a result, conditions ernment in Latin America has proven surprisingly rare of political stalemate between branches have frequently led (Shugart 1995), it is not uncommon for Latin American presidents to use constitutional decree powers or even presidents to confront legislatures in which their party or extra-constitutional forms of decisionmaking. Policy- faction holds only a plurality or is even in the minority. In making in Brazil in the early days of the Collor adminis- parliamentary systems, the electoral incentives of the prime tration provides examples of the former; Peru under minister and backbenchers are more tightly aligned, which Fujimori is an example of the latter. The potential for stale- serves to maintain party and coalitional discipline. mate also explains the attraction of the formation of high- Presidents lacking firm party support in the legislature level technocratic teams that operate outside of normal cab- must engage in difficult and costly coalitional politics for inet, ministerial, or bureaucratic channels. each and every item on their legislative agenda.6 Even if these devices prove useful in breaking logjams in This division of powers has implications for administra- the short run, they do not solve the problem of institution- tive design and the reform of the state (Moe 1990; Moe and alizing coherent decisionmaking and policy implementa- 43 DEVEIOPMENT IN LATIN AMERICA ANI) THE CARIBBEAN RIO DO JANEIRO CONFERENCE, 1995 tion over the long run. Presidents can, however, create their will be politicized and that policy will swing widely own agencies, authorities, and commissions. These agen- between alternating governments. cies may serve as "pockets of efficiency" within an other- For the moment, the more common political problem wise inefficient bureaucratic organization. The creation of in Latin America is the combination of fragmentation-a independent statutory agencies or boards to carry out par- high number of effective parties (Sartori 1976, p. 185; ticular policy initiatives-an important but understudied Powell 1982, pp. 80-84)-and weak internal party disci- feature of the recent expansion of the Latin American pline. Brazil, Ecuador, and Peru all exhibit this syndrome, state-clearly reflects the efforts of executives to "lock in" as did Bolivia immediately following its transition to their policy preferences against future reversal and to build democratic rule. The principal effect of fragmentation is administrative channels for currying political support. the difficulty it poses for coordination: within the ruling In sum, one set of factors that influences administrative coalition, between executive and legislative branches, and design is the degree of conflict or cooperation between the among different levels of government. Party fragmenta- president and the legislature and the powers of the presi- tion in presidential systems compounds the chances that dent. Where president and legislature are aligned, or where executives will become politically isolated and powerless the president enjoys substantial legislative powers, there is to pursue their agenda (Mainwaring 1992). The incen- greater likelihood of creating coherent administrative tives for small parties to cooperate with the government structures. Where president and legislature are at odds, are weaker than in a parliamentary system since there is where the president is constitutionally limited in his capac- no ability to threaten early elections and the temptations ity to take initiatives, or where the respective powers of the of legislative blackmail are correspondingly greater. two branches are ambiguous, institutional reforms will Coordination becomes even more difficult when the cen- take a less coherent form. This is true in part because of the trifugal pressures in fragmented systems are compounded greater likelihood of competitive political interference in by strong ideological polarization or sectarian tendencies, the existing bureaucratic structure, in part because of com- as has been true in Peru in the recent past. peting efforts to construct new agencies that are responsive Latin America also has a number of political systems to political command. with a low level of fragmentation and relatively cohesive party systems. Mexico has been a dominant party system, Party systems in Latin America though with increasing competition. Colombia and Costa The effects of presidentialism on economic policy and Rica stand out as stable two-party democracies of relative- institutions will depend on the nature of the party system, ly long standing. Chile retains a relatively high number of and in particular on the extent of its polarization or frag- effective parties, but has moved in the direction of two mentation. Polarization is defined by the ideological dis- major party blocs. By contrast, Argentina, Venezuela, and tance between the extreme parties in the system. (Sartori Uruguay appear to be moving toward a larger number of 1976, pp. 132-137; Cox 1990). Though polarization is effective parties than in the past, with the Uruguayan case notoriously difficult to operationalize, it can be measured further complicated by institutionalized competition with- by the strength of leftist, populist, and "movement" in the major parties. parties. A more cohesive party system can offset some of the The crises of the 1980s had the surprising effect of sub- problems of presidential rule noted above while avoiding stantially weakening such parties or transforming them in the pitfalls of polarization and fragmentation (Weaver and a more pragmatic direction. Nonetheless, as recent devel- Rockman 1993; Shick 1993). Competition is organized opments in Venezuela show, the resurgence of populism is between a smaller number of larger parties and we would an ever-present possibility in Latin America. Clearly, it is thus expect politicians to crowd the political center. The much more difficult to reform the state when there are left and movement parties which have resurfaced in more sharp divisions among contending parties and interest cohesive systems, particularly Chile and Argentina, have groups over what the government should do. Under these had strong incentives to move toward the center. When conditions, there is greater likelihood that the bureaucracy things are going well, they are less likely to press for the 44 REFORM OF THE STATE IN LATIN AMERICA wholesale reversal of government initiatives; when things factors are also at work, and in particular the extent to are going badly, they are less likely than in the past to grav- which electoral rules encourage politicians to cultivate a itate toward radical, polarizing solutions or to back strikes, personal reputation. Where politicians have incentives to demonstrations, and protests that complicate the ability of cultivate the personal vote, they are more likely to develop governments to act. narrow constituent bases of support and to press for specif- The small number of large parties will also have a mod- ic policies at the expense of party platforms (Cain, erating influence on the way interests are aggregated. In Ferejohn, Fiorina 1987). The implications for the reform of countries with fragmented or polarized party systems, anti- the state are outlined succinctly by Shugart and Nielson reform groups are likely to have a stronger political voice. (1994b, p. 18): "in decentralized systems, party programs In cohesive systems, interest groups operate in the context are constantly being scavenged by individual politicians for of encompassing coalitions in which diverse interests are their idiosyncratic interests-they seek to break up nation- represented and among which compromises must be struck al policies into localized or issue-specific parcels in appeal (Olson 1982). to narrow groups." These particularistic policies take the The implications of the party system for policy and form of patronage, pork, and the drafting of statutes that administrative reform will depend on what has come are cast in general language, but that are in fact designed before. In fragmented party systems, the move toward a to appeal to a narrow constituent-and even individual- more cohesive party framework can provide the oppor- base of support. tunity to organize stable bases of legislative support for A number of inter-related rules affect the extent to presidential programs. In cohesive party systems of long- which party control is centralized, but two are worth standing, the problem is how to avoid parties becoming emphasizing in the Latin American context. The power of machines for the dispensation of patronage through the party leaders is enhanced when they control access to the public sector. This tendency will depend on a final feature ballot and the order in which candidates are elected and of the party system: the ability of party leaders to exercise where voters vote for parties rather than individual candi- control within their own ranks. dates. Closed-list rules, which dominate in most Latin American systems, should in theory encourage loyalty to Internal party organization the party leadership and its platform-assuming one In discussing the parliamentary-presidential debate, it was exists! A more open and decentralized nomination proce- noted that legislators in a presidential system tend to be dure and a ballot structure that allows voters to choose responsive to particularistic interests.8 However, this individuals rather than party slates allows entrants to free- might be due to the lack of party discipline rather than to ride on the party label while simultaneously encouraging presidentialism. Where party leadership is strong, there is them to curry a personal reputation for the provision of greater prospect of enforcing programmatic discipline. particularistic goods. Party strength is likely to be reflected not only in intra- Politicians' behavior is also affected by whether they party organization, but in the design of legislative institu- compete against members of their own party, as they do in tions themselves. Strong parties are more likely to favor some multi-member district systems. In such competition, rules and institutions that further buttress party disci- party label has no consequence. As the size of the district pline, such as strong oversight or control committees and goes up, and the individual politician is competing with extensive agenda-setting and committee assignment pow- more members both of the opposition and her own party, ers for party leaders. Of greatest interest here, however, is this competition becomes more fierce. The only way to con- the fact that strong parties are also more likely to favor duct such rivalry is by stressing personal traits that differ- effective government. entiate the candidate; in effect, politicians are encouraged The strength of the party leadership is contingent in the to pursue what Ramseyer and Rosenbluth (1994) call a first instance on overall economic performance and the gov- "niche" strategy that rests on the provision of particularis- ernment's popularity; success strengthens ruling parties tic goods and personal services. and weakens the opposition. However, deeper institutional Brazil provides a virtual textbook case of an electoral 45 DEVEIOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO (CONFERENCE, 1995 system in which there are strong incentives to cultivate a crucial to the functioning of any democracy; it is a defining personal vote (Ames 1995). Brazil's deputies are elected characteristic of the modern state. From an efficiency per- through a system of open-list proportional representation. spective, delegation is the organizational equivalent of the Each state is a single, at-large multimember district, rang- division of labor since it allows gains from organizational ing in magnitude from 8 to 70 seats. State parties select specialization and expertise. candidates in conventions, giving politics a strong provin- Delegation also plays a crucial role in solving collective cial flavor, and parties cannot refuse to renominate incum- action problems. For example, legislators have a collective bents. Voters can cast ballots either for the party or for interest in effective fiscal management because it affects individuals, but most opt for the candidate and only candi- overall economic performance and thus their reputations date votes affect the order of election within the party. A as incumbents. But legislators also have electoral concerns common strategy for building electoral support in such a that may tempt them to seek particularistic benefits for system is to concentrate on geographically narrow baili- their constituents. If all legislators succeed in this strate- wicks within the district. As Ames (1995, p. 341) shows, gy, for example through legislative logrolls, then it is easy "deputies with more clustered votes tended to be pro- to see how suboptimal policy might arise; Barbara Geddes Congress, antiexecutive, supportive of state intervention (1994) has called this the "politician's dilemma." Even if and welfare, and supportive of popular democracy." Above the problem is recognized, it may be difficult for parties all, these legislators sought pork at the expense of a nation- or legislators acting collectively to organize appropriate ally-defined agenda. A second strategy is to court support responses because of conflicts over the distribution of ben- from particular functional groups, such as teachers or the efits. Delegation to "control committees" within the construction industry; such a strategy results in a kind of legislature, to party leaders, to the executive, or to legislative capture, in which the policy agenda of the legis- bureaucratic agencies can solve these collective action lator is driven disproportionately by the interests of a nar- problems. row constituency. In either case, the policy consequences The benefits of delegation have given rise to what might are deleterious. be called the technocratic fallacy: the idea that difficult and Centralized party control is certainly not a guarantee of contentious policy problems can be solved by simply good economic policy. Centralized parties might well have removing them from the hands of politicians and from ideological platforms that are hostile to economic reform, interest group pressures and assigning them to tech- and the distribution of private goods is also of use in a cen- nocrats.9 However, while politicians in a democracy have tralized system (Geddes 1994); Venezuela and Costa Rica an interest in delegating for efficiency reasons, they also provide examples (Coppedge 1988). However, strong par- have an interest in controlling and monitoring bureaucrat- ties are more likely to devise mechanisms for controlling ic agents so that they are attentive to politicians' electoral, the distribution of private goods, either within the party or constituent, and interest group concerns.10 through delegation to reformed administrative structures There are a number of ways politicians seek to accom- (Shugart and Nielson 1994a, 1994b). The controlled dis- plish the objective of bureaucratic control; these may be tribution of political goods-and even a certain amount of divided into ex ante and ex post, or oversight, mechanisms patronage and pork-may actually have a salutary effect on (McCubbins and Schwartz 1984; Kiewit and McCubbins the reform process by building support and compensating 1991; McCubbins, Noll, and Weingast 1987, 1989). The losers. The key issue is guaranteeing that such political first and most obvious ex ante means is through the legis- goods are distributed in a relatively efficient way that does lation or statute itself, for example, by specifying the scope not undermine efficiency objectives; that, in turn, depends of the regulatory decisions that are delegated to agencies on the relationship between politicians and bureaucrats. and the legal tools that an administrative agency can use (McCubbins 1985).1 A second ex ante control mechanism Delegation and efficient government is through the screening and selection of personnel. Even if This process of delegation from legislators to the executive executives and legislators are willing to establish a rela- branch and from presidents to ministries and agencies is tively independent, meritocratic civil service, they are like- 46 REFORM OF THE STATE IN LATIN AMERICA ly to insist on political control or at least veto power over Finally, we must consider the conditions under which top administrative appointments. administrative agencies are capable of maintaining their Politicians are also likely to exercise ongoing (ex post) autonomy and independence over time. In contrast to the oversight over agencies. One way of doing this is through technocratic approach to bureaucratic reform, I argue auditing-monitoring and reporting requirements. that bureaucracies and agencies gain their independence However, these "police patrol" mechanisms (McCubbins precisely by building bases of organized constituent sup- and Schwartz 1984) are quite costly and run up against port (Evans 1992). This proposition finds validation both both moral hazard problems and the difficulty of specifying in the analysis of civil service reform itself-in which against all future contingencies. public sector workers constitute the key interest group- This problem can be overcome by establishing decision- and in evidence from two quite disparate policy areas: the making structures that build institutional or interest group conduct of monetary policy and the design of institutions checks (veto points) into the agency's decisionmaking for targeting the poor. process. For example, politicians may require intra-agency consultation or empower affected parties directly. This can Reforming the civil service occur by allowing interest groups to comment on the The moving force behind civil service reform in the past agency's decisionmaking, by structuring participation in decade has been fiscal constraints. The growth in govern- regulatory agencies, by granting constituents standing in ment spending on salaries, wages, and benefits was unsus- quasi-judicial administrative procedures, or by strengthen- tainable prior to the fiscal crises of the 1980s. The squeeze ing the judicial process more generally. These "fire alarm" on government revenues that followed forced a sharp com- structures are less costly, reveal less biased information, and pression in government spending. Most developing coun- shift policymaking authority to the bureaucracy while tries, including those in Latin America, did not respond by allowing for the ongoing representation of affected parties. reducing public employment; to the contrary, public sector The "reform of the state" can thus be seen as a political employment expanded. Public sector wages fell dramati- process of striking a balance between the efficiency gains to cally, however, and wage scales became more compressed. be achieved by delegation, the interests of executives and At first, the perceived solution to the problem was sim- legislators in controlling bureaucratic agents for political ply to cut the size of the civil service, sometimes in an arbi- ends, and the need for politicians and bureaucrats to remain trary, across-the-board fashion. As it was recognized that responsive to organized interest groups. cutting the size and pay of the bureaucracy could reduce Three aspects of the political economy of institutional rather than improve performance, attention shifted to the reform must therefore be separated. The first, and the one determinants of organizational efficiency. Just as the litera- that has received by far the most attention is the analysis of ture on rent-seeking offered political reasons why govern- how bureaucracies can be designed to align the incentives of ment intervention might distort the allocation of resources, individual civil servants around larger social and organiza- so principal-agent models produced a parallel diagnosis of tional goals. The "new institutionalism" and the application the sources of bureaucratic inefficiency. of simple principal-agent models have gone a substantial The first observation, and one to which the World Bank way in addressing these organizational design problems. has given particular attention, was that pay levels were too The second and equally important question is under- low and provided inadequate or even perverse incentives to standing the conditions under which politicians will find it public sector workers (Nunberg and Nellis 1990; Lindauer in their interest to support efficient administrative struc- and Nunberg 1994; Chaudhry, Reid, and Malik 1994). tures in the first place. An analysis of the reform of the civil Falling public sector wages produced a well-documented service and of the establishment and reform of regulatory set of problems including difficulties in recruiting quality and administrative agencies suggests that the answer to civil servants in the upper organizational ranks; declining this second question can be found in part in the character- morale and effort; and increased absenteeism, moonlight- istics of political institutions outlined in the previous ing, and corruption (Klitgaard 1988; Gould and Amaro- section. Reyes 1983). Bureaucracies also responded to pay cuts by 47 DEVELOPMENT IN LATIN AMERICA AND TIIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 launching countermeasures that only increased the com- tems in Latin American bureaucracies have typically erred plexity of pay systems, for example, by increasing reliance on the side of overcentralization, not only with respect to on bonuses and nonmonetary compensation. Although the management of personnel but with respect to the con- there are important debates on strategy, the central thrust trol of a/l inputs such as pre-control of expenditure deci- of employment and pay reform for addressing these prob- sions; central assignment of employment slots; centralized lems is increasingly clear (Nunberg 1994; Reid and Scott pre-approval of hiring, firing, promotions, and salary 1994; Nunberg 1995): targeted reductions aimed at redun- adjustments; and detailed specification of performance dant workers; incremental downsizing through recruit- review procedures. A system that monitors on the basis of ment freezes, natural attrition or privatization; adjustment agency outputs provides greater flexibility to managers and retraining programs to mitigate the political as well as and focuses monitoring efforts on more appropriate indi- economic costs of downsizing; and a pay structure that is cators while simultaneously aligning incentives around competitive with comparable work in the private sector. the ultimate agency goals of producing particular public A second and closely related set of issues has to do with goods and services. Again, the general direction of reform the internal incentives to effort. A number of practices in is clear (Nunberg 1995). Ministers should hold agency Latin America tend to weaken these incentives, including heads responsible for output and efficiency; grant them tenure guarantees based on performance evaluation, low greater discretion in the control of inputs, including hir- investment in training, and compressed salary scales (Reid ing and firing decisions; and improve the technical quali- and Scott 1994, pp. 40-42; Klitgaard 1991, ch. 6). These ty of financial auditing and monitoring procedures. anti-competitive features of bureaucratic organization are These observations concerning the internal sources of exacerbated by various barriers to entry, such as limiting bureaucratic failure have been buttressed by lessons drawn the pool of job applicants for all positions except for entry- from apparent success stories. As with economic policy level and the very highest ranks to the civil service itself. more generally, the East Asian cases are held up as models. Again, there are differences in strategy on how to overcome Analyses of the Japanese bureaucracy have long stressed these problems. Nonetheless, the general direction of features that conform to the "internal incentive" model just reform is clear: positive incentives through decompression sketched: meritocratic recruitment; high levels of status of wage scales, more competition for advancement, and and remuneration, particularly at the senior grades; intense more discriminating evaluation systems coupled with competition for advancement; and idiosyncratic institu- stiffer punishment for corruption and abuse of office tions such as the 'amakudari' system that rewards loyal and (Nunberg 1995). successful civil service careers with lucrative private sector Finally, an even broader complex of problems related to positions upon retirement (Silberman 1993, pp. 198-222; the way lower levels of the bureaucracy have been con- Koh 1989; Pempel 1994). Similar analyses of the internal trolled, monitored and evaluated in Latin America exists. incentive structure of the bureaucracy have been advanced Any personnel system faces a tradeoff. Granting agencies to explain coherent economic policymaking in Korea, discretion has advantages with respect to flexibility. Taiwan, Hong Kong, and Singapore (see for example Burns However, it carries risks that lower levels within the orga- 1994). nization will lack sufficient capacity to manage personnel These incentive-based models of bureaucratic inefficien- decisions effectively, will pursue an independent ideologi- cy sidestep a more fundamental explanation for internal cal agenda, or simply shirk. Centralized control of person- bureaucratic inefficiency: that politicians prefer it that way. nel has the advantage of economies of scale and guarantee- Paying closer attention to patterns of recruitment reveals ing uniformity, but can weaken both motivation and flexi- the critical links that exist between the bureaucracy and bility. Drawing on the lessons of the advanced industrial politicians and suggests the conditions under which states, Nunberg (1995) shows that both systems can work. bureaucratic reform is more or less likely. However, she argues that the more decentralized system is To understand these political strategies requires a differ- demanding of administrative capacity. entiated view of the civil service as encompassing several As Reid and Scott (1994, p. 45) show, monitoring sys- distinct classes of workers (Stevens 1994). First is what 48 REFORM OF THE STATE IN LATIN AMERICA might be called the "core" civil service, which in turn is The balance between various criteria for appointment made up of an "inner core" of professionals that occupy top will vary depending on the institutional factors outlined in managerial positions and the remainder of staff support and the previous section. For example, presidents who sit atop line workers. Clearly the quality of public policy will be strong encompassing or established parties are more likely strongly conditioned by the professionalism, expertise, and both to favor meritocratic reform and to be able to imple- stability of the administrative elite, and it is usually this ment it. The choice of top advisors is more likely to be dri- group that is the target of incentive reforms designed to ven by calculations of competence because the ruling make public service more attractive. Beyond the core civil party's interests are encompassing and include a desire to service, however-and typically larger in size-there are attract respected independents. Though such governments employees engaged in separate services, including teachers, may pursue a partisan strategy with respect to inessential health workers and the police, budget-dependent agencies, appointments, their interests with respect to the reform of and public enterprises. Finally, there are a large number of the lower ranks of the bureaucracy are also more likely to workers that are hired on a short-term, even daily basis, be influenced by broader programmatic interests, particu- typically at the discretion of ministries responsible for pub- larly the efficient delivery of services. lic works programs. Curiously, executives from parties with strong ties to An undue emphasis on internal bureaucratic rules over- labor may also be willing to pursue a strategy that favors looks the political logic driving government policy toward meritocratic and loyalty considerations rather than partisan these different classes of employees. Many of the occupants ones (Geddes 1994, p. 148); Menem provides an example. of high bureaucratic office in Latin America are political The key interest group with respect to civil service reform appointees made directly by the president or indirectly by is, of course, civil servants themselves. Securing their sup- his appointed ministers. The logic of these appointments port or at least acquiescence thus constitutes the primary reflects very clearly the politician's dilemma outlined political challenge. The Peronists were capable of achieving above. Presidents and their ministers clearly seek expertise one of the most dramatic reforms of the civil service in on highly technical issues such as macroeconomic policy; Latin America in part because of the concentrated powers their reputations for competence among both the electorate Menem enjoyed, but also because of the ruling party's his- at large and with investors hinges on such perceptions of torical ties with labor. competence. Politicians often have strong incentives to By contrast, presidents with weak party support in the appoint technocrats, and technical advisors have played an legislature, with weak ties to labor, or who face strong important role in the economic reform process in the last pressure from legislators face different incentives. Such decade (Centeno 1994). executives are less likely to confront or bargain credibly However, political appointments are also made with at with public sector unions and more likely to use the least three other objectives in mind: to guarantee particu- bureaucracy as a source of patronage. They are more likely larized benefits for constituents; to guarantee particularized to use top appointments to solidify a core base of support benefits for party activists; and to secure the support of leg- and to build legislative or interest group support. In times islators (Geddes 1994, p. 135). These calculations play a of crisis or even flagging popularity, ministers are likely to role not only at the top-for example, in the allocation of be sacrificed on short-term political grounds, generating a ministerial and sub-ministerial portfolios-but at the correspondingly high level of instability. Nafm (1994, pp. lower levels of the bureaucracy. A crucial political fact in a 25-26) finds, for example, that since 1988, the average number of Latin America countries is that certain segments Latin American minister held his job for less than fifteen of the bureaucracy, including teachers and employees of months. Though he suggests that these low averages prob- state-owned enterprises, are extensively unionized and can ably had to do with inadequate pay, he also notes that this constitute a major barrier to civil service reform. The hir- average was driven up by relatively long tenures in Mexico ing of short-term and casual workers can provide a kind of and to a lesser extent Chile and Colombia; Mexico and indirect social safety net that can be targeted quite narrow- Chile are precisely the countries in the continent with the ly for political ends. most cohesive ruling parties. 49 DEVELOPMENT IN LATIN AMERICA AND THR CARIBBEAN: RIO DF JANEIRO CONFERENCE, 1995 In weaker political systems, including those that are par- tems, career paths are less predictable and seniority plays less ticularly vulnerable to labor protest, the approach to civil of a role. These arrangements are tolerable to potential civil service reform is likely to take a fragmented or "compart- servants because they have the option of returning to non- mentalized" (Geddes 1994, pp. 143-44) form. Presidents government work. Silberman argues that this "professional" will be willing to increase the competence of agencies that orientation is more likely to arise in competitive democratic perform functions of key importance to the government's contexts in which governments seek to limit the costs of overall electoral chances; for example, a number of countries patronage and corruption while still maintaining control granted greater independence to central banks in the con- over the bureaucracy through political appointments. duct of their personnel policy (Maxfield 1994, ch. 5) because Though a Japanese model of civil service reform has inflation had become a salient electoral issue. But this strat- been suggested for Latin America, it is clear that the high- egy might be coupled with an unwillingness to tackle ly competitive nature of democratic politics in the region is reform of other ministries or agencies. more likely to push in the direction of the second, "profes- To understand the implications of these observations sional" approach to bureaucratic organization; the main for reform strategies demands a closer examination of the question is how to get there most efficiently. In countries options. Bernard Silberman (1993) provides a useful entry with "strong" governments-strong presidents and parties point into the question. Silberman argues that modern backed with robust legislative and labor support-there is bureaucratic organizations have evolved along one of two greater plausibility in pursuing encompassing reform distinct lines. The first he labels "organizational." Under strategies that are administratively centralized and seek to this approach to organizing the bureaucracy, individuals cover the entire bureaucracy. It is even possible that some commit to a bureaucratic career path prior to entering countries may succeed in moving toward Silberman's more office. An independent government agency screens eligible demanding "organizational" model for the upper reaches of candidates through highly specialized courses of universi- the bureaucracy, though Argentina's attempt to create such ty training or specific schools designed exclusively as an administrative elite did not prove successful. training grounds for the civil service. Commitment to the However, the best should not be the enemy of the good. bureaucratic career is lifelong, career tracks are highly pre- In weaker governments, a partial reform strategy based on dictable though competitive, and individuals are strongly pilot programs and an agency-by-agency approach is likely socialized into bureaucratic norms, including those of spe- to be more in line with political incentives: politicians gain cific agencies. Such a system is typically associated with from reform of key agencies responsible for core govern- low-level political appointments to high-ranking bureau- ment functions, particularly with respect to economic pol- cratic positions; in Japan, for example, the prime minis- icymaking, while maintaining some latitude with respect ter's direct appointment powers in the bureaucracy are to other portions of the bureaucracy. Such a partial strategy limited to the ministers! Silberman argues that this orien- may also have the advantage of providing "localized" but tation emerges when new political leaders seek to provide concentrated bases of support for bureaucratic rationaliza- assurances that they will not behave in an arbitrary man- tion; the significance of such support can be seen by broad- ner and build a highly independent elite cadre of civil ser- ening the discussion to an examination of the political vants to achieve this objective; Meiji Japan and design of agencies more generally. Napoleonic France constitute examples. Under the contrasting "professional" orientation, charac- The political design of regulatory and teristic of the United States, individuals "train" for the administrative agencies bureaucracy by acquiring specialized professional expertise, Civil service reform raises the question of the extent to for example, as lawyers or economists. Individuals frequent- which executives and legislators are willing to shield the ly enter the civil service laterally at high levels; as a result, bureaucracy from political pressures on the conduct of per- the bureaucracy is more permeable to interests and values sonnel policy. However, there is also the broader question of from the outside. Given that the appointment powers of the conditions under which politicians will delegate political executives tend to be more extensive in such sys- policy-making responsibility to autonomous and indepen- 50 REFORM OF THE STATE IN LATIN AMERICA dent agencies, and the organizational arrangements that stability is always reversible and reputation emerges only will guarantee that those agencies have the independence over time. Delegation can provide such assurances by trans- required to consider the public interest and the incentives ferring authority to agencies that have both a mandate and to do so."2 incentives to pursue stable policies. This process of delega- This question will be a central one for Latin American tion might occur through the signing of international countries over the next decade for three reasons. First, agreements, as with the Maastricht treaty, but more com- though economic reform implies that the core ministries monly it comes through a strengthening of the central will not intervene directly in markets to the extent that they bank. have in the past, the government must take on a variety of In the 1990s, four Latin American countries moved in the new regulatory functions to guarantee that markets work direction of more independent central banks: Argentina, efficiently; the oversight of the financial sector and compe- Venezuela, Colombia, and Mexico (Maxfield 1994, ch. 4). tition policy provide examples. Second, privatization has Chile should be added to this list. Although Pinochet loosened the government's ability to control firm behavior strengthened the independence of the central bank in the directly in a number of sectors, including utilities, 1980 constitution, negotiations with the opposition in telecommunications, and segments of the transportation 1988-89 guaranteed that those provisions would not be industry. New regulatory structures will have to be devised overturned during the transition to democratic rule. to oversee these activities. Finally, the process of political In all five cases, strong partisan backing constituted opening and democratization has given rise to new social an important precondition for the de jure strengthening demands for regulation in areas such as the environment, of central banking institutions. This strengthening occupational health and safety, and product liability, as well occurred both through changes in the central bank's as calls for improved social services. mandate, such as giving greater weight to price stability The design of efficient administrative and regulatory or limiting the obligation to finance government institutions is obviously a vast topic, yet two seemingly con- deficits, and through changes in appointment processes tradictory observations are important for understanding the and procedure that guaranteed independence, such as politics of successful reform strategies. First, though politi- stipulating terms of office that are independent of the cians can delegate authority to autonomous and indepen- electoral cycle or granting greater leeway in the hiring dent government agencies, they do so to solve particular and promotion of personnel. political problems. The efficiency of delegation is thus Although Pinochet had hoped to stack the board of the affected by the broader political and institutional features of Banco Central de Chile with his own appointees, negotia- government outlined above; governments will vary in their tions with the opposition led to several institutional and willingness to grant broad bureaucratic discretion. Second, personnel compromises. However, the opposition was at the independence of bureaucratic and regulatory agencies that point cohesive, united in its political strategy, and sur- ultimately rests not simply on statute, but on their effec- prisingly in agreement with the government on the virtues tiveness in providing services to interested constituencies of maintaining macroeconomic stability. In Argentina, the who provide agencies with support, and even protection. process was somewhat more protracted, but a new central Perhaps the clearest example of delegation has come in bank statute was passed in mid-1992 by the Peronist gov- the area of monetary policy. As with the reform of the civil ernment (Miller 1993, pp. 1073-74); as with earlier service, economic crisis has served a catalytic role in moving reforms, this one drew on strong legislative backing. politicians toward granting greater independence for core Venezuela and Colombia took somewhat different routes to economic policymaking institutions. Inflation has become a central bank reform. In Colombia it was incorporated ini- highly salient political issue and macroeconomic stability is tially into the 1991 constitution, while in Venezuela it was seen as crucial for attracting both foreign and domestic handled by statute. Nonetheless, the importance of strong investment (Haggard and Maxfield forthcoming). Yet gov- partisan leadership is clear. Mexico's introduction of new ernments face an obvious problem in establishing their central banking legislation in May 1993 also conforms to credibility in the conduct of monetary policy, namely, that expectations as do the continuing difficulties in reforming 51 DEVELOPMENT IN LATIN AMERICA AND TIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 central banking institutions in Brazil. objective not only the alleviation of poverty but the politi- While politics is important in explaining the willing- cal motive of securing support for reform programs (see ness to grant greater de jure independence to central banks, Cordoba 1994 on Mexico). such legal autonomy is only a necessary rather than suffi- As a result of this important political motivation, politi- cient for the conduct of an independent and stable mone- cians have had a strong interest in seeing such programs tary policy. For example, Cukierman, Webb, and Neyapti work, and have been willing to experiment with new insti- (1992) find that independence defined in terms of legal tutional arrangements to guarantee that they do. First, as rules has an influence on monetary policy in the advanced with central banking, some of the independence comes states but not in developing ones, where turnover is high- from the mandate itself. Most of the funds use targeting er and informal channels of political influence operate to a mechanisms based on objective poverty and income criteria greater degree. Yet even studies of the advanced industrial to reach beneficiaries and have clearly specified project cri- states have noted that legal independence is typically but- teria; as a result, their operations are more transparent. tressed by patterns of representation within the bank itself Second, most of the funds have a high degree of proce- that constitute checks on political manipulation. dural autonomy that protects them from political interfer- These checks may be intergovernmental or involve the ence in the project approval process by either politicians or legal empowerment of key social interests. Susanne interest groups. Key to achieving this objective have been Lohmann (1994) has shown how the independence of the a number of exceptions to normal bureaucratic regulations German Bundesbank is not simply a function of statute, and procedures. Probably the most important has been the but of strong representation on the bank board by regional choice of private sector managers to direct the funds' oper- appointees. Federalism reduces the likelihood that the cen- ations and related exemption from public sector rules on tral government will control appointments in such a way staff recruitment and salaries. Glaessner and others (1994, that they could use the bank for partisan ends. Mexico con- p. 5) note a variety of other ways in which the funds have fronts the opposite problem. Even in the face of strong gained independence: statute granting the bank independence, the centralization of the political system and the power of the president No less important has been the exemption of most of makes it difficult to establish checks and balances that the funds from government procurement and dis- guarantee that interference will not occur, even when the bursement procedures. .. . Perhaps even more impor- president himself wants it. tant was that as autonomous entities, the availability In the United States, the financial system itself plays an of the funds' resources was subject neither to the important role in checking monetary policy. The indepen- vagaries of the annual budget cycle and central gov- dence of the Federal Reserve system in the United States is ernment cash management, nor to the often cumber- buttressed by the fact that it is owned by the banking sys- some mechanisms for transferring central govern- tem. Similarly, Sylvia Maxfield (1994) has argued that ment funds to local and municipal governments. independent central banks in developing countries are more likely where the domestic financial system is strong. The political stability of the funds has not solely been a Similar points may be made by looking at a policy area function of these "internal" features of their organizational completely different than central banking. How can the design; it has also been related to the fact that they have poor be effectively targeted? One mechanism for doing this been "demand driven" and thus actively engaged a geo- that grew out of the crisis of the 1980s was the creation of graphically dispersed set of constituents. The funds are social investment funds (Graham 1994; Glaessner and oth- financial intermediaries rather than implementing agen- ers 1994). Some, such as Bolivia's pioneering Emergency cies. Local and provincial governments and nongovernmen- Social Fund, were launched by presidents; others, such as tal organizations have thus been mobilized to participate in Peru's, were passed by legislatures. In all cases, however, the choice, design, execution, operation, and maintenance the funds were initiated in conjunction with stabilization of SIF fund projects ranging across basic health care and and structural adjustment programs, and had as their nutrition, education, water supply, and sanitation services. 52 REFORM OF THE STATE IN LATIN AMERICA Similar points could be made by examining the myriad knowledge of local conditions and prices allow geographi- policy areas that have been characterized by deregulation cally dispersed subunits to deliver services more efficiently and reregulation (Baer and Conroy 1993), however, the within their jurisdiction. Increasing the number of essential points would be the same. First, institutional providers also decreases the inappropriate homogeneity of reform of regulatory agencies arises to solve political prob- service provision typically associated with a high degree of lems, and not before. Second, it is most likely to be stable centralization and increases the probability of innovations and thus credible where there is strong legislative support that can be transferred to other jurisdictions; decentraliza- and where the party system is not polarized or fragmented tion thus increases organizational learning through intra- in a way that would lead investors to expect the possibility organizational competition. of future policy reversal. Finally, the procedures that gov- Theorists of organization have emphasized that despite its ern the operations of regulatory agencies, including the presumed advantages, intraorganizational decentralization representation of affected interests, can serve as an impor- generates a number of control and incentive problems; for a tant protective device by building in checks and veto review see Cremer, Estache, and Seabright (1994). The high- points against undesirable policy change. er level of the organization faces both adverse selection and moral hazard problems: lower levels know what information Decentralization their inputs are based on, can use them to their own advan- A second central area of debate about the reform of the state tage, and have incentives to shirk or distort policy, particu- centers on the relative merits of centralization and decentral- larly by serving local clients at the expense of the govern- ization of government. This debate has been confused by the ment's programmatic purposes. multiple meanings given the term. An influential definition Yet an equally important problem is that this form of offered by Rondinelli and Nellis (1986, p. 13) refers to: decentralization does not establish institutionalized checks on government action and thus permits programs to be the transfer of responsibility for planning, manage- manipulated for political ends. Indeed, it is somewhat puz- ment, and the raising and allocation of resources zling why executives and the leaders at the top of ruling from the central government and its agencies to: a. parties would prefer the more radical step of transferring field units of central government ministries or agen- powers to independently elected state and local govern- cies; b. subordinate units or levels of government; c. ments. First, such delegation reduces the prerogatives of semiautonomous public authorities or corporations; executives, who typically use gubernatorial and municipal d. areawide, regional or functional authorities; e. appointments as a mechanism for building bases of elec- nongovernmental private or voluntary organizations. toral and social support. Second, downward delegation to lower levels of government restricts the policy freedom of Each of these forms of decentralization poses quite dif- ministers and central government officials as well. By ferent political and organizational problems. The problems maintaining central control, administrative deconcentra- surrounding delegation to semiautonomous public author- tion permits the executive to equalize the distribution of ities have already been discussed. The last-the assignment resources and services not across the entire country on the of tasks to private social actors-raises a series of important basis of need (as the normative theory of fiscal federalism issues about privatization of services, civic associations, and would suggest), but across the politicians required to main- NGOs that are beyond the scope of this paper (Cernea tain a ruling coalition. Decentralization with continuing 1988). I focus here on the first two forms of decentraliza- central control allows ministries to respond in a targeted tion, which Rondinelli and Nellis label deconcentration way to the electoral needs of both executives and geo- and devolution respectively. graphically-rooted legislators, particularly where govern- In the first form of decentralization-deconcentration to ments are politically vulnerable. lower levels within existing agencies-tasks and authority Carol Graham's (1994, pp. 98-106) work on the pueblos are passed downward in the hope of generating production jovenes or shantytowns of Peru is instructive on this point efficiencies. This might occur in several ways. Specialized and provides a point of comparison to the more effective 53 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO IDE JANEIRO CONFERENCE, 1995 social investment funds discussed in the previous section. this rule could give rise to a complex set of overlapping Graham shows how the pueblos jovenes have a rich variety jurisdictions covering different policy areas (Oates 1972; of local self-help organizations such as soup kitchens and Olson 1969, 1986) Second, since tastes vary across juris- mothers' clubs, some autonomous, some fostered or sup- dictions, decentralizing the allocation of taxing powers ported by municipal governments. On coming to office in and service provision will more closely match the distri- 1985, the APRA government initiated two centrally- bution of local preferences and thus enhance welfare. administered programs for the urban poor: a Program of In addition to the advantages of decentralization with Direct Assistance (PAD) and the Program of Temporary respect to production and allocative efficiencies, delegation Income Support (PAIT). Graham shows that despite a to lower but independent levels of government has an impor- decentralized organizational structure that included local tant political advantage: it will institutionalize checks on offices, both were manipulated for party ends, often in an government that are lacking in the model of intraorganiza- effort to upstage or undermine local governments con- tional decentralization just sketched. These checks occur trolled by the opposition. Moreover, both also had the through the introduction of political competition at the local effect of marginalizing and "crowdihg out" local organiza- level. Political competition constitutes a form of monitoring, tional initiatives. Such criticisms have also been leveled since it provides incentives for those seeking public office to against elements of Mexico's PRONOSOL program, ferret out those policies that would not be ratified by the which, despite apparent efforts to decentralize, retains a local electorate or that have failed in implementation. highly centralized structure that mirrors that of Mexico's Political competition also creates opportunities for local strong-president, party-dominant political system policy entrepreneurship as political entrants devise and (Cornelius, Craig, and Fox 1994, pp. 14-15) publicize alternative programs in their effort to secure elec- The second form of decentralization-devolution to toral support. The positive effects of encouraging the lower levels of government-is more interesting, because development of NGOs at the local level come not only the resurgence of state and municipal governments consti- from their direct provision of services-itself a form of tutes one of the most important concommitants of the tran- slack-reducing competition-but through the performance sition to democracy in Latin America. The larger Latin of similar monitoring functions. American countries already had federal traditions at the However, the decentralization process has proven time of the transition to democratic rule. In Brazil, guber- extremely problematic. In some countries, revenue trans- natorial elections had been hotly contested under military fers have run ahead of expenditure or functional transfers, rule despite electoral rules that disadvantaged the opposi- contributing to central government fiscal problems. tion in a number of ways, and Argentina has retained its Transfers are still encumbered with central government federal structure. Mexico is much more centralized politi- requirements, and local revenue raising capacity is falling cally because of the extraordinary powers of the president, in some countries. but it also has a formally federal system and recent state Some of those problems have to do with sheer bureau- elections are increasingly contested. The transfer of powers cratic capacity. A leitmotif of the analysis of decentraliza- to provincial and municipal governments is also visible in tion in Latin America is that state and local governments unitary systems such as Chile and Colombia, or nominally are incapable of managing the tasks that have been hand- federal systems such as Venezuela, in which governors had ed to them (Campbell, Peterson, and Brakarz 1991, pp. previously been appointed. 38-43; Bird 1994, p. 10). Building such capacity is thus The theory of fiscal federalism advances a number of no less important at the local level than it is at the central; reasons to believe that this transfer of powers and respon- without it, hopes for an increase in production efficiencies sibilities is salutary. First, each public service should ide- are unrealistic. ally be provided by the jurisdiction having control over However, as the analysis of civil service reform at the the minimum geographic area that would internalize central government level has shown, capacity is only part of benefits and costs. It is plausible that for a number of ser- the problem. The political and organizational incentives vices, this jurisdiction would be small, though in theory that characterize the relationship between central and local 54 REFORM OF THE STATE IN LATIN AMERICA levels of government can also be problematic. Three such The second problem has to do with the political incen- problems are the continuing political interest of the central tives of the provincial and local governments themselves. It government in exercising policy control; the political diffi- is a standard finding of the fiscal federalism literature that culties faced by local governments in assuming responsi- its beneficial effects are related not only to the transfer of bilities and the corresponding incentives to shirk and responsibilities, typically service provision, but also to the maintain their dependence on the central government; and enhancement of local fiscal capacity. However, the typical features of local government organization that make them pattern has been for the transfer of resources to occur prior less-than-perfectly representative of constituent interests to the assumption of full policy responsibilities or local fis- and vulnerable to capture by local elites. cal strengthening. The political reasons for this pattern are The interest of central government authorities in main- obvious. Such transfers constitute an unmitigated plus for taining control over local government spending priori- local politicians by enhancing the ability to deliver services ties-typically through the design of intergovernmental while simultaneously relieving local governments of the fiscal transfers and grants-can be justified on both public difficult task of raising taxes and user fees to fully cover the goods and equity grounds. Continuing control might be incremental cost of their provision. However, the pattern is appropriate if the full transfer of authority results in juris- also clearly unstable. Once such transfers are in place it dictions of inadequate scale to fully capture the externali- becomes politically difficult to withdraw them because of ties from the provision of public goods. Control is also jus- the perverse incentives that result. tified by concerns of both interpersonal and interjurisdic- The difficulties of moving toward real fiscal federalism tional equity. can be better understood if the relationship between levels However, it is equally plausible that the interest in of government is viewed as a bargaining game. The capac- maintaining central control, and thus the design of inter- ity of the local government to influence or blackmail the governmental fiscal transfers, is directly related to coali- center will hinge on the political vulnerability of central tion-building and electoral strategies. government officials. This, in turn, is a function both of In more centralized systems, we would expect the geo- short-term electoral and coalitional constraints and more graphic allocation of spending to be strongly influenced by enduring institutional features of the political system. the executive, as appears to be the case in Mexico. Spending In federal systems such as Argentina and Brazil, state decisions by the Salinas administration's National Solidarity governments are large and governors wield quite substan- Program (PRONOSOL) have been concentrated in the pres- tial political power. In Argentina, members of the Chamber idential office, and have been used not only for the broader of Deputies are elected from closed party lists and Senators purpose of maintaining support for the structural adjust- are elected in provincial legislatures by plurality, two for ment effort (Cordoba 1994), but also for more targeted elec- each province and two from the capital. Thus not only are toral purposes (Molinar Horcasita, and Weldon 1994). deputies elected provincially, but provincial party organi- Interestingly, despite a Municipal Reform Act in 1984, zations have substantial independence. This tendency effective political power has remained at the state and fed- toward the provincialization of politics is reinforced by the eral level; genuine delegation to municipal government has timing of elections. Only one half of the deputies and one been stymied (Rodriguez 1993). third of the senators are elected concurrently with the pres- In countries where the personal vote is more important, ident. This staggering of elections means that provincial such as Brazil, the design of intergovernmental fiscal trans- electorates vote frequently, and if the president is to avoid fers is likely to be heavily conditioned by the triangular the ever-present possibility of a divided government, he relationship between the president or minfister, individual must be continually attentive to regional demands. legislators, and local governments that fall within the leg- Not surprisingly, there was a clear relationship between islator's bailiwick. Barry Ames (1995) provides interesting the weakness of the first Argentine democratic government evidence from Brazil on how legislators seek to build and and the deterioration of the balance between central and buttress crucial local bases of support by acting as brokers provincial governments. Since intergovernmental fiscal between ministries and local governments. transfers under Alfonsin took a highly discretionary form, 55 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 there was an incentive for the provinces to compete in run- smaller groups, or even individuals, and there are reasons to ning deficits in order to secure a larger share of the grant. believe that the barriers to political entry may be lower at As a result, provincial government expenditures-particu- the local level. On the other hand, the problems of capture larly for wages and salaries-increased dramatically while by local elites or party machines, and even of intimidation revenues as a share of GNP actually fell slightly. The pre- of opponents, is a perennial one in Latin America. transfer fiscal deficit of the provinces in 1986 was a full 6.2 Given this indeterminacy and the need for further percent of GNP, financed by a combination of a posteriori research, we can only conclude by noting again that insti- discretionary grants from the Ministry of Finance and tutional arrangements will play an important role in deter- strong pressures on the central bank to bail out provincial mining the responsiveness of local government just as they financial institutions. One purpose of the 1988 Revenue do at the central government level. There are a variety of Sharing Law was precisely to overcome this collective institution-building activities that could reduce slack and action problem by making transfers more predictable and increase responsiveness to citizen demands by improving transparent. the ability to monitor what local governments do. Some of Yet ruling parties may even be vulnerable to a munici- these fall under the rubric of "capacity," such as increasing pal electoral cycle, particularly where there are nonconcur- the local capability of both governmental and nongovern- rent elections that turn municipal contests into referenda mental actors to analyze the effects of alternative policy on the government's performance. The Belaunde govern- choices. Other measures relate to the goal of increasing the ment in Peru faced particularly strong electoral challenges transparency of government action, such as making public from the left and populist opposition in municipal elec- the performance records of the government with respect to tions, challenges which played a role in derailing his reform particular issues (roads constructed, sewers extended, hous- program. es fitted with potable water, and so on). Thus the central problem of reordering intergovern- The ultimate check on government must come through mental fiscal relations can be seen as one of credible com- institutionalized forms of participation. This may eith'er mitments. Can the government commit to greater control be "corporatist," such as building in NGO participation in over transfers, for example, by establishing firm rules? The areas in which they have expertise, or "legislative," such as answer is clearly "yes," even in federal systems. Argentina adopting forms of local governance in which citizen par- was able to reverse the difficulties it faced through a ticipation is maximized. Elected municipal councils work- reform effort in 1988 and Brazil is currently considering ing either with a city manager or mayor that hold open how to manage the difficulties created by the revenue- meetings are superior in this regard to mayors who oper- sharing provisions of its 1988 constitution. However, the ate without such advisory or legislative bodies, and are exercise of control rests on political and institutional fac- thus more likely to make decisions privately, or in consul- tors. Mexico has had few problems with state-level tation with narrow constituencies. finances, because the executive branch is strong and has However, features of the national party system may also little political dependence on the governors. In Argentina make an important difference at the local level. Strong and Chile, the strength of ruling coalitions was the basis national parties with local roots are likely both to com- of the reform effort. In Brazil, change will hinge on the municate local policy preferences upward and to act as a ability of the new administration to rally support for con- source of discipline on the nature of local candidate selec- stitutional change, even against the interests of legislators tion. Such discipline will be lacking where local political in the ruling party. officials have an incentive to forge independent alliances Finally, there is the key question of whether the struc- with legislators around particularist programs. ture of local government is conducive to an improvement in the quality of governance. Opinion on this issue remains Conclusion divided, and the key questions are ultimately empirical In other work, I have emphasized the distinction between rather than theoretical. On the one hand, local govern- the initiation and consolidation of economic reform ments should be more responsive to the preferences of (Haggard and Kaufman 1995, ch. 5). This distinction is 56 REFORM OF THE STATE IN LATIN AMERICA also of use in understanding the process of administrative might first appear. It is typically grounded on the assumption that change or "reform of the state." The initiation of reform politicians seek re-election (Mayhew 1974). However, this may be implies a rupture with the past that is more likely when affected by term limits or by incentives to use electoral office as a the power ofcentraldecisonmakers . M r i. stepping stone to other positions, both governmental and non- the power of central decisionmakers is high. Major initia- governmental. Nonetheless, I assume that politicians are responsive tives appear to be associated with the achievement of some to some constituent base, either through an electoral or lobbying degree of executive autonomy not only from interest connection. groups but from legislators as well. This might occur 4. A theoretical literature has also begun to explore the policy through "honeymoon" effects and "mandates" following and administrative consequences of parliamentary and presidential . . . , . . , . . ~~~~~rule (Moe 1990; Weaver and Rockman 1993; Moe and Caldwell electoral victories, or by the exploitation of legislative or ' decree powers. However, it appears most effective when 1994; Palmer forthcoming). 5. The existence of fixed terms for both president and legislature backed by explicit delegation from legislative coalitions, has also been a target of criticism. On the one hand, the bias in Latin In consolidating institutional reform, by contrast, polit- America toward a no re-election rule means that good presidents are ical leaders are faced with the challenge of stabilizing nor capable of staying on. On the other hand, it is extremely difficult expectations around a new set of incentives. For reforms to to change governments when the legislature and the president have be credible, economic agents must believe that they cannot lost political support and exhausted leadership potential. Presidentialism served to prolong economic crises in Brazil and Peru, where presidents Sarney, Collor, and Garcia outstayed their effective- makers or of electoral challengers. Achieving this continu- ness. In Bolivia and Argentina in the 1980s, lame duck presidents ity, especially across changes of administration, implies dif- were forced to resign before the expiration of their terms. Changes of ferent patterns of state-society relations from those that government would arguably have come earlier and more smoothly facilitate policy innovation. Such consolidation ultimately under parliamentary rule through votes of no confidence. rests on political support from discrete groups of private 6. Given their divergent political interests, divided political authority can also create problems even if the president's own party sector beneficiaries, and at least the acquiescence of the holds a legislative majority, and will be still more marked when exec- major political forces competing within the political sys- utives are limited to a single term, as they typically are in Latin tem. Without such tacit or explicit alliances between America. politicians, technocratic elites, and those gaining from the 7. See Geddes 1994 on bureaucratic corruption in presidential reform effort, reform attempts will necessarily falter. systems. If true, these findings have important implications for 8. This section draws extensively on Shugart and Nielson 1994a administrative reform. In particular, they call into question and 1994b and the analysis by Ramseyer and Rosenbluth (1994) of administrative reform. In particular, they call into question the Japanese electoral system. what I have called the technocratic fallacy: the idea that the 9. For similar criticisms see O'Donnell 1991, 1994; Bresser goal of administrative reform is to remove policymaking Pereira, Maravall, and Przeworski 1993. from the hands of politicians through delegation to insu- 10. Of course, they may not always be able to do so. Principal- lated bureaucratic agencies. Rather, the objective is to agent models have suggested a number of reasons why government achieve such delegation while also satisfying the underly- bureaus and agencies may exercise substantial discretion beyond ing political objectives of politicians. Like policy reform politicians' control: bureaucratic control of information; agency- ing political obeciesopltiinclientele links that protect agencies from their nominal political itself, the design of new administrative structures must be overseers; and the high cost of sanctioning bureaucratic malfeasance seen as a coalition-building process. or of redirecting agency behavior through new legislation (Weingast and Moran 1983). Notes 11. Of course, the threat of crafting new legislation constitutes an 1. This is more true of devaluation and trade liberalization than ongoing instrument of political control. it is of privatization, but the generalization still holds. 12. Such delegation is not only important for the coherence of 2. This observation can be given a formal treatment. 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Kent 60 REFORM OF THE STATE IN LATIN AMERICA Comment on "Reform of the State in Latin America," by Stephan Haggard EDGARDO B OEN I NGER HREE POLITICAL PROCESSES THAT ARE OCCURRING IN LATIN AMERICA LIE AT THE HEART of the macro level of state reform: the establishment and consolidation of democratic institutions, the transformation of state-controlled to market-oriented economies, and the search for policies and programs to cope with poverty, inequality of opportunity, and extreme disparities in incomes and assets. Firm political choices, responsiveness, effectiveness, and efficiency are required to keep these process- es on track. Politicians and technocrats must agree on policy to gresses reduces the likelihood of divided governments and achieve sustained, coherent action. To facilitate consensus, ties congressional candidates to presidential platforms and technocrats should be encouraged to play political roles, national policies. As a result postelectoral government politicians should continue learning more about economic policy is more consistent. Second, politicians in Latin matters, public decisionmaking should be based on estab- America should continue delegating authority to lished consultative mechanisms, and coalitions between the autonomous agencies and regulatory bodies. Delegation, minister responsible for economic policy and those respon- however, must assure that political goals can be achieved sible for political affairs should be developed. In addition, without giving agencies discretionary powers that can lead politicians and technocrats should ensure compatibility to arbirrary administrative actions or new forms of state between policies and measures that are friendly to growth interventionism. and those that will enhance equity. As agreement is reached on the fundamentals of eco- Reform priorities in Latin America should include the nomic policy and as citizens become more sensitive to gov- development of stronger legislatures and independent and ernment performance and the evils of inflation, politicians modern judiciaries. Reforms should also address the polar- are finding it increasingly important to consider national ization that has affected Latin American politics in the issues and policy goals as crucial inputs in defining their past. Fragmentation of the party system and lack of inter- behavior. Recognizing that growth is a requisite for nal cohesion and discipline must be reversed. Electoral sys- expanding employment, increasing salaries, and enhancing tems with moderate proportionality, thresholds, and a lim- equity also encourages politicians to alter their actions. ited number of seats per district are also required. Presidentialism is likely to prevail in Latin America in What can Latin America do to reduce opposition to the foreseeable future despite strong theoretical arguments reform? First, simultaneous election of presidents and con- favoring parliamentarism. Presidential regimes should be Edgardo Boeninger is president of Corporaci6n Tiempo Dos Mil and former minister secretary general of the presidency of Chile. 61 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 engineered to include clear, constitutional definitions of comprehensive reforms are costly in terms of transaction legislative and executive powers and be limited to short costs and costs of learning new rules and procedures. Third, (four- to five-year), singLe terms. Limiting administrations comprehensive reforms require that policymakers simulta- to a single term will eliminate the opposition's need to neously deal with a broad range of issues and so make it dif- adopt negative policies that destroy incumbents' chances ficult to reach agreement on specific solutions. Lack of con- for reelection and that make it difficult to reach consensus sensus provides an opportunity for coalition building on national issues. It will also reduce temptations to abuse among opponents of reform. The challenge, then, is to power and strengthen democratic institutions as faith is reform gradually within the bounds of local managerial put into institutions instead of individuals. capability while avoiding control by local parties, ensuring All-in-one reforms present some inherent problems. coherent national policies, and responding to equity First, bureaucracies are not capable of absorbing all the concerns. changes that accompany comprehensive reforms. Second, 62 REFORM OF THE STATE IN LATIN AMERICA Comment on "Reform of the State in Latin America," by Stephan Haggard R OGER D O U GLA S P OLITICIANS' ATTEMPTS TO SATISFY THE DEMANDS OF INTEREST GROUPS OFTEN LEAD to economic and social problems as well as demands for government reform. Therefore, rather than focus on special interest groups, the state should concentrate on consumers, voters, and taxpayers. How can interest group politics and its problems be overcome? First, political leadership is vital. Leadership requires understanding that political survival depends on making quality decisions and that compromises with interest groups lead to voter dissatisfaction and political suicide. It also requires an understanding that voters place a higher value on improving their medium-term prospects than on actions that make things look good in the short term. When governments focus on immediate satisfaction, the accumulated costs must be paid at some point in the future. Ideally, governments should accept initial costs and temporary discomfort in exchange for longer-term benefits. The objectives of interests groups are complex and environment needed to ensure that objectives are met, and diverse. None welcomes the idea that their privileges may ensure that the maximum amount of competition takes place. be removed, and so all work to protect their interests at the As a natural result government activities will become decen- expense of taxpayers and consumers. Consensus among tralized as government functions move to the private sector. interest groups rarely takes place before quality political Using this common-sense approach, the need to concentrate decisions are made. Instead, it develops as the implications on objectives based on what is best for the country and not of these decisions become apparent. what is best for a particular interest group becomes clear. If the interests of consumers and taxpayers are put first This was the general approach used in New Zealand a number of other issues will fall into place. First, the gov- over the past ten years. In general, where quality decisions ernment's role in serving the interests of consumers were made, political problems desisted; where there has becomes obvious. Second, governments will begin to con- been compromise and government has given into interest centrate on doing the things they do best. Finally, politi- group pressures, political problems remain. cians will learn to avoid getting tied up in the means and In 1984 New Zealand's government surplus was 9 per- will concentrate on end results, such as better health care cent or more. Today the government surplus is 3 percent. and better education. Inflation for the twenty years to 1984 was one and a half The politician's role is to focus on desired outcomes, set times the OECD average. For the past three years it has the policy agenda and objectives, determine the regulatory been less than 2 percent. Growth for the twenty years to Roger Douglas is former minister of finance of New Zealand. 63 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 1984 was half the OECD average. In 1994 it was 6 percent. come from those who have lost privileges. For example, in Government debt was more than 70 percent of GDP before New Zealand farmers lost their subsidies as a result of the 1984. Today it is less than 40 percent. Within three years reform, but they became advocates of continued reform government debt as a share of GDP is expected to drop to once they saw its benefits. If interest groups think that they 20 percent, with all foreign debt repaid by 1997. The labor can influence politicians, they will try to gain political sup- market was highly regulated in 1984. Today it is highly port for their interests rather than adapt to the changes deregulated by OECD standards. The personal tax rate has brought about by reform. dropped from 66 to 33 percent. Corporate taxation has Genuine reform implies a need for politicians to trust dropped from 48 to 33 percent. Government spending as a the public. Politicians need to tell the public what is share of GDP has fallen to 7 percent. Employment is grow- wrong, what they intend to do to correct it, why their pro- ing faster than it has in twenty or thirty years. Government posals are better than others, and the advantages and dis- assistance has been dramatically reduced, import protec- advantages of proposed reforms. Consistent policy and tion has been lifted, and tariffs have been lowered. Public credibility increase confidence. sector reform has taken place, improving productivity and Finally, three additional points about implementing accountability mechanisms. Privatization has also taken reforms should be mentioned. First, reform programs place. often become unhinged because of uncertainty. The public Until reforms people could only be appointed to top needs to know where politicians and governments are positions from within the public sector; now they can be going, and know that government will be consistent. appointed from anywhere in the world. Pay and employ- Second, interest groups always underestimate their ability ment are the responsibility of the chief executive of each to adjust. Third, if the costs of compensation for losers in department. The government has a balance sheet and a reform are too high, evidence of the benefits of the reforrn profit and loss statement and works on accrual accounting. will be delayed. With structural reform the most ardent support may Mr. Haggard replies Sir Roger rightly emphasizes the role of leadership and continually preoccupied with the task of fiscal reform. Fiscal public considerations in initiating reform. A quest for con- reform and stabilization are important not only for econom- sensus among interest groups can be paralyzing when try- ic and welfare reasons but also because they permit reason- ing to develop a reform program. But it is important to able disagreements over policy to be reconstituted. note that New Zealand's reforms benefited from powerful Organized support and interest group politics are impor- party backing in a majority system with a very powerful tant in consolidating reform in democracies. New Zealand prime minister. The reform program in New Zealand only is a relatively egalitarian country without great disparities began with the formation of a new government. in wealth and income where democratic institutions are There is no single model of what a government should firmly entrenched; Latin America is the opposite. Thus the look like. In fact, democracy is precisely about legitimate need for reform as well as the associated risks are greater in disagreement and competition between parties. Latin America. Taking those risks is the task of politicians, Nevertheless, it is impossible to have meaningful dialogue not of academics. and democratic competition over policy if governments are 64 REFORM OF THE STATE IN LATIN AMERICA Comment on "Reform of the State in Latin America," by Stephan Haggard MA RI O HE NR I Q UE S I MON SEN M ~ UCH HAS BEEN SAID ABOUT THE REFORM OF THE STATE IN LATIN AMERICA, BUT little analysis has been performed on the economic theory of the institutions involved. What makes politicians oppose certain types of economic and social structures? A strong president with congressional support is more likely to successfully implement I, T _ -reform, especially when accompanied by discipline and organization. In Brazil a matrix sys- tem of "rows"-the political parties-and "columns"-the sectoral interests (land owners, Protestants, and so on) guides the political process. Presidential campaigns are financed by the columns, votes go to the rows, and loyalty is reported. The columns usually get more than the rows. The cultural, political, and institutional evolution that has tain monopolies in oil or telecommunications, where it has been taking place in Latin America over the past ten years has no advantages over the private sector. been influenced by the collapse of the Bretton Woods system The Brazilian government has approved a number of con- in the early 1970s, escalating inflation in the OECD countries stitutional reforms. Besides political skill, cultural change in the late 1970s, the transformation of the European social drove many of these reforms. Seven years ago, a nationalistic democracies (France, Italy, and Spain now adhere to market Constitution was adopted. Today it is being reformed. What economies), deregulation and privatization trends, liberaliza- caused the change? Ideas about the role of the state-and not tion in the United States (Reagan) and England (Thatcher) the composition of parties-have changed. during the 1980s, the fall of the Berlin Wall in 1989, and the The government will play a less important role in pro- collapse of the Soviet Union in 1991. The evolution came duction after privatization, mainly as regulator. Regulation about because Latin America and Caribbean countries recog- is unnecessary in privatized industries because the laws of nized that the state was too involved in the production of pri- the market are sufficient. Regulation is required in private vate goods and does not possess the mechanisms required to services and public utilities, however. Still, there is no ideal respond quickly to the demands of a market economy. model for regulating, say, the telecommunications indus- The state should retain control over ensuring public try. A number of approaches have been tried, but no one safety and printing currency. In Brazil both the police and best solution has been identified. organized crime have shaped public safety. With respect to Nor is there a model for improving public bureaucracy. printing currency, the monetary policy in Brazil is passive. Efficient bureaucracies require training, proper structuring Currency printing is approved by the Central Bank and of bureaucratic careers, and financial incentives. A common executed by commercial banks. The state should not main- problem for Latin American countries, however, is limited Mario Henrique Simonsen is vice president of the Getulio Vargas Foundation and former minister of finance and planning of Brazil. 65 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFFRENCF, 1995 resources for achieving these goals. conference is helpful in understanding and assuming future Much has already been done in terms of reform. But challenges. many changes have yet to take place. The discussion at this 66 Why Are Latin America's Savings Rates So Low? An International Comparative Analysis SE B ASTI AN EDWARDS D URING THE PAST FEW YEARS THERE HAS BEEN RENEWED INTEREST, IN BOTH ACADEMIC and policy circles, in issues related to economic growth. New models and empirical studies have analyzed different aspects of this problem, including the conditions under which growth can be sustained through time. From a policy perspective this interest has been particularly high in Latin America, where, as a consequence of the debt crisis of the 1980s, growth came to a halt for almost a decade. By 1992, and after a long and impressive process of market-oriented reforms, the nations of Latin America had recovered and were once again growing. Analysts and policymakers, how- ever, consider the average real rate of growth for 1992-94-approximately 3 percent-to be modest and estimate that the rates of economic expansion should accelerate significantly to compensate for the stagnation of the "lost decade."' In discussing these issues, a number of authors have pointed out that low savings rates are seriously constraining the Latin American countries. According to the World Bank (1993a), the median ratio of gross domestic savings to GDP was only 20 percent in Latin America in 1991-more than 15 points below that of the East Asian countries. Traditional analyses of savings and growth have concen- nent increase in growth rates.2 This is because in the pres- trated on two important issues: (a) the effect of higher sav- ence of externalities the marginal return to capital will be ings on long-run growth and (b) the impact of an increase bounded from below, and, under certain conditions, will in domestic savings on investment. Neoclassical models, exceed the rate of time preference. In this case the private inspired by the work of Solow (1956), suggest that an sector will face a permanent incentive to add to the stock of increase in savings ratios generates higher growth only in capital, and long-run growth will be sustained. the short run, during the transition between steady-states. In an open economy, however, increases in domestic savings According to this view, the long-run equilibrium rate of are not necessarily translated into higher domestic investment. growth will depend exclusively on structural demographic In principle, if capital is internationally mobile, changes in variables. However, recent models based on theories of domestic savings and investment can be completely indepen- endogenous growth developed by Romer (1986) and Lucas dent. Savings generated in country A can be fully or partially (1988) predict that higher savings-and the related invested in country B. If domestic savings and investment are increase in capital accumulation-can result in a perma- uncorrelated, increases in the former will not be translated into Sebastian Edwards is former chief economist of the Latin America and the Caribbean Regional Office at the World Bank. The author is grate- ful to Fernando Losada and Sebastian Valdes for helpful assistance and comments, Eliana Cardoso for comments, and Shahid Yusuf and Carmen Reinhart for discussions. 67 DEVELOPMENT IN LAIIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 a higher capital stock, and thus will not result in accelerated or has offered limited help to policymakers who ask how growth. If, on the other hand, the degree of international cap- saving rates can increase (see Schmidt-Hebbel and others ital mobility is limited, higher domestic savings will generate 1994 for a comprehensive survey). higher investment and growth. The extent to which domestic The purpose of this paper is to investigate the process of savings and investment are correlated ultimately is an empiri- determining savings rates in the world economy and to ana- cal matter, as argued by Feldstein and Horioka (1980). lyze why savings ratios in Latin America traditionally have Abundant empirical evidence suggests that domestic savings been so low. The analysis is based on international compar- are highly correlated to aggregate investment. This indicates isons; data from thirty-eight countries-both OECD mem- that, on average and over long periods of time, changes in cap- bers and less-developed nations-are used to estimate a ital accumulation respond mostly to changes in domestic sav- number of panel and cross-country regressions. An impor- ings (see Frankel 1985; Feldstein and Bacchetta 1991; and tant feature of the paper is that, in contrast with previous Montiel 1994). work, it distinguishes between private and government sav- Empirical work by Barro (1991), De Long and Summers ings.3In particular, I assume that government savings are not (1991), Edwards (1992) and others, has recently provided completely exogenous, and that they respond to both eco- support to the notion that capital accumulation-and thus nomic and political determinants. More specifically, I draw savings-are central for understanding growth differentials on the recent literature on the political economy of macro- across countries. Moreover, Young (1994) argued that cap- economic policy, and I argue that governments act strategi- ital accumulation, and not technological progress, explains cally when deciding how much to save. In the empirical the splendid growth performance of the East Asian "tigers": analysis presented in this paper, I have also made an effort to the Republic of Korea, Hong Kong, Singapore, and incorporate the role of a large number of variables-includ- Taiwan. The empirical evidence, however, is less clear when ing policy, demographic, structural, and political factors-as it comes to explaining savings behavior across countries or possible determinants of savings ratios. The results obtained along time. Existing work has been affected by the lack of provide insights on why savings rates differ across countries, detailed reliable data, and has either been controversial, as and will hopefully help determine an agenda for future, in the case of the interest responsiveness of private savings, detailed, country-specific research in the area. TABLE I Private, government, and national savings rates, various regions, 1970-93 (percent) 1970-82 1983-93 FIRST QUARTILE MEDIAN THIRD QUARTILE AVERAGE FIRST QUARTILE MEDIAN THIRD QUARTILE AVERAGE Private savings Latin America 13.1 13.2 21.7 16.1 10.9 14.7 17.9 13.8 Asia na na na na 17.4 19.1 22.9 20.2 Africa 11.4 14.4 18.9 15.2 10.7 16.7 19.5 15.6 Industrial countries 18.0 21.6 23.4 21.3 18.3 21.3 23.4 21.3 Government savings Latin America -0.7 1.7 6.6 3.3 -1.3 2.4 5.5 2.2 Asia 0.0 2.7 8.8 4.4 0.0 1.6 9.0 3.9 Africa -1.6 0.9 2.1 0.6 -1.3 1.0 4.5 0.9 Industrial countries -0.5 2.0 3.8 1.8 -3.6 -0.1 1.3 -0.8 National savings Latin America 14.5 19.4 27.7 19.8 14.0 17.8 19.1 15.3 Asia 4.9 24.8 26.7 18.8 18.8 23.8 28.5 24.5 Africa 10.8 15.5 18.7 16.4 10.6 17.5 22,1 16.8 Industrial countries 19.6 22.8 25.8 23.1 17.5 19.1 23.4 20.4 na is not available. Source; International Monetary Fund dara. 68 WHY ARE LATIN AMERICA'S SAVINGS RATES SO LOW? AN INTERNATIONAL COMPARATIVE ANALYSIS Recent behavior of savings rates Latin American, Asian, African, and industrialized coun- in Latin America tries for the 1970-82 and 1983-93 periods (see the appen- Broad comparative analyses of savings behavior traditionally dix for a list of the countries included in this sample). have been plagued by data problems.4 Savings are usually Figures 1-11 illustrate, for all years for which there is estimated in a questionable way-usually as residuals-and information, the evolution of private, public, and aggregate until very recently, comparable data on private savings were gross national savings for a group of eleven Latin American restricted to a handful of advanced countries. Moreover, large countries. Figures 12-16, by way of contrast, present com- international data sets on net savings are not currently avail- parable data for five East Asian nations. able. In this paper I use a new data set assembled by the A number of interesting findings emerge from this International Monetary Fund that distinguishes between table. First, during the most recent period (1983-93), private and government national savings ratios and permits Latin America's private savings ratios have been the lowest undertaking empirical work on their determinants. in the world. Second, these data confirm that in the Table 1 contains the averages and distributions of pri- post-debt crisis period, private savings rates have tended to vate, public, and aggregate national savings for a group of decline in Latin America. Third, and interestingly enough, FIGURE 1 FIGURE 2 Savings in Argentina, 1985-92 Savings in Bolivia, 1988-92 Percentage of GDP Percentge of GDP 35 10 30Prvt 15 10 Total Private 5~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ -5 10 .. . .. . . .. . . .. . . . . . . -10 . Public -15 0 1985 1986 1987 1988 1989 1990 1991 1992 1988 1989 1990 1991 1992 FIGURE 3 FIGURE 4 Savings in Brazil, 1977-92 Savings in Chile, 1983-92 Percentage of GDP Percentage of GDP 40 25 35 Total 30 20 25- 20 IS Total \>10'/ -5 Public __0_ _ _ _ _Public 1977 1979 1981 1983 1985 1987 1989 1991 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 69 DEVELOPMENI IN LATIN AMERICA AND THE (CARIBBEAN: RID DE JANEIRoI CONFERENCE, 1995 government savings behavior is quite different: during the Latin America being once again at the bottom of the scale. 1983-93 period the Latin American countries in this sam- The data on the evolution of savings ratios for five high- ple exhibited comparatively high ratios. In fact, the region performing Asian countries provide important contrasts has the highest median and the second highest average (see figures 12-16 and table 1). These East Asian countries government savings rates during 1983-93. This is partic- not only have had very high aggregate saving rates- ularly important because the generation of relatively high between 30 to 40 percent- but also have been very stable. government savings is a rather recent phenomenon in Latin A second fundamental difference between the Latin America, and one that rests on somewhat fragile bases. American and the East Asian countries is that the contri- Moreover, recent data suggest that in some countries fiscal bution of government savings to total national savings is discipline may be slipping, generating a reduction in the significantly higher in East Asia. While, historically, gov- government's contribution to aggregate savings.5 And ernment savings have barely contributed to national sav- finally, when private and government savings are consoli- ings in Latin America, in the East Asian countries they dated in table 1, the picture continues to look bleak, with represent 25-40 percent of aggregate savings. The section FIGURE 5 FIGURE 6 Savings in Colombia, 1980-92 Savings in El Salvador, 1978-92 Percentage of GDP Percentage of GDP 25 20 20 ; . Total aJ i A 15 5 1 -0 Private 1 0 5 0 5 - Public Public 0 -5 198( 1982 1984 1986 1988 1990 1992 1978 198( 1982 1984 1986 1988 1990 1992 FIGURE 7 FIGURE 8 Savings in Mexico, 1980-92 Savings in Paraguay, 1985-92 Percentage of GDP Percentage of GDP 25 35 30 2( Total 25 - - ~~~~~~~~Total 15 2 ~~~~~~~~~~~~~~~~~~~~15 Private \2 oa,..< 10 1 Public . _ W ~ ~ Pub;ic 0 0 t980 1982 1984 1986 1988 1990 1992 1985 1986 1987 1988 1989 1990 1991 1992 70 WHY ARE LATIN AMERICA'S SAVINGS RATES SO LOW? AN INTERNATIONAL COMPARATIVE ANALYSIS on estimation systematically attempts to explain cross- Ostry, and Reinhart 1994), and how the existence of liq- country differentials in government savings rates, using uidity constraints impact on private savings decisions some insights from recent models on the political economy (Jappelli and Pagaho 1994). The comprehensive surveys of macroeconomic policymaking. by Gersovitz (1988), Deaton (1989), and Schmidt- Hebbel and others (1994) suggest, however, that this lit- Savings rates determination: erature is somewhat fragmented; individual studies tend Theory and policy controversies to focus on one, or at most two, aspects of the problem. Abundant theoretical literature on the determinants of Because of its many policy angles and vast theoretical private savings is now available. Different authors have complexity, no single model has been able to deal with analyzed specific aspects of the problem, including how every dimension of the savings issue. This fragmentation savings are affected by social security contributions has also been present-although to a lesser extent-in (Feldstein 1980), how changes in interest rates affect the empirical literature on the subject, as authors typi- intertemporal consumption (Gylfason 1993; Ogaki, cally have concentrated on a few possible determinants of FIGURE 9 FIGURE 10 Savings in Peru, 1979-92 Savings in Trinidad and Tobago, 1980-92 Percentage of GDP Percentage of GDP 35 40 30 35 25 30 15~~~~~~~~~~~~~~~~~~~~~2 10 ZO ~~~~~~~~~~~~~Total \ _ _) .,, ,,. ., ,.- ~ ~~ ~ ~~~~~~~~~~~ 0 'P_iPubli 1979 1981 1983 1985 1987 1989 1991 1980 1982 1984 1986 1988 1990 1992 FiGURE 11 FIGURE 12 Savings in Venezuela, 1980-92 Savings in Japan, 1970-92 35 4 Pecntg of Totalenag fD 35 25 305 . u... \ '~~~~~ Total .3 20 - - 25 15 20 15 1980 198 4 1986 1988 1990 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 71 DEVELOPMENT IN LATIN AMERICA ANI) THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 private savings in their attempts to understand their deal with the analytics of private sector savings behavior evolution.6 focusing on some important policy controversies. This dis- In contrast to the case of private savings, there has cussion provides a conceptual base for the empirical analy- been almost no theoretical or empirical work explaining sis of the section on estimation. Second, I develop a the behavior of government savings through time or framework based on political-economy considerations for across countries.7 Almost every analysis on the subject analyzing the process of government savings behavior. The has either ignored the process by which government sav- main implications of this approach are used in the empiri- ings are determined or assumed that they are completely cal analysis of cross-country government savings. exogenous. What makes this especially surprising is that, as noted in the preceding section, government savings The analytics of private savings behavior historically have provided a substantial share of total Whether and how much to save are fundamentally national savings in rapidly-growing economies. intertemporal decisions. Households have to decide how The purpose of this section is twofold. First, I briefly much of their current income to consume in the present FIGURE 13 FIGURE 14 Savings in Malaysia, 1985-92 Savings in Singapore, 1985-92 Percentage of GDP Percentage of GDP 35 45 Total To I 30o . 35 25 \3/ 30 20 / Private >\ >>, 25 Private 15 20) 10------- - Publ -- Public 5 5 0 0 1985 1986 1987 1988 1989 1990 1991 1992 1985 1986 1987 1988 1989 199() 1991 1992 FIGURE 15 FIGURE 16 Savings in Thailand, 1985-92 Savings in the Republic of Korea, 1978-92 Percentage of GDP Percenitage of GDP 35 41) ,111,,,Total 30 Total >- ^ 35 .P >; Tetal 25 3 rvt 2 5 fl . . ~~~~~~~~~~~3 o~ / . 20 Private 20 Is 15 10 -- Public11 5 .--------.---- Public ----- 0 1 1985 1986 1987 1988 1989 1990 1991 1992 1978 1980 1982 1984 1986 1988 1990 1992 72 WHY ARE LATIN AMERICA'S SAVINGS RATES SO LOW? AN INTERNATIONAL COMPARATIVE ANALYSIS and how much to put aside for future consumption.' This any two periods has to be equal to the expected discount fundamental insight has been captured by a number of rate. An important implication of this result is that indi- models that have focused on intertemporal optimization, viduals will use borrowing and savings to smooth con- including the life-cycle theories originally developed by sumption through time. More specifically, if the marginal Franco Modigliani.9 Possibly the easiest way to formulate utility is convex there will be a precautionary motive for sav- this problem for an (infinitely-existing) individual is as ings. Because situations of low consumption are particu- follows: larly painful, households will tend to save during "plentiful" years to provide for hard times.'" This means (1) maxf (E{U(c,,g,)e 1 dt} that savings will tend to be higher in those economies 0 where income is more volatile. From an empirical point of subject to: view, this suggests that with all other things equal, savings rates will be higher in countries with a higher share of agri- (2) Jct-r?dt < W culture. oc e If the utility function in (1) is quadratic and the rate of time preference is equal to the interest rate, consumption (3) W = y (1 -; T)e 'dt, will be equal to the annuity of wealth as predicted by the 0 permanent income hypothesis, and there will be no precau- tionary savings (see Deaton 1989). A number of authors (4) St = Eyt(l - d- ptc]t have argued, however, that the observed behavior of con- sumption and economic growth contradict the permanent- income hypothesis (see, for example, Carroll and Summers (5) -k < St < yt(l - ( ) 1991 and Carroll and Weil 1993).12 In spite of its simplicity, the model sketched above is able to capture a number of the controversies that have E is the expectations operator; U( ) is the instantaneous dominated the savings-policy debate during the past few utility function, which is assumed to be concave; p is the years. The rest of this subsection discusses some of the most rate of time preference, and r is the interest rate. c, is pri- important policy issues in this literature. vate consumption in period t, and g, is consumption of pub- lic goods during that period; at this point their supply is Real interest rates and private savings assumed to be exogenous. W is total wealth, yt(l - 'T,) is net The effect of increases in (real) interest rates on savings has income, T, is the tax rate in period t, S, is savings and is possibly been the most broadly discussed topic in this field. defined as [y,(1 - ,) -pt,c); if in a given period S is negative, From a purely analytical perspective the answer is straight- the individual in question is borrowing from the financial forward. It is easy to see from equations (1) through (5) that system. The third restriction, -k < S, < y, (1 - T,), estab- changes in r will have an ambiguous effect on private savings. lishes that savings has to be less than net income, and bor- Whether they respond positively or negatively will depend rowing cannot exceed k. This equation establishes a on the relative strengths of the substitution and wealth "borrowing constraint," which, depending on the circum- effects (see Gylfason 1993 for a recent discussion on the sub- stances, may or may not be binding. In general, this bor- ject). The early financial liberalization literature in LDCs rowing constraint is expected to be more restrictive with argued that one of the most important objectives of these less-developed financial systems. A particular form for the reforms was to generate, among other things, a significant borrowing constraint is that at any point in time t, real increase in domestic savings. In the original models of finan- wealth cannot be negative-W, > 0. 1 cial repression of McKinnon (1973) and Shaw (1973), allow- The first order conditions of this problem are well ing (real) interest rates to rise to market levels altered the known in the case where the borrowing constraint is not intertemporal rate of substitution, encouraging aggregate binding: the ratio between expected marginal utilities in savings.'3 73 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Empirical studies for a large number of countries-both itive savings from income during their productive years, advanced and developed-have found, however, only a weak and once again negative savings when they are old and interest-rate elasticity of aggregate domestic savings. retired. Also, if individuals have positive bequest motives, Boskin (1978) found a very low elasticity for the United they will tend to leave some wealth to their heirs. States. A number of studies for the case of developing coun- According to this view, then, aggregate private savings tries, including Giovannini (1983), have failed to find a sig- will be affected by the age distribution of the population. nificant effect of interest rate changes on private savings. If there are a large number of inactive people relative to McKinnon (1991) recently has acknowledged that "aggre- those in their productive years, aggregate savings will be gate savings, as measured in the GNP accounts, does not relatively low. In their classical studies, Modigliani (1970) respond strongly to higher real interest rates" (p. 22).14 and Leff (1969) used cross-country data (mostly in The evidence suggesting that savings have a low degree advanced nations) to test this hypothesis. They found, as of responsiveness with respect to interest rates has have numerous authors after them, that differences in prompted analysts and policymakers to consider alternative demographics indeed play a key role in explaining differ- policy mechanisms to encourage savings. Some countries, ences in savings. such as Chile in the mid-1980s, relied on tax reforms Modigliani (1970) also argued that in a life-cycle set- aimed at discouraging consumption.'5 More recently a ting income growth will have an important positive effect number of authors have suggested that shifting the tax base on private savings. This is largely the result of aggregation from income to consumption will encourage thrift in the across households. To the extent that the economy is grow- economy as a whole. From an analytical point of view, these ing, workers' savings will increase relative to retirees' policies rely on the assumption that there is a high dissavings and, thus, measured aggregate savings will intertemporal substitution in consumption. As pointed increase. As Bosworth (1993) has pointed out, however, out, until recently the existing evidence did not support there also will be an effect in the opposite direction. In a this contention, shedding some doubts on the effectiveness growing economy, workers will anticipate future income of these tax-based mechanisms to increase aggregate sav- increases and, as a result, will tend to increase present ings.'6 In an important recent paper, however, Ogaki, consumption and reduce savings. The dominant positive Ostry, and Reinhart (1994) argue that the degree of or negative is ultimately an empirical matter. A problem intertemporal substitutability of consumption is a function with analyzing this issue empirically, however, is that of the level of income per capita. Their empirical results, there is a two-way causation. On the one hand, growth using a large macroeconomic data set, support this view. will tend to affect savings through the mechanisms just The financial liberalization hypothesis should be inter- described, and on the other, savings will tend to impact preted broadly, going well beyond the effect of higher inter- growth through its effect on capital accumulation. Some est rates on savings. Data from the rapidly-growing East authors, however, have tried to deal with this endogeneity Asian countries suggest that a number of institutional problem through a series of mechanisms, including the use developments in those nations-including efficient pruden- of instrumental variable techniques and the computation tial supervision and the encouragement of postal savings- of causality tests. In a recent paper, for example, Carroll have positively affected private savings. Unfortunately, it is and Weil (1993) used detailed household-level data to deal extremely difficult to find time-series or cross-country data with this issue and have concluded that there is evidence on these indicators for empirical work. Defining appropriate suggesting that growth indeed affects private savings proxies for the degree of financial development is, indeed, positively. 7 one of the challenges faced by empirical researchers. The positive influence of growth on savings has played a central role in recent analyses of successful development Time profile of income flows, demographics, experiences in East Asia. According to the World Bank and economic growth (1993b), for example, there has been a "virtuous circle" According to life-cycle models, individuals will have neg- going from higher growth, to higher savings, to even higher ative savings when they are young and have very low pos- growth in these countries. Naturally, politicians and policy- 7 4 WHY ARE LATIN AMERICA'S SAVINGS RATES SO LOW? AN INTERNATIONAL COMPARATIVE ANALYSIS makers would like to know how to get on this virtuous regardless of the way in which the expansion of govern- circle! ment expenditure is financed. If, on the other hand, the public values public goods, the effect of an increase in Borrowing constraints their provision will depend on the degree of substitutabil- The extent to which individuals can actually dissave when ity of c and g on the individual's utility function in equa- young will depend on their ability to borrow. If the bor- tion (1). From an empirical and policy perspective, it is rowing constraint in equation (5) is binding, the marginal important to determine whether increases in government utility of present consumption will exceed the (dis- savings will be offset fully by declines in private savings, counted) expected utility of future consumption; house- or if the offset coefficient will be lower than one. Another holds would like to increase present consumption but will important policy issue is whether changes in alternative be unable to do so (Zeldes 1989). In most models, once the taxes-value-added tax, assets tax, income tax-will have borrowing constraint is made less stringent, present con- the same effect on private savings (see Kotlikoff 1984). sumption will increase and, thus, national savings will Corbo and Schmidt-Hebbel (1991) used a thirteen-coun- tend to decline.18 What makes this result particularly try data set to analyze the macroeconomic consequences of interesting is that it suggests that financial reform pro- higher public savings. In particular, they investigated the grams long advocated by a number of economists, such as extent to which an increase in government savings would McKinnon (1973) and Shaw (1973), could result in a reflect a decline in private savings. They found that, reduction in savings, capital accumulation, and, ulti- although government savings crowd-out private savings, mately, in the rate of growth. In an important recent the magnitude of this effect is far below the one-to-one paper, Jappelli and Pagano (1994) used cross-country data relationship suggested by the simple Ricardian equiva- on required down-payments for mortgages as a proxy for lence doctrine; overall, their empirical analysis strongly borrowing constraints. Their econometric results on data indicates that an increase in public savings will be trans- for advanced countries support the idea that relaxing these lated into higher aggregate savings.19 Corbo and Schmidt- constraints will reduce savings and economic growth. In Hebbel also found that, on average, increasing public their analysis of household savings behavior for a group of savings through reduced expenditures is more effective developing countries, Schmidt-Hebbel and others (1992) than increasing taxation. used beginning-of-period money balances as an indicator Another important implication of the life-cycle frame- for the stringency of the borrowing constraint, and found work-and one that can be easily incorporated into the that its coefficient was negative. formal model-is that private savings will be affected by the extent and coverage of social security systems. If indi- Taxes, government consumption, and social security viduals perceive that when they retire they will get high The model presented above suggests that fiscal policy- social security benefits, they will tend to reduce the changes in g or T-will have an effect on consumption and amount saved during their active days (Feldstein 1980).20 saving decisions. What is interesting about this formula- From a policy perspective this suggests that social security tion is that both present and future taxes will tend to reform that replaces a government-funded system by a pri- reduce savings. This means that, to the extent that the gov- vately administered one tends to increase private savings. ernment is subject to an inrertemporal budget constraint, it will not matter whether increases in government con- Other potential determinants of private savings sumption are financed by higher taxes or by issuing gov- Although the model presented above captures the essentials ernment bonds. This is, of course, the Ricardo-Barro of household savings decisions, it has some limitations. In proposition, that government bonds are not net wealth (see particular, the model ignores consumers' heterogeneity, and Barro 1974). thus the effects of income distribution on savings; it does Increases in government consumption also will affect not incorporate directly the role of human capital accumu- private savings. If the public does not value government lation; it deals only partially with issues related to the effect consumption, savings will decline; this will be the case of the degree of development of the capital market; it does 75 DEVELOPMENT IN LATIN AMERICA ANI) THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 not incorporate the possible effects of macroeconomic sta- Tabellini 1992). This type of approach can be extended bility, including inflation; political considerations, such as fruitfully to address cross-country differentials in govern- the effect of political turmoil, violence, and instability on ment savings rates. savings do not have a direct role; open-economy angles are Assume that there are two political parties (L and R) that ignored; and the role of firms' savings is not taken into alternate in power according to some probability rule. account. Models with heterogeneous agents generally pre- Further, assume that L and R have different preferences: dict that households with higher income will tend to save a while L prefers a vector of goods h, R prefers vector f. The higher proportion of their income. At the aggregate-com- amount of these goods that society can produce and con- parative level this has been interpreted to mean that coun- sume will depend, in part, on the level of government sav- tries with more unequal income distribution will tend to ings and investment. Savings, however, are translated into have a higher savings rate. From the instability perspective, higher investment, production, and consumption after a it has been suggested that both macroeconomic as well as lapse of time. It is possible, then, that while the party in political instability will tend to have a negative effect on power increases government savings, the projects will come aggregate savings. Open-economy models add two perspec- to fruition when its opponent are in power (for a formal tives to the analysis. First, domestic interest rates will be description of the model see, for example, Edwards and linked to international interest rates; second, in open Tabellini 1994). economies, agents can use foreign borrowing to smooth con- In this setting the authorities' incentive to increase gov- sumption through time. This means that foreign savings ernment savings-and thus the ability to produce public generally will act as a substitute for domestic savings. In the goods-will depend on two fundamental political-economy empirical analysis reported below I include many of these variables: first is the probability that the party in power will variables as possible determinants of cross country-differ- still be in office in the subsequent period. If this probability ences in aggregate private savings. is low, the opposition party is likely to be in office once the projects mature, and will get the credit from the increased Explaining government savings: production of the public goods. Naturally, under these cir- A political economy perspective cumstances the incentive to increase savings will be low. The Studies on savings traditionally have focused on aggregate recent political-economy literature on inflation and stabiliza- national savings and private savings, and tended to ignore tion has associated the probability of the incumbent to the process of determination of government savings. And remain in office with the degree of political instability of the yet, as discussed in the section on Latin America, govern- country in question. This analysis predicts, then, that the ment savings can be a fundamental component of national higher the degree of political instability, the lower govern- savings, representing in some cases-and especially in the ment savings. The second determinant of government's successful East Asian nations-between 30 and 40 per- incentive to save is the extent to which the political parties cent of the aggregate. Most studies make the very sim- have different preferences. In the extreme case where their ple-but implausible-assumption that government preferences are exactly the same, there will be a high incen- savings are exogenous, and are set by the economic tive for the government to save-even if the probability of authorities in a way that maximizes (the present value of) remaining in office is low. The difference in party preferences society's welfare. has been referred to in the political-economy literature as the In recent years a number of authors have relied on degree of political polarization. This analysis predicts that, insights from public choice and game theory to study gov- with other things given, a greater degree of polarization will ernment behavior (see Persson and Tabellini 1990 for a result in lower government savings. In regression analyses, comprehensive discussion). Many of these models assume however, it has been difficult to find empirical counterparts that political parties alternate in power, and that the group for political polarization. Some authors, such as Cukierman, in office acts strategically, in an intertemrporal sense, when Edwards, and Tabellini (1992), for example, have argued making decisions that have economic consequences span- that the frequency of politically motivated attacks and assas- ning more than one period (Cukierman, Edwards, and sinations are appropriated proxies. 76 WHY ARE LATIN AMERICA'S SAVINGS RATES SO LOW' AN INTERNATIONAL COMPARATIVE ANALYSIS Estimation them are measured with error; and third, there are a series In this subsection I present the results obtained from the of instances of endogeneity, which sometimes raises ques- estimation, using a thirty-six-country data set-eleven tions of causality.21 To deal with these issues I have defined industrial and twenty-five developing countries-of private proxies for some of the variables of interest, and I have esti- and government savings equations. The estimation was per- mated the private savings equation using instrumental formed using all available panel data from 1970 to 1992. variables (IV) techniques. As is usually the case with panel Some equations also were estimated on cross-country data data regressions, it is rather difficult to find appropriate based on averages for 1983-92. The results obtained from instruments. In this paper I have used lagged values of the these equations were then used to address the question of endogenous variables, as well as variables that are exoge- why saving rates are so low in Latin America. nous to savings but correlated to some of the endogenous variables, such as exports and population growth, in Private savings response to this problem.22 Based on the theoretical discussion in the previous section, Table 2 contains the results obtained from the estima- a number of equations of the following type were estimated tion of private savings equations using instrumental vari- for private saving rates: ables on panel data for the 36 countries listed in the appendix. The dependent variable is the ratio of private (6) Stk = a. Ltk + al Gtk + a3 Ftk + a4 Mtk + a5 Dtk national savings to GDP and was obtained from the + a6 Efk + a7 Ptk + a8 Stk + ltk International Monetary Fund. The independent variables fall in the different categories described above, and were where the subindex tk denotes country k in period t. Stk is defined in the following way: the private national savings rate for country k in period t; * Age dependency: population younger than 15 years old L is a vector of life-cycle variables, including the age- plus the population over 65 years old, as a percentage of dependency ratio, the rate of growth of per capita GDP, working-age population. This variable was taken from the the ratio of old and young population. G is a vector of varn- World Bank data set. According to the life-cycle hypothe- ables related to fiscal policy, and in principle it includes sis its coefficient should be negative. the government savings rate, government consumption, * Urban population: proportion of total population that and social security taxes as proportions of total taxes lives in urban areas. This variable was taken from the (which are used as a proxy for expected social security ben- World Bank data set, and according to the precautionary efits). F is a vector of variables that capture the character- savings model discussed above, its sign should be negative. istics of the financial sector, including its degree of * Government savings: This variable was obtained from the development. Of particular interest here are the degree of IMF's data set. Its coefficient is expected to be negative, financial depth of the economy and the extent to which capturing the fact that government savings will tend to borrowing constraints are binding. Ideally, F would also crowd-out private savings. An important issue is how close include measures of the real interest rate and the borrow- to -1.0 this coefficient is. If it is not significantly different ing-lending interest rate spread; however, this variable is from -1.0, increases in government savings will not be only available for a small number of developing countries. fully offset by reductions in public savings. M refers to macroeconomic stability variables, including . Growth per capita: This variable was defined as a three-year the rate of inflation; E includes variables related to the moving average of the rate of growth of per capita GDP. The external sector, such as the current account balance (or for- raw data were taken from Summers and Heston (1991). The eign savings); P is a vector of variables that captures the life-cycle model suggests that its coefficient should be posi- characteristics of the political system; and S captures all tive. Carroll and Summers (1991), however, have argued that other variables not included above. in a more complete model of consumer behavior, the rela- The estimation of private savings equations of the type tionship between growth and savings is ambiguous, and that of (6) presents several challenges. First, there are no data on in the short run they should be negatively related. To avoid all the relevant independent variables; second, a number of simultaneity problems the equations are estimated with 77 DEVELOPMEN'I' IN LATIN AMERICA AND TILE CARIBbEAN: RI)O E JANlIR() CONFERENCE, 1995 TABLE 2 Determinants of private savings Instrumental variables, paniel data, t-statistics in parentheses VARIABLE Rl R2 R3 R4i R5 R6 R7 R8 Developing Developing Developing Sample All All All All All countries countries countries Age dependency -0.148 -0.088 -0.056 -0.074 -0.083 -0.054 -0.281 -0.056 (-2.609) (-1.659) (-2.231) (-2.179) (-1.246) (-2.684) (-1.206) tJrban population - - -0.028 -0.065 -0.069 -0.073 -0.087 -0.12 (-1.070) (-2.552) (-2.940) (-1,696) (-1.086) (-3.229) Government savings -0.545 -0.542 -0.554 -0.547 -0.576 -0.578 -0.65 -0.359 (-8.338) (-7.456) (-7.611) (-6.657) (-7.181) (-4.386) (-3.483) Growth per capita 0.456 0.306 0.425 0.592 0.581 0.488 0.877 0.521 (1.785) (2.360) (3.559) (3.587) (2.390) (2.835) (2.805) GDP per capita - .000684 .0)0(0549 .000558 .000579 .00142 - .00110 (3.307) (3.172) (3.471) (2.567) (2.152) Money/GDP 0.05 0.045 0.051 0.029 0.049 0.209 0.289a (1.619) (5.150) (2.082) (4.326) (3.466) (3.286) (3.490) Private sector credit 0.056 0.045 0.074 0.055 0.053 0.049 (1.619) (3.638) (3.280) (3.110) (2.217) Social security -0.124 -0.267 -0.33 -0.155 -0.167 -0.253 -0.563 -0.116 (-41.703) (-6.813) (-7.983) (-4.360) (-4.711) (-3.346) (-4.400) (-1.531) Real interest rate -0.951 - - - - -0.038 (-0.515) (-1.104) Current account -- 0.517 0.533 0.38 0.564 0.625 (3.658) (1.444) (1.846) (2.785) Inflation -- -0.043 0.012 - - - 0.671 -- (0.595) (0.617) (1.080) Income distribUtion -0.011 0.069 - - (3.591) Political instability - _ 1.193 - - -1.72 __ (1.031) (--3.361) Political assassinations - - o 0.689 - - - (1.200) R 2 0.439 0.547 0.484 0.379 0.365 0.374 0.401 0.605 N 355 179 243 318 318 173 90 100 a. Beginning of period money ratio used as regressor. instrumental variables-see below for a detailed description tionally has been the case, as a proxy for the depth and on the instruments used. Carroll and Weil (1993) use causal- sophistication of the financial system, its coefficient should ity tests and find that growth "causes" aggregate savings. be positive (McKinnon 1973). If, however, it is taken as a * GDP per capita: taken from Summers and Heston. To the measure of the extent to which different countries face a bor- extent that more developed countries save a higher propor- rowing constraint, its coefficient should be negative (see the tion of their income, its coefficient will be positive. discussion in the preceding section for details). * Money/GDP: A number of variables were used. The first * Private sector credit: This variable can be considered a two were constructed as yearly ratios of MI and M2 to GDP. closer proxy for borrowing constraints and is defined in two Also, the ratio of the initial (1970) stocks of MI and M2 to alternative ways: the first is the yearly ratio of credit to the GDP were used. In all cases the raw data were taken from private sector to total domestic credit; the second is the the IMF's International Financial Statistics. This is one of the same ratio for the initial year, 1970. As discussed earlier, most difficult variables to interpret. If it is taken, as tradi- the borrowing constraint should affect private savings pos- 78 WHY ARE LATIN AMERICA'S SAVINGS RATES SO LOW? AN INTERNATIONAL COMPARATIVE ANALYSIS itively. Both indexes were constructed from raw data (1968) and Modigliani (1970) in their pioneering work. obtained from the International Financial Statistics. When alternative demographic variables were used instead * Social security: obtained from the World Bank's data set. of age dependency, the results were basically unaltered. The It is defined as the ratio of public expenditure for social coefficient of the ratio of urban population is negative and security and welfare to total public expenditures. It is a significant in most regressions, supporting the "buffer- proxy for expected social security benefits, and its coeffi- stock" approach to private savings (see Deaton 1989). cient is expected to be negative. The coefficient of government savings was significantly * Real interest rate: defined as the ex-post real deposit inter- negative in every regression. However, more important, est rate. The raw data were obtained from International from a policy perspective it was always significantly differ- Financial Statistics. According to the model presented ent from -1.0. For example, in equation Rl the 95 percent above, the sign of the coefficient of this variable is undeter- confidence interval is (-0.673, -0.416). This indicates that mined a priori. while higher government savings crowd out private sav- * Current account: defined as the ratio of the current ings, there is not a one-to-one relationship, and that account balance to GDP, obtained from the World Bank Ricardian equivalence does not hold strictly. data set. Its coefficient measures the degree of substi- The coefficient of social security is negative and signifi- tutability between foreign savings (or current account cant at conventional levels in all the regressions where it deficit) and national private savings. If foreign savings was included. This is consistent with previous findings by crowd out private savings, the estimated coefficient of this Feldstein (1980), and gives support to the notion that variable would be positive. reforms that replace government-run (and partially funded) * Inflation: defined as the rate of change of the CPI. This social security systems with privately-run capitalization variable captures the degree of macroeconomic stability, systems will result in higher private saving rates. Notice, and its coefficient is expected to be negative. however, that a reform of the social security system will * Income distribution: defined as the ratio of income received tend to reduce government savings in the short run. The by the poorest 40 percent over income received by the reason is that during the transition from the old regime to highest 10 percent. To the extent that lower-income house- the new one, the government will continue to have obliga- holds save a smaller proportion of their income, its coeffi- tions to (older) retirees, but will receive no contributions cient is expected to be positive. The data were taken from from active workers. Also, it is possible that privately the World Bank data set. administered social security systems could result in "exces- * Political instability: Three variables were used. The first sive competition," in which a high percentage of contribu- is a proxy for the degree of structural political instability in tions are spent on advertising. Diamond and Valdes-Prieto each country. An index defined as the frequency of transfers (1994) have argued that this has been the trend in Chile's of government for the 1971-82 period was used. The other privatized social security system. two are the frequency of politically-motivated assassina- Also, the regressions reported in table 2 show that the tions and attacks. These variables were taken from Edwards rate of growth of per capita GDP is significantly positive. and Tabellini (1994). The expected sign of their coefficients This result was obtained previously by a number of is negative. 23 authors-most recently by Collins (1991), Bosworth Equations R1-R5 in table 2 refer to the complete sam- (1993) and Carroll and Weil (1993)-and provides support ple, while equations R6-R8 are restricted to developing to the hypothesis that there is a "virtuous circle" that goes countries. These results are quite revealing.24 The R2s are from faster growth to increased savings to even higher quite high, bordering on 0.5 in most cases. As suggested growth.25 When GDP per capita was added to the regres- by life-cycle models, the coefficient of the age dependency sions, its coefficient was always positive and significant, ratio is significantly negative, indicating that demograph- indicating that, all things being equal, more advanced ics play an important role in explaining differences in pri- counties tend to save a higher percentage of GDP-Collins vate savings across time and countries. This coincides with (1991) reports a similar result in her analysis of ten devel- the results obtained by a number of authors, including Leff oping countries. 79 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 The next three independent variables in table 2- rowing constraints will require constructing more reliable money/GDP, private credit and real interest rate-are indicators of the extent of these constraints. proxies that try to capture the extent of development of The coefficients of real interest rates in table 2 were the financial market, the severity of the borrowing con- insignificant everywhere it was included. This is consistent straint, and the degree of "financial repression. "The coef- with results obtained by a number of previous researchers ficient of the money/GDP ratio is always significantly (see McKinnon 1993), for example. Moreover, when an positive, suggesting that countries with a "deeper" finan- interactive real interest rate-real GDP per capita term was cial system will tend to have higher private saving rates. included, the result did not support Ogaki and others' To investigate the robustness of this result, several alter- (1994) finding suggesting that the degree of intertemporal native definitions of this index were used, including yearly substitutability in consumption increases with the degree MI and M2 ratios, as well as beginning-of-period ratios. of development. When alternative measures of the effi- When this was done, however, the estimates did not ciency of the financial system, such as the spread between change in any significant way. The coefficient of private lending and deposit interest rates, were included in the credit also was significantly positive in all regressions regressions, their coefficients were not significant.26 where it was included. Overall, these results do not pro- The current account balance was significantly positive in vide support for the view that borrowing constraints have every regression, but the estimated coefficient was smaller resulted in lower savings. This contradicts evidence pre- than one, indicating that increases in foreign savings crowd sented by Schmidt-Hebbel and others (1992) and by out private savings in a less than one-to-one fashion. Also, Jappelli and Pagano (1994) who found that, using differ- the inflation and political instability coefficients were not ent samples, relaxing borrowing constraints negatively significant in any of the regressions where they were affected private savings. There are several possible expla- included. Income distribution data are available for a very nations for these results, including that the share of private small number of countries-mostly advanced. In one of the credit is a poor proxy for borrowing constraints and that regressions its coefficient was significantly positive; how- these operate on household savings only, and not on cor- ever, to get a clearer perspective on the role of this variable porate or total private savings. Unfortunately, more ade- additional data would be required. quate measures of borrowing (or liquidity) constraints, To check the robustness of the results, I performed a such as the down payment required to buy a house, are series of tests. In particular, I added variables related to only available for a small number of advanced countries. macroeconomic stability (variability of inflation), the open The role of these type of constraints- including restric- economy (degree of openness and variability of the real tions on consumer credit-possibly constitutes one of the exchange rate), and the structure of the economy (share of most important unresolved issues in research on savings manufacturing, mining, and agriculture in GDP). Their behavior. To investigate the issue further, I estimated coefficients were not significant. I also analyzed whether cross-sectional regressions using average data for the the results reported in table 2 were driven by outliers. To 1983-92 period. The instrumental variables estimates do this, I estimated Cook's distance statistics to identify yielded a positive coefficient for the money/GDP ratio, and variables with a high degree of "influence" on the results. a negative one for the ratio of private sector credit over total These observations turned out to correspond to Bolivia; domestic credit. The following is an illustration of the when they were excluded from the regression, however, the type of result obtained (numbers in parentheses are results discussed above did not change in any meaningful t-statistics): way. Finally, I reestimated the equations using White's pro- cedure for estimating the variance-covariance matrix under PSAV = 1.83(3.2) Growth -. 35(-2. 1) GovSav -1.0(-1.9) Old -.619(-2.2) heteroskedasticity; again the results elaborated above were Young + .138(1.6) Money/GDP -.062(-1.9) Private credit-. 104(-1.7) not altered. Social security + 49.233(13.474); N = 39; R2- 0.57. The computation of standardized beta coefficients indi- cates that per capita GDP growth is the most important More detailed and convincing analyses on the role of bor- variable for explaining cross-country differences in private 80 WHY ARE LATIN AMERICA'S SAVINGS RATES SO LOW? AN INTERNATIONAL COMPARATIVE ANALYSIS TABLE 3 cantly different from zero.27 This suggests that the degree of Private savings and Latin America urbanization plays a significantly more negative role in Latin Dummy variables estimation; t-statistics in parentheses America than in the rest of the sample. A possible explana- VARIABLE COEFFICENT ESTIMATES LAC DUMMIES tion for this is that, within the context of the buffer-stock Age dependency -0.133 -0.174 approach to savings, the traditional role of government in (-3-143) (-0.729) providing a safety net in the cities has reduced precautionary Urban population 0.013 -0.626 savings. What is more important, however, is that these (0.450) (-3.084) results suggest that the policy variables and growth coeffi- Government savings -0.596 0.383 cients are not significantly different across samples. (-6.524) (1.195) Regarding the second possible explanation, an analysis Growth per capita 0.649 -0.486 (2.923) (-1.559) of the left-hand-side variables unveils significant differ- GDP per capita -0.0000560 0.0004 ences between the Latin American countries and the rest of (-0.262) (3.298) the sample. This is the case both for demographic variables Money/GDP 0.041 0.05 5 (3.826) (0.206) (Latin America has a much higher age-dependency ratio, Private sector credit 0.062 -0.098 for example), growth, and policy variables such as social (3.298) (-1.466) security and government savings (see table 4). The results Social security -0.119 0.013 in tables 3 and 4 suggest that the poor levels of Latin (-2.976) -0.990 American private savings are mostly a consequence of dif- Current account 0.527 -0.384 (3.357) (-1.289) ferent levels of savings determinants, and not so much due R2 0.454 to structural differences in the private savings function. N 306 - F - 3.75 Government savings Note; Estimates include Latin American dummy variables for each regressor. The coeffi- Table 5 contains the results obtained from instrumental cients in the third column represent the dummy estimates. variable estimations of government savings equations using both panel data as well as cross-country variables for savings. This coincides with Bosworth's (1993) results. In 1983-92.28 In addition to political instability and polar- equation R2, for example, the beta statistic for growth is ization-proxied by politically motivated attacks and 3.43; the other variables with relatively high betas were assassinations-some of the independent variables included government savings (-1.36) and money/GDP ratio (0.87). in the private savings regressions were incorporated into The title of this paper asks why savings rates are so low the regressions.29 The dependent variable was obtained in Latin America. The results presented in table 2 suggest from the IMF, and the independent variables were defined that this can be the consequence of a series of factors. First, as discussed above. some of the coefficients of the private savings equation for TABLE 4 Latin America may be different from those for the rest of Latin America and rest of the sample: the countries in the sample. Second, even if the same equa- General statistics tion can describe private savings across regions, the value of LATIN AMERICA REST OF THE SAMPLE the left-hand-side variables may be different in the Latin VARIABLE MEAN STANDARD MEAN STANDARD nations. Naturally, a third possible explanation is a combi- DEV. DEV nation of the previous two. Private savings 13.40 5.60 18.90 7.60 To test whether the coefficients pertinent to the Latin Government savings 2.10 5.90 2.50 14.90 countries were different, I reestimated the equations in table Growth 0.90 3.70 1.10 0.30 Ml/GDP 10.90 5.0 22.30 28.70 2 with Latin America dummy variables for every coefficient M2/GDP 26.30 9.40 53.70 23.90 (see table 3 for the results obtained in the case of equation Private credit 0.70 0.30 0.67 0.31 R5r A e oCurrent account -3.10 4.00 -2.80 4.20 R5). As can be seen, only the dummies for two of the coefrn- Aedpnec .6 01.7 01 > ~~~~~~~~~~~~~Age dependency 0.76 0.12 0.67 0.19 cients-urban population and GDP per capita-are signifi- Social security 18.40 13.50 16.80 16.00 81 DEVELOPMENT IN LATIN AMERICA AND THE C.ARIBBEAN: RIO De JANEIRO CONFERENCE, 1995 TABLE 5 not permit discrimination between the political-economy, Determinants of government savings strategic-behavior approach proposed in the previous sec- VARIABLE R9 RIO Rll tion, and alternative models based on governments' politi- cal weaknesses (see Edwards and Tabellini 1994 for a Sample Panel' Panel Cross-section discussion on these two families of models). Eotimation method IV IV-Fixed effects IV As in the case of private savings, the coefficient of Age dependenicy 1.657 0.402 0.042 (0.298) (0.321) (0.533) growth is significantly positive. Moreover, the computation Urban populationi 0.078 -0.153 - of standardized beta coefficients indicates that this is the (3.334) (0.941) most important variable in explaining cross-country differ- Social security - - -0.008 ences in government savings (political instability is the sec- (-0.103) ond most important beta coefficient). Growthi per capita 0.632 0.794 1.801 (4.140) (7.270) (3.285) Interestingly enough, and contrary to the private sav- GDP per capita -0.0004 -0.00062 -0.00018 ings case reported in table 2, neither the demographics, (-2.627) (-2.412) (-1.032) social security, or money/GDP variables have significant Money/GDP -0.012 -0.001 -0.074 coefficients. As in the case of private savings, the coefficient (-1.240) (-0.183) (0;~747) Current account 0.378 0.532 0,822 of the current account is significantly positive, indicating (5.044) (4.570) (2,449) that a higher level of foreign savings-that is, a reduction Political instability -0.82 -0.363 -0,511 in the current account balance-has been associated with a (-2.900) (-5.183) (-2.569) lower government savings rate. Its coefficient, however, is Political assassinations -0.1812 significantly below unity in both panel regressions reported (-0.2 59) Attacks -0.0901 -0.018 -0.002 here-for example, in equation R10 the 95 percent confi- (-2.701) (-4,149) (-0.358) dence interval is (0.29, 0.75), indicating that the degree of RK2 0.439 0.484 0.365 offset is not one-to-one. N 334 334 38 Note: t-statistics are in parentleses. Concluding remarks a. The following were used: assasinations, lagged growth per capita, lagged investment, M e ration of social security expenditrres to total expenditure, frequency of transfer of Most empirical studies on national savings have either aggre- political power, attacks, lagged currenrt account balance, urbanizaiton, openness, infla- gated private and government savings or have concentrated tion, ratio of broad money to GDg, and government consumption. on private savings behavior under the assumption that gov- ernment savings are exogenous. This is indeed puzzling. As can be seen, the results obtained differ from those for There are solid theoretical reasons for believing that both private savings, reported in table 2, and provide some sup- types of savings are determined in very different ways; and, port for the political-economy perspective on government perhaps more importantly, in rapidly growing economies savings. In every equation the coefficient of political insta- government savings have made fundamental contributions bility was significantly negative. This suggests that in to national savings. This paper provides evidence that clearly countries with higher political turmoil public savings will suggests that the processes of determination of private and tend to be lower than in countries with a more stable polit- government savings are significantly different. While private ical environment. Interestingly enough, when alternative savings respond to demographic variables, social security measures of political instability were used-such as the expenditures, and the degree of depth of the financial sector, estimated probability of government changes-the results government savings do not. Government savings, on the were maintained. However, the proxies for polarization- other hand, are affected by an important type of variable that politically-motivated attacks and assassinations-were sig- does not affect private savings: the degree of political insta- nificantly different from zero in only some of the bility of the country in question. However, both private and regressions. It is important to note, however, that in spite government savings are affected by real growth and by the of these positive results, the regressions reported here do current account balance or foreign savings. 82 WHY ARE LATIN AMERICA'S SAVINGS RATES SO LOW' AN INTERNATIONAL COMPARATIVE ANALYSIS TABLE 6 Tax rates in the pre-reform and post-reform periods (percent) PERSONAL CORPORATE WITHHOLDING TAXES INCOME TAX INCOME TAX ON FOREIGN REMITTANCES' Country 1985-86 1991 1986 1992 1986 1993 Argentina 16.5-4.5 6-30 0-33 20 23 17 Bolivia 30 13 0-30 0 25 13 Brazil 0-6 10-25 29-50 25-40 25 22 Chile 0-57 5-50 10-37 15-35 40 38 Colombia 0-49 5-30 40 30 40 12 Costa Rica 5-50 10-25 0-50 30 15 18 Dominican Republic 2-73 3-70 0-49.3 0-49.3 20 30 Ecuador 19-40 10-25 0-59 0-44.4 40 36 El Salvador 3-60 10-50 0-30 0-25 22 20 Guatemala 11-48 4-34 0-42 12-34 16 17 Honduras 3-40 3-40 0-55 0-40.2 10 18 Mexico 3-55 3-55 5-42 0-35 37 22 Nicaragua 15-50 6-50 0-45 0-35.5 20 30 Panama 13-56 2.5-56 0-50 2.5-45 30 22 Paraguay 5-30 0 0-30 0-30 23 25 Peru 2-56 5-56 0-40 0-30 42 19 Uruguay 0 0 0-30 0-30 30 - Venezuela 12-45 4.5-45 18-67.7 20-67.7 20 15 Regional average 5-36 7-47 3.4-46.3 8.6-36.5 27 22 a. Simple average. Source. Shome 1994. TABLE 7 Value-added tax rates (percent) DATE VAT COUNTY INTRODUCED OR PROPOSED AT INTRODUCTION JANUARY 1994 Bolivia October 1973 5, 10, 15 14.92a Brazilb January 1967 15 9, 11 Brazil' January 1967 15 17 Chile March 1975 8,20 18 Colombia January 1975 4, 6, 10 8,14,20,35,45 Costa Rica January 1975 10 8 Dominican Republic January 1983 6 6 Ecuador July 1970 4,10 10 El Salvador September 1992 10 10 Guatemala August 1983 7 7 Haiti November 1982 7 10 Honduras January 1976 3 7,10 Jamaica October 1991 10 12.5 Mexico January 1980 10 10 Nicaragua January 1975 6 5, 6,10 Panama March 1977 5 5,10 Paraguay July 1993 12 10 Peru July 1976 3, 20,40 18 Venezuela October 1993 10 10 a. Effective rate. Legislative tax-inclusive rate is 13 percent. b. On interstate transactions, depending on region. c. On interstate transactions. 83 DEVELOPMENT IN LA'ITIN AMERICA AND 'I'l{E CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 From a policy perspective, the results reported in this provide enough information regarding the transition from paper suggest that there are a number of possible avenues- low to higher savings rates. However, evidence from a many of them discussed in policy literature-for raising pri- score of countries-including the "East Asian miracle" vate savings in Latin America. An increase in the degree of nations-suggests that an increase in private domestic depth of the financial sector will tend to have an important savings ratios is a rather slow process (World Bank effect. Interestingly, for the period under consideration the 1993b). This evidence also indicates that a drastic increase ratio of MI to GDP in Latin America was almost one-half of private savings usually has been influenced by an impor- of that of the rest of the sample. What is less clear, however, tant factor not captured in the regression analysis: the cre- are the mechanisms by which this could happen. Also, the ation of an institutional environment that instills results presented here have not resolved the question of the confidence in small savers-the case of postal savings in impact of borrowing constraints. While the panel data East Asia is a good example of this type of institution. analysis did not unearth such an effect, cross-section results This, jointly with the econometric results discussed here, provide some evidence in support of the notion that relax- suggests that the development of new institutions, such as ing the borrowing constraint may reduce savings. Further new social security systems tailored after the Chilean expe- research on this issue will be needed before a clearer picture rience, could play a fundamental role in increasing private emerges. At this point, however, it seems that the most savings. fruitful type of research along these lines would be micro- Another important finding is that government savings, economic in nature. In particular, investigating how the in turn, will be positively affected by the creation of social increased access to consumption credit affects household and political institutions that reduce the degree of political saving decisions would be particularly important. instability. Countries that have a "national project" and The results also suggest that the reduction of where political forces coexist in relative harmony will find government-provided social security benefits would it easier to increase government savings. This suggests, increase private savings. Again, however, additional then, that the strengthening of democracy will have impor- progress in this area would require detailed microeco- tant, and fairly direct, positive effects on growth and eco- nomic analysis of specific country experiences. In that nomic progress. sense, the study of the Chilean case appears to be particu- As a consequence of the debt crisis, most Latin larly promising. American countries had to reform their public finances. Tax Perhaps one of the most important results refers to the systems have been rationalized and become more efficient; role of public savings as a determinant of private savings. the number of tax rates has been reduced, their level has While the results strongly suggest that higher govern- been harmonized with international rates, and the number ment savings will depress private savings, they will do of exemptions eliminated. Tables 6 and 7 provide a sum- this in a less than one-to-one fashion. In fact, the results mary of the most important reforms in tax rates. In spite of suggest that an increase in government savings of 1 per- these important changes, however, in some countries pub- cent will generate a decline in private savings of approxi- lic sector revenues continue to be rather low (see Edwards mately 0.55 percent, with a consequent increase in 1993). In fact, the increases in government savings national aggregate savings of 0.45 percent. To the extent reported in table 1 have been attained through a reduction that this net increase in national savings results in higher in expenditures-especially in infrastructure. There is now capital accumulation and growth, it would be possible to a growing consensus that a further increase in government begin the "virtuous circle" discussed above. savings will need to come from improved tax administra- It should be noted, however, that due to the nature of tion-including the reduction of evasion-and increased the data-very short time series and a rather large number reliance on user fees for services provided to the well-to-do of cross-sections-the results reported in this paper do not (World Bank 1993a). 84 WHY ARE LATIN AMERICA'S SAVINGS RATES SO LOW? AN INTERNATIONAL COMPARATIVE ANALYSIS Appendix poorer nations. Countries included in the empirical analysis 4. See Gersovitz (1988) for a discussion on data problems in aggregate savings studies. IMFCODE COUNTRY 5. See, for example, Financial Times, October 28, 1994. 122 Austria 6. See Gersovitz (1988) for a broad survey on savings and devel- 124 Belgium opmenr. Aghevli and others (1990) provide a complete discussion 128 Denmark of recent trends and prospects. Hayashi (1986) provides a fascinat- 134 Germany ing analysis of Japanese savings, and deals with the question of why 136 Italy 142 Norway Japan's savings rate is so high. 156 Canada 7. Summers (1988) provides a (partial) exception. See also the 172 Finland discussion in Feldstein and Bacchetta (1991). 178 Ireland 8. Most empirical studies have associated private savings to 182 Portugal household savings. This is not strictly correct, since in a number of 186 Turkeyconrecrpat 196 New Zealand countries corporate savings are an important component of the 218 Bolivia aggregate. In this paper I follow most recent authors, and do nor 223 Brazil deal with the theory of corporate savings. See, however, Gersovitz 228 Chile (1988) for a discussion. The empirical analysis of section IV, how- 233 Colombia ever, includes both household and corporate savings. 253 El Salvador 273 Mexico 9. See, for instance, Modigliani and Brumberg (1954). 288 Paraguay 10. On borrowing constraints, see, for example, Deaton (1989) 299 Venezuela and Zeldes (1989). 429 Iran 11. For a detailed discussion on precautionary savings when the 524 Sri Lanka marginal utility is convex, see, for example, Caballero (1990). 564 Pakisian 12. Carroll and Summers (1991) present evidence suggesting 566 Philippines that two key implications of the permanent-income hypothesis are 576 Singapore not borne out in U.S. data. First, contrary to this hypothesis, antic- 578 Thailand ipated income growth and consumption are not uncorrelated; sec- 622 Cameroon ond, the (real) rate of interest is not a strong determinant of the rate 652 Ghana 664 Kenya of growth of consumption. 684 Mauricius 13. See Fry (1988) for surveys of these types of models. 686 Morocco 14. In spite of the relative unresponsiveness of savings to higher 694 Nigeria interest rates, financial reforms still have important effects on growth 724 Sierra Leone through improvement in the quality of aggregate investment, and 742 Togo 744 Tunisia especially private investment. For example, in a series of studies Getb (1989), Fry (1988), and McKinnon (1991) have found robust evi- dence supporting the hypothesis that a reduction in the degree of Notes repression of the capital market will tend to increase the productiv- 1. See, for example, World Bank (1993a) and CEPAL (1994). ity of investment. This work also suggests that reducing financial 2. See, for example, the family of Ak models pioneered by instability, and especially inflation, will also have an important posi- Rebelo (1991). There is now abundant literature on endogenous tive effect on the return to investment. Also, recent work by King growth. See, for example, Grossman and Helpman (1991) and Sala- and Levine (1993) provides support to the idea that more developed i-Martin (1992). See Gersovitz (1988), Deaton (1990) and financial sectors have been associated with faster total factor produc- Schmidt-Hebbel and others (1994) for detailed surveys on the links tivity growth. between savings and development. 15. That provision was altered in the 1990 tax reform. See the 3. For example, in what is possibly the most comprehensive discussion in Edwards (1993). See also Edwards and Cox-Edwards recent cross-country study of savings determination, Carroll and (1991). Weil (1993) use aggregate savings without making a distinction 16. Carroll and Summers (1991) have argued that the compari- between private and government savings. The lack of appropriate son of the evolution of Canadian and U.S. tax systems provides an data traditionally has affected efforts to study in detail the behav- ideal natural experiment for investigating the way in which tax ior of savings in a broad comparative setting. Although advanced regimes affect savings rates. They conclude that tax systems that and select middle-income countries have distinguished between the encourage postponed consumption, such as Canada's, indeed result two types of savings, these data have not been available for the in higher savings. 85 IDEVELOpMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CIONFERENCE, 1995 17. Surprisingly, however, a number of empirical studies on savings Fund, Washington, D.C. continue to ignore the endogeneity of the rate of growth. See, for exam- Barro, R. 1974. "Are Government Bonds Net Wealth?" Journal of ple, Schmidt-Hebbel and others (1992) and Doshi (1994). Political Economy 82. 18. Gersovitz (1988) makes the important, but often forgotten, . 1991. "Economic Growth in a Cross-Section of Countries." point that even though savings will be higher with borrowing con- Quarterlyjournal of Economics 106 (August). straints, household's welfare will tend to be lower. Boskin, M. 1978. "Taxation, Savings and the Rate of Interest." 19. On Ricardian-Barro equivalence, see Barro (1974). journal of Political Economy 86 (supplement): 20. Strictly speaking, what matters is the relation between con- Bosworth, B. 1993. Savings and Investment in the Open Economy. tributions and expected social security benefits in the future. Washington, D.C.: The Brookings Institution. 21. In particular, the rate of growth of GDP per capita, the (real) Caballero, R. 1990. "Consumption Puzzles and Precautionary interest rate and the current account are likely to be endogenous. Savings." Journal of Monetary Economics 25. 22. In the cross-section estimates I dealt with 1983-92 averages. Carroll, C., and L. Summers. 1991. "Consumption Growth Parallels In this case endogenous variables for 1970-82 were used as some of Income Growth." In D. Bernheim and J. Shoven, eds., National the instruments. Although this procedure does not fully deal with Saving and Economic Performance Chicago: University of Chicago causality, it provides a convenient way to handle the simultaneity Press. issue. Carroll, C., and D. Weil. 1993. "Savings and Growth: A Reinter- 23. When alternative indices-such as the estimated probability pretation." NBER Working Paper 4470. National Bureau of of government change-are used to measure political instability, Economic Research, Cambridge, Mass. the basic results reported here were obtained. Collins, S. 1991. "Saving Behavior in Ten Developing Countries." 24. The countries used in the regressions were chosen according In D. Bernheim and J. Shoven, eds., National Saving and to data availability and are listed in the appendix. The rate of Economic Performance. Chicago: University of Chicago Press. growth of GDP per capita, real interest rates, and the current Corbo, V., and K. Schmidt-Hebbel. 1991. "Public Policies and account balance were considered endogenous variables. The follow- Saving in Developing Countries." journal of Development Economics ing instruments were used: a constant, age dependency, lagged 36 (1): 89-115. moving average of growth, money/GDP, private credit, lagged real Cukierman, A., S. Edwards, and G. Tabellini. 1992. "Seigniorage, interest, government savings, social security, lagged current Political Instability and Inflation." American Economic Reviewv 72 account, income distribution, political instability, GNP per capita, June). government consumption ratio, lagged investment, inflation, open- De Long, B., and L. Summers. 1991. "Equipment Investment and ness, and population growth. Economic Growth." Quarterly Journal of Economics 106 (August). 25. 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Research, Cambridge, Mass. Leff, N. 1968. Economic Policymaking and Development in Brazil, Zeldes, S. 1989. "Consumption and Liquidity Constraints: An 1947-1964. New York: Wiley. Empirical Investigation." Journal of Political Economy 97 Lewis, A. 1955. The Theory of Economic Growth. London: Allen and Unwin. (April): 305-46. 87 DEVELOPMENT IN LATIN AMERICA AND T'HE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Comment on "Why Are Latin America's Savings Rates So Low? An International Comparative Analysis," by Sebastian Edwards C A RL O S LAN G O NI G ROWTH RATES IN EAST ASIA AND LATIN AMERICA DURING THE FIFTEEN YEARS PRIOR TO the Latin American debt crisis were quite similar. But within that period savings rates increased from 23 percent to 29 percent in East Asia; in Latin America savings rates moved only slightly, from 19 percent to 20 percent. Why has East Asia been able to save more and outperform Latin America given similar growth rates? Three fundamental elements led to different levels of performance. First, growth in Latin America has always been accompanied by inflation; in East Asia steady growth and low inflation rates have been main- tained. Second, the export market has grown in East Asia; in Latin America export performance has been poor. Third, East Asia has been able to reconcile growth with income distribution; in Latin America growth has had a negative impact on the distribution of income. The difference in savings rates between East Asia and Assuming that growth in Latin America can be Latin America contributes to the difference in performance increased by higher public savings rates and given that between the two regions. The rate of public savings in public savings rates are relatively low, the prospects for Latin America is strikingly low relative to East Asia. The growth in the region are very high. Social security and fis- low savings rate in Latin America is closely related to the cal reforms are two ways in which Latin America could inflation caused by a chronic public sector deficit. stimulate public savings. Two institutional differences contribute to the differ- Increased private savings rates in Latin America could ence in public savings in East Asia and Latin America. also contribute to growth. Levels and composition of pri- First, East Asia is less tolerant of public sector debt than vate savings are affected by variations in demographic fac- Latin America. Thus the inflation and lower public savings tors, the extent of chronic inflation, real rates of return, and that come with public debt have also been less prevalent in market, policy, and institutional uncertainties. For exam- East Asia. Second, East Asia has swiftly and efficiently ple, anticipated, predictable rates of return increase the adjusted to large public sector imbalances. In Latin propensity for private savings. Likewise, a stable political America adjustment has been long and difficult. Without environment that minimizes political and institutional this fundamental fiscal element, low inflation and sustain- uncertainties increases private savings. Although chronic able growth are difficult to achieve. inflation may encourage voluntary private savings, these Carlos Langoni is director of the Getulio Vargas Foundation and former president of the Central Bank of Brazil. 88 WHY ARE LATIN AMERICA'S SAVINGS RATES SO LOW? AN INTERNATIONAL COMPARATIVE ANALYSIS savings will be in the form of short-term, liquid invest- Neither short-term savings nor short-term foreign capi- ments. Long-term, stable savings are essential for financing tal finance sustainable growth. Instead, policy reforms that sustainable growth. Pension fund reform could stimulate expand privatization opportunities and draw foreign direct longer-term savings. investment into Latin America will help attract the desired composition of foreign savings. 89 DEVELOPMENT IN LATIN AMERICA AND T'HE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Comment on "Why Are Latin America's Savings Rates So Low? An International Comparative Analysis," by Sebastian Edwards YU NG CH U L PARK A LTHOUGH IT MIGHT NOT SEEM OBVIOUS, ECONOMIC GROWTH HELPS BOOST PUBLIC SAV- ings. For example, suppose a country experiences an export boom. The increase in exports will increase the incomes of the working productive population. Tax revenue, in turn, increases more than proportionally. As a result public savings, aggregate savings, and investment increase. Political stability, the current account balance, and economic growth also increase public savings. And as public savings increases, the use of funds becomes very important. Public savings can be transferred to the private sector or used for public investment. Both uses can lead to a virtuous circle of saving and growth if the corresponding investments are efficient. The effects of borrowing constraints on consumer Asia's high savings rates. Corporate savings in Korea behavior and private savings derive from a country's con- account for 45-50 percent of private savings. This high sumption and stage of development. Specifically, liquidity level of savings is a result of firms' profit maximization constraints are not likely to affect consumption and savings behavior and their reliance on self-finance. Again, this is a during the early stages of development because at that result of liquidity constraints and underdeveloped capital stage consumers' concerns are focused on meeting daily markets. needs. At the second stage of development, when incomes Finally, outward-oriented development strategies have rise and more durable goods are purchased, borrowing con- contributed indirectly to Korea's increase in private savings straints and import restrictions have a greater effect. This (from 8 percent of GNP during the 1960s to 35 percent effect is less powerful during the mature stages of develop- today). After these strategies were implemented in the ment, when consumption is centered on services such as early 1970s a substantial portion of agricultural workers travel, entertainment, and health care. Borrowing con- moved to urban settings and began working in manufac- straints reinforced by import control have played an impor- turing industries. The resulting increase in labor-intensive tant role in increased savings and growth rates in the commodities allowed Korea's exports to surge. Thus export Republic of Korea. promotion policies helped generate higher levels of Corporations are a second factor contributing to East savings. Yung Chul Park is a professor at the University of Korea. 90 WHY ARE LATIN AMERICA'S SAVINGS RATES SO LOW' AN INTERNATIONAL COMPARATIVE ANALYSIS Floor Discussion of "Why Are Latin America's Savings Rates So Low? An International Comparative Analysis," by Sebastian Edwards A, MEMBER OF THE AUDIENCE COMMENTED THAT CONCENTRATING ON PUBLIC SAVINGS to increase aggregate savings is a questionable approach given the poor impression most citi- zens have of the way governments use resources. Rather, policymakers should focus on how public savings are used. During the early stages of development there should be greater emphasis on increasing private savings. Improving the investment climate as a whole would attract and encourage foreign investment and thus would generate the kind of financial reform that leads to increased private savings. And financial reform generates greater potential for growth than public savings. Another member of the audience said that Edwards' Yung Chul Park (discussant) agreed that East Asia's paper shows that there is a fall in private savings and an experience is not applicable to Latin America. Increased increase in public savings after reform. One possible expla- savings in East Asia were a result of financial and import nation is the fall in inflationary tax. restrictions. In market-oriented economies like those in Eliana Cardoso, lead economist of the China and Latin America-where open financial markets allow citi- Mongolia Department of the World Bank, questioned zens to import luxury consumption goods and borrow from whether there is a lesson from East Asia for Latin America. international sources-such restrictions are not effective. For example, in China the private sector saves 40 percent The broader question is whether, in an increasingly lib- of GNP while the public sector dissaves. The high level of eralized and economically integrated world, Latin private savings can be attributed to growth and to the fact American governments should be concerned with savings that 80 percent of workers are not covered by the social at all. After all, Park said, international savings and foreign security and pension system. This is not a path that Latin investment can contribute to savings if domestic savings America should follow. Policymakers in Latin America fall. Thus an environment that is favorable to sustainable should instead be encouraged to increase public savings. investment is more important than savings. Furthermore, in Korea liquidity constraints cause relatively Carlos Langoni (discussant) said that governments high levels of savings. Again, this approach should not be should use fiscal reform to increase public savings and encouraged in Latin America. Efforts are being made in improve efficiency in the allocation of public resources. Latin America to improve citizens' welfare, not to impose Brazil, for example, is considering fiscal reform that will restrictions that force them to save more. Public savings is make the tax system more efficient and equitable. The need often invested in inefficient public enterprises. Latin for private savings, trade liberalization, and consumer credit American governments should reduce their overall fiscal expansion produce challenging short-term problems, how- deficits rather than save more. ever. If stabilization, trade liberalization, and consumer 91 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 credit expansion take place at the same time, short-term tinued, it is important to consider their net effect on over- private savings and stabilization may be negatively affected. all savings. Specifically, as countries move toward capital- But, Langoni said, Latin America is not in a position to ization from pay as you go systems, it is important to choose between increased private or public savings. There is measure the tradeoff between increased private savings and room and a need to increase the level and efficiency of both. the large public liabilities that will result as the reforms are Edwards felt that East Asia's economic history and expe- put into effect. riences provide useful information from which Latin An audience member asserted that the lessons that had America can benefit. Both regions' successes and mistakes been derived from Mexico during the conference were provide lessons for the rest of the world. superficial and self-serving. The Mexican crisis should be On the issue of whether savings and investment are analyzed more seriously and responsibly. According to the related, Edwards said that some studies have suggested a speaker no attempt had been made to tie Mexico's policies, correlation between the two variables, while others show based on World Bank recommendations, to the results that the correlation breaks down in less-developed coun- Mexico had gotten. Moreover, the format and organization tries and as the world moves toward an open, international of the conference did not facilitate real dialogue; rather, it economy. We should continue to examine this issue. suggests that the World Bank is only interested in dis- On the issue of whether public savings should be used pensing advice. to finance private investment, Edwards said that increases Edwards responded that the presence of participants of in public savings do not necessarily mean that public various backgrounds, including nongovernmental organi- spending on private investment should also be increased. zations and academics commonly known as World Bank Instead, public investment in social projects should be critics, and the varied dialogue taking place at the confer- evaluated in terms of social rates of return, shadow prices, ence show that the Bank is committed to a dialogue with and other traditional analytical methods and should be its member countries. The Bank is interested in hearing undertaken only if the rates of return are sufficiently high. both the consenting and dissenting views of its colleagues. Given that infrastructure has long been ignored in Latin Edwards hopes that continued dialogue and feedback will America, public spending in this sector should be encour- lead to a virtuous circle, with each regional conference con- aged if the social rates of return are adequate. tributing more than the previous to improving develop- When evaluating social security reforms, Edwards con- ment in Latin America and the Caribbean. 92 Latin America and the Caribbean in the World Economy CARLO S A. P RI MO B RA GA , J U LI O NOGU S, A ND S ARATH RAJAPATI R ANA OEVER THE PAST TEN YEARS MOST COUNTRIES IN THE LATIN AMERICA AND THE CARIBBEAN (LAC) region liberalized their trade regimes, breaking away from trademark inward-orient- ed strategies of development. Trade liberalization has been pursued not only unilaterally but also in the context of regional integration arrangements and, more recently, in response to multilateral commitments negotiated in the Uruguay Round. Not since early in this centu- ry have so many countries in the region been as open to foreign trade and investment. Trade liberalization has often been implemented as part renewed fiscal adjustment programs posed at the time of of a broader package of structural reforms designed to pro- recent democratic elections. mote macroeconomic stabilization and to redefine the role Yet the crisis has increased the political clout of those of the state in these economies; this has been called the who demand more protection, and against this back- neoliberal agenda. By mid-1994 significant progress had ground the need for countries to pursue corrective actions been achieved in trade reform and the conventional wisdom has been reinforced. These include ongoing attempts to was that the most difficult stages in the process had been stabilize the macroeconomy on a sustained basis, rein- surpassed. forced efforts to maximize transparency, particularly in The financial crisis triggered by the devaluation of the the context of preferential trade arrangements, and the Mexican peso in December of 1994 has been interpreted by development of institutions that are able to resist protec- some as posing a challenge to the neoliberal strategy. In tionist pressures. this paper we argue that in spite of heightened economic We begin our analysis by examining the reasons behind risks to the reform programs, a wholesale return to protec- the observed outward-oriented trend and by documenting tionism is unlikely. The best reassurances of this include progress under different modes of liberalization (unilateral, the economic ideas of the leadership elite of the region, the regional, and multilateral) until 1994. The effects of these economic benefits that the new policies have already gener- trade reforms are also briefly reviewed. The paper discusses ated, and the determination that many governments have how in some countries, domestic macroeconomic imbal- shown in dealing with the crisis, in spite of the risks that ances, currency appreciation, unemployment, and changes Carlos A. Primo Braga is senior economist in the Telecommunications and Informatics Division, Industry and Energy Department, at the World Bank. Julio Nogues is executive director for Argentina, Bolivia, Chile, Paraguay, Peru, and Uruguay at the World Bank. Sarath Rajapatirana is economic adviser in the Operations Policy Group, Operations Policy Review Department, at the World Bank. Assistance and comments from A. Amjadi, C. Fink, J. Tavares de Araiijo, Jr., L.A. Winters, A. Yeats, and Cherian Samuel are gratefully acknowledged. Joy Troncoso provided excellent support to process the paper. The findings, interpretations, and conclusions are the authors' own and should not be attributed to the World Bank, its Board of Directors, its management, or any of its member countries. 93 DEVELOPMENI IN LATIN AMERICA AND TIIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 in the external environment have strengthened the forces in FIGURE 2 favor of backsliding. Although regional agreements have The speed of world trade integration, 1971-93 resulted in significant increases in intraregional trade flows Growth raet,,tfeh m of -rr,hndie export for several countries, we argue that close surveillance of dimport volumes i-tgro-th rre, of.otput their compliance with basic economic principles should be 1(_ a continuous process to ensure that they remain a positive U1 Latin 8 USub-Saharan factor on the road toward trade liberalization. Then the role South of institutions in sustaining an outward-oriented trade Europe and Central regime is discussed. The final section gives conclusions and igh-income recommendations. 4 Trade policies in Latin America and the Caribbean: The liberalization trend 2 In the mid-1980s countries in the LAC region typically dis- played above-average levels of protection in the developing ON world (figure 1). This reflected not only widespread reliance L_ L on import-substitution industrialization strategies, but also the recourse to trade instruments to cope with the foreign- debt crisis that erupted in 1982. It is worth noting that 1971-85 1986-91) 1991-93 LAC countries diminished rather than increased their inte- Source: World Baok 1995a. gration with the world economy over the 1971-85 period (figure 2). greater reliance on price mechanisms rather than govern- Since then, things have changed dramatically (table 1). ment intervention, reductions in import and export barri- As pointed out by several authors (Alam and Rajapatirana ers, and the pursuit of transparency (for example, a shift 1993 and Rodrik 1994, among others) there has been a from nontariff barriers to tariffs). These measures have rush toward freer trade, although the journey was far from often been complemented by reforms of exchange rate complete by 1994. Trade reforms have typically involved a regimes (for example, the elimination of multiple exchange rates), regulatory reforms, and financial market liberaliza- tion and by the opening of the capital account. FIGURE 1 The economic case in favor of a liberal trade regime is Trade protection in developing countries, mid-1980s well known. Under a liberal trade regime resources are 11))i^ Averagee triff rae (perceot advlotet) employed in line with comparative advantage, economies 90 |l Average -ariff rate for -rnuofttre e od (percent d vabotre) of scale can be better exploited, and innovation and diffu- 801 U| (vrhpertcftooriffpoontn.tfimearedbyr sion of knowledge are promoted. There is also ample evi- I -~~~~pre of rlartiff poatriora _oee ykoleg hr ml 70 ... * *a dence that countries that are able to sustain trade liberal- 60 M ization outperform those that fail in their liberalization attempts (Michaely, Papageorgiou and, Choksi 1991; Nogues and Gulati 1994; Edwards 1993a). Still, trade lib- 40 eralization is often resisted by policymakers. 30 1.x.Ans- is r t J s a What fostered the liberalization trend in Latin America 20l 5 nfs 0 a 2 s . f 1ff in the 1980s? The usual "suspects" identified in the litera- 10 ture (Dornbusch 1992; Edwards 1993b) include the "tri- 0 Ote oc er OhrCrbenSoh cnrl umph" of the neoliberal ideology, the demonstration effect Other North West Other Caribbean South Central Africa Africa Asia Americ Americ of the Asian "tigers," mounting frustration with the poor Source: Erzan, Kuwahara, Marchesc, and Vossenaar 1989. results of inward-oriented trade regimes, and support from 94 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY TABLE I Some indicators of trade regimes before and after reform (percent) COVERAGE OF QRS ON IMPORTS AVERAGE UNWEIGHTED (PERCENTAGE OF TARIFF LINES LEGAL TARIFF RATES TARIFF RANGE UNLESS OTHERWISE NOTED) COUNTRY POST-REFORM POST-REFORM POST-REFORM (PRE-REFORM YEAR) PRE-REFORM (1993) PRE-REFORM (1993) PRE-REFORM (1993) Argentina (1988)' 38b 12 0-50 0-20 62 (of dom. prod.) Minimal Bolivia (1985) 12' 8 na 5-10 na Minimal Brazil (1987) 51 14 0-105 0-35 39 Minimal Chile (1984) 35 11 35 0 Minimal 0 Colombia (1984) 61 12 0-220 5-20 99 1 Jamaica (1981) na 20 na 0-45 na 0 Mexico (1985) 24d l3d 0-100 0-20 92 (of dom. prod.) 20 (of dom. prod.) Peru (1988) 66 16 0-120 15-25 100 Minimal Trinidad and Tobago (1989) na 41b na 0-103b na 4 Uruguay (1987) 32 15 10-55 0-20 0 Minimal Venezuela (1989) 37 19 0-135 0-50 40 10 a. Argentina imposes a statistical tax that has varied over time, and now stands at 3 percenr. b. Includes tariff surcharges. c. Import-weighted average tariff, d. Production-weighted average tariff. multilateral institutions for freer trade. A complementary region was integrating with the world at a faster pace than argument is that the economic crisis of the 1980s diffused any other developing region, and during 1991-93 the inte- the political opposition against trade reform. The influence gration rate was four times faster than in 1986-90. This in of sectoral interests was curtailed as the redistributive costs itself is a remarkable fact for a continent that was with- of trade liberalization were dominated by the potential drawing from world trade as a consequence of its inward- benefits of stabilization (Rodrik 1994). Trade reform oriented policies just a few years ago (see figure 2). became a popular way to signal a clear break with the dis- credited economic policies of the past, and in this context Recent reforms was a major element of the neoliberal agenda. Not all countries in the region liberalized their trade In what follows we first review the journey toward freer regimes at the same time or to the same extent. Chile, trade in the region. In doing this, we examine not only uni- Bolivia, and Mexico can be characterized as early trade lateral trade reforms, but also trade liberalization accom- reformers with major policy changes being reinforced in plished on a regional and preferential basis and at the multi- the 1985-88 period. Argentina, Brazil, Colombia, Peru, lateral level.2 Uruguay are recent reformers, while Jamaica, Trinidad and Tobago, and Venezuela are even more recent reform- Unilateral reforms ers. The largest concentration of reforms during the Overall trends 1984-94 period occurred from 1989-91. In terms of the Unilateral trade reforms implemented in the LAC region strength of the reforms, as indicated by low average tar- since the mid-1980s amounted to significant trade liberal- iffs and minimal use of quantitative restrictions, Bolivia, ization. The countries analyzed in this section (Argentina, Chile, and Colombia lead the group. Jamaica, Trinidad Bolivia, Brazil, Chile, Colombia, Jamaica, Mexico, Peru, and Tobago, and Venezuela remained either with more Trinidad and Tobago, Uruguay, and Venezuela) have liber- quantitative restrictions (QRs) in place or with higher alized their trade regimes to a greater extent than at any tariffs when compared to the average for the region by time in the post-World War II period. This trend has 1994. Argentina, Brazil, Mexico, and Uruguay fall into clearly helped accelerate the region's is rate of integration the middle group with respect to the extent of trade with the rest of the world. In fact, during 1991-93 the liberalization. 95 DEVELOPMENT IN LATIN AMERICA AND THIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Arguably, the most important part of the trade liberal- trade liberalization originally planned for 1994. Some QRs ization packages was the reduction of QRs, allowing prices on agricultural goods remained, but overall, Colombia was to allocate resources in a more efficient manner (Dean, able to liberalize its trade regime very rapidly. Jamaica Desai, and Riedel 1994). On the import side, QRs were began liberalization in 1988 but the real effort was delayed replaced by tariffs, and tariff levels as well as their disper- until early 1991. It reduced QRs on few agricultural items sions were reduced. On the export side, various specific and tariffs to the 0-45 percent range adopted by Caribbean export promotion measures (for example, subsidies) were Community and Common Market (CARICOM). The max- reduced and streamlined. As mentioned above, this gener- imum common external tariff was reduced to 20 percent in al package of reforms was adopted by the countries at dif- late 1992. Peru undertook strong trade liberalization dur- ferent times and in different intensities. ing 1990-92 and reduced tariffs to a maximum of 35 per- Bolivia, Chile, and Mexico, as the earliest reformers, had cent by 1993. Quantitative restrictions, subsidies and price a longer time period for the resource shifts to take place and controls were eliminated as a part of that process. Peru for new investment to be guided by relative prices that today stands in marked contrast to its highly protected reflected world prices more closely. Chile refined its already trade regime that existed in the mid-late 1980s. Uruguay liberalized trade regime during the 1989-91 period by resumed trade liberalization after having abandoned a lib- adopting a uniform 11 percent tariff. It continued with the eralized trade regime in the early 1980s due to macroeco- protection of the motor car industry due to a long-term nomic imbalances. During the 1987-92 period it reduced agreement with the industry that had been in existence the use of QRs to nearly zero, significantly curtailed the use since the 1970s. Chile also has few agricultural items sub- of reference prices, and brought the average tariff down to ject to variable levies. Bolivia began a strong stabilization 15 percent. effort in 1985, which has helped implement its trade Trinidad and Tobago and Venezuela liberalized their reforms. It has a very liberal trade regime with only two tar- trade regimes even more recently than the other countries iff rates of 5 percent and 10 percent, respectively, and no discussed here. Both countries had experienced strong significant QRs. Mexico also undertook an early reform dur- terms of trade improvements as oil exporters. This, com- ing the 1987-89 period but at a slower pace than Chile and bined with large increases in domestic expenditures, led to Bolivia. The pace of reforms was accelerated in preparation an appreciation of their exchange rates. In the case of for NAFTA, but some sectors such as the petroleum sector Trinidad and Tobago high tariffs combined with extensive continued to be protected. use of QRs, particularly in agriculture, had led to a pro- Argentina, Brazil, Colombia, Jamaica, Peru, and tected trade regime. Starting in 1992, and with the float- Uruguay began their trade reforms later than the countries ing of the Trinidad and Tobago dollar, it was able to reduce discussed above. In Argentina the government of President tariffs, though it has remained a more protected country Menem began a strong liberalization program simplifying compared to other countries discussed here, both in terms a highly protective and complex trade regime to one with of reliance on QRs and with respect to average tariff level. few tariff levels. It removed all QRs except those on a few Venezuela, on the other hand, began its trade liberalization items including motor vehicles. In 1991 Argentina in 1989 and undertook strong reforms in 1990, when some reduced and streamlined all of its regional promotion poli- 98 percent of its QRs were eliminated. However, the coun- cies. Brazil's trade liberalization was concentrated during try reintroduced exchange controls in 1994 as it found the 1990-93 period, when almost all of its QRs were itself in the throes of a foreign exchange crisis related to the removed. It reduced its tariff categories significantly and its domestic banking sector problems. maximum tariff was brought down from 85 to 35 percent. Table 1 provides some indicators of the process of trade Colombia had to abandon an earlier trade liberalization in reform in the region. These reforms have some unique fea- 1984 because of adverse terms of trade and domestic tures. First, they represent a departure from past, when eco- macroeconomic disequilibrium. In 1989, under the gov- nomic crisis led to trade policy tightening rather than trade ernment of President Gaviria, efforts were made to acceler- liberalization.3 Second, they were implemented across the ate the rate of reforms to achieve in 1991 the measure of board rather than confined to particular activities. There 96 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY was little effort to provide made-to-measure protection, as the issue of hemispheric integration from a North-South in the past episodes that invariably led to the return to pro- perspective. At the same time, the implementation of tection. Third, they were accompanied by other policy mea- Mercosur (the Southern Cone Common Market) rekindled sures, including strong stabilization efforts, particularly fis- interest in regionalism from a South-South perspective. cal consolidation, deregulation, privatization of large state- More recently, the Summit of the Americas-the meeting owned activities, and financial and labor market reforms. of thirty-four Western Hemisphere governments held in Fourth, countries were less reluctant to devalue their cur- Miami in December 1994-issued a declaration calling for rencies at the time of trade liberalization than in the past. the negotiation of a Free Trade Area of the Americas There was a significant change in the attitudes to the use of (FTAA) by 2005. the exchange rate as an expenditure switching instrument. The renewed interest in regionalism in LAC is captured Finally, there were external factors that provided a support- in figure 3, which summarizes the number of RIAs. The ive backdrop to the unilateral reforms, including the nego- 1990s have witnessed a resurgence in interest in regional- tiations under the Uruguay Round, support for trade liber- ism, with Europe and the Americas characterized by the alization from international financial institutions, and most intense introduction of new preferential trade arrange- opportunities for further liberalization at the regional level ments. In most cases trade within regional groups has created by the new regional agreements. increased substantially over the 1985-94 period (figure 4). The majority of the countries in the Americas belong Regional integration arrangements now to one or more of the following regional integration In a parallel development to the unilateral trade reforms, arrangements: NAFTA, the Andean Pact, the Caribbean several new regional integration arrangements (RIAs) were Community and Common Market (CARICOM), the launched or revived throughout the hemisphere. The Central American Common Market (CACM), Mercosur, announcement of the Enterprise for the Americas Initiative and the Latin American Integration Association (LAIA).4 in June 1990 and the negotiation of the North American There is also a wide network of bilateral arrangements in Free Trade Agreement (NAFTA) brought new attention to the region (for example, Chile-Mexico and Colombia- Venezuela). NAFTA and Mercosur, however, are by far the FIGURE 3 most significant new RIAs on the continent, both in terms The proliferation of regional integration arrangements, 1948-94 of trade flows and markets involved. There is extensive literature on the reasons behind this Number of RlAs renewed interest in regionalism.5 The roots of the "new 60 * Rest of the eoeld 50 Americrs * Eurape-relat U FIGURE 4 40 Growth in intraregional trade in selected LAC regional 30 arrangements Shaee of intra-regional expoets 20 18 16 10 E4 12 ME .. 10 0 8 1948-59 1960-64 1965-69 1970-74 1975-79 1980-84 1985-89 1990-94 6 Period 4 Note: Reflects number of RIAs signed (most of them notified under Article XXIV or the 2 Enabling Clause to the GATT). Only agreements involving reciprocal concessions were considered. Figures include agreements that are not currently in force. Most RlAs in the 0 Americas involve LAC countries. The only exceptions are the U.S.-Israel free trade Mercosur Andean CACM CARICO LAI agreement (which was classified as an American RIA given the relative weight of the 1985 5 1992 U 1994 U.S. economy) and the Canada-U.S. free trade agreement. Soarors: WTO 1995; appendix. Source: United Nations, COMTRADE Data Bank, IDB 1995. 97 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO OE JANEIRO CONFERENCE, 1995 regionalism" can be traced back to the past decade. First, might occur at the level of specific tariff lines.9 the widening and deepening of the European Community The new RIAs identified in the appendix have not (now the European Union, EU) and the decision of the explicitly raised their barriers against nonmembers and United States to explore the regional route (beginning could therefore be characterized as open trading blocs. with the Israel-U.S. free trade agreement in 1985) had an Nevertheless, RIAs create a bias in favor of discrimination important demonstration effect (as had been with the that needs to be closely monitored. The difficulties Treaty of Rome in the previous outbreak of regional ini- involved in implementing the common external tariff tiatives in the 1960s). Second, fears about the fate of the (CET) with respect to some products in the cases of the multilateral trade system (generated by protracted negoti- Andean Pact, the Central American Common Market, ations in the Uruguay Round) and the popular perception CARICOM, and Mercosur suggest that it is difficult to that the world economy was becoming increasingly use tariff harmonization as a mechanism to foster addi- regionalized also contributed to this process. Third, RIAs tional liberalization. Typically, these arrangements have began to be perceived as mechanisms to advance econom- dealt with sensitive products by adopting exception lists ic integration beyond conventional' liberalization of trade and longer timetables for convergence to the CET. The in goods by promoting "deep integration" (liberalization good news is that LAC countries seem to be complying of trade in services, the harmonization of regulatory informally with the disciplines of Article XXIV. The bad regimes, coordination of macroeconomic policies, and so news is that the "flexibility" in determining exception on). Fourth, some countries pursued RIAs with major lists qualifies the commitment to open regionalism. It is trading partners because they feared a future surge in pro- important to reduce the number of products in those lists tectionist practices (for example, the growing popularity to a minimum and to avoid tinkering with the tariffs of "fair trade" instruments such as antidumping actions). applied to these products. Fifth, RIAs have also been rationalized as instruments to The new RIAs often involve a subgroup of the mem- "lock in" economic reforms and foster the credibility of bers of a pre-existing RIA. Moreover, many RIAs are new trade regimes. being formed between members of different pre-existing RIAs have advanced trade liberalization beyond unilat- arrangements. As pointed out in Lustig and Primo Braga eral measures. In spite of this, the dangers posed by RIAs (1994), these overlapping agreements have prompted are well known.6 They can become exercises in managed reluctant trading partners in the original regional bloc to trade, not to mention their second-best nature as devices proceed more rapidly with the establishment of free trade for trade liberalization in the case of small economies. A within the original arrangement. This has been the case necessary but not sufficient condition for regional initia- in the Andean Pact with respect to Ecuador, for example. tives to be compatible with global free trade is that they be Costa Rica's impatience with the slow pace of the Central organized as open trading blocs. For a bloc to be character- American Common Market, in turn, drove it to seek a ized as open, trade and investment barriers against non- bilateral free trade agreement with Mexico. However, members must not be raised.7 this process of overlapping RIAs is far from ideal because The "Understanding of the Interpretation of Article it creates a morass of nonuniform bureaucratic proce- XXIV" negotiated in the Uruguay Round helped to clarify dures for enforcing commitments, not to mention con- the General Agreement on Tariffs and Trade (GATT) disci- flicting demands on member countries (as illustrated by plines with respect to regional arrangements.8 It provides, for Mexico's situation as a member of both LAIA and example, guidelines for evaluating the general incidence of NAFTA). duties and charges before and after the creation of a customs A negative by-product of the proliferation of RIAs is union, based on the comparison of weighted average tariff the growing importance of rules of origin for regional rates and customs duties. Hence, from a "legal" perspective, a trade in LAC. Rules of origin are the instrument used to customs union could be characterized as GATT-compatible as determine which goods and services in a free trade area long as the weighted average trade barrier against outsiders (FTA) or in a customs union are entitled to preferential did not increase with its formation, even though increases treatment. In customs unions, given the existence of a 98 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY common external barrier, rules of origin are equivalent to by a change in the negotiating strategy, reflecting the domestic content requirements, also being used to deter- impact of unilateral trade reforms. In other words, coun- mine quota eligibility when quantitative restrictions tries that were already implementing unilateral trade lib- apply. In FTAs, however, rules of origin impede trade eralization found it to their advantage to link these deflection schemes in which outsiders could use the part- reforms to multilateral negotiations as a way to foster ner in the FTA with the lowest trade barriers to trans- reciprocal offers. There was also growing appreciation in ship their products to members with more protected the region of the fact that the GATT system, which markets. They can, however, be used to export protec- evolved into the World Trade Organization (WTO) as a tion. In practice, this means that one partner can effec- result of the Uruguay Round, despite its shortcomings, tively impose its higher external trade barriers on anoth- provides the best alternative to restrain the unilateral er partner who has lower restrictions on an input used to actions of large economic powers. produce a good qualifying for duty-free treatment with- These developments translated into a growing partici- in the FTA.10 Moreover, they impose nontrivial econom- pation of LAC countries in the multilateral system; this ic costs in terms of required administrative procedures by evolution is summarized in table 2. Since 1986, fourteen governments and compliance efforts by firms.11 additional countries from the LAC region have acceded to In sum, regionalism has so far complemented efforts the GATT, and by 1995 there were working groups ana- in the region geared to promote outward orientation. In lyzing the accession of Ecuador and Panama to the WTO. some cases, RIAs were promoting freer trade in noncon- As this process is completed, the whole region will have ventional areas (for example, services liberalization under commitments at the multilateral level. NAFTA) and expanding the amount of trade flows that Table 3 summarizes the tariff offers made by a selected are not hampered by trade barriers (for example, 85 per- group of LAC countries. More remarkable than the extent cent of products trade among Mercosur countries has of liberalization generated by the negotiations (figures flowed freely since January 1, 1995). It is important, reported do not include unilateral tariff reductions), is the however, to recognize that RIAs increase the appeal of significant increase in tariff bindings offered by LAC coun- more subtle forms of protectionism under the guise of tries.12 This has an important effect in signaling more sta- managed trade practices (for example, the adoption of bility in terms of market access and by making future restrictive rules of origin). increases beyond the bound ceilings more difficult. By participating more actively in the negotiations, LAC Multilateral liberalization countries obtained significant tariff reductions in a series of The participation of LAC countries in the Uruguay Round products that are highly relevant to them (table 4). Even of multilateral trade negotiations further illustrates the more impressive is the impact of the negotiations in elim- new attitudes toward trade liberalization in the region. In inating nontariff barriers to LAC exports to OECD markets previous rounds, LAC participation was limited because as illustrated by figure 5. These results tend to enhance the many countries were not GATT-contracting parties and effectiveness of outward-oriented development strategies had mixed feelings about the neoliberal trade regime. One over time. of the main characteristics of the role played by LAC coun- It is important, however, to recognize that some of these tries, along with other developing countries, in previous benefits will take a long time to materialize. In textiles and GATT negotiations was their emphasis on the need for spe- clothing, for example, existing quantitative restraints will cial and differential treatment for developing countries, be gradually removed over a ten-year transition period. thus challenging the multilateral trade system's principle Moreover, the process of liberalization is backloaded, as of nondiscrimination. nearly half of the products will only be free of quantitative As the Uruguay Round evolved, however, LAC coun- restrictions by the tenth year. In agriculture, the tariffica- tries adopted a much more proactive role in the negotia- tion of nontariff measures is expected to increase the trans- tions and engaged in meaningful exchanges of offers with parency of trade in agricultural products. However, in other contracting parties. This in part can be explained many cases the level of bound tariffs produced in this 99 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 TABLE 2 TABLE 3 The region's membership in the GAlT/WTO Tariff concessions agreed to in the Uruguay Round multilateral trade system, 1948-94 IMPORT- NEGOTIATION ROUNDS PERCENTAGE OF IMPORTS WEIGHTED AVERAGE lTHAT WERE GATT BOUND MFN TARIFF RATES' PERIOD AND NUMBER LAC MEMBERSHIP IN THE URUGUAY ROUND' NAME OF PARTICIPANTS (YEAR OF ACCESSION) TARIFF POST-UR COUNTRY PRE-UR POST-UR REDUCTIONS' BOUND RATES' Geneva Round 1947; 23 countries Brazil (1948) Cuba(1948) Argentina 17.1 100 4.2 31.0 Annecy Round 1949; 29 countries Chile (1949) Brazil 16.0 100 1.1 29.0 Torquay Round 1950-51; 32 countries Dominican Republic (1950) Chile 100.0 100 0.0 25.0 Geneva Round 1955-56; 33 countries Haiti (1950) Colombia 4.4 100 3.6 39.7 Dillon Round 1960-61; 39 countries Nicaragua (1950) Jamaica 0.0 100 12.5 56.3 Kennedy Round 1963-67; 74 countries Peru (1951) Mexico 100.0 100 0.9 34.1 Tokyo Round 1973-79; 99 countries Uruguay (1953) Peru 17.1 100 12.8 33.7 Uruguay Round 1986-94; 125 countries Trinidad and Tobago (1962) Venezuela e 100 2.6 31.6 Jamaica (1963) a. Merchandise imports during 1986-91 were used as weights. Guyana (1966) b. Imports from the world (excluding manufactruring imports from partners in free Argentina (1967) trade areas) were used as weights. Barbados (1967) c. Weighted average tariff reduction measured by dT/(1 +T). Averages cover only those tariff lines ola which thsere were tariff reductions in tlhe applied toriff. Suriname (1978) d. Averages cover only those tariff lines for which rates are bound. Colombia (1981) e. Venezuela became a contracting-parr in 1990. Belize (1983) Source: Finger, Ingco, and Reincke forthcoming. Mexico (1986) Antigua and Barbuda (1987) Bolivia (1990) duction of these themes in the negotiating agenda, but Costa Rica (1990) gradually became active participants in the negotiations. Venezuela (1990) El Salvador (1991) The results of the round in these areas offer significant flex- Guatemala (1991) ibility for developing countries and as a consequence will Dominica (1993) not impose major adjustment costs in the short run.13 Paraguay (1993) St. Lucia (1993) Moreover, in the case of services-an area in which the St. Vincent potential benefits of trade liberalization are significant- and Grenadines (1993) Grenada (1994) the amount of MFN liberalization accomplished was quite Honduras (1994) limited given the many qualifications and exemptions St. Kitts and Nevis (1994) claimed by the participants. Most offers entail a standstill Source; GArT. promise (that is, a commitment not to introduce new dis- process is prohibitive (in the 100 to 300 percent range), tortions) and as shown in table 5, developing countries typ- implying that little effective liberalization will occur in the ically cover a smaller subset of service activities in their short run. In general, the LAC region is an efficient agri- offers than developed economies. The offers of the LAC cultural producer and the results of the Uruguay Round region, in particular, are very close to the average for devel- have been a disappointment for the region. However, on a oping countries, and suggest that there is substantial scope more positive note, it can be argued that the Uruguay for further progress in this area. Round has laid the basis for future liberalization of agricultural trade in the same way that previous rounds of Some effects of trade liberalization negotiations promoted freer trade in manufactured Trade liberalization has helped to integrate these products. economies in the world economy in an unprecedented way. Services, trade-related intellectual property rights The average rate of integration indicated in figure 1 masks (TRIPS), and trade-related investment measures (TRIMs) different performances among the countries of the region. were the so-called "new issues" negotiated in the Uruguay The effects of the reforms can be grasped by the changes in Round. Most LAC countries initially opposed the intro- trade ratios.14 The indicator developed in table 6 takes the 100 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY year following initiation of the liberalization episode and eralization for all countries (table 6). Part of the early takes the average of the changes in this ratio through 1994 export growth was associated with parallel stabilization to measure changes in trade orientation. Trade ratios efforts that reduced domestic demand. In the case of change with changes in world demand, prices of the Argentina, the figures for 1994 also indicate strong export exports and imports, and domestic supply elasticities for growth, part of which is associated with the improved exportables and importables, and exchange rates. Indicators resource allocation that has helped to raise productivity and of openness for all the countries, however, show increases. reduce costs. Moreover, there were discernible trends in Because different countries introduced their trade reforms increasing investments in the tradable sectors in most at different times, using 1993 or 1994 as the end year tends countries. Rapid export growth was also experienced by to underestimate the increase in openness of the recent Bolivia, Chile, Colombia, and Trinidad and Tobago and reformers. The reason is that the dynamic adjustment to more recently by Uruguay. One important feature of the significant policy changes takes time. For example, while increase in exports is the change in their composition. Thus Bolivia has had nine years to respond to its policy shifts of Chile became a strong agricultural exporter, while the non- the mid-1980s, Argentina liberalized very slowly in 1989 traditional exports of Brazil, Colombia, and Jamaica and significantly during 1990-91. Thus, in contrast to responded to new incentives. Bolivia, Argentina has had fewer years to adjust to its open On the import side, a somewhat regular pattern was trade regime. repeated. Imports surged at the time of the liberalization There were significant increases in exports following lib- but fell to a slower rate of growth after a few years. In some TABLE 4 Reductions in bound tariffs on critical export products for the region (percent) DEVELOPED NORTH WESTERN COUNTRIES WITH A HIGH EXPORT INTEREST PRODUCT GROUP ECONOMIES AMERICA EUROPE IN THE PRODUCT GROUP Textiles and clothing 22 15 20 Belize, Costa Rica, Dominican Republic, El Salvador, Grenada, Guatemala, Haiti, Honduras, Jamaica, St., Lucia, St. Kitts and Nevis, Uruguay Metals 59 63 35 Argentina, Bolivia, Brazil, Chile, Cuba, Dominica, Guyana, Peru Trinidad and Tobago, Venezuela Mineral products, precious metals and stones 52 31 22 Bolivia, Colombia, Nicaragua, Uruguay Fish and fish products 26 19 18 Belize, Cuba, Ecuador, Honduras Other agricultural products 48 49 44 Nicaragua, Paraguay, Peru, Uruguay Chemicals and photographic supplies 42 42 35 Bahamas, Jamaica, Suriname, Trinidad and Tobago Oilseeds, fats and oils 40 43 34 Argentina, Bolivia, Brazil, Paraguay Fruits and vegetables 36 38 32 Antigua and Barbuda, Chile, Costa Rica, Dominica, Ecuador, Grenada, Honduras, Jamaica, St. Lucia, St. Vincent and the Grenadines, Suriname Coffee, tea, cocoa, sugar, and so on 34 35 29 Barbados, Belize, Brazil, Colombia, Costa Rica, Cuba, Dominican Republic, Ecuador, El Salvador, Guatemala, Guyana, Grenada, Haiti, Honduras, Jamaica, Nicaragua, Peru, St. Kitts and Nevis, Trinidad and Tobago Note: For industrial products (GATT definition) the tariff reducrion is trade-weighted using as weights the imports of the product group from all sources into the region in question. For agricultural products the reductions refer to simple averages. a. Only product groups critical to four or more countries are reported. A product group is defined as being crirical if it accounts for 20 percent or more of foreign exchange earnings from exports of industrial products (excluding petroleum-related products) or agricultural products, respectively; and accounts for 5 percent or more of total merchandise exporcs (excluding petroleum). Trade data for 1988 were used as weights in the calculations. Soarce: Blackhurst, Enders, and Francois 1995. 101 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 FIGURE 5 Impact of the Uruguay Round on nontariff barriers facing Latin America and the Caribbean in OECD markets Nontariff barrier coverage (percent) 90 so Pre-Round 70 60 50 40 30 20 I0 10 ,A^ ,>e-N P~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ost-Round u a ,a a5 a a Ia a a | .- > z~~~~~~~~~ Note: The following measures were included in the computation of the nontariff barrier coverage ratio: tariff quoras; increased duries, safeguard duties, retaliatory duties, and customs surcharges; variable levies atid flexible import fees; non-automatic licensing and discretionary licensing; quotas and prohibitions; voluntary export restraints, Multifiber Arrangement qtioras and other restraints including textile restraint agreenients, and orderly marketing arrangements; other quantitative restrictiotis; other restrictions imposed under the Multifiber Arrangement; minimum, reference, or other import price controls; voluntary export price restrainrs; state monopoly of imports; and Ir;cal concenr regulations. Soiirce: World Bank-UNCTAD SMART database. cases import growth picked up again due to the apprecia- Another important feature of trade during this period tion of exchange rates following capital inflows into the was the increase in intraregional trade as a result of the region. Moreover, Argentina, Brazil, Colombia, and Mexico regional trade agreements. Trade between Colombia and experienced strong import growth as income recovered fol- Venezuela increased rapidly (by 24 percent a year during lowing stabilization. 1985-94), as did trade as between Argentina and Brazil and between Chile and Argentina, which had concluded bilater- TABLa 5 al trade agreements. This is to be expected since the coun- Commitments on market access for services tries in the sample were affected by actions taken either on a bilateral basis or in the context of a broader RIA. In this SERVICES COMMITMENTS NUMBER AS SHARE OF context, they have been reducing barriers to trade at a faster OF COMMITMENTS MAXIMIJM POSSIBLE pace than with the nonmember countries. BONR GRtJ INSRIEATVTE PRET COUNTR GROIJ IN SEVICE CTIVITES (PECENT)In sum, unilateral liberalization was the most potent of High-income countries 2,423 54 all paths taken to trade liberalization, a fact confirmed by sevelarge; vauntrialeleies and2flexibleimport1fers;59 n-a c l g asimilar experiences in other parts of the world. In fact, Europe and CentraliAsia 2,362 54 without unilateral trade liberalization taking place, both Arrange6meninimum, rfrence, 2o6 regional and multilateral efforts coutld not have borne fruit. North American W 193 60 Middle East and North Aprica 178 16 The dangers of backsliding Sub-Saharan Africa 3 15 9 TaBLE alnada and theUnitedStates.The countries in the sample have by and larges adhered to Soiirce: Compiled by tlle authors based on GAT-a 1994b. their unilateral trade liberalizatiof programs. In addition, 1 02 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY in many countries intraregional trade has been liberalized al commitments now constrain individual actions by LAC as part of the agreements reached. Against this progress, a countries in a much more effective way than in the past. few retrogressions have arisen from macroeconomic devel- Brazil, for example, will have to comply with its tariff opments, including the reappearance of fiscal deficits. In bindings in the WTO over time and had its Mercosur part- some countries these macroeconomic problems have been ners to be notified of recent tariff increases using the avail- essentially of their own making. In others the problems able "list of exceptions." In the same vein, Mexico was surfaced only after Mexico's crisis produced a blow to the recently precluded from using trade restrictions in a more confidence of investors. The contagion effect that led to comprehensive way in response to the peso crisis because of problems in the financial sectors also resulted in fiscal its NAFTA commitments. problems. This is not to deny that some of recent trade measures Trade and fiscal policies may have taken place in response to demands for protection. Time and again, experience has shown that lack of macro- However, based on what we know from the LAC region, the economic stability, meaning, most often, fiscal deficits, has bulk of the recent trade measures that have implied reversals been accompanied by reversals of trade liberalization poli- have been taken very hesitantly and only as part of policy cies. Nevertheless, reversals were not a necessary outcome measures to strengthen the fiscal positions, including tax of the macroeconomic situation. In the past, when serious revenues. These fiscal adjustments have been a crucial signal reversals occurred in Latin America, important fiscal dise- to investors that fiscal discipline will continue to be a major quilibrium and weakened political support for structural goal in a region that not long ago suffered from high infla- reform policies were present (Nogues and Gulati 1994). tion. Furthermore, in some countries increased taxes, includ- There is ample evidence that major reversals in trade ing tariffs, have been imposed on a temporary basis. liberalization have been associated with serious macroeco- The retrogressions so far have been limited and most nomic disequilibriums in the form of high and growing governments in the LAC region remain committed to lib- fiscal deficits. Therefore, it must be clear to governments eral and open trade regimes. Nevertheless, these recent that open trade policies should be supported by prudent episodes have left a clear message, namely, the need to sus- fiscal policies. In recent years the experience of many suc- tain stable macroeconomic conditions. Moreover, decisions cessful countries, like Chile, suggests that strong fiscal dis- for temporary relief for activities that may genuinely need cipline and a conservative monetary policy must be put in some adjustment assistance require transparent processes. place to maintain open trade policy. For a number of rea- It is also important to note that multilateral and region- sons, fiscal surpluses may be warranted. First, a surplus TABLE 6 Changes in trade orientation (percent) OPENNESS INDEX TRADE PLOWS TRADE REFORM COUNTRY PERIOD PERIOD CHANGE PERIOD EXPORT GROWTH IMPORT GROWTH Argentina 1989-91 1988-94 8.01 1990-94 5.63 31.62 Bolivia 1985-88 1984-93 3.56 1986-93 8.46 4.76 Brazil 1990-93 1989-94 5.19 1991-94 6.99 9.97 Chile 1988-91 1987-94 4.17 1989-94 10.42 12.75 Colombia 1989-91 1988-94 5.93 1990-94 10.87 18.29 Jamaica 1988-91 1987-93 1.61 1989-93 3.54 4.53 Mexico 1987-89 1986-94 6.16 1988-94 4.10 19.06 Peru 1990-92 1989-93 6.98 1991-93 4.21 8.23 Trinidad and Tobago 1990-92 1989-94 12.21 1991-94 12.31 9.36 Uruguay 1987-92 1986-94 6.14 1988-94 7.93 12.83 Venezuela 1989-91 1988-94 1.69 1990-93 7.15 6.26 Note: The change in the openness index is measured as the average of the changes in the ratio between the year prior to the initiation of the liberalization episode and 1994. The change in export and imporc growth is measured as rhe average of the changes between the year following the initiation of the liberalization episode and 1994. Source; World Bank data. 103 DEVELOPMEN'T' IN LATIN AMERICA AND TI4E CARIBBEAN: R10 DE JANEIRO C()NFERENCE, 1995 puts the country in a better position to cope with domes- Exchange rate regimes and capital flows tic or external shocks, such as an unforeseen reduction in Theoretically, there is no single best exchange rate regime. tax revenues or deterioration in the terms of trade. Second, The fundamental issue is not the nature of an exchange rate research shows that a fiscal surplus adds to the savings rate regime, but the fiscal and monetary policies that accompa- (Corbo and Schmidt-Hebbel 1991), and in Latin America ny it. Latin American countries that have succeeded with where savings are relatively low, this is an important con- their reform programs have different types of exchange rate sideration. Third, a surplus reduces the need for inordinate regimes even though all of them adopted flexible exchange capital inflows and therefore reduces the problems associ- rates or devalued their currencies at the time of trade liber- ated with currency overvaluation. Finally, a fiscal surplus alization. Some countries, like Peru, have free floating and a conservative monetary policy may improve the cred- rates. Others, like Chile, have managed floats. Still others, ibility of the reform program. Of course, a fiscal surplus is like Argentina, have a fixed exchange rate and a monetary not always necessary if the fiscal and monetary authorities policy responding to currency board arrangements. All of have sufficient credibility and if the private sector savings- these countries have succeeded in maintaining their differ- investment balance responds to their policies. ent exchange rate regimes while simultaneously reducing Signs of a weakening fiscal position or accelerated mon- inflation-in some cases considerably. The reason is that etary growth may signal the resurgence of future inflation they have all followed sound fiscal and monetary policies. and trigger a consumption boom. This occurred in Mexico In contrast, the countries that followed lax fiscal and mon- toward the end of 1994 when a lax monetary policy and a etary policies, such as Mexico during 1994, have faced decline in the real interest rate led to a consumption boom important problems that have required major additional that compromised the sustainability of the current account adjustment policies and the abandonment of the previous deficit. In contrast, other countries that suffered from exchange rate policy. crises, such as Argentina, continued to implement conserv- There is also the issue that Latin America started its ative fiscal and monetary policies (Barro 1995). reform program from a situation characterized by low Many countries that faced fiscal deficits recently have domestic savings. The evidence shows very clearly that far- raised tariffs. However, it is not at all clear that fiscal adjust- reaching liberalization of trade and investment and ambi- ment in the form of higher tariff rates will help these coun- tious privatization programs have opened more investment tries meet revenue targets. Other things being equal, the opportunities than domestic savings can finance. In order increase or reduction in tax receipts resulting from higher tar- to close the gap, different countries have resorted to foreign iffs depends on a number of issues, including the starting savings, which led to increased current account deficits. position. It is of interest that in Chile lower and more uni- Faced with an important savings gap, individual countries form tariff policies have resulted in a better revenue perfor- have the choice of limiting capital inflows in order to mance than in many other countries in the region (Nogues reduce currency overvaluation or letting the market deter- and Gulati 1994; Pritchett and Sethi 1994; Rajapatirana mine the outcome. Again, in our view, the issue is not so 1994). much that of choosing between controlling or not control- The crisis triggered by the devaluation of the Mexican ling capital inflows, but of consistently choosing policies peso has made evident the fragility of the fiscal situation of that avoid fiscal and monetary problems and induce fast many Latin American countries. Unlike in the past, most growth of overall factor productivity. countries in the region are responding well by announcing Chile has for some time been cautious and has chosen to and implementing policies that will strengthen their fiscal limit capital inflows. Because of this, and also because of positions. While some trade policy measures have been increasing domestic savings (which in 1994 reached 25 implemented in order to reinforce other fiscal measures, percent), this country has had declining current account these have been relatively marginal and generally tempo- deficits. The important lesson from Chile's experience is the rary. The dismantling of these measures depends on extraordinary increase in domestic savings (from an average whether countries in the region will be able to shift to more of 13 percent of GDP in 1984 to 28 percent in 1994), not sustainable and solid fiscal positions. the importance of limiting capital inflows. After prudent 104 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY fiscal and monetary policies, strengthening the financial year (Cavallo and Mondino, 1995). sector and creating a private pension system are some of the While the type of exchange rate regimes in place does fundamental policies that explain this performance. These not by itself determine the trade or macroeconomic out- policies are being implemented by many countries in the come arising from external shocks (such as changes in the region, and therefore, we expect that over time the region terms of trade and capital flows), fixed exchange rate will improve its savings performance and will be less vul- regimes put enormous responsibility on fiscal authorities to nerable to changes in capital flows and fluctuating real maintain macroeconomic equilibrium and the competitive- exchange rates. ness of exports. In contrast to Chile, Argentina deepened its reform pro- gram in early 1991 and moved to a competitive market Trade liberalization and unemployment economy quickly to provide the country with the best Another factor that would threaten open trade is the polit- chance of shifting to a sustainable competitive market ical fallout of rising open unemployment. Increased unem- economy. Decades of inflationary policies had destroyed ployment usually weakens the support for stabilization and investment opportunities and led to economic retrogres- trade reform programs. These conditions also increase the sion, ending with the hyperinflation of 1989. Accelerated demand from different interest groups for relief measures growth of investment was considered fundamental in order and therefore tend to increase the political efforts required to increase the overall productivity of the economy. Several from governments in order to sustain the economic trans- policies, including complete liberalization of capital flows, formation policies. The government can respond to these were introduced to achieve this outcome. Because of this, pressures in a number of different ways, some of which may Argentina relied more on foreign savings during the 1990s partially reverse the trade liberalization policy. and, as has been the case in Chile, this strategy led to an In Latin America trade liberalization policies have been increase in the domestic savings rate. just one component of very ambitious reform programs. The value of the currency relates this to trade and export Most often these policies have also been accompanied by performance. If a country chooses to limit capital inflows to major stabilization, deregulation, and privatization poli- avoid overvaluation, it runs the risk of limiting investment cies. In many cases government employment has also been and delaying productivity improvements. In contrast, a considerably trimmed down. Depending on the initial con- country may choose a policy of free capital movements and ditions and the speed of the reforms, these policies may avoid the negative consequences of currency overvaluation have a strong impact in reducing the short-run demand for by maximizing investment and accelerating improvements labor and increasing the unemployment rate. in overall productivity. This is the strategy that has been In some countries, including Argentina and Chile, the followed by Argentina. In early 1991 Argentina fixed the open unemployment rates reached high levels at some point exchange rate vis-a-vis the dollar and clearly, by any con- following the economic reforms. In Argentina, for example, ventional measure, the currency of Argentina has appreci- the open unemployment rate increased steadily from 6 per- ated. Nevertheless, this situation has not stopped the coun- cent in 1990 to 12.2 percent in 1994. In Chile the open try from experiencing improved export performance. For unemployment rate reached a high of 19.6 percent in 1982, example, during 1994 total exports increased by 20 per- but it has declined significantly since then, and in 1994 it cent, and during the first four months of 1995 they have stood at 5.9 percent. Obviously, it would be wrong to con- increased by 47 percent. In fact, after months of experienc- clude that the increasing unemployment problems in these ing negative trade balances, in April 1995 the country countries were the consequence of the trade liberalization experienced a trade surplus. This experience shows once measures. First, when there are many policies being imple- again that policy stability and consistency may more than mented simultaneously, it is risky to attribute unemploy- compensate for apparent currency overvaluation induced by ment to different parts of the program. Second, there have large capital inflows. Obviously, the key to understanding also been labor supply responses. For example, in some this has been a high rate of overall productivity growth, countries, including Argentina, the reform program has which during the last four years has been above 5 percent a induced an increase in the labor force participation rates of 105 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFFRENCE, 1995 women and increased immigration flows from poorer neigh- declined, and in 1994 stood at 8.9 percent. boring countries. Nevertheless, we think it is fair to assume In summary, the experience surveyed above shows that that in the short run, ambitious trade liberalization pro- accelerated and ambitious reform programs have some- grams may have exacerbated the unemployment problems. times resulted in increasing unemployment. High unem- What are appropriate ways of dealing with this prob- ployment rates have also been observed in countries where lem? There are at least two different issues. First, govern- the labor market remained heavily regulated. As this sec- ments have to make sure that the labor market is work- tion indicates, reformers should, at an early stage, invest ing properly, that is, that wages respond efficiently to part of their political capital in passing the legislation that shifts in the demand and supply for labor. Second, there is necessary to improve the functioning of the labor market. may be some employment problems that persist even if Waiting too long increases the social costs of the transition there is a well functioning labor market. In these cases and may result in serious political tensions that could jeop- governments could help with temporary relief measures. ardize the trade liberalization goals. Although reversals of However, care must be taken not to let this inhibit past liberalization attempts have been partially influenced improved labor allocation.15 by inappropriate labor market policies, we do not know of Increasing unemployment may be not so much the out- any recent liberalization attempt where unemployment come of sudden and ambitious policy changes or problems of problems have led to reversals. This is a test of the political information and skill mismatch; it may be due to policy dis- support for recent reform programs. tortions in labor markets. The case of Argentina is illustra- tive. Clearly, the major economic reforms implemented in Institutional arrangements in trade policymaking recent years have been accompanied by a significant increase In many of the countries analyzed in this paper, institu- in the unemployment rate. In our view, increases in unem- tional reform was not introduced at the same time as trade ployment should be linked to the fact that decades of eco- liberalization measures were implemented. Reasons for this nomic policies based on corporativist-populist principles had are: 1) because trade liberalizations were undertaken at rendered, at the eve of the reform program, onerous labor times of crises, there was little opportunity to simultane- market regulations. These included anti-employment acci- ously reform trade institutions; 2) the need to make the dents legislation, collective bargaining set at the level of the new trade regime credible adds to the complexity of insti- industry rather than the enterprise, and high and distorted tutional reform; 3) at the time of liberalization, trade poli- taxes on wages that are used to finance social security and cy had been ad hoc and little attention was paid to a sys- inefficient public health programs. tematic approach to institutional issues; and 4) GATT con- In this regard, the case of Peru is also of interest. Since ventions for anrtidumping, countervailing, and the provi- the government of Velasco Alvarado in the early 1960s and sion of safeguards were planned to be adopted at a later late 1970s, labor security legislation in Peru was closely date.'6 enforced by the Ministry of Labor. This legislation reduced In Argentina almost all trade-related functions were pre- drastically the creation of productive employment oppor- viously carried out by the Ministry of the Economy. The tunities in the formal sector and generated serious micro- responsibilities for external trade negotiations were shared economic adjustment problems. These problems became with the Foreign Ministry (GATT 1992). However, in 1993 evident during the liberalization attempt of 1980-82 and Argentina established a National Trade Commission contributed to the failure of this attempt (Nogues 1991). responsible for advising the government on trade policy and The second trade liberalization program initiated in 1990 for considering the requests for protection on a continuous has been implemented under economic policies that were basis. Its mandate includes investigations regarding unfair far superior to those that prevailed in 1980-82. These poli- trade practices, analysis of safeguards and the extent of cies included prudent fiscal and monetary policies and a injury, and remedies to alleviate injury. These reforms have major deregulation of labor markets, including the dis- brought about dramatic change. Previous to the reforms, mantling of the labor security legislation. After peaking at any import price that was 15 percent below the domestic 9.9 percent in 1993, the open unemployment rate has price could be countered by a reference price that would 106 LATIN AMERICA ANI) THE CARIBBEAN IN THE WORLD ECONOMY equate that import price to the domestic market price. and export certificate schemes. These remained in place at In Bolivia the Ministry of Exports and Economic the time of the trade liberalization. The 1992 reforms Competitiveness is responsible for trade policy formulation established a new Foreign Trade Ministry that stipulated and implementation within a general policy framework set stringent criteria for safeguards, countervailing, and by the Ministry of Planning and Coordination. There is no antidumping. These are subject to public inquiry. Under formal procedure for discussion of trade policy measures the new Colombian law, actual injury must be demonstrat- with the private sector nor an independent authority to ed. It is not sufficient to discuss potential injury. The relief consider contingent protection. Despite this, Bolivia granted is restricted to one year. In this sense, Colombia's remains one of the most open economies on the continent. law is more stringent than GATT's guidelines regarding In Brazil, before the reforms of the 1990s, day-to-day contingent protection. trade policy was heavily influenced by CACEX, a depart- In Jamaica, too, trade reforms were taking place in a ment under the Banco da Brazil and the main instrument pre-existing institutional framework. There, trade policy for implementing protectionist policies. During the strong was largely the responsibility of the Ministry of Finance. liberalization phase that began in 1990, CACEX was Trade policies were closely coordinated with foreign closed. Trade policy formulation is now mainly the respon- exchange allocation. Jamaica has also changed its trade pol- sibility of the Foreign Trade Department (DECEX), a sub- icymaking apparatus. Although the decisions are still made sidiary body of the National Secretariat of the Economy. The at the ministerial level, other agencies are consulted when Ministry of Foreign Affairs deals with multilateral and antidumping and countervailing issues are to be contem- regional negotiations. The Customs Tariff Technical Office plated. A consumer representative was added to the and the Foreign Trade Technical Office administer trade antidumping committee. A one-year sunset clause was policy guidelines, dumping investigations, issuance of introduced for antidumping and an expiration date was import and export licenses, and the provision of certificates defined for countervailing duties. of origin. The Chamber of Foreign Trade is responsible for In Mexico the Ministry of Trade and Industrial coordination among different ministries. Promotion (Secretaria de Comercio y Fomento Industrial - Chile introduced one of the most wide-ranging trade SECOFI) is principally responsible for formulation and reforms of any country in the 1 970s. However, no attempts implementation of trade policies and negotiations with for- were made to change the institutional framework, despite eign trade. Its activities are closely coordinated with other the radical trade policy reforms. The main reform was led ministries involved in trade related activities, such as the by the Minister of Economy (Corbo 1991). Institutional Ministries of Finance and Public Credit, Agriculture and reform came in 1986 when Chile established a National Water Resources, and Energy, Mines, and Parastatal Commission on Trade. Its purpose was to register com- Industries. Mexico has been reforming its trade policy in plaints against unfair trade practices, undertake neutral the context of NAFTA negotiations. It has a central dispute inquiries, establish the veracity of the claims of injury, and settlement commission. Wider public interest has to be propose remedies in the instance of demonstrable injury. taken into account in dumping and subsidization inquiries The process is transparent. The request for an inquiry has but no formal mechanism exists. to be published within thirty days of the application and In Peru trade policymaking is decentralized and there- the commission has to give the results of its analysis with- fore highly dependent on cooperation among government in ninety days. The remedies proposed could be, and entities. In the formulation of policies, the Ministry of indeed have been, tariff surcharges to the extent of the Economy and Finance takes into account private sector pro- apparent foreign subsidy. posals expressed in formal coordination meetings or ad hoc Formulation and implementation of trade policy in working groups. However, no formal, periodic trade policy Colombia also followed complex processes. A powerful review is made by any independent body. It enacted trade implementation authority, the Instituto Colombiano de antidumping and countervailing legislation in 1991 and Comercio Exterior (INCOMEX), was in place as well as com- their implementation is overseen by the Dumping and plicated rules governing duty drawbacks, export credit, Subsidies Surveillance Commission. 107 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 The situation in Trinidad and Tobago was not very dif- Argentina, Brazil, Chile, Colombia, and Uruguay. In ferent from Jamaica. Decisions regarding changes in tariffs, Jamaica and Trinidad and Tobago the ministries of finance QRs, stamp duties, surcharges, exemptions, and the like continue to be involved with trade policy. The centraliza- were made by the Ministry of Finance under advice of the tion of trade policy decisions would serve national interests Industrial Development Corporation, which reported to better than a sectoral ministry. Third, there have been the Minister of Trade. Institutional arrangements for trade attempts to introduce measures to provide relief to activi- policy continued as in the time of the trade liberalization. ties that have been subject to increased competition from The main change in trade policy institutions was made imports. Many countries have used reference prices more later, with the creation of three corporations to administer than antidumping duties. Fourth, many countries have trade, industry, and export development concessions, made their institutions more consistent with GATT rules including contingent protection. The government is in the even though those rules themselves were evolving. Finally, process of defining an appropriate framework in which the there were some attempts to provide support for export new institutions can operate. interests through public interventions. Chile gives subsi- In Uruguay, too, trade liberalization was not accompa- dies to small and medium-size exporters under nied by any change in the trade policy institutions. Trade PROCHILE. Colombia reformed its plethora of promotion policy was made by the Minister of the Economy and schemes to be confined to a Bank for Foreign Trade and an Finance. The implementing authority was the Office of Export Promotion Trust. Trinidad and Tobago created an Planning and the Budget (Michelin 1994). Uruguay had a Export Development Corporation for this purpose. tariff commission in the past, but it had not been used much. In 1992 Uruguay established a commission to con- Remaining agenda for reforms sider and help resolve issues relating to the injury of Despite the strong reforms from the mid-1980s to the early domestic industry due to import surges. However, it was 1990s, there are many aspects of the trade regime that need the Minister of Finance who would decide on the type of to be addressed to take advantage of the new opportunities measure to be adopted should a situation of dumping, sub- for greater integration with the world market. These sidization, or similar unfair trade practice be directed at opportunities have arisen with the successful completion of domestic industry. the Uruguay Round and improved market access in areas Venezuela became a member of GATT in 1990, adopted that have been traditionally protected in industrial country the GATT antidumping and anti-subsidy codes in 1993, and markets. appointed an independent antidumping commission with no The different country groups discussed above share com- connections to industry or the sector ministries. The com- mon themes in regard to the unfinished agenda. Long-term mission was expected to balance consumers, the interests of macroeconomic stability is still not ensured. In many coun- producers, and the users of imported goods. An independent tries, including Argentina and Brazil, the fiscal discipline regulatory commission was also appointed to maintain achieved by the central government has not translated into domestic competitiveness. Like the other countries in the similar actions by provincial and state governments. This region, Venezuela centralized trade policy authority, making task is somewhat difficult due to the independent authori- it independent from sectoral and related industries. ty of state and provincial governments to increase The institutional reforms identified above lend them- expenditures. selves to a few generalizations. First, institutional changes Another source of pressure for rolling back liberalization that support the liberalized trade regimes typically fol- could arise from the adjustment difficulties in some sectors lowed, rather than led, policy reform. Perhaps this is an with an inherent lack of flexibility, such as agricu!ture, inevitable sequence given the effort required to bring about where mobility is limited and political power is strong. institutional changes, with its political economy ramifica- With cars, textiles, and clothing, urban labor can pressure tions. Second, there has been an attempt to focus on trade politicians to maintain protection. policy institutions by moving them from different agencies There is a need to subject some protected sectors to to a single agency or ministry. This is the experience of greater competition and make their participation in world ]08 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY trade more open. With the exception of Argentina, Brazil, due to increases in open unemployment, pose serious chal- and Uruguay, agriculture continues to be protected. Chile lenges to the policymakers of the region. In this sense trade uses a variable levy to protect some agricultural commodi- policy reform is not a single event but a continuous and ties. Producers who have to pay higher wages to offset high complex process subject to macroeconomic, political, eco- food prices are put in a less competitive position than other nomic, and institutional factors. countries outside the region. The continued protection of Unilateral trade reforms have quickly opened individual agriculture through import surcharges and reference prices, economies in the region, some faster than others. The early particularly in Jamaica and Trinidad and Tobago, imposes reformers, such as Bolivia, Chile, and Mexico, have an unnecessary cost to those economies. achieved a measure of openness that rivals that of other Other parts of the remaining agenda for trade reforms more successful trading regions. The recent reformers, such have to do with relatively high tariffs found in Brazil, as Argentina, Brazil, Colombia, Jamaica, Peru, and Trinidad and Tobago, and Venezuela. Tariffs in some coun- Uruguay, have also implemented comprehensive trade tries exceed the regional average tariff range of approxi- reforms. The more recent reformers, like Trinidad and mately 10-15 percent. Moreover, some countries, such as Tobago and Venezuela, have a larger agenda to complete, Venezuela, still rely on QRs to a significant extent. and in Venezuela some setbacks caused by domestic finan- The remaining agenda also includes the reform and reori- cial sector crisis have arisen. The agenda for unilateral pol- entation of institutions that make trade policy These insti- icy reforms is incomplete because many countries have rel- tutions have, by and large, remained in the earlier milieu atively high levels of nominal protection compared with that was designed to be inward-oriented. With the liberal- their counterparts in other parts of the world; some coun- ized policy regimes and the new rules for trade policy arising tries have wide dispersions in protection and fewer contin- from the Uruguay Round, trade policymaking institutions ue to rely on QRs as import protection devices. Moreover, have to be reformed. With the reduction in traditional forms the repercussions of the recent Mexican peso crisis have led of protection, new forms have arisen and the use of some countries to raise their tariffs. Venezuela, on the other antidumping and countervailing duties is increasing. These hand, had to introduce exchange controls in dealing with actions have been sanctioned within the existing institution- the domestic banking crisis. In the area of unilateral al structure of trade policy. Indeed, it is institutions that will reforms, a possible agenda would include reduction of the anchor the policy regimes and give permanence to the dispersion and average tariffs to more reasonable levels, reformed policy. It is important in this context to create such as in Chile. mechanisms to balance producer and consumer interests Regionalism has been an instrument for greater trade when considering contingent protection under unfair trade opening in LAC. The revival of pre-existing agreements, practices.17 such as the Andean Group, the CARICOM, and CACM, and the signing of new agreements, such as Mercosur and Conclusions and recommendations NAFTA, have given a greater impetus to the outward ori- Today, the LAC region is more open than in all its entation that has been pursued under unilateral reforms. post-World War II history and is integrating faster with There are also ambitious objectives leading to "deep inte- the world economy than any other region. Remarkable as gration" going beyond trade in goods to address services, this fact is relative to the trade orientation in the region a harmonization of regulatory environments, and macroeco- few years ago, there is no room for complacency. There are nomic coordination. Trade among the regional groups has factors at work that could cause backsliding. Moreover, increased faster than with the rest of the world, such as there is an incomplete agenda to be addressed unilaterally, within Mercosur and between Colombia and Venezuela. regionally, and multilaterally. Although there is no wide- However, there are concerns that while these arrangements spread intellectual retreat from freer trade in the region and have been so far open (in the sense of not explicitly dis- reforming governments have won by handsome majorities criminating against nonmembers), increasing integration in recent elections in both Argentina and Peru, macroeco- could lead to some degree of exclusivity. Some countries nomic instability and waning political support for reform, may not be willing to accept a wider set of rules than those 109 DEVELOPMENT IN LAI'IN AMERICA AND THIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 in a conventional trade agreement. This may impede Two factors are fundamental for maintaining macroeco- regional agreements from becoming building blocks for nomic stability. First, a strong fiscal discipline and conserv- closer integration with the world economy. The trend ative monetary policy is needed. Second, maintaining sta- toward regionalism also poses challenges with respect to bility is not so much related to the type of exchange rate the application of rules of origin, which in turn could regime in place as it is to fiscal and monetary policy. Fiscal become new trade barriers. And the coexistence of different surpluses help to increase credibility, contribute to raising agreements creates complex issues for meeting different private savings, and reduce the need for inordinate reliance requirements with respect to preferences and regulatory on external finance. When combined with sound judgments convergence. The antidote to these problems is to maintain regarding the manner in which a surplus is achieved, the relative open trade regimes, not to increase the cost to entry of new rates of return to public and private investments, and alternatives partners, and to follow Article XXIV of the GATT in spir- to holding domestic financial assets, fiscal surpluses may be needed it as well as in law. to emerge out of the ripple effects of external crises. Also, it is the Multilateral trade liberalization will further contribute monetary policy of the country, not the type of exchange to integrating the region with the rest of the world. rate regime, that determines real exchange rate stability. Because these countries ventured to liberalize their trade Although fixed nominal exchange rates have helped coun- unilaterally, they were ready and able to participate in the tries to stabilize prices rapidly, the same arrangement can Uruguay Round as equals. Nearly all the countries are now cause real exchange rate appreciation and unravel trade members of WTO and they have adopted, by and large, its reforms if fiscal and monetary policies are not consistent rules for domestic and multilateral trade policy. The mul- with the exchange rate. Thus maintaining real exchange tilateral trade negotiations have bestowed access to markets rate stability under a fixed nominal exchange rate system that had been previously restricted and opened new oppor- puts enormous responsibility on fiscal and monetary tunities in agriculture, services, textiles, and clothing. authorities. Nevertheless, the opening will be slow because agriculture Although the region implemented strong trade policy continues to be protected, textile and clothing liberaliza- reforms during the mid-1980s to the early-1990s, institu- tion is backloaded, and many service areas are yet to be tional reform lagged behind. In fact, in many countries the opened. However, to take advantage of the increased access same institutions that implemented inward-oriented poli- in the future, the countries of the region have to address the cies continued well into the late 1980s. Institutional unfinished agenda for reforms. Indeed, in light of recent reform, when pursued, has included the centralization of events related to the Mexican peso crisis, a case can be made trade policy in a sector-neutral authority, adoption of to increase the speed and intensity of the reforms, to GATT rules for antidumping and countervailing protec- increase their credibility, and to take advantage of tion, use of independent commissions for inquiring into improved market access. cases of exceptional protection, and adoption of a more Macroeconomic stability concerns have to be addressed transparent processes for determining injury and remedies. quickly. In this regard the key policy issue is fiscal disci- While not all the countries follow the same rules, the pline. More often than not, macroeconomic instability was region has adopted more neutral trade policy rules and engendered by fiscal disequilibrium. The need to address institutions than before. As in the case of the unfinished this issue becomes even more important because external policy agenda, a substantial agenda also exists on the insti- shocks, created by situations such as the Mexican peso cri- tutional side. The institutions must have central but inde- sis, can create macroeconomic difficulties faster than before pendent bodies to consider exceptional protection and due to closer integration of financial markets. Unstable must continuously evaluate the costs of protection, trans- exchange rates retard exports and create overall macroeco- parency of processes and inquiries, and proper balancing of nomic management problems that have adverse feedback consumer and producer interests. These reforms will help effects on trade regimes. Moreover, instability could lead to to anchor freer trade policy in sound trade policy institu- high open unemployment and political problems, inhibit- tions and in turn will contribute to the permanency of ing the achievement of the unfinished trade agenda. open trade regimes. 110 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY Appendix Regional integration arrangements ACRONYMS TITLE ACRONYMS TITLE ANDEAN PACT Andean Subregional Integration Agreement FTAA Free Trade Area of the Americas (Cartagena Agreement) LAIA/LAFTA Latin American Integration Association/ CACM Cenrral American Common Marker Latin American Free Trade Association CARICOM Caribbean Community and Common Market MERCOSUR Mercado Comun del Sur (Southern Cone Common Market) CARIFTA Caribbean Free Trade Association NAFTA Norch American Free Trade Agreement CUSFTA Canada-United Stares Free Trade Agreement OECS Organization of East Caribbean States EAI Enterprise for the Americans Initiative TABLE Al Americas-related regional integration arrangements NICARAGUA/ EL SALVADOR CAFTA' CACM CARIFTA ANDEAN PACT Status Superseded Superseded Operational Superseded Operational Date of signature (or establishment) 9 March 1951 10 June 1958 13 December 1960 15 December 1965 26 May 1969 Date ofentry in force 21 August 1951 2June 1959 13 December 1960 1 May 1968 16 October 1969 Type of agreement FTA FTA CU FTA CU North America Canada Mexico United States Central America Belize Costa Rica * (1962) El Salvador Guatemala Honduras Nicaragua Panama Caribbean Antigua and Barbuda The Bahamas Barbados Dominica Grenada Jamaica Montserrat St. Kitts and Nevis St. Lucia St. Vincent and Grenadines Trinidad and Tobago South America Argentina Bolivia Brazil Chile b Colombia Ecuador Guyana Paraguay Peru Uruguay Venezuela * (197.3) Other Israel 111 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 TABLE Al Americas-related regional integration arrangements (continued) ISRAEL- ARGENTINA- CARICOM LAIA (LAFTA) OECS (ECCM)' UNITED STATES BRAZIL Status Operational Operational Operational Operational Superseded Date of signature 4 July 1973 August 1980 (or establishment) (18 February 1960) (1968) October 1980 22 April 1985 29 July 1986 Date of entry in force I August 1973 2 June 1961 2 July 1981 1 September 1985 29 July 1986 Type of agreement CM FTA CU FTA d North America Canada Mexico United States Central America Belize * (1974) Costa Rica El Salvador Guatemala Honduras Nicaragua Panama Caribbean Antigua and Barbuda The Bahamas * (1983) Barbados Dominica * (1974) Grenada * (1974) Jamaica Montserrat * (1974) St. Kitts and Nevis St. Lucia * (1974) St. Vincent and Grenadines * (1974) Trinidad and Tobago South America Argentina Bolivia Brazil Chile Colombia Ecuador Guyana Paraguay Peru Uruguay e Venezuela Other Israel 112 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY TABLE Al Americas-related regional integration arrangements (continued) CANADA- EL SALVADOR- CHILE- COLOMBIA- UNITED STATES GUATEMALA MERCOSUR MEXICO VENEZUELA Status Superseded Operational Operational Operational Operational Date of signature (or establishment) 2 January 1988 1991 26 March 1991 1991 1991 Date of entry in force I January 1989 October 1991 29 November 1991 1 January 1992 Type of agreement FTA FTA CM FTA FTA North America Canada Mexico United States Central America Belize Costa Rica El Salvador Guatemala Honduras Nicaragua Panama Caribbean Antigua and Barbuda The Bahamas Barbados Dominica Grenada Jamaica Montserrat St. Kitts and Nevis St. Lucia St. Vincent and Grenadines Trinidad and Tobago South America Argentina Bolivia Brazil Chile Colombia Ecuador Guyana Paraguay Peru Uruguay Venezuela Other Israel 113 DEVELOPMENT IN LATIN AMERICA AND TIE4 CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 TABLE Al Americas-related regional integration arrangements (continued) COLOMBIA- NUEVA MEXICO- VENEZUELA- ECUADOR OCOTEPEQUE AGR. CENTRAL AMERICA CENTRAL AMERICA NAFTA Status Operational Operational Prospective Prospective Operational Date of signature (or establishment) 1991 1992 20 August 1992 1992 17 December 1992 Date of entry in force 14 May 1992 1 January 1994 Type of agreement FTA CU FTA FTA FTA North America Canada Mexico Unired States Central America Belize Costa Rica El Salvador Guatemala Honduras Nicaragua Panama Caribbean Anrigua and Barbuda The Bahamas Barbados Dominica Grenada Jamaica Montserrat St. Kitts and Nevis St. Lucia St. Vincent and Grenadines Trinidad and Tobago South America Argentina Bolivia Brazil Chile Colombia Ecuador Guyana Paraguay Peru Uruguay Venezuela Other Israel 114 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY TABLE Al Americas-related regional integration arrangements (continued) CHILE- BOLIVIA- ECUADOR- GROUP COLOMBIA- VENEZUELA PERU PERU OF THREE CHILE Status Operational Operational Operational Prospective Operational Date of signature (or establishment) 2 April 1993 13 November 1992 8 December 1992 April 1993 December 1993 Dare of entry in force Type of agreement FTA FTA FTA FTA FTA North America Canada Mexico United States Central America Belize Costa Rica El Salvador Guatemala Honduras Nicaragua Panama Caribbean Anrigua and Barbuda The Bahamas Barbados Dominica Grenada Jamaica Montserrat St. Kitts and Nevis St. Lucia St. Vincent and Grenadines Trinidad and Tobago South America Argentina Bolivia Brazil Chile Colombia Ecuador Guyana Paraguay Peru Uruguay Venezuela Other Israel 115 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 TABLE Al Americas-related regional integration arrangements (continued) MEXICO- MERCOSUR- MERCOSUR- CHILE- COSTA RICA EAI CHILE BOLIVIA FTAA NAFTA Status Prospective Superseded Prospective Prospective Prospective Prospective Date of signature 1994' 19910 1994 1994 1994 1994 (or establishment) Date of entry in force 2005I' Type of agreement FTA FTA FTA FTA FTA FTA North America Canada Mexico Uniited States Central America Belize Costa Rica El Salvador Guatemala Hoiidsiras Nicaragua Panama Caribbean Antigua and Barbuda The Bahamas Barbados Dominica Grenada Jamaica Montserrat St. Kitts and Nevis St. Lucia St. Vincent and Grenadines Trinidad and Tobago South America Argentina Bolivia Brazil Cliile Colombia Ecuador Gtiyana Paraguay Peru Uruguay Venezuela Other Israel Note: Numbers in parentheses are year of accession for countries that were not among the original founding members. CJ = cusroms union; FTA = free trade area; CM = common market; PTA = preferential trade agreement. Type of agreement refers to the stated objective, not necessarily what has beetn achieved. Negotiations for a CARICOM-Venezuela FTA and a CARICOM-Colombia FTA are also under way. Cuba, Haiti, and Suriname do not participate in any of the regionial integratiorn arrangements listed in this table. a. Multilareral Treaty for Free Trade and Econtomic Integration of Central America, which was superseded by the CACM in 1960. b. Chile withdrew in 1976. c. The Organization of Eastern Caribbean States (OECS) superseded the East Caribbean Common Market (ECCM) that was established in 1968. d. Initially designed as a sectoral customs union. e. Uruguay joined the Argentina-Brazil Program of Economic Cooperation negotiating trade concessions via LAIA mechanisms. f Expected date of signature. g. Reflects signature of bilateral framework agreements between the tJnited States and other countries (or groups of countries) in the hemisphere. h. The plan of action of the Summit of the Americas determines that negotiations should be concluded no later than 2005. 116 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY Notes 12. By binding a tariff, a country pledges not to raise the tariff 1. The political economy of trade reform (that is, its distribu- above the bound level. The Uruguay Round Agreement allows for a tive implications) provides an explanation for this resistance. gradual phase-in of tariff reductions. The offered most-favored- Although trade liberalization is typically welfare enhancing, it nation (MFN) rate, however, must be effective no later than January generates winners and losers. It is easier to identify ex ante who the 1, 1999. An eventual increase in a tariff beyond the bound rate losers will be (for example, inefficient import-substituting indus- requires the country to negotiate compensation for the affected trad- tries and related factors of production, bureaucracies that control ing partners. the distribution of the rents associated with protection). The win- 13. The TRIPS agreement will require significant reform in the ners, on the other hand, cannot be easily sorted out in advance (for intellectual property rights (IPR) regimes of several LAC countries. example, firms that will become successful exporters once the anti- Its potential negative welfare implications (from a static perspective) export bias of the economy is reduced) and are too diffuse to lobby are, however, significantly diluted by the long transitional periods for their interests (for example, consumers). adopted. For the region, the main task ahead is to transform their 2. As pointed out by Corden (1995), among others, these two IPRs regimes in effective instruments to promote innovation. For last modes of liberalization bring additional benefits because of reci- further details on the implications of TRIPS for developing countries procity. Regional preferential arrangements and multilaterally nego- see Primo Braga (1995). tiated liberalization improve the conditions of market access for 14. The trade ratio for any given year is not an unambiguous indi- exports of the country participating in the process. In the case of cator of openness since it reflects the size of the country. Thus, small regionaLism, however, these additional benefits come at the cost of countries have larger ratios than large countries. However, changes in potential trade diversion. the ratios are a more reliable indicator, since the changes wash out the 3. Before the 1980s, increases in current account deficits typical- bias arising from the size of the country. The trade ratio is defined as ly led to increasing trade restrictions and improvements in the cur- R = (X+M)IY where X = exports, M = imports, and Y = gross rent account to trade liberalizations. See Little, Cooper, Corden and domestic product. Rajapatirana (1993). 15. A comprehensive analysis of employment-unemployment 4. see appendix and table Al for a comprehensive list of RIAs in issues is presented in World Development Report 1995: Workers in an the Americas, Integrating World, World Bank (1995). 5. See, for example, De Melo and Panagariya (1992), Nogues and 16. Finger (1995) has noted that GATT provisions regarding Quintanilla (1992), and Anderson and Blackhurst (1993). For a dis- "exceptional protection" make political rather than economic sense. cussion of this topic with a focus on Latin America see Edwards 17. The Australian Industrial Commission came close to such an (1993b), Primo Braga, Safadi, and Yeats (1994), and IDB and institution in the late 1970s. 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"Tariff Rules, Tariff Revenue, of the Uruguay Round of Multilateral Trade Negotiations. Geneva. and Tariff Reform: Some New Facts." World Bank Economic Review - . 1994b. The Results of the Uriuguay Round of Multilateral Trade 8 (January): 1-16. Negotiations: Market Access for Goods and Services. Geneva. Rajapatirana, Sarath. 1994. "Trade Policies, Macroeconomic Hallett, Andrew Hughes, and Carlos A. Primo Braga. 1994. "New Adjustment and Manufacturing Exports." In Montague J. Lord, Regionalism and the Threat of Protectionism." Journal of the ed., Manufacturing Trade in the Latin American Countries. Japanese and International Economies 8 (December): 388-421. Baltimore: Johns Hopkins University Press. Herin, J. 1986. "Rules of Origin and Differences between Tariff . 1995. "Post Trade Liberalization Policy and Institutional Levels in EFTA and in the EC." Occasional Paper 13. EFTA Challenges in Latin America and the Caribbean." Policy Research Secretariat, Geneva. Working Paper 1465. World Bank, Washington, D.C. IDB (Inter-American Development Bank). 1995. "Economic Rodrik, Dani. 1994. "The Rush to Free Trade in the Developing Integration in the Americas." Periodic Note. Washington, D.C. World: Why So Late? Why Now? Will It Last?" In S. Haggard IDB/ECLAC (Inter-American Development Bank/Economic and S. Webb, eds., Voting for Reform: Democracy, Political Commission for Latin America and the Caribbean). 1995. Trade Liberalization, and Economic Adjustment. New York: Oxford Liberalization in the Western Henisphere.Washington, D.C. University Press for the World Bank. 118 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY Spriggs, John. 1991. "Towards an International Transparency World Bank. 1993. The East Asian Miracle: Economic Growth and Institution-Australian Style." World Economy 14 (une): 165-80. Public Policy. New York: Oxford University Press. United Nations Economic Commission for Latin America and the . 1995a. Global Economic Prospects and the Developing Countries Caribbean. 1994. "Open Regionalism in Latin America and the 1995. Washington, D.C. Caribbean." LC/1.808(CEG. 19/3). . 1995b. World Development Report 1995: Workers in an Valdes, Alberto, and Barry Schaeffer. 1993. "Domestic Integrating World. New York: Oxford University Press. Surveillance for Transparency in Agricultural Trade and Price World Trade Organization. 1995. Regionalism and the World Trading Policy: Progress Report." World Bank, Washington, D.C. System. Geneva. 119 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Comment on "Latin America and the Caribbean in the World Economy," by Carlos A. Primo Braga, Julio Nogues, and Sarath Rajapatirana MAX C ORDEN U_ ' NTIL THE 1980S TRADE LIBERALIZATION IN LATIN AMERICA WAS ASSOCIATED WITH balance of payments improvements. Since then, however, there has been a worldwide rever- sal in this trend. Trade liberalization in developing countries is now viewed as part of a process stimulated by balance of payments crises. This development can be observed both within Latin America and throughout the world in countries such as Australia, China, India, Indonesia, and New Zealand. Discussions of trade liberalization encompass the issue tion policies, trade restrictions may have to eventually be of exchange rates and the problems generated by real cur- imposed in times of crisis. In this event the best strategy is rency devaluation strategies. Liberalization is usually asso- to be prepared. Other temporary strategies, such as simple ciated with real currency devaluations, and when countries and uniform tariff arrangements that avoid unnecessary face adverse terms of trade, real deprecations coupled with market distortions, should be contemplated as well. nominal fixed exchange rates eventually lead to reversals in Small and medium-size countries in developing regions trade liberalization. Thus a strategy that avoids the need for are including export boom strategies of manufactured real depreciation can assist in the implementation of suc- goods in their economic growth policies. The success of cessful, continuous trade liberalization policies. these strategies will depend on how quickly the world To avoid trade restrictions governments should adopt pre- moves toward multilateral trade liberalization. The ventive measures that help avoid situations that create a need for European Union is currently looking inward, focused on its real devaluation and changes in exchange rates. For example, own liberalization. The United States and Japan, on the countries that experience favorable terms of trade should run a other hand, seem to be moving toward isolationism and fiscal surplus or develop a stabilization find. That way, when protectionism. Such trends hinder the development of an there is a decline in the terms of trade, there will be no need to open world economy. adjust the exchange rate. Likewise, when a private investment Since the economies of Latin America's three largest boom occurs fiscal surpluses should be run to offset the effect. economies are less dependent on free world trade than That way, governments can afford to run a fiscal deficit when smaller countries, the responsibility for reversing this trend flows into the private sector decrease. will fall on the smaller countries. Moreover, regional trade Although these examples provide strategies for avoiding agreements should not distract from efforts to keep the real currency devaluations and reversals in trade liberaliza- world system open. Max Corden is a professor at Johns Hopkins University. 120 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY Comment on "Latin America and the Caribbean in the World Economy," by Carlos A. Primo Braga, Julio Nogues, and Sarath Rajapatirana WILLI AM LE WI S F _ OR BUSINESS PEOPLE, THE BENEFITS OF TRADE GO FAR BEYOND SHIFTING OUTPUT, JOBS, AND productivity from one region to another. More important, trade increases competition, which stimulates productivity, encourages better use of resources, increases output and job opportuni- ties, and produces innovation in products, services, and goods. In developing countries privatization, foreign direct investment, and antitrust policies con- tribute to competition. The threat of extinction that surfaces with privatization, more than the incentive for increased profits, generates competitive intensity and pres- ductivity between the public and private banking industries sure to improve. Although trade is important in promoting for the same functions. In addition, the regional private competition in some manufacturing sectors, foreign direct telecommunications company's total factor productivity is investment is more important for generating competition in twice that of the country as a whole. In food processing the the rest of the economy. Foreign direct investment promotes state will have to go beyond the three factors that increase world-class performance by allowing domestic producers to competition (privatization, foreign direct investment, and overcome shortcomings in local inputs. The development of antitrust policies) and enforce tax payment and collection effective, efficient pro-competition policies through and adherence to sanitation and health restrictions. antitrust actions is also important. As Sweden has taught us, These positive changes and productivity improvements lack of global exposure in all sections of the economy results increase employment. And although labor market reform is in stagnation, regardless of the extent of deregulation. essential, product market reform is ultimately more impor- Growth in Latin American exports and the opening of tant. In Europe, for example, where product market restric- trade could lead to tremendous protectionist pressures in tions have precluded the development of top-quality world trade. These pressures would be difficult but not practices in the service industry, employment is limited. impossible to overcome. Competition could perhaps be stimulated here through for- Several of these examples apply to Latin America. In eign direct investment. Brazil, for example, there is a 50 percent difference in pro- William Lewis is director of the McKinsey Global Institute. 121 DEVELOPMENT IN LATIN AMERICA AND TIIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Comment on "Latin America and the Caribbean in the World Economy," by Carlos A. Primo Braga, Julio Nogues, and Sarath Rajapatirana J O S E ARTUR DE NOT ME DE I RO S T HHE ADVANTAGES OF INCLUDING OPEN TRADE IN MACROECONOMIC POLICY ARE WELL known. But the costs of transition-including political costs for economies, such as Brazil, undergoing stabilization-should be studied more extensively. Along with open economic policy measures, fiscal balance must be attained without provoking recession. Trade policy must be considered within a wider macroeconomic framework that varies in terms of advances and recessions. Open trade is beneficial only to the extent that it is a long-term tendency and a country's internal obligations are met. Open trade in Brazil has come about too quick- ly and too ambitiously. More attention should be paid to consolidating achievements in order to pre- serve the achievements of the past five years. References to the international atmosphere are based cent; imports increased by an annual average of 12.5 per- on an overly positive evaluation of the results from the cent. On the other hand Brazil's exports to LAIA coun- Uruguay Round. It is important to carefully consider the tries in the Mercosur increased almost 21 percent a year. risks that external instability can bring to the region. Two conclusions can be drawn from these facts. First, Also, concentrating on domestic policies is not sufficient Latin American countries have been practicing open to complete the task of linking Latin America to the trade in the region. Second, the rest of the world has had global economy. External conditions also have to be more opportunity to export to the region than the region considered. has had to export to the rest of the world. In democracies customers are usually the people who There have been, disparities in the liberalization benefit from open trade. Customers are not organized in process in Latin American countries. In Brazil, a country permanent lobbies, however, and those who do not bene- of great industrial maturity and considerable state con- fit from open trade are vocal and organized. The limited trol, liberalization has been painful and has affected priv- political power of groups who benefit from open trade ileged groups more deeply than in other countries. Every may directly affect the possibilities of expanding and country that cuts subsidies should calculate them to bet- maintaining open trade in the region. ter understand the cost of opening trade. In Brazil the Between 1990 and 1994 Brazilian exports to the rest cost has been great when measured in these terms. of the world (except Latin American Integration It is a mistake to think that the Uruguay Round has Association, or LAIA, countries) increased only 2 per- had a significant influence on opening trade in Latin Jose Artur Denot Medeiros is Brazil's permanent representative to the Latin American Integration Association in Montevideo. 122 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY America. It was just the opposite: opening was responsi- gin are inherent to treaties of this kind and must be ble for greater participation. At the beginning of the tolerated. Uruguay Round Latin American countries had almost Some observers have claimed that institutional reform reached the formal level of the industrial nations; after has not accompanied opening efforts in Latin America. the summit they found they had no significant influence This is not true for Brazil. The Brazilian government ini- on the meeting's agenda or on the definition of outcomes. tiated important institutional reforms in trade policy as Some concerns exist about the integration of Latin it opened. In this regard reforms in Brazil were more America with a free trade market using the rules of the radical than in other countries. General Agreement on Tariffs and Trade (GATT) and the Sectors that oppose open trade are still alive and lob- World Trade Organization (WTO), especially concerning bying in a democratic way. For example, agriculture in the exception specifications. However, the exceptions are Latin American countries-and certainly in Mercosur a temporary mechanism and are related to the countries' countries-is less protected and has suffered fewer inter- taxation systems. ventions from the state than in many industrial coun- The importance of regional agreements in increasing tries, especially those in the European Union. These wealth and productivity has not been mentioned. countries underestimate their ability to adjust to new Mercosur is perhaps the most spectacular example, with situations. trade business tripling in just three years. Although In conclusion, Latin America is gearing up for open there have been concerns about the possibility of protec- trade. Since there are high political costs associated with tionist escape and the difficulty of administrative rules the process, it should be treated with great care to pre- of origin in regional integration agreements, rules of ori- vent protectionist interests from returning. 123 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Floor Discussion of "Latin America and the Caribbean in the World Economy," by Carlos A. Primo Braga, Julio Nogues, and Sarath Rajapatirana A MEMBER OF THE AUDIENCE SUGGESTED THAT THE AUTHORS HAD UNDERESTIMATED THE importance of the cost of trade liberalization. The need to avoid reversals and to fight for com- plementary trends, especially relating to de facto markets, should be given more importance. Practically speaking, the treatment of foreign capital may be more important than the manage- ment of the capital account. Foreign capital brings technology, adjustment, adaptation, and exports. Moreover, we should consider the implications of conditionality relating to labor when discussing NAFTA. The trend is toward greater conditionality on labor, which implies less flexibility adaptating to trade liberalization. Another audience member asked whether the prolifera- during the 1980s, overall productivity growth has tion of free trade agreements in Latin America presents bar- increased by more than 5 percent a year for the past four riers to unilateral liberalization, the greatest source of bene- years. A significant portion of that productivity gain can be fits from trade, in most countries. Another audience mem- attributed to open trade and the substantial amount of cap- ber said that the paper did not pay sufficient attention to ital goods imported into Argentina. NAFTA, the free trade agreement of the Americas, and the Rajapatirana said that trade reform must be viewed as Caribbean countries. For example, the special problems of part of a package, since reforms are not made in isolation. the smaller countries in terms of external liberalization were Although he agreed that the paper did not sufficiently ignored. These countries have unique problems and require address this issue, it does emphasize the macroeconomic additional measures to assist in the adjustment process. factor, which should be the most immediate component Nogues responded that the region's small and medium- taken into account. Although some trade reforms have size countries should unite to convince the three largest taken place in Latin America, a trade regime and the economies to maintain and expand open markets. Further, accompanying institutional reform that balances the inter- recent evidence shows that short-run gains far outweigh ests of consumers and producers need to be developed. the costs of trade liberalization. Thus the cost of trade lib- The panel was then asked to explain the World Bank's eralization was not discussed in depth. position on the relationship between labor and trade. Argentina provides an example of a situation where Nogues said that World Development Report 1995: Workers in trade liberalization in terms of importing capital goods has an Integrating World addresses the issue of labor standards in been fundamental in explaining overall productivity depth. As the report shows, raising labor standards in inter- growth. Although Argentina experienced a 40 percent national trade negotiations transforms labor from a tool that decline in overall productivity growth for nearly a decade makes sense in theory to a protectionist instrument. 124 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY A member of the audience then asked how the approach Sri-Ram Aiyer (chair) summarized by saying that evi- of open regionalism can lead to effective building blocks, dence shows that trade liberalization increases competi- and whether regions are moving toward building blocks. tiveness, outputs, and income. In Latin America, more Braga said that there is reason to be concerned about the than any other region, the World Bank is focusing on proliferation of regional trade arrangements and adminis- competition policy and reform to improve the climate for tration of trade flows. In 1970 rules of origin were so cum- foreign direct investment. In this regard the objective bersome for manufactured goods that countries were will- should be the creation of trade and harmonization of ing to pay tariffs rather than comply with complicated standards. Latin America should listen to advice to put rules and administration. The World Bank, the Inter- pressure on its three largest economies to minimize iso- American Development Bank, and the Organization of the lationism. The small and medium-size countries need to American States can help ensure transparency in Latin group together to shift attitudes on an international America in terms of trade agreements. scale. 125 DEVELOPMENT IN LATIN AMERICA ANI) THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Concluding Remarks SRI -RAM A I YER M i r R. SRI RAM AIYER (CHAIR) SUMMARIZED THE MAIN CONCLUSIONS OF THE PAPER, THE comments on it by Professor Corden, Dr. William Lewis and Ambassador Jose Denot and the discussion that ensued from the audience. Mr. Aiyer noted that the paper provided four principal conclusions. First, Latin American and the Caribbean countries have more open trade regimes at present than anytime in their post World War II history. Second, these trade regimes have withstood external shocks including the December 1994 shock that arose from the Mexican peso crisis. Instead of restricting trade, which they would have done in the past, these countries continued on the path of trade liberalization, unilaterally, through regional trading arrangements and multilaterally within the context of the Uruguay Round. Third, there were still areas for reform in some of the countries which related to reducing protection further, under- taking factor market reforms and those related to increasing domestic competitiveness. Finally, the institu- tional arrangements for trade policy making had to be reformed to be in accord with the new and more lib- eral trade regimes. Many countries continued to have trade policy making institutions that came into exis- tence during periods of strong protection. Mr. Aiyer noted that Professor Corden's comments on incentives and institutions are in place to attract foreign the paper provided an international context for trade direct investment, of a long term nature, to activities that reform, emphasized the need to maintain fiscal viability lead to transfer of technology. This aspect has often been and exulted that developed countries should help the trade overlooked by countries that have liberalized trade regimes liberalization process of the Latin American and Caribbean in this Region. Mr. Aiyer remarked that Ambassador Denot countries by further opening of their domestic markets. was concerned with the cost of adjustment in undertaking Summarizing Dr. Lewis' comments, Mr. Aiyer emphasized trade reforms and that Brazil has made important institu- the importance of private foreign direct investment to tional reforms with respect of trade policy making accompany trade reform to lead to a more efficient and rapid mechanisms. technology transfer. The combination of these two factors The comments from the audience were also summarized has led to substantial increases in productivity in the private by Mr. Aiyer. They related to the need to appreciate the sectors of these countries as revealed in the studies that Dr. problems of small economies in the global liberalization Lewis has conducted Elaborating on this, Mr. Aiyer empha- process and the importance of undertaking factor market sized that more liberalization of trade was not enough and reforms, particularly with respect of the labor market. that it was essential that Governments ensure that proper Continued labor market rigidities would inhibit the re- 126 LATIN AMERICA AND THE CARIBBEAN IN THE WORLD ECONOMY allocation of resources that trade reforms attempted to should include issues relating to regional integration, com- achieve and reduce the benefits arising from reforms. Mr. petition policies and factor market reforms. He added that Aiyer thanked the authors, the commentator and the mem- the third Annual Bank Conference on Development in bers of the audience for contributing to a very interesting Latin America and the Caribbean, to be held in Montevideo discussion and noted that a future agenda for such meetings in 1997, would focus on trade. 127 Poverty, Inequality, and Human Capital Development in Latin America, 1950-2025 JUAN LU I S LO NDO NO LA ATIN AMERICA IS KNOWN THROUGHOUT THE WORLD FOR ITS WIDESPREAD POVERTY AND inequality. Today, one out of three Latin Americans lives in poverty and 86 million people in the region struggle to survive on incomes of less than $1 per day. Although there are differ- ences from country to country-in some places the wealthiest 10 percent of the population has 84 times the resources of the poorest 10 percent, while in others the ratio is "only" 15 to 1- 15 out of 17 countries in the region have higher than expected levels of inequality given their levels of development. This paper argues that the most important factor con- of economic development. The difference in education lev- tributing to the persistence of inequality and the increase els between Latin America and successful Asian countries in poverty is the lack of adequate education for new gener- has increased in recent years. Latin America's illiterate ations. Indeed, several factors-economic growth and labor force-people who reach age 25 without schooling or structural transformation of the economy, the convergence with incomplete primary education-continues to grow at of regional per capita income, and the diminishing rates of excessive rates. The number of families dependent on illit- return on education-have combined to lower the region's erate workers closely parallels the number of families who inequality. But the slow expansion of human capital devel- are living in poverty. opment has counteracted development and resulted in a Not all the news is bad. The percentage of the popula- statistically stagnant level of high inequality. tion living in poverty declined steadily between 1950 and The average Latin American worker has two years less 1980. Since then it increased slightly in the 1980s during education than would be expected given the region's level the region's economic crisis and then declined during Juan Luis Londonlo is principal human resources economist in the Latin America and the Caribbean Technical Department at the World Bank and former minister of health of Colombia. The author is grateful to Oscar Altimir, Alejandra Cox-Edwards, Xavier Gorostiaga, Eduardo Vlez, and Donald Winkler for useful comments, and to Marcus D. Rosenbaum for editing this paper. The findings, interpretations, and conclusions expressed here are entirely those of the author and do not necessarily represent the views of the World Bank, its Executive Directors, or the countries they represent. 129 DEVELOPMENT IN LATIN AMERICA AND TUIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 1988-94 as Latin American countries continued to adjust Honduras and Guatemala and Andean countries like Peru external and fiscal imbalances. However, even as the per- and Bolivia are often scrutinized and portray an image of centage of poor people in the population declines, the destitution for the entire region. Amid this poverty, of region's growth rate is insufficient to reduce their absolute course, there are scenes of great wealth. number. If the current rate of growth continues, poverty This section examines the depth of poverty in the Latin will grow at a rate of two people per minute during the next America and Caribbean (LAC) region, and the extent of decade. inequality that accompanies it. Only a rapid increase in human capital development can bring the region out of poverty quickly. In fact, what the The excess of inequality in Latin America region needs is a human capital shock: universal basic educa- The level of inequality in the LAC region is deep as well as tion for all young people within the next two decades to diverse. Figure 1, which graphs the Gini coefficients-a bring the average education of the labor force to 9 years per coefficient that measures income inequality'-of various person. countries shows that levels of inequality vary between 0.63 Although high growth without human capital develop- and 0.42 within the region. This indicates that in some ment will reduce the number of poor people over tirne, countries the wealthiest 10 percent of the population have increased education levels will get the job done much more 84 times more resources than the poorest 10 percent while quickly. Moreover, this paper argues that rapidly expand- in other countries the ratio is "only" 15 to 1. As the figure ing education will in itself lead to higher growth rates. shows, the greatest levels of inequality can be found in Rapid acceleration of education will be expensive. Direct Honduras and Peru; the lowest can be found in Uruguay costs will amount to an additional expenditure one-half to and Barbados. one full point of a nation's GNP over the next 25 years, Although country-to-country differences exist, 15 out of depending on the speed of the process. Young people and 17 countries in the region have higher than expected levels their families will pay a cost, too, as they will be kept out of of inequality given their levels of development. Empirical the labor market longer while pursuing their education. estimates of the Kuznets curve-which predicts inequality The payoff, however, is high and fast. If the additional according to levels of development-for a sample of 102 income generated by this additional education were taxed countries show that on average the Gini coefficient for at today's rates, the required additional investment could Latin American countries is 4.1 points higher than coun- soon pay for itself. After about 20 years, the demand for tries with similar per capita income levels.2 education would increase more slowly than the economy The diversity of inequality and income per capita in the due to demographic transition. region produces a clear excess of inequality for most Latin A rapid increase in the development of human capital throughout Latin America will provide the surest and FIGURE 1 quickest road out of poverty. A dynamic expansion in Inequality in Latin America- human capital expansion coupled with growth-enhancing an international comparison policies would substantially accelerate growth, eliminate Giii coefficient the excess of inequality in the region, and upgrade the stan- dard of living for 70 percent of Latin Americans living in 0.65 HON poverty today. (.6() PER ECU BRA Inequality and poverty in Latin America during 05 N BOsAL GUA AMEX the past four decades cii- c AC pattern 0.45 , ,_A RG Latin American is notorious for high income inequality and URU Worldwide pattern widespread poverty. Pictures of favelas clinging to the hill- 0 sides around Brazilian cities are familiar to people through- 5.5 6 6.5 7 7.5 8 8.5 9 out the world. Central American countries such as Log per capita income 130 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT IN LATIN AMERICA, 1950-2025 American countries and for the Latin American region as a tries, adopted a poverty line of $2 per person per day across whole. In fact, the estimated Gini coefficient for the region the region.5 This paper emphasizes the differences among of 0.563 is higher than Yotopoulos's4 estimate for all the countries in the region and uses a line for the region of $2 developing world (0.501) and higher than expected given per capita per day. To estimate extreme poverty-the poor- level of development in LAC (0.50). est of the poor-half the value of the poverty line was used. In 1995, 35.1 percent of the population in Latin Continental poverty: Regional structure and trends America and the Caribbean was living below the poverty line and 18.8 percent below the extreme poverty line. This Regional differences translates into 165.6 million poor Latin Americans in Several worthwhile attempts have been made to define 1995, 86.3 million of whom were extremely poor, living on Latin America's poverty level-that is, to define the level of a daily income of approximately $1 per person. income at which the standard of living is considered unac- The highest incidence of poverty in Latin America is in ceptable. The Economic Commission for Latin America, Central America, where approximately 60 percent of the after a detailed study of consumption patterns in nine population is poor (figure 2). The lowest incidence is in the countries, placed the poverty line between $1.66 and $2.47 Southern Cone, where approximately 10 percent of the per person per day, depending on the country. The World population is considered to be poor. Falling between these Bank, based on detailed income information from 12 coun- two extremes is the Andean region, the Caribbean coun- tries, Brazil, and Mexico where poverty levels are 44 per- FIGURE 2 cent, 38 percent, 35 percent, and 26 percent, respectively. Poverty and extreme poverty in Latn Amerca, 1995 The incidence of extreme poverty falls into a similar order: Percentage of the population 36 percent in Central America, 5 percent in the Southern a. Poverty Cone, 25 percent in the Andean region, 19 percent in the 70 Central Caribbean countries, 23 percent in Brazil, and 17 percent 60 * in Mexico. 50 While problems of poverty in Brazil, Central America, Andean and Haiti are well known, the problem of poverty in Latin 40 Caribbean America is more pervasive and widespread than is gener- 30 ally recognized. In absolute numbers, the population of * Mexico 20 extreme poor in Mexico is higher than the rest of Central 1 0 Southern Cone America and the Caribbean combined; the number of extreme poor in the Andean countries is twice that of 7 7.5 8 Central America and approximately equal to that of Percapitaincome(logarithm) Brazil. Given such variances across the region, the solu- b Extremepaverty tion to the problem of poverty in Latin America must be 50 region-wide. 40 Central The evolution of poverty in Latin America 30 The incidence of poverty in Latin America has decreased 3Anean over the long term as shown in figure 3, panel A. 20 Caribbeans * TOTAL Specifically, the population living below the poverty line Brazil decreased 20 to 25 percentage points between 1950 and 10 *Mexico 1995. However, high, stable Gini coefficients mean that * Southern Cone the rate of per capita income growth in the region-1.8 7 7.5 8 8.5 9 95 percent-has not been sufficient for the absolute number of Per capita income (logarithm) poor to decrease. In fact, the number of poor people in 131 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 FIGURE 3 FIGURE 4 Poverty in Latin America, 1950-95 Eruption of urban poverty in Latin America, 1970-95 a. Head-count ratios Millions of persons Percentage of the population 200 65 60 150 55 100 50 45 ~~~~~~~~~~~~~~~~~~~50 40 35 0 1970 1975 1980 1985 1991) 1995 30 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 most important characteristic of Latin America poverty in b. Absolute numbers the last few decades. Millions of persons In summary, the region's 1.8 percent economic growth 180 pretgot 170 and the rapid relocation of the labor force to the cities have 160 resulted in a decrease in the incidence of poverty in Latin 150 America. However, the absolute number of poor people has 140 l 130 not decreased. In fact, the absolute number of poor today is 120 twice what it was 40 years ago. 110 100 Changing factor of Latin American inequality 9(1 80 Distribution of income in Latin America has not changed 70 1950 1955 1960 1965 1970 despite the rapid development process of the past decades. In this same time period, poverty has tended to increase. This section examines why. Latin America increased from 92 million in 1950 to 165.6 million today (figure 3, panel B). The decreasing role of traditionalfactors of The incidence of poverty in the region has evolved dif- inequality ferently over time. While it decreased slowly from 1950 to Economists associate unequal income distribution with the 1965, the absolute number of poor increased considerably. distribution of assets within a population or with the dis- Between 1965 and 1970 the incidence of poverty accelerat- tribution of the market power of the owners of these dif- ed, and between 1970 and 1980 poverty levels remained ferent assets. Thus, when economists look for causes of the constant. The reversal in economic growth in the 1980s pervasive and persistent income inequality in Latin resulted in a further increase in the incidence of poverty in America, they look at both unequal asset distribution and the region to approximately 40 million new poor. And the differences in market power between actors in different while the short economic recovery of recent years has helped sectors. reverse the increase in the incidence of poverty, it has not In the 1960s, studies attributed the high level of been enough to reduce the absolute number of poor. inequality in several Latin American countries to the These poor people are increasingly found in the cities of uneven distribution of land.6 At the end of the 1950s, half Latin America. Figure 4 demonstrates that although the of the population lived in rural areas and agriculture repre- absolute number of poor has increased substantially in the sented more than a third of the national product. At that last 25 years, the number of poor living in rural areas has time, rents from land made up as much as 15 percent of the decreased. The urbanization of poverty is probably the national revenue or 20 percent of household income and 132 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT IN LATIN AMERICA, 1950-2025 contributed substantially to regional income inequality. In FIGURE 5 addition, as urban activities became five times more pro- Inter-regional income inequality in Latin America, ductive than rural agriculture from 1950 to 1970, the gap 1950-95 between labor productivity in the two areas widened and a. Convergence ofper capita income analysts' interests shifted towards modes of interaction Percentage difference from regional average between industry and agriculture.7 25 Now, 40 years later, and in accordance with normal pat- 20 Rest of South America 1 5 terns of development, the importance of agriculture has 10 . diminished tremendously. Currently, the agriculture sector 5 barely represents 10 percent of the GNP and employs 0 scarcely more than 20 percent of the labor force of the -5 - -- entire continent. Rents from agriculture account for only 2 10 Mexico and Central America , -15-- to 3 percent of overall household income. Differences in 20 - - rural-urban productivity are now half of what they were at -25 the beginning of the 1970s and thus, on a regional scale, -30 the importance of uneven land distribution or urban pro- ductivity gaps has decreased. b. Effect of regional dispersion on income ineqaality Studies looking at other income-generating assets in Gini coefficient trying to explain the region's widespread inequality have 0.595 not been particularly convincing due in part to the fact 0.590 that the distribution of the ownership of fixed urban assets 0.585 has not been fully studied in Latin America. The percent- 0.580 age of the population owning their homes has grown slow- 0.575 ly since the early 1970s, indicating that inequality in these 0.570 assets must not have increased. Productive urban assets are 0.565 . . believed to be concentrated, but changes in this area have not been studied. And since the relationship of capital to 0.555 output in urban areas has not increased much since the 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 1970s, the contribution of these assets would not be expected to increasingly contribute to aggregate inequali- income of urban laborers and peasants deteriorated, and ty. Likewise, financial assets do not seem to be responsible they in turn demanded higher wages. These actors' institu- for the continuing inequality. Financial assets have actual- tional ability to defend their income share therefore became ly been growing faster than income in the past two a basic factor in generating persistent inflation. However, decades, and most of the rents have disappeared as finan- the opening of the economy in the 1980s and growing cial markets have been deregulated. If anything, this price competition seem to have broken the vicious cycle of should have led to lower inequality; but as we have shown incompatible market forces that led to high inequality inequality persists. through inflation. Thus, economists have again turned Lack of solid documentation of changes in asset holdings their attention to long-term factors that generate in rural and urban areas has altered the focus of income dis- inequality. tribution in Latin America to market behavior differences The variance of per capita income from country to coun- among agents. In the 1980s Keynesian and Latin American try contributes substantially to regional inequality; so, per- structuralist ideas were combined to explain the persistence sistence in the heterogeneity of levels of development of Latin American inequality.8 Having market power in among Latin American countries could explain the high price fixing, they reasoned, entrepreneurs tended to finance levels of inequality. However, evidence indicates that in the investments by increasing prices. As a result, the real long-term income disparity among countries has actually 133 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 diminished considerably. Panel A of figure 5 shows how the FIGURE 6 per capita income in South American countries, excluding Educational insufficiency in Latin America Brazil, was 20 percent above the continental average in the a. Internationalperspeetive 1950s while Brazil's income was 25 percent below average. Years ofeducatioo ofadult population By the 1980s, these gaps had become insignificant. The 14 reduction in the dispersion of per capita income among the 12 United StEr es Northern Europe Latin American countries was sufficient to have a substan- 10 Central Europe tial effect on regional income inequality. A simple simula- Korea, Taiwan, Singapore, Hong s Eust Europe tion presented in panel B of figure 5 suggests that this fac- Southern Europe tor alone seems to have contributed to a reduction of more 6 America than 2 Gini coefficient points in the region. 4 Arabcountries If income from land has contributed less and less to 2 A regional inequality; if the possession of physical and finan- 0-1 cial urban assets has not contributed increasingly to 5 6 7 8 9 10 11 inequality; if monopoly market forces have decreased with Logarithm per capita income (PPP) the opening of the economies; and, if per capita income has b. Lahn America in historicalperspective, 1950-95 tended to converge among countries, the persistent Years of educarion Expected/observed ratio inequality in Latin America must be rooted in another 2.1 2.0 income-generating factor: human capital. 6 education 1.9 1.8 Has educational expansion caused income 5 1.7 inequality? 1.6 What is the relationship between the persistence of 4 1.5 1.4 inequality and poverty and the formation of human capital - ., 1.3 in Latin America? This section suggests that the slow O -- - Observed education 1.2 expansion of educational opportunities for young people in 2 1.1 the past 25 years has not been sufficient to overcome the 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 relative scarcity of human capital in the labor force in Latin America. In fact, it has caused inequality in human capital to increase and has contributed greatly to the growth of the level of education reached in different regions of the semi-permanent poverty that plagues the region. world. Asian countries and countries that are or have been There is a strong, empirical association between a coun- socialist-China or Eastern Europe-tend to have higher try's level of development and education of its labor force. educational levels than expected for their level of develop- The statistical results of a correlation of the educational ment. Latin America, the Arab countries, Africa, and level of the population above age 25 with per capita income southern Europe-Greece, Italy, Spain, and Portugal- adjusted for international purchasing power for the 173 tend to have lower educational levels than expected. Latin countries in the world are very strong9 and allow accurate America, with an average of 5.2 years of education for the calculations of countries' expected level of education adult population in 1995, has approximately two years less according to their level of development. The non-linear education than expected. relationship between education and per capita income indi- Human capital development can be characterized by cates that the intensity of education tends to increase with contrasting the education of the labor force since World economic development, accelerating substantially at inter- War II with the expected values (figure 6, panel B). At the mediate levels of development such as those that LAC beginning of the post-war period, the labor force had 2.4 countries have seen in the past decades. years of education. For the level of development at that This "pattern" is used in panel A of figure 6 to evaluate time the expected level of education was 4 years. The edu- '34 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT IN LATIN AMERICA, 1950-2025 FIGURE 7 Slow expansion of education has caused serious distrib- Education level of the labor force in ution disparities in Latin America. The scarcity of human Latin America and Southeast Asia capital that resulted from prolonged low levels of education Years of education of incoming generations could have contributed to the 10 increase in unequal distribution of human capital.10 For 9 Korea, Taiwan, Singapore, HongKairig example, in a society in which there is no education for 7 .. w anyone, the level of education is zero as well as the variance 6 of education among the population. In a society where the 5 - entire population reaches the maximum level of education, the variance is again, zero. However, as a country moves 3 Latin America from zero to maximum levels of education, the variance of 2 - - hiad Malaysia, Indonesia, Philippines 2 education increases, reaches a peak, and then decreases. 1950 1955 1960 1965 1970 1975 1990 1985 1990 Although the variance depends to a great extent on the rel- ative emphasis that each country places on basic or higher cational gap of the labor force therefore was 1.6 years. At education, international experience suggests that the max- the beginning of the 1980s the gap had grown to 2.5 years imum educational inequality results when average educa- as Latin America had 4 years of education and the expect- tional levels reach 6.3 years. ed level of development was 6.5. And although the educa- When the successful Southeast Asian countries reached tional level of the labor force in the 1980s in Latin America such a turning point in the mid-1970s, the spread in edu- expanded at approximately the same rate as the rest of the cation within the population was sufficient to decrease world, a gap between observed and expected education lev- income inequality. Young people entering the labor market els continues to exist today. (The apparent closing of the with more education in the last 20 years have found pay gap since 1979 is a result of the fall of per capita income in structures increasingly egalitarian-not derived from the this decade for Latin America, and does not indicate extra reduction of rates of return on education. progress in education.) In contrast, in Latin America the slow expansion of edu- In summary, compared to the rest of the world, the level cation has prolonged the phase of increasing educational of education of Latin America's labor force since World inequality; and new education is contributing systemati- War II has been lower than it should have been, given its cally to larger income inequality among the working pop- level of development. Also, the current level of education is ulation. Had higher levels of education been evident in the insufficient, as is the expansion of the educational system. 1950s, increases in education would have caused relatively Educational insufficiency is particularly high in Latin little income inequality and would have reversed after the America when compared to Asia. Figure 7 compares the FIGURE 8 development of Asian and Latin American education over time. The four most successful Asian countries-Hong Changing factors of inequality, Latin America, 1950-95 Kong, the Republic of Korea, Singapore, and Taiwan (China)-had a considerable educational advantage at the Gini coefficient beginning of the 1960s and have widened the gap with 0.55 t,. Latin America substantially since then. In fact, the level of o. education in Latin America today is at the same level as 0.53 that of the Asian countries in 1970. In comparison, in the 0.49 1960s the level of education in Indonesia, Malaysia, the 055 5 Philippines, and Thailand was slightly more than half of 0 .45 Latin America; in the 1980s these countries reached equal 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 levels of education; today, the level of education is greater U Effects: Income growth, income convergence, migration in those countries than in Latin America. l Effects of human development inequality 135 DEVELOPMENT IN LAI'IN AMERICA AND TIIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 beginning of the 1980s. But, faced with a low level of edu- lowered the Gini coefficient by almost two points.'3 cation from the start, the accumulation of human capital On the other hand, while these three factors were low- contributed greatly to labor income inequality." ering income inequality, the growing uneven distribution The effects of educational expansion and other causes of of human capital tended to make income inequality rise. In inequality are presented in figure 8.1' During the last 40 fact, as is shown in the chart, the dispersion of human cap- years, three forces have contributed to a decrease in income ital pushed the Gini coefficient up 5 percentage points. The inequality in Latin America: sum of the four effects was approximately zero for the entire * Economic growth along with the structural transformation in period 1950-95, thus creating the statistical appearance of the economy, which resulted in the reduction of the Gini inequality inertia.'4 coefficient by 1 percentage point through the end of the 1970s; Education and poverty * The convergence of regional per capita income, which resulted Educational expansion in Latin America has been particu- in a reduction of the Gini coefficient by at least 2 percent- larly slow for the poorest sectors of the population in Latin age points during the same period; and America. A comparative look at Southeast Asia shows the * The diminishing rates of return on education, which also extent to which educational expansion in Latin America FIGURE 9 Education of the labor force in Latin America and Southeast Asia Millions of persons a. Without education b. University education 55 14 50 12 Southeasr Asia Latin Americ 10 45 0 8 ' 40 6 35 -'.--~'. 60 Southeast Asia Latin America 4 30 2 25 0 1950 196) 1965 1970 1975 1980 1985 1950 1960 1965 1970 1975 198(0 1985 c. Functionally illiterate di Secondary education 120 03 110 60 oces s 100 Lt 50 90 80 4 70 Southeast AsiaLatnAnrc 30 20 50 4.0 10 1950 1960 1965 1970 1975 1980 1985 1950 1960 1965 1970 1975 1981) 1985 Nate: Functional illiterate includes no education and incomplete primary education. 136 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT IN LATIN AMERICA, 1950-2025 has been uneven. Both groups of countries had similarly America (figure 9, panel D). sized labor forces at the end of the 1950s (80 million peo- Educational expansion in Latin America led to more ple). In Southeast Asia, due to the influence of the four less functionally illiterate people, more university educated developed countries, 47 million people had no education. people, and fewer workers with secondary schooling com- At that same time in Latin America, 34 million had no pared to Southeast Asia. education. In the last 30 years, as seen in panel A of figure The evolution of poverty in Latin America is not a sepa- 9, the absolute number of people with no education in rate issue. The absolute number of family members depen- Southeast Asia has decreased by one-fifth while the number dent on insufficiently educated workers evolved in the last increased by one-sixth in Latin America. In contrast, the 40 years parallel to the population with income below the evolution of the university-educated population-panel B, poverty line. As seen in figure 10, in 1950 there were almost figure 9-in the two groups of countries has been different. 80 million poor in Latin America, poverty being measured At the beginning of the 1960s both regions had 800,000 by income or by lack of human capital. In the subsequent university-educated people in their labor forces. And 20 years, 35 million new poor were comparable in number through the beginning of the 1970s, both regions incorpo- to those dependent on workers with insufficient education. rated 100,000 university-educated people annually in their In the 1970s, a decrease in the rate of growth in poverty labor force. After this point, levels of education in Latin related to income seems to have benefited the population America grew at a quicker rate; 2 million more university- with no education the most. After the inadequate perfor- educated people were incorporated into the labor force in mance of the 1980s, the number of poor rose again in both Latin America by the end of the 1980s. categories, reaching 160 million. Given the income fluctu- Clearly, the education problem in Latin America was ations of the economic cycle, poverty in Latin America can rooted in the lower levels of the educational spectrum. be associated over long periods of time with persons depen- Latin America's relatively low coverage in primary educa- dent on others who lack human capital. The close link tion led to higher absolute numbers of the adult population between education, poverty, and inequality has been found with no education. As can be seen in figure 9, panel C, consistently in micro cross section studies, but this is the while Southeast Asia stabilized its functionally illiterate first time it is shown in a dynamic regionwide analysis.15 population, Latin America's practically doubled in the last 30 years. At the same time, 20 million more people with Summary secondary education-with completed primary education The above analysis shows that inequality in Latin America and with complete or incomplete secondary education- as a whole is very high with a Gini coefficient 5-6 per- entered the labor market in Southeast Asia than in Latin centage points above expected. Given Latin America's level of development, the analysis also suggests that with the rel- FIGURE 10 ative convergence of per capita income among the different Two measures of poverty in Latin America sub-regions of Latin America and with transformations in Millions of persons rural production and labor conditions, income inequality 180 should have reached a peak and then decreased over the past 170 20 years. However, due to the slow expansion of educa- 160 Poverty by illitera tional opportunities in the region over the last two decades, 150 this has not been the case. At the beginning of the post-war 140 period Latin America's labor force had half the education 130 120 / _z expected according to international standards. Educational 110 Poverty by income expansion did not reduce this imbalance as it did in other loo . parts of the world such as in Southeast Asia. In addition, 890 / Latin American educational expansion has been slow and has discriminated against the poorest sectors of the popula- 70 1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 tion. It has left a growing part of the labor force without 137 DEVELOPMEN'I IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO (CONFERENCE, 1995 education. The growth of the functionally illiterate labor amount of poverty in the region will be determined by the force in the past 45 years closely parallels the growth of the level of economic growth. As seen in figure 11, the world population living below the poverty line. economy reached a 1.9 percent annual increase in per capi- ta income between 1991-94. Latin America's per capita Inequality, poverty, and human capital in the income, after its stagnation during the 1980s, grew at 1.9 next four decades percent in the first part of the 1990s. This growth level The previous section stated that inequality in Latin could be maintained for the next 10 years."6 America has not decreased and that poverty has increased The prolongation of economic growth recovery in Latin in the past 45 years despite the loss of importance of agri- America in the next decade could, according to our esti- cultural rents and the rapid convergence of per capita mates, reduce the percentage of the population living below income among the sub-regions. The dynamics of the urban the poverty line. As shown in panel A of figure 12, the inci- labor market seem to be the main cause of inequality in dence of poverty would decrease from about 35 percent to recent years since insufficient human capital formation 30 percent from 1995 to 2005. However, given the project- kept the distribution of educational benefits from equitably ed growth of the population, decreases in the incidence of reaching the population. poverty would not be enough to reduce the absolute num- This section studies the future of poverty and inequali- ber of poor in Latin America. Panel B of figure 12 shows ty in Latin America. The first part examines projected that the number of Latin Americans living in poverty would poverty resulting from expected economic growth and pre- continue to grow at a rate of 1 million people per year- sents alternative scenarios for improvements in equality and a reduction in poverty in the next few decades. The sec- FIGURE 12 ond part shows how the accumulation of human capital Poverty in Latin America, 1970-2005 could promote both the desired equality and the economic a. Head count ratio growth needed to reduce poverty. The third part calculates Percentage of the population the financial consequences of human capital accumulation 50 and its implications for income distribution. 45 A first look at the future 40 The methodology used in the first section to reconstruct the hypothetical evolution of poverty in Latin America in 35 the last 45 years can be used to project the evolution of poverty in the future. If inequality remains static, the 30 FIGURE 11 25 1970 1975 1980 1985 1990 1995 2000 2005 World economic growth, 1966-2004 b. Absolute numbers Per capita annual growth 5 Millions of persons 190 4 1966-73 180 I dustrial countries 170 3 ~~~~~~~~~~~~~~~~~~~160 World econor, 1974-90 1995-2004 150 2 I s>XN,b, # ~~~~~~~~~~~~~~~140 Latin Americ-a, _ - . / 120 0~~~~~~~~~~~~~~~~~~~~~2 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999 2002 110 Source: World Bank data. 1970 1975 198(1 1985 1990 1995 2000 2005 138 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT fN LATIN AMERICA, 1950-2025 FIGURE 13 years, decrease in the following decade, and increase Expected growth in Latin America again-to 1988 levels-in 2015. Third, if per capita Dollars per capita growth accelerates to 3.0 percent annually, the increase in 5,000 the number of poor that resulted from the crisis of the 4,500 Ceschup(3.0%) 1980s could be eliminated by 2005; by 2015 the number 4,000 .- of poor would decrease to 100 million, the same number 3,500) Potential GNP (2.4%) 3,000 o registered in 1965. 2,500 - '' Alternatively, there are three scenarios based on lowering 2,0()()00;X _A>'' I-nertiWg-oth(1.9%) inequality in the region, which result in a reduction in 1,000 poverty. First, if the excess 5 percentage points of inequali- 50)) ty were gradually eliminated, poverty would be reduced to 1950 1955 19601965 19701975 198()1985 19901995 2000 2005 2010 2015 144 million in 2005 and to 122 million in 2015, even if growth remains very low. Second, if this gradual reduction equivalent to two additional poor people per minute- of excess inequality were combined with an increase in the reaching 176 million people living in poverty in 2005. annual growth rate to 2.4 percent-the world average-the Although a 1.9 percent per capita income growth rate number of poor would be reduced to 100 million in 2015. greatly surpasses the stagnant per capita income in And finally, a 3.0 percent growth rate would lead to a dra- 1975-90, it is lower than the region's historical growth matic reduction in the number of poor to 104 million in rate, lower than the expected growth in other parts of the 2005 and to 64 million in 2015. Thus, to reduce poverty, world, and insufficient to reduce poverty in Latin America. the elimination of inequality in income distribution and In fact, a 1.9 percent per capita growth rate is actually economic growth are equally effective. Their combined lower than the growth rate for Latin America between effect could have an enormous impact on the elimination of 1950 and 1974 (2.24 percent), lower than the growth rate poverty in Latin America. expected in the next decade for industrialized countries (2.4 percent), and lower than the growth rate for develop- Catching up in human capital: The size of the ing countries (3.3 percent). An annual growth rate of 1.9 challenge percent for Latin America in the next decade is not a sign Macroeconomic performance in Latin America over the of recovery. Growth at this rate would cause a permanent past 20 years has shown that growth cannot be sustained gap between the region's actual and potential GNP without macroeconomic equilibrium and that while (derived by projecting observed growth from 1950 to adjustments are necessary to stabilize imbalances in fiscal 1974), as indicated in figure 13. or external accounts, stabilization and macro adjustments Low growth and persistent inequality is not inevitable. Economic growth is based to a great extent on the results FIGURE 14 of an accumulation of resources and improving resource Poverty projections: Alternative scenarios of economic growth and income distribution allocation. Inequality is not an "stylized fact" but rather the result of many forces subject to the influence of policies. Millions of persons 200 This simulation model can be used to project the evo- High i.,quah,y, 0rI lution of poverty given different economic growth rates = 160~~~~~~~~~~~~~~~~~~~~~5 and different levels of inequality. Six scenarios for the evo- 160 t _. lution of poverty are shown in figure 14. First, if inequal- 140 ity remains constant at today's high level and if growth 120 '- 4,, remains slow, poverty will continue to increase steadily. 100 .,, Second, if inequality remains constant and per capita 80 . annual growth increases to the 2.4 percent world average, poverty would stabilize at its current level for 10 more 60 970 1975 1980 1985 1990 1995 2000 2005 2010 2015 139 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 are not enough to renovate economic growth. Renewing post-war development process with serious educational economic growth requires increases in resources or insufficiencies in its labor force and how the rate of educa- improving the efficiency of their use and allocation. tional expansion has not been sufficient to close the gap. Government efforts to adjust to financial and exchange The average level of education of the labor force is the rate interventions and the liberalization of commerce also aggregate of educational levels reached by different gener- foster economic growth, as has been the case in the last 10 ations. To identify the relationship between the economy years. and the educational system, the changes in education for The following pages explore a cornplementary factor future generations that will enter the labor market should that contributes to more growth and less inequality: be studied. To this effect, the reconstruction of the educa- human development. tional history of Latin American post-war generations fol- lows. 17 The dynamics of human capital accumulation Three different phases in the history of Latin American 1950-1990 education are shown in panel A of figure 15. As expected, Insufficient education is one of the largest dynamic prob- the dynamics of human capital accumulation were neither lems that the Latin American economy must resolve in continuous, homogeneous among regions, nor stood out trying to reconcile accelerated growth with equality. The on an international scale. While new generations entering first section illustrated how Latin America entered the the labor market in the 1950s received an increasing rate of education, that growth stopped for the 80 million peo- ple entering the work force in the 1960s and 1970s. Later, FIGURE 15 educational expansion in the 1970s increased the human Education of the Latin American labor force, 1950-90 capital of the work force during the 1980s.18 a. For the whole region Regional differences in years of education over time are Years of education shown in figure 15, panel B. The delay in educational 7 expansion in the 1960s and 1970s was the greatest and 6 New workers took more time in the two largest countries of the region- Mexico and Brazil-and coupled with the regression in 5 / Brazil at this time explains the lack of progress in educa- tion during this period (figure 16). Progress has been made 4 M , Average labor torce .......... in the past decade in Central America, the Andean Region, 3 FIGURE 16 2 The education gap: Latin America compared with 1950 1955 1960 1965 1970 1975 198() 1985 199( international patterns, 1950-90 6. The new laborforce in three subregions Observed/expected Years of education 1.0 10 Rest of South America 9 ().9 8 7 6 Meico and Central America () 7 5 . _ _ > , '>, Mexico and Central America 4 ,, ^ ,_-- ~ Brazil o.6 3 - - - - -- 0.5 . ....... Brazil 2 1950 1955 1960 1965 1970 1975 1980) 1985 1990 (0.4 Year each generation entered the labor market 1950 1955 1960 1965 1970 1975 1980 1985 1991 140 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT IN LATIN AMERICA, 1950-2025 and the Southern Cone, but not in Mexico or Brazil. slowly increase; in the third case the rate would increase very rapidly. Future human capital requirements If the rate of education were to grow at the same rate as The high level of educational insufficiency in the Latin it has in the last two decades, the average worker in the labor American labor force is a result of a development pattern force would receive 7.2 years of education by 2020. And, as scarce in human capital. And efforts over the last 15 years mentioned earlier, because the number of years of education have not been sufficient to eliminate the problem. Today, required to achieve slow growth is greater (7.9), the rate of the Latin American labor force has little more than five years growth of education would have to expand more quickly of education. For current levels of development, the expect- than it has in the past two decades. If, for example, levels of ed level of education is slightly more than seven years. This education grew at a rate of 1 year every 10 years, slow equates to an average gap of two years per worker. This gap growth would be achieved and Latin America would reach is much higher for Brazil and Mexico since their levels of international standards of required education by 2020. If the development today are associated with three more years of average level of education grew faster at a rate of 1 addition- education per worker. These two countries make up 93.5 al year of education every 5 years, Latin America would percent of the educational gap in Latin America. achieve rapid economic growth. The average level of education for the labor force is 1.9 In short, eliminating human capital insufficiencies percent for the slow growth pattern studied in the previous within the rapid growth scenario requires a substantial section, 2.24 percent for the historical pattern, and 30 per- acceleration in the growth in education for future genera- cent for the rapid growth pattern. The different patterns of tions. The magnitude of the change required is shown in economic growth represent enormous differences in human figure 17. As shown, to achieve accelerated growth, future capital requirements for the labor force (table 1). For 2005, generations must receive an average of 12 years of educa- 7 years of education would be required to achieve slow tion by 2015, implying that the increase in education growth; for rapid growth, 8 years would be required. For the must double the rates of growth that have occurred over the year 2020, 7.9 and 9.1 years would be required. past 40 years. These human capital requirements can be fit into the three scenarios of human capital formation in the next Quantitative dimensions of the possible quarter century. In the first case, the average educational accumulation scenarios level of the labor force would grow at the same rate regis- Acceleration in the accumulation of human capital tered in the last decades. In the second case, the rate would requires considerable financial resources. To quantify TABLE 1 Scenarios for human capital accumulation FIGURE 17 Education of new generations in Latin America 1995 2005 2020 Years of education Years of education required 13 for different growth rates 12 Kd Slow (1.9 percent) 6.0 7.0 7.9 Moderate (2.24 percent) 6.5 7.5 9.0 11 Rapid (3.0 percent) 7.3 8.1 9.1 10 / Moderate Years of education available 9 for different growth rates 8 / - 0 - - Slow Average labor force Slow 5.2 6.0 7.2 7 Moderate 5.2 6.2 7.9 6 Rapid 5.2 6.5 9.0 5 New labor force 4 Slow 6.5 7.6 8.6 Moderate 6.5 8.5 lo.4 3 1950 1960 1970 1980 1990 2000 2010 2020 Rapid 6.5 10.1 12.0 Year each generation entered the labor market 141 IDEVELOPMENT IN LATIN AMERICA AND THF CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 FIGURE 18 Figure 19 shows that the proportion of GNP designat- Settings for educational expansion ed to basic education financing could remain relatively a. Number ofstoedents constant only in a slow educational expansion scenario.20 Millions of students For Latin America's human capital to converge with inter- 250 national patterns, an additional half a percentage point of the GNP each year for the next 25 years would need to be 2()0 R 'd invested. For rapid convergence with international pat- / u ,vdrate terns, investments would have to increase one full per- 150 centage point of GNP over the next 10 years after which additional resources would not be required due to demo- 100 graphic trends.21 For slower convergence, investments 50 / would have to increase each year for the next 25 years- although less than a full percentage point-and would o) begin to decrease only in 2025. Nevertheless, as shown in 1950 1 960 1970 1980 1990 2000 2010 2020 2030 2040 figure 20, additional public expenditure of half a point of b.Covrage ofthe population GNP on basic education would allow Latin America to Percentage of the population 5 to 24 equal financial commitments to education in the rest of 100 Rapid the world. 90 Despite the additional expenditures required over the 80 -odr,,t,c -. next 25 years and regardless of the pace of the convergence, an increase in investments as a share of GDP is not 70 permanent. 60 50 Some regionwide implications 41) Macroeconomic effects 30 The acceleration in the accumulation of human capital has 1950 1960 1970 1980 1990 2000 2010 2020 2030 2040 enormous implications for Latin American economic growth. Its effects can be measured using international these dimensions of human capital accumulation, a simpli- estimates of the impact of education on aggregate produc- fied algorithm to accumulate flows of students and their tion. Using Lau's results for Latin America,22 the accelera- direct financing was designed. Likewise, a simple model of macroeconomic consistency to evaluate the costs and social FIGURE 19 benefits of the accumulation of human capital was used. Expenditure on basic education under alternative Today, there are approximately 125 million students in scenarios, 1995-2040 Latin America.19 This equates to 65 percent of the total Percentage of GNP population between ages 5 and 24. In absolute terms, this 4.0 demographic group will continue to grow over the next 20 Rd years and will stabilize at an absolute 207 million young by 3.5 2015. If educational expansion continues at the present rate, there will be 200 million students with a 95 percent 3 0 e coverage of the relevant population by 2055. In the mod- erate acceleration scenario, the same 95 percent coverage --------- ~1Slw and the same 200 million students would be reached by 2025. In the rapid growth scenario, those levels would be reached by 2005 (figure 18). 2.1 970 1980 1990 2000 2010 2020 2030 2040 142 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT IN LATIN AMERICA, 1950-2025 FIGURE 20 fraction of the total cost of education. The net present Worldwide public expenditure on basic education, value of an investment of somewhat less than $1.0 bil- 1993 lion24 is $2.0 billion in the next 50 years, slightly more Percenrage ofGNP than the region's current GNP. The rate of return is 24.1 4.0 OECD percent, which is high when compared to other 3.5 AAfrica Former Socialist investments. The rate of return is subject to two parameters. If the WORLD 3.0 Ui opportunity cost for each student is 10 percent less-for India East Asia - f cpt 2.5 Other Asia E Latin America example, 78 percent of per capita income-the rate of Middle East return would be 36 percent. If the effect of educational expansion were similar to Southeast Asia, the internal rate China 1.5 * of return would be 110 percent. If both parameters are lo changed simultaneously, the return would be 136 percent. 6.5 7 7.5 8 8.5 9 9.5 10 These high rates of return indicate that the investment in Log (income per capfra) human capital would pay for itself by taxing the addition- al income created by education at a 9 percent marginal rate. tion of human capital accumulation in the rapid scenario This is less than today's marginal tax rate. brings an additional growth in per capita product of 0.7 In fact, the impact of educational expansion on econom- percentage points per year over the next 15 years and an ic growth could be even greater. Recent literature has iden- average of 0.8 percentage points per year for the period tified enormous benefits associated with the spread of 2000-25. If Southeast Asia is used as a guide for the knowledge that this simple method does not recognize,25 impact of education on economic growth, the effects on per such as its effect on foreign trade.26 The recent expansion of capita growth are 1.1 percent and 1.2 percent for both peri- world trade has been relatively greater for goods with a ods respectively. After 2025, the direct impact on growth higher human capital content than in earlier periods. A would begin to decrease because of a slowdown in human high expansion of human capital in the labor force will pro- capital accumulation brought on by the decrease in student vide Latin America a comparative advantage less subject to population and universal coverage. abrupt fluctuations of basic products. The considerable expense that goes beyond the direct costs associated with providing educational should not be The effects on income distribution and poverty minimized. Education also represents an opportunity cost Rapid acceleration of educational opportunities will have for young people who could join the labor force at an earli- enormous implications on resource allocation, factorial er age if they were not in school. Since most of the educa- tional expansion taking place is among young people who FIGURE 21 would have ended their education before finishing sec- Financing of human capital accumulation, 1995-2050 ondary education, the opportunity cost associated with Percenrage of GNP additional years of education is significant. Assuming the 12 annual opportunity cost per student is 86.3 percent of annu- - Benefits: additional outpur al per capita income,23 the economic cost of massively edu- cating the new generations is a considerable fraction of the 8 GNP, which could surpass 10 percent in the next 15 years. 6 Figure 21 presents estimates of the costs and benefits 4 of human capital accumulation under a fast growth sce- nario. The chart shows that the costs associated with cap- 2 ital accumulation are concentrated in the initial phase and 0------------- that the cost of providing educational services is only a 1995 2000 2005 2010 2015 2020 2025 2030 2035 2040 2045 2050 143 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 FIGURE 22 ution among the population in different countries was cal- Education: Channels toward equity in three culated by Ram. The relationship between educational expansion scenarios level, per capita income, and the rate of return has been cal- a. Standard deviation of human capital assets culated by the author of this paper.28 The hypothetical Standard deviation effect of educational expansion on inequality indicators 5.0 between 1970 and 2025 was calculated based on these Slow empirical regularities. 4.S The results in figure 22 indicate that educational expan- sion over the past 25 years in Latin America contributed to 4.0 increasing educational inequality among the population.29 However, education's contribution to the inequality of asset 3.5 ' holdings would change once the average level of education Rapid reaches 6.3 years. Once past this level, the distribution of educational assets improves rapidly with further education. 3.0 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 Panel A of figure 22 shows that the accelerated accumula- tion of human capital positions the curve's turning point b. Iherarns an edacation toward the end of this century, allowing for a later rapid Percentage rate of return 18.5 decrease in the population's distribution of income-which 18.0 would take place in 2018 if education spread slowly. 17.5 Educational expansion, nevertheless, must have had an 17.0 important impact on education returns in the past 25 years 16.5 as panel B of figure 22 shows. Given the expected effect on 16.0 economic growth, the acceleration of human capital in the 15.5 next decade could have a minimal impact on the evolution 15.0 Rapid of future return rates. 14.5 The relative impact of capital accumulation on the dis- 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 tribution of income in Latin America through the two channels mentioned above can be contrasted with other income distribution, and the price system of the economy, models following the Kuznets methodology. Figure 23, and indirectly on individual and family income distribution which complements and extends the time period of the through the pricing system. While its effects can only be results of the section on educational expansion and income identified through careful general equilibrium analysis27 inequality, presents a synthesis of these effects. this paper uses a simpler yet less complete methodology to According to the classic Kuznets curve, Latin America analyze the impact of different paths of human capital accu- should have reached its highest point of inequality well mulation on income distribution. If an individual's labor before World War II and thus, inequality during the post- income is seen as the return of his human capital, the vari- war economic growth period should have been less wide- ance of the logarithm of income for the population can be spread. Also, since the region's growth ran parallel to a expressed in terms of the rates of return on human capital systematic decrease in per capita income differentials and the distribution of human capital among the among the various sub-regions, reduction in the Gini coef- population. ficient by several points should have also been evident. The Using this methodology, educational expansion affects evolution of human capital seems to have been the force labor income distribution by changing the distribution of that counteracted the effect of the two previous factors. As the population's educational assets or by changing the rate can be seen in the chart, even if post-war human capital of return on these assets. As mentioned, a typical empirical accumulation in Latin America had been similar to inter- relationship between the level of education and its distrib- national patterns, labor inequality would have risen. 144 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT IN LATIN AMERICA, 1950-2025 However, as analyzed above, Latin America did not have FIGURE 23 enough human capital accumulation during the entire Expected progress in equity under fast human period. Therefore, the contribution of human capital to development, 1995-2025 inequality could have been less in the first years after the Gini coefficient war. By the same token, educational expansion would have 0.60 increasingly contributed to inequality in the last four 0.55 ix gs'~C.Z~ decades. As Kuznets would have predicted, the particular characteristics of educational expansion in Latin America oso .g50 Os during this period were uneven enough to keep the Gini coefficient from decreasing. 0.45 The situation could change dramatically however if human capital is accelerated as suggested above. Given 0.40 the combination of the effects of acceleration on the vari- - 351. l . l . . . . l l . l IIIIIIIIIIIIIL ance of educational capital and the rates of return, the dis- 1980 1985 1990 1995 2000 2005 2010 2015 2020 2025 . Effects: income, convergence, migration tribution of income could change dramatically in the next '± Effects of human capital inequality few decades. As shown in figure 23, the distribution of labor income could reach the maximum point of inequal- ity before the end of the century, after which the Gini coefficient of labor income would decrease systematically. Summary and conclusions In the absence of other elements that cause inequality, the Income inequality in Latin America has been the highest in Gini coefficient for global income distribution could the world since the post-World War II period. Over the decrease five or six percentage points in the next 20 years. past 20 years this persistent inequality combined with This is precisely the global decrease in inequality that mediocre economic growth has led to 50 million more poor would reduce the number of poor people in 2015 to a third people in the region, the highest increase in absolute terms of today's level (see figure 23). in the 20th century. This paper argues that Latin America's high inequality, Summary increasing poverty, and slow economic growth are related. Low expectations for economic growth in the medium term Specifically, it argues that the unsatisfactory manner in and weak efforts to remove the factors that cause inequali- which human capital has developed during this period is the ty in Latin America are not enough to reduce poverty in the main factor behind poor performance. Low investment in next 10 years. To eliminate poverty permanently, collective basic education has meant scarcity and uneven distribution efforts should be directed toward accelerating human capi- of human capital, both of which have contributed to an tal growth. Today, Latin Americans are deficient in educa- increase in poverty and the persistence of high inequality in tion by an average of two years. If recent tendencies of slow the past 20 years. The high level of income inequality has educational expansion continue, the insufficiency could reduced support for basic education and in turn, education- become three years, and Latin America will be further from al quality, expectations, and demands have been reduced. As achieving dynamic development. a result there are an increasing number of functional illiter- On the other hand, choosing to close the education gap ates, a weakened economic growth process, and weakened in the next 15 years will be an expensive undertaking-but efforts in the region to expand democracy. returns on this investment are very high. Given its major The average worker has two years less education than effect on economic growth, the investment can finance expected given the region's level of economic development. itself. Additionally, accelerating human capital accumula- This gap has not diminished during the past decades. In tion in the above mentioned manner would be enough to fact, the variance of education of the working population is raise the standard of living for more than 100 million poor now the highest in the world. This situation, combined people in Latin America. with low expectations for economic growth in the mid 145 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 term will produce increasing numbers of poor people for Notes the next 20 years-prolonging the vicious circle of social 1. The Lorenz curve shows the fraction of total income received development in Latin America. by each percentile of the population ranged from lowest to highest This paper calls for action to break that vicious circle. income bracket. The Gini coefficient is the area between the diago- nal and the Lorenz curve divided by the area of the triangle formed by the diagonal and the bottom and right sides of the square. If to eliminate the education gap in the next two decades, everyone has the same income, the Gini coefficient is zero. If all expanding schooling up to secondary education to 200 income is concentrated in the hands of one individual, the Gini coef- million students and allowing 95 percent of the young ficient is one. population to complete basic education, Because of the 2. With 141 observations for 102 countries, the regression line connection between human capital development, income fitted is inequality, and poverty the expansion of basic education Gini = 0.36 + 0.241n (Income) -0.02 (In(lncome))*2 - 0.18Dsoc + 0.041Dlac (5.1) (4.3) (4.6) (8.2) (2.7) will eliminate all five points of excess income inequality in R2= 0.49 the region, and, if accompanied by a reasonable increase in 3. The technique of aggregation was developed by Sherman economic growth, will lead to a virtual elimination of Robinson "Income distribution within groups, among groups and poverty in the region. This "human capital shock" will overall: a rechnique of analysis." Princeton University, Research turn the region's vicious circle into a virtuous one. Program in Development Studies. Discussion Paper 65, 1976. 4. Aggregates of income inequality across countries have been made by Pan Yotopoulos. "The World Distribution of Income: some financial resources. Public expenditure on basic education estimates." Pakistanjournal of Economics, 1976; Albert Berry, Fran.ois must increase at least 0.5 percent of GNP over the next 25 Bourguignon, and Christian Morrison, "The Level of World years. With that effort, Latin America will catch up with Inequality: How Much Can One Say?" In The Review of Income and the rest of the world in its public financing of basic edu- Wealth, 1983; and Margaret Grosh and Wayne Nafziger, "The cation. The effort will also lead to a high rate of return. Computation of World Income Distribution." In Economic Development Economic growth in per capita income will accelerate and Cielteral Change, 1986. 5. ECLAC. Magnitud de la Pobreza en America Latina en los Anos almost 1 percent per year during the next four decades. 80. Santiago de Chile, 1991. George Psacharopoulos and others. And the social rate of return will be at least 24 percent. If Poverty and Income Distribui'ion: The Story of the 80s. Washington, The combined with growth enhancing policies, the social rate World Bank, LATAD, 1993. of return could surpass 100 percent. Moreover, this invest- 6. See Richard Nelson, Paul Schultz, and Richard Slighton. ment can be self-financed by taxing the additional income Structural Change in a Developing Economy. Princeton University Press, 1969; William Cline. "Distribution of Income and Development: A at current tax rates. Survey of Literature," Journal of Development Economics, 1975; Armando Unfortunately, more than money is needed to imple- di Fillipo, "Raices hist6ricas de las estructuras distributivas de America ment this "human capital shock." Current institutional Latina." Cuadernos de la CEPAL, 1977; Eliana Cardoso and Albert structures of the schooling system in the region might Fishlow. "Latin American Development 1950-1980." NBER Working have been adequate for the region's early stages of devel- Paper 161, 1989. opment, but the bureaucratic and inflexible organization 7. See Albert Berry. "Resource Transfers between Agriculture is now seriously limiting educational improvement and and Non-Agriculture." Toronto University, 1978; Lance Taylor. Modelos Macroecondmicos para los Paises en Desarrollo. Mexico, Fondo de expansion. To be effective, financial efforts must coincide Cultura Econ6mica, 1988. with institutional development that incorporates econom- 8. The World Bank produced a classic study. See Lance Taylor, ic and social rationality in the social service of education. and others. Models of Growth and Distribution for Brazil. Oxford With fairer financing, pluralistic and autonomous modes University Press, 1980. of organization, incentives for efficiency and quality, more 9. Using 173 observations from the UNDP's Human Development competitive provision of services, and more informed con- Report, 1994, the following regression line was obtained: Ln(Educa)= -14.4 i 3.2 ln(Income) -0.15 In(Income)2 sumers,30 the "human capital shock" will improve eco- (27.6) (5.8) (4.4) R24=0.70 nomic growth and social development as well as provide a fertile ground for a profound and sustainable democracy. 10. The argument is presented inJuan Luis Londofio, "Kuznetsian 146 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT IN LATIN AMERICA, 1950-2025 Tales with Attention to Human Capital." Paper presented at the 21. This is the situation of Southeast Asia today, where the early Third Inter-American Seminar on Economics in Rio de Janeiro in demographic transition made it possible to accelerate the growth of 1990. It was formalized by Rati Ram's "Educational Expansion and the new labor force and improve its quality without taking a grow- Schooling Inequality: International: Evidence and Some ing proportion of resources from the GNP See Nancy Birdsall, David Implications," The Review of Economics and Statistics, 1990. Ross, and Richard Sabot, "Inequality and Growth Reconsidered," 11. The exception to this was Colombia, recording a decrease in IDB, 1994. the rates of return for education, which more than compensated for 22. Lawrence Lau, Dean Jamison, and Frederic Louat, "Education the growing inequality of human capital. See Juan Luis Londofio. and Productivity in Developing Countries: An Aggregate Distribucio6n del Ingreso y Desarrollo Econdmico: Colombia en el Siglo XX. Production Function Approach," The World Bank, WPS 612, Bogotr, Tercer Mundo Editores, 1995. March, 1991. 12. The results on this chart are a first order approximation. As 23. This parameter is derived as follows: 71.8 percent of Latin the Gini coefficient is not decomposable, I decomposed the variance America's population is of a working age. The participation rate is of the logarithm of income consistent with that Gini coefficient, 35.9 percent, with an average unemployment rate of 7 percent, so assuming a log normal distribution. 33.4 percent are employed. Productivity per worker, therefore, is 3 13. All studies for different Latin American countries confirm this times the income per capita. The population between 12 and 24 trend. See George Psacharopoulos, Returns to Education: An International years of age has a specific labor participation of 50 percent, by which Comparison. San Francisco, Elsevier, Jossey Bass, 1973. "Returns to its expected income might be about 1.5 times income per capita. Education: An Updated International Comparison." Comparative With returns to experience at 2.8 percent annually, his or her Education, vol. 17, 1981. "Returns to Education: A Further income would be 57.6 percent of the income of an average worker. International Update and Implication." TheJournal of Human Resources, Therefore, 1.5*0.576 = 0.863 is the parameter used. vol. 20, 1985 and "Returns to Investment in Education: A Global 24. Billion is used as one million million. Update." World Development, 1994. 25. Paul Romer reviews the literature in "Human Capital and 14. See Oscar Altimir's articles, "Cambios en las Desigualdades Growth: Theory and Evidence." Carnegie Rochester Conference Series on del Ingreso y la Pobreza en America Latina." Mexico, DF, El Trimestre Public Policy, 32, 1990. More recent and extensive is Robert Barro Econjmico, 1994, and "Distribuci6n del Ingreso e Incidencia de la and Xavier Sala-i-Martin: Economic Growth, New York: McGraw Hill, Pobreza a lo Largo del Ajuste." Santiago de Chile, Revista de la Cepal, 1995. 52, 1994. 26. See Jeff Lewis, Sherman Robinson, and Zhi Wang, "General 15. See a summary in Sam Morley, Poverty and inequality in Latin Equilibrium Analysis of Effects of Human Capital and Trade on the America. Baltimore, The Johns Hopkins University, 1995, and Ariel International Distribution of Labor," Washington: The World Bank, Fiszbein and George Psacharopoulos, "Income Inequality Trends in 1995 (Background paper for the 1995 World Development Report, Latin America in the 1980s." In Nora Lustig, (editor) Coping with Workers in an Integrating World). Austerity: Poverty and Inequality in Latin America. Washington, 27. I have applied this general equilibrium methodology to Brookings Institution, 1995. Colombia's income distribution for the period 1938-88, Londofio, 16. The World Bank. Global Economic Prospects and the 1995. Developing Countries, International Economics Department, 1995. 28. Ram's equation (op. cit.) is: International Monetary Fund. World Economic Outlook, 1995. StDev = 1.492Educ - 0.118 Educ2 17. We use Barro and Lee's database on the average level of educa- (25.8) (14.4) R2=0.96 tion of the labor force for 1950-85, adding for 1990 data from the Londofio's equation for 64 countries is UNDP Human Development Report 1994. The education for the new labor Returns = 0.18- 0.OIOEduc + 0.012Educ2 force was generated with a small model of demographic consistency (1.6) (1.4) R2 = 0.40 18. The delay between the middle of the educational cycle and Psacharopoulos's data for 28 Latin American countries at the end of entrance into the labor market is about 10 years. the '80s fits this regression: 19. See UNESCO, Statistical Yearbook, 1995. Returns= -2.16 + 0.65lnY - 0.0441nY2 - 0.0641nEd 20. This analysis has not considered the costs of university educa- (50.0) (2.1) (2.1) (2.9) R2=0.53 tion. If its cost per student education is five times more than for basic 29. A similar result was found in Brazil by J.G. Almeida dos Reis education, Latin American invests approximately 0.8 percentage and Ricardo Paes de Barros in "Wage Inequality and the Distribution points of the GNP in university education. The growth of university of Education,"Journal of Development Economics, 1991. education captured at least 40 percent of all the additional resources 30. This argument is developed in Juan Luis Londoilo, "An hor- invested in education in the past twenty years. izontal mode of social organization." Washington, 1996 (Mimeo). 147 DEVELOPMENT IN LATIN AMERICA ANI) THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Comment on "Poverty, Inequality, and Human Capital Development in Latin America, 1950-2025 ," by Juan Luis Londonho OSCAR ALT I MI R I NEQUALITY IN LATIN AMERICA CAN BE MEASURED USING AGGREGATE DATA FOR THE REGION. However, an aggregate approach does not take into account the variability of inequality among Latin American countries and could present methodological problems. For example, levels of inequality vary with the coverage that is taken into account. Specifically, inequality at the national level is greater than inequality at the urban level. Moreover, different definitions of inequality can lead to the grouping of heterogeneous observations, creating methodological problems. Still, the results are the same when reliable data and a sound methodology are used: Latin America has an unusually high level of inequality. Inequality in Latin America has evolved in various ways. inequality than before the crisis. The other countries, Until the 1980s Argentina, Chile, and Uruguay, countries despite having regained full production, had high postcri- with low and interrupted levels of growth, experienced sis levels of inequality. high levels of inequality. In countries with high growth In some countries the reduction in rural poverty rates, such as Colombia and Mexico, inequality fell until before the 1980s had an important effect on overall this period. During the 1980s inequality increased in most poverty levels. Although overall poverty increased con- Latin American countries. But there were variations siderably in most countries during the crisis, rural pover- throughout the decade. In the mid-1980s levels of inequal- ty did not. ity stabilized; at the end of the decade these levels dropped With respect to the need to generate a virtuous circle slightly. Regardless of these short-term trends, the level of between growth and equality, sustained growth should aggregate regional inequality was about the same at the be based on international competitiveness, which end of the 1980s as during the pre-debt crisis period. requires modernized technology and a better-educated Inequality levels in Latin America today are relatively workforce. If these goals are achieved, Latin America consistent with post-debt crisis levels when measured in could observe greater levels of equality. Here the com- aggregate terms. But different trends surface in individual plementary effects of growth and equality are apparent. countries. At the end of the crisis countries that had not Economic reforms directed at increasing production regained full production and that had per capita incomes and stimulating fixed capital investment must be accom- below precrisis levels experienced higher levels of inequal- panied by education reform. Education reform implies an ity than before the crisis. Of those countries that had investment in human capital and should work toward regained full production by the end of the crisis, only providing equal access to quality education for all. Colombia and Uruguay experienced lower levels of Oscar Altimir is deputy executive secretary of the United Nations Comisi6n Econ6mica para Am6rica Latina y el Caribe (CEPAL) in Chile. 148 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT IN LATIN AMERICA, 1950-2025 Comment on "Poverty, Inequality, and Human Capital Development in Latin America, 1950-2025," by Juan Luis Londoino XAB I ER GOROSTIAG A, S. J. P V OVERTY TODAY IS MORE URBAN AND LESS EQUITABLE THAN IN THE PAST. INEQUALITY IS becoming more pronounced as the globalization of economies advances without employment growth. Latin America needs a new, profound education system to respond to these new inequal- ities, new poverty, and to the new concept of growth without employment. How should Latin America proceed with education reform? To start with, it is important to link growth, distribution, social integration, and human capital. Education reform cannot be more of the same, or more resources for the same type of education. Latin America needs a system that does not sepa- rate basic from university education; education should be seen as a continuum from preschool to universi- ty to postgraduate levels. Thinking about how to proceed with education reform the education problem. Nor does it improve the quality of raises several questions. How can we improve the quality of education at the primary and secondary levels. teachers and of their teaching? How can we get universities Research at the university level has been abandoned in to improve their education, including textbooks? How can Latin America because of insufficient resources. The impact we educate teachers at the secondary level so that they can of this loss is magnified when one considers that university prepare students adequately for university? How can we research is an additional source of resources for the educa- get universities to design timely courses that reflect the tion system and is fundamental to improving the quality of globalization of today's world? How can universities take primary and secondary education. International organiza- advantage of global education systems such as internation- tions should be encouraged to provide domestic research al university exchange programs? How can we create cata- capital. lyst institutions that promote development in Latin The most important adjustments to be made in Latin America? America's education system are not only in terms of quan- Latin America has lost competitiveness in the interna- tity and finances but also in quality and content. The tional market even though the number of university grad- region needs an education system that instills both wisdom uates has increased from 500,000 to 8,000,000. Thus and talent in the region's future pioneers. merely increasing the number of graduates does not resolve Xabier Gorostiaga, S.J. is rector at the Universidad Centroamericana in Nicaragua. 149 DEVELOPMENT IN LATIN AMERICA AND THE C(ARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Comment on "Poverty, Inequality, and Human Capital Development in Latin America, 19 5 0-2 02 5, " by Juan Luis Londoino AS PAS IA CAM ARGO A GENDA 21 IS A PROPOSAL FOR SUSTAINABLE DEVELOPMENT THAT CONSIDERS DEVELOP- ment and environmental issues simultaneously. Within its forty points the agenda focuses on poverty and social organization and rethinks the concept of development from both a social and economic viewpoint. To understand the differences between industrial and developing countries it is important to consider environmental issues. Eighty percent of the world's natural capital is consumed by twenty per- cent of the world's population. Agenda 21 addresses this imbalance and proposes new ways to use and pro- duce the world's resources. Quality of life should not be measured only by income or education. The avail- ability of transportation, basic sanitation, housing, and water is also important to consider. Also important are dignity, well-being, and culture. Participation-instilling local power where centralization but only completes the equivalent of four grades. Education prevails-is one of the greatest challenges confronting Brazil. policies must therefore focus on quality, not quantity. Brazil's leaders welcome the participation of civil society, such Important considerations in education include the need for as nongovernmental organizations. Local power can be used to an emphasis on building up citizenship starting at the basic rebuild what industrial society has destroyed and can con- education level, a new administrative approach in which tribute to the development of an integrated society. schools are seen as management units, and more attention to The quality of education in Brazil is very low. For exam- informal education and more frequent use of media ple, the average child in Brazil attends eight years of school resources. Aspasia Brasileiro Alcantara de Camargo is executive secretary of Brazil's Ministry of the Environment. 150 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT IN LATIN AMERICA, 1950-2025 Comment on "Poverty, Inequality, and Human Capital Development in Latin America, 1950-202 5 ," by Juan Luis Londoino O S CAR JORGE E D U ARD O D URAO T _ HE PARTICIPATION OF NONGOVERNMENTAL ORGANIZATIONS (NGOs) AT THIS CONFERENCE demonstrates the desire for a more intense dialogue between government and society. NGOs represent a segment of civil society that has participated in discussions, followed projects, and played a role in elaborating and reviewing policies. NGOs live in the real world, and they have seen poverty in frightening proportions. And they have seen that the economic recovery of the 1990s has not reduced poverty or inequality in Latin America. Should social inequalities in Latin America be attrib- on education policies but also on generation of new jobs, uted solely to the slow pace of education? Recent social income, public health, and so on-all of which suggest troubles in Brazil and other parts of region show that acces- changes in policies. Will Latin American governments be sibility to assets such as land, urban or rural, and the able to make these investments and take responsibility for immense financial accumulation encouraged by inflation implementing a strategy encompassing all of these issues? and high interest rates also have contributed to the prob- What role should the private sector play in confronting this lem. challenge? The low levels of education in Brazil are also influenced Postadjustment strategies have been one of the themes by the current situation in the labor market. Job offers are of this conference. Events like the Mexican crisis, however, falling, the informal economy is growing, and pressure on indicate that our focus should be on a permanent strategy children to prematurely enter the job market is increasing. of adjustment. Thus human capital investment should be based not only Oscar Jorge Eduardo Durao is executive director of the Federacao de 6rgaos para Asistencia Social e Educacional (FASE) in Brazil. 151 DEVELOPMENT IN LATIN AMERICA AND Il'E CARIBBEAN: RIO OF JANEIRO CONFERFNCE, 1995 Comment on "Poverty, Inequality, and Human Capital Development in Latin America, 1950-2025 ," by Juan Luis Londoino R UTH C ARD O S O EW MEASUREMENT STANDARDS SHOULD BE USED TO IMPROVE RESEARCH AND TO N better understand the relationship between poverty and education, an issue much more com- plex than currently recognized. A number of projects complementing formal education are being carried out in Brazil. For example, to provide the poor with the technical knowledge and skills needed in today's job market, the government is considering a computer instruction program for primary school students. During the project analysis it was discovered that many small community associations are already conducting exper- imental projects for the poor in this area. Although these programs may be of limited significance, at least they exist. Perhaps the education question should be asked in a dif- system in Brazil, using complementary actions to build on ferent way: How can there be social progress in Brazil when a conservative structure. such poor indicators exist? The answer is that obstacles One brief comment about urban population should be such as low schooling standards and discriminatory schools mentioned. It has been said here that the urban population block the way. has been uprooted. However, the uprising of the marginal Improving the quality of education requires both people never occurred, due in part to the creation of com- strengthening teaching requirements and changing ways of munity activity centers. Today the urban civil society is thinking. Brazilian schools still reflect Brazil's worst behav- highly organized-and thus is ready for and able to imple- iors and biases: prejudice, discrimination, and so on. The ment reforms. challenge is to understand the complexity of the education Ruth Cardoso is president of the Conselho do Programa Comunidade Solidaria and first lady of Brazil. 152 POVERTY, INEQUALITY, AND HUMAN CAPITAL DEVELOPMENT IN LATIN AMERICA, 1950-2025 Floor Discussion of "Poverty, Inequality, and Human Capital Development in Latin America, 1950-2025," by Juan Luis Londoino A N AUDIENCE MEMBER EXPRESSED THE VIEW THAT EDUCATION SHOULD BE VIEWED AS AN issue of national sovereignty. Countries can be divided into two groups: those that are slow and those that are quick to respond to technological demands. The education problem will be solved by either meeting or failing to meet these inevitable requirements. In countries that meet these demands poverty should be greatly reduced or even eliminated. Another audience member expressed surprise at the absence of a success story in the paper. He pointed out that in a small city in southern Brazil a second school meal is being provided for all public school stu- dents. In addition, a small domestic television network is being used as a pedagogical resource. The expe- rience has been a success: absenteeism has fallen and student and teacher performance has improved. As for the municipality, the number of school hours was increased without increasing the number of classrooms or increasing spending on new teachers. Another audience member expressed surprise at the media can be a powerful educational tool outside of the absence of a success story in the paper. He pointed out that education system, and this form of "parallel" schooling in a small city in southern Brazil a second school meal is should not be ignored. being provided for all public school students. In addition, Londofio responded to the questions and points. First a small domestic television network is being used as a ped- he noted that Oscar Altimir (discussant) had illustrated agogical resource. The experience has been a success: absen- the point of diversity among countries and differentiated teeism has fallen and student and teacher performance has between short-term and long-term dynamics. But short- improved. As for the municipality, the number of school term trends are determined by longer-term tendencies, hours was increased without increasing the number of so the macro factors on which economists focus are small classrooms or increasing spending on new teachers. deviations from the fundamentals of long-term trends. Another member of the audience said that education With regard to human capital and demand, the paper cannot let go of cultural traditions, even as it contemplates presented correlations between the level of economic the technological future. growth in Latin America and the education of the most Another person said that it was essential to have the recent generation. Those countries that grew more in the nongovernmental organizations (NGOs) and other private past five years were those where the labor market achieved associations present in order to develop more realistic solu- more education. The differences in stock were likely under- tions to education problems. estimated because education data in Latin America repre- The last commentator from the floor observed that the sent much less real learning than in other countries. 153 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Specifically, arid although the data are incomplete, a child important achievement in the past ten years. However, if in Korea may study up to twice as many hours as a child in these rights are not delivered in terms of concrete programs Latin America. with concrete results, it will be difficult for democracies to Generating human capital requires human capital, continue. Londofio continued. For example, the production of human The need to generate incentives to provoke social partic- capital is closely related to the education of teachers, doc- ipation and stable competition in the provision of services tors, and nurses. Thus it is important to strengthen the makes it necessary to rethink the current process of decen- public sector's role in encouraging the pursuit of these tralization. Latin America is decentralizing in a closed careers. bureaucratic model. For example, instead of having a single The intellectual environment now. recognizes that edu- Ministry of Health there are thirty-three, one in each region cation is a basic social subject on which development poli- with their own bureaucratic procedures. The institutional cies should focus. Ten years ago, 5 percent of the World design of decentralization must be put into perspective. Bank's investment portfolio was directed to the social sec- Latin American countries are facing complex problems tor. By 1994, 30 percent of its portfolio was invested in with limited resources. This complexity often causes poli- health and education projects. This percentage is expected cy efforts to become dispersed. to increase. Londofio said that in the case of poverty-a dynamic, The guarantee of rights such as access to health and edu- multisectoral, complex problem-we should try to avoid cation in most Latin American countries has been an social policy dispersion. The results will be worth the efforts. 154 Education Reform in Latin America and the Caribbean: An Agenda for Action ERNE S TO SC HIE FE LB E IN LT ATIN AMERICAN AND CARIBBEAN COUNTRIES UNDERGOING RAPID ECONOMIC GROWTH ARE demanding better-trained human resources. Although these demands have not yet been met, it is possible to trace the causes of the delay and to suggest an effective agenda for action. However, the agenda must be tailored to each country's social consensus, level of financial resources, and specific education strategies. Development trends, demands, productivity (McKinsey Global Institute 1994). and challenges During the first half of the 1990s many Latin American A new development model-based on opening national and Caribbean countries managed to put the legacy of the economies to international competition, attracting foreign 1980s-a decade of economic crisis, with prolonged peri- investment, achieving macroeconomic equilibrium, dereg- ods of import substitution, budget deficits, inflation, and ulating economies and labor markets, acquiring technolog- authoritarian rule-far behind them. Now they are con- ical transfers, implementing democratic governance, and centrating on increasing their ability to grow and to curb reducing inequality-has contributed to rapid economic poverty (Burki and Edwards 1995). With annual economic growth in many countries in Latin America and the growth of about 3.2 percent, Latin America and the Caribbean (ECLAC-UNESCO 1992; World Bank 1993; Caribbean is now the second fastest-growing region in the Birdsall, Ross, and Sabot 1994). This new model has taken world. But as economies open, local businesses will be economic activity to new levels, increasing competitiveness forced to compete with companies that have a long-stand- and adaptability to change. But it has also brought new ing tradition of human resource development and with demands, such as the need to complement economic, social, countries that have a much richer supply of people at all and political success with a labor force that is able to adapt, levels (Coles 1994). The challenge for private sector man- grow, and improve. Free trade zones and increasing pres- agers in the region is to achieve an internationally compet- sures for economic integration with industrial countries itive labor force that is able to adapt to continuous techno- make these pressing needs for better-trained human logical change, to acquire new information, methods, and resources a priority for countries constrained by low labor ideas, and to take on new functions and tasks. Ernesto Schiefelbein is director of the Oficina Regional de Educaci6n para America Latina y el Caribe, United Nations Educational, Scientific, and Cultural Organization, and former minister of education of Chile. The author is grateful to Ricardo Carciofi, Juan Casassus, Ana Marfa Corvalan, John Durston, Hans Fritzche, Pablo Gonzalez, Carmen Luz Latorre, Miguel Nufiez, Richard Pelczar, Juan Prawda, Joseph Ramos, Jose Rivero, Rolando Sanchez, David Silva, Juan Carlos Tedesco, Eduardo Velez, Donald Winkler, and Kin Bing Wu for help- ful comments, and to Andrea Cirillo for editing. 155 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 At the same time political parties and citizens are ly 90 percent of the students in Finland perform at a high- putting pressure on governments and congress people to er level than the highest-scoring 10 percent of students in provide the education that is required to participate in the Venezuela (Schleicher and Yip 1994). new social context; to curb drugs, AIDS, and environmen- Sustained economic growth is associated with the rate of tal problems; and to ensure peace, civil commitment, and accumulation of new knowledge and the pace of techno- solidarity (Mayor 1994; Augier 1994; BID-CEPAL- logical change (World Bank 1994a, 1994b), and successful PNUD 1995). All groups now agree that the quality of edu- private firms continually learn and adapt through the effort cation must be improved (UNESCO 1990). of all workers (Montero 1995). These findings have three Demands for higher-quality and better-distributed important implications for education. First, workers must education in the region are also supported by the influ- be able to readily acquire new skills-increasing the ence education has had on economic outcomes in East importance of basic competencies learned in primary and Asia, by recent research on the multiple impacts of edu- secondary schools. Second, workers should continue cation, and by international comparisons of educational expanding their stock of knowledge-largely the role of achievement. East Asia's experience shows that better higher and graduate education. Third, retraining opportu- education and reduced inequality contribute to economic nities must be available throughout workers' lives (World growth that, in turn, contributes to investment in educa- Bank 1994a, 1994b). Moreover, the basic competencies tion (Birdsall, Ross, and Sabot 1994). These findings are (language, mathematics, and communication skills) must consistent with the link between growth and initial lev- be enhanced by the development of responsible attitudes, a els of human capital for ninety-eight countries during creative approach to problem-solving, and teamwork in the 1960-85 (Barro 1991). However, educational achieve- workplace (Kamii, Clark, and Dominick 1994). Thus edu- ments in Latin America and the Caribbean are growing at cation and training must confer the ability to apply logic a slower rate than in East Asia (Londofio 1995), and many or scientific thinking, define problems, collect data, estab- of the weakest elements of the region's countries are relat- lish facts, and draw valid conclusions. ed to their human resources (World Economic Forum New management styles are also changing the way 1994). education systems operate. New priorities, such as Basic education contributes to growth by increasing the responding to client demands, using interactive learning, productivity of labor, improving health, reducing fertility, delivering standardized inputs in a timely manner, abid- and equipping people to participate fully in an open econo- ing by the law, and fulfilling commitments also require my and in society (McGinn and Borden 1995; Lockheed and new and innovative approaches to education (Montero Verspoor 1991). For example, girls' education levels are 1995). associated with the age at which they marry, use contracep- In Latin America and the Caribbean, where less than tives, and use health care systems. Thus higher levels of edu- half the population is able to communicate in writing, cation tend to reduce sick leave by improving health. these economic and political changes present an unprece- Furthermore, the social rates of return to each education dented challenge to education systems. This challenge level are higher than market interest rates throughout Latin requires a change in the attitudes and culture of the pop- America and the Caribbean (Psacharopoulos 1993; ulation and its leaders (Coles 1994) and is linked to the Psacharopoulos and Ng 1994; Birdsall 1995). In addition, larger issue of income inequality, which must be education helps reinforce democratic institutions or tradi- addressed when analyzing and designing strategies tions, builds national economic capacity, and promotes fair (Londofio 1995). governance, all of which are increasingly recognized as key Few education systems in the region are equipped for elements in the effective implementation of sound econom- their new missions. Thus education reform must take ic and social policies. advantage of the opportunities that the twenty-first centu- Finally, international comparisons of educational ry offers (ECLAC-UNESCO 1992). Governments are com- achievement suggest that the quality of education in the mitted to reforming education systems and increasing LAC region must be improved quickly. For example, near- human capital investment. Now is the time to act. 156 EDUCATION REFORM IN LATIN AMERICA AND THE CARIBBEAN: AN AGENDA FOR ACTION TABLE I Enrollments in Latin America and the Caribbean, 1960-92 (percent) EDUCATION LEVEL 1960 1970 1980 1990 1992 Preschool Rate of coverage, 0-5 age group 2.4 3.3 7.8 16.7 17.4 Primary school Net enrollment rate, 6-11 age group 57.7 71.0 82.9 87.1 87.5 Gross enrollment rate 72.7 90.7 104.5 106.7 106.3 Secondary school Net enrollment rate, 12-17 age group 36.3 49.8 62.9 66.2 68.0 Gross enrollment rate 14.6 25.5 45.3 52.5 53.2 Higher education Net enrollment rate, 18-22 age group 6.2 12.6 26.1 29.1 27.5 Gross enrollment rate 3.6 7.6 16.4 20.6 21.4 Note: The gross enrollment ratio is the number enrolled in a level of education, whether or not they belong in the relevant age group for that level. The net enrollment ratio is the number enrolled in a level of education who belong in the relevant age group, expressed as a percentage of the population in that age group. Source: UNESCO Statistical Yearbook 1994; CELADE data. The state of education in Latin America and the Primary and secondary education Caribbean Despite the expansion in student enrollments and multiple Since the 1960s Latin America and the Caribbean has made attempts at reform, the quality and relevance of public edu- remarkable progress in expanding access to education and cation are inadequate in most countries in the region increasing the number of days students attend each year (Schiefelbein and Tedesco 1995). The six main causes of (table 1). Classroom processes have not changed much, how- poor performance are limited overall learning time, includ- ever. Most public schools have been unable to deliver ade- ing time for homework; lack of basic inputs, including quate education on a sustained basis, and research produc- learning materials and trained teachers; poor selection and tivity in universities is low. Still, a number of successful preservice training of teachers; policies that conflict with projects suggest that effective reforms can be implemented. research findings; inefficient allocation of inputs for poor More children than ever attend school, and access to basic students; and lack of incentives for improvements. Low education is almost universal. Primary school access jumped salaries for teachers also explain why there is little interest from 60 percent in the early 1960s to more than 90 percent in teaching as a career. by the 1990s. In 1992 the average enrollment of the 6-11 Testing programs have shown that the average public age group was 87.5 percent; enrollment by the age of 9 is school student learns roughly half of what is achieved by close to 95 percent. The average student attends more than students in private schools and that only half of fourth- six years of schooling, although only four grades are com- grade students are able to understand what they read (Chile pleted. Although income inequality has not been a con- 1995; Argentina 1994). International comparisons show straint for primary enrollments, it does affect students' abil- that cognitive achievement in Trinidad and Tobago and ity to learn and to continue on to secondary education. More Venezuela-the countries with the best education systems than half of the 12-17 age group is enrolled in secondary in the region-is closer to levels in Africa than in East Asia education, but 15 percent is still enrolled in primary educa- (Arancibia and Rosas 1994) and that there are serious equi- tion (UNESCO 1995). Between 1960 and 1990 higher edu- ty problems (Schleicher and Yip 1994). In Chile, where cation gross enrollments increased from 4 to 21 percent in most inputs have improved and structural reforms have the region. Several countries have established a comprehen- been implemented, achievement scores held steady sive structure for advanced training; however, the actual between 1982 and 1990 for every socioeconomic group, research produced by universities has had very little impact and the achievement gap between the best 5 percent of on the region's economy (World Bank 1994a). schools and the worst 5 percent increased. 157 DEVELOPMENT IN LA'I'IN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 As international comparisons have shown, achievement are female and all work part time; however, expected scores of students in public urban-marginal and rural pri- salary levels are based on full-time compensation for well- mary schools (especially in indigenous areas) are usually trained male teachers. Problems in the public system are about half those of wealthy students (Wolff, Schiefelbein, exacerbated because the best teachers tend to move to and Valenzuela 1993). Poor public schools also have shorter better jobs in other fields or to private schools, where school years and daily schedules that provide some students salaries may be five to ten times higher. Thus pressure for with fewer than 800 hours a year of learning opportuni- better salaries-in the form of annual teacher strikes that ties-compared with 1,200 hours or more for students in are usually backed by political leaders-for public sector good private schools, close to the industrial country average. teachers is continuous. Yet teacher salaries have not This limited amount of time for learning is usually caused increased, strikes have eroded achievement levels, and the by the short supply of public school space (resulting in dou- formation of unions has not improved teaching methods. ble shifts) and teachers' time. Teacher shortages, in turn, are Additional problems, such as selectivity, tracking, and mainly caused by poor allocation of teaching staff (Oliveira teacher preservice training, exist in secondary education, 1989; ECLAC-UNESCO 1992). A substantial amount of where the range of net enrollment rates is much larger than time in poor schools is wasted on unproductive activities in primary education (table 2). Countries must develop clear such as checking attendance and resolving discipline prob- expansion policies (Crouch 1995) and define when and what lems. Moreover, between one-fifth and three-quarters of all types of technical education should be supplied. Finally, schools are multigrade. Teachers in these schools have not teacher training institutions should balance subject and been given special training or appropriate material for their pedagogical training with a hands-on approach. Solutions challenging assignments. should take into account the huge gap between student Inequality is particularly difficult to curb in Latin expectations and the current content of secondary education. America and the Caribbean because most public school managers send their children to private primary and sec- Higher education and research ondary schools and so are not affected by poor achievement An analysis of higher education shows the need to strength- in public schools. But even the top 10 percent of students en research facilities, provide competitive salaries for per- in the region's private schools are only performing near the forming research, launch national programs for doctoral industrial country average (Wolff, Schiefelbein, and training, increase externally reviewed competitive research Valenzuela 1993). project funding, support effective accreditation, and devel- Poor-quality public education is linked to a vicious op public information systems that reduce the uncertainty circle of complex social factors that are resistant to associated with the long-term lagged effects of higher-edu- reform. Few high-school graduates are interested in cation training. teaching careers because of the low professional satisfac- In recent years the region's higher education system has tion resulting from low salaries and poor student achieve- expanded to include about 8 million student and 1 million ment. Few teachers choose teaching as a first-choice faculty members. Increasing enrollments, accompanied by career; most fall back on it because they are not accepted cuts in public spending, have created a massive system that in more prestigious fields. This negative selection bias is is fiscally unsustainable and of varying-often poor-qual- especially detrimental given that successful teachers ity (Brunner and others 1994; Schwartzman 1995). Only require high levels of formal knowledge (Rowan 1994; 20 percent of the faculty has doctoral training (Boyer, Buchmann and Floden 1993). And since, in the absence Altbach, and Whitelow 1994; Schiefelbein and Apablaza of effective assessment methods, all teachers assume that 1993), and half of the faculty has supplemental employ- they meet the required standards for teaching, demands ment-including a large share of full-time faculty. The for higher salaries tend to be continuous (Hatry, Greiner, performance of higher education has also been affected by and Ashford 1994). the decline in academic standards for high school gradu- Salary demands are also affected by gender and work ates, the result of increased access for less-privileged popu- schedules. More than two-thirds of the region's teachers lations and dwindling resources per student (Winkler 158 EDUCATION REFORM IN LATIN AMERICA AND THE CARIBBEAN: AN AGENDA FOR ACTION TABLE 2 Gross schooling rates in Latin America and the Canibbean, 1965 and 1991 (percentage of age group enrolled in the system) PRIMARY SECONDARY HIGHER PRESCHOOL REGION/COUNTRY 1991 1965 1991 1965 1991 1965 1991 Latin America and the Caribbean 15.8 98 106 19 52 4 17 South America 15.2 107 Argentina 21.6 101 104 28 71 14 43 Bolivia 9.8 73 89 18 34 ~ 5 23 Brazil 15, b 108 107 16 39 2 12 Chile 18.0 124 101 34 72 6 23 Colombia 9.3 84 111 17 55 3 15 Ecuador 6.3 91 116a 17 56d 3 20' Paraguay 4.7 102 109 13 30 4 S. Peru 18. 1b 99 117 25 68 8 38 Uruguay 21.6 106 99 44 84 8 32 Venezuela 20.8 68 27 34 7 30a Central America and Panama 7.2 90 Costa Rica 12.2 106 103 24 43 6 28 Dominican Republic 13.9a 87 89 12 74e 2 19 El Salvador 8.9 82 76 17 25 2 16 Guatemala 5.0 50 81 8 23 2 9' Haiti 3.1, 50 56' 5 22a 0 If Honduras 5.9 80 108 10 31 1 9 Mexico 21.2 92 114 17 55 4 14 Nicaragua 8.3 69 101 14 44 2 10 Panama 9.3 102 105 34 61' 7 24 English-speaking Caribbean 31.1 Aruba 29.9 102 Bahamas 104 92 20' Barbados 106 87b 18 Belize 94 British Virgin Islands 36.8 112 Dominica 29.8 106' Grenada 35.5 111 Guyana 17.5 102 57' 5C Jamaica 41.6 109 106 51 62' 3 9 Sr. Kirts and Nevis 35.1 9gc St. Lucia 12.2 104' St. Vincent and the Grenadines 114 Suriname 35.0 130 54' 9a Trinidad and Tobago 4.7 93 95 36 79 2 7 Source: World Bank 1992; UNESCO, Statistical Yearbook 1991; SIRI-OREAL-UNESCO data. a. 1990; b. 1989; c. 1988; d. 1987; e. 1986; f. 1985. 1990). Furthermore, the distribution of higher education quality of graduates (Neave 1988). At the same time growing across socioeconomic levels remains unequal: the wealthiest social demands and changing labor market needs have fifth of the population receives nearly half the public subsi- encouraged the development of private and nonuniversity dies dedicated to higher education, while the poorest fifth higher-education institutions. Two-year technical centers and receives just 5 percent (Puryear and Brunner 1994). four-year professional institutes now enroll more high-school The massive increase in enrollment has forced govern- graduates than traditional universities in several countries. ments to control the product rather than the process. The These new higher-education institutions have helped balance careful monitoring of processes that could be carried out in a the highly politicized nature of public Latin American uni- few elite institutions has been replaced by attention to the versities and have introduced flexibility in higher-education 159 DEVELOPMENT IN LAT'IN AMERICA AND TI-E CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 policies. However, applicants are often not fully aware of the cation and in the number of projects implemented over the differences between the types of institutions. Better informa- past decade. Government spending on education was 3.7 tion should be available for students and parents to make percent of regional GNP in 1990, a slightly larger share rational decisions when selecting the institution and career than in East Asia (3.4 percent) but less than in Africa (4.7 that will consume their time and money. percent). Another 1.0 percent of GNP was spent by the pri- Although research is concentrated in a few universities, it vate sector (World Bank 1994b; ECLAC-UNESCO 1992). is also increasingly carried out by public and private research Although the financial crisis of the early 1980s cut public institutes and large enterprises. Some universities play a spending in education by 30 percent, spending levels have major research role in most countries, but their research is since recovered to 1980 levels. Still, these levels are much constrained by faculty lacking doctoral training and proper lower-one-tenth in U.S. dollars-than the levels in incentives, especially financial. Although consortiums of industrial countries. postgraduate programs, research projects, and fellowships for Rather than increase teachers' salaries, the recovery in doctoral studies are rare, successful examples of joint univer- education financing was used to lower student/teacher sity and public and private research projects do exist ratios in primary schools from 27 to 23, extend the daily (Schwartzman 1995). Still, it is difficult for young schedule, distribute learning materials, widen access to researchers to plan a career that will ensure a reasonable rate preschool, and develop research and graduate training. of return and standard of living. As a result Latin America is Lowering student/teacher ratios while holding teacher in an extremely weak position in producing and using salaries steady has not been an effective policy, however, knowledge. The percentage of GDP allocated to research and and research suggests that the same amount of money could development is one-fifth the proportion allocated by OECD be spent increasing the number of students per teacher (up countries and barely one-third the share in East Asia's newly to a certain level) as well as teacher salaries. industrializing economies (table 3). Externally reviewed The large number of repeaters reflects the inefficiency of research project funding is increasing, however, and some the region's education systems. In 1991, 29 percent of stu- countries have recently started reimbursing universities for dents enrolled in primary school were repeaters. Each year overhead costs and increasing funding levels. about $2.5 billion-nearly one-third of public primary education spending-is spent on repeaters. The figures are Government efforts, financing, and innovations similar for secondary and higher education Latin American and Caribbean countries' interest in educa- (ECLAC-UNESCO 1992; Wolff, Schiefelbein, and tion is reflected in the amount of resources allocated to edu- Valenzuela 1993; Schiefelbein 1994). The costs in terms of TABLE 3 Science and technology indicators, selected regions LATIN OECD EAST ASIAN NEWLY SOUTHERN AMERICA COUNTRIES INDUSTRIALIZING EUROPEAN INDICATOR ECONOMIES COUNTRIES' Per capita research and development expenditures (U.S. dollars) 10 448 23 44 Percentage of GDP allocated for research and development 0.5 2.5 1.4 1.0 Research and development expenditures per engineer or scientist (U.S. dollars) 34,858 141,861 50,160 60,647 Engineers and scientists per 100,000 economically active people 650 115 185 University graduates per 100,000 inhabitants' 156 592 478 191 University graduates in engineering and technology (percent) 19.5 15.6 19.6 17.5 Research and development expenditures by source (percent) Public sector 78.8 4:3.1 35.6 46.4 Private sector 10.5 52.5 61.4 49.5 Foreign sources 3.4 0.4 2.9 3.9 Other 7.3 4.0 0.1 0.2 Note: Covers different years between 1988 and 1990. a. Greece, Portugal, Spain, Turkey, and Yugoslavia. b. Data are for the mid-I 980s. Source: ECLAC/UNIDO Industry and Technology Division data. 160 EDUCATION REFORM IN LATIN AMERICA AND THE CARIBBEAN: AN AGENDA FOR ACTION wasted time and accumulated frustration are even larger ships and externally reviewed research project funding. than the cost of repeaters, however. Finally, there are successful regional collaborative programs The financial crisis of the early 1980s caused higher in key areas such as biology and biotechnology (PNUD education and research and development expenditures in 1995). Widespread implementation of successful programs the region to decline or level off. The lack of resources for could improve achievement levels and help raise teacher expansion provided strong incentives for public universi- salaries. ties to improve internal efficiency, obtain resources from The causes of delay and relationships between policies, student fees (coupled with well-designed student loans programs, and recent progress must be carefully identified mechanisms), sell services, or hire individuals with exper- when setting priorities and designing reform strategies tise in university administration rather than politics (Brown 1994; Hatry, Greiner, and Ashford 1994; Slavin (Riggs 1964). When these new sources of financing are 1991; Levin 1990). Financing in itself has not yet been added, it becomes possible to achieve growth in higher identified as a cause of poor performance, given that in education even as public spending per student declines some countries the resources required to buy time and basic (World Bank 1994a). But increased coverage does not inputs could be obtained by reallocating resources, improv- mean better quality. Research and development expendi- ing efficiency, removing "ghost" teachers from payrolls, or tures remain near half of one percent of GDP; East Asia's using private sector financing. newly industrializing economies spend three times that amount. Causes of poor performance Even though little is known about effective innovations in Reasons for hope education, important advances in the analysis of education Despite the gloomy state of education in Latin America systems have helped identify causes of poor quality and and the Caribbean, a number of successful programs and inequality (Tedesco 1994). Latin American and Caribbean policies have the potential to improve education (UNESCO countries should discuss these causes at the national level to 1993b; ECLAC-UNESCO 1992; Oliveira 1989). First, promote consensus and to ensure that long-term education there are good schools and universities, run mainly by the policies are implemented effectively. private sector, although they mostly cater to rich students. Recent studies in the United States suggest that estab- Second, vocational or technical on the job training is being lishing an environment for effective learning requires offered by institutions such as SENAI (Brazil) and SENA redefining the roles of teachers and students. Learner-cen- (Colombia), and dual education programs are viewed favor- tered instruction and an active role for the learner in con- ably by private industry. Third, massive changes in prima- structing meaning should be emphasized (Hatry, Greiner, ry and secondary school processes have been implemented and Ashford 1994). Moreover, the traditional view of by Escuela Nueva (Colombia) and P-900 (Chile), where self- teachers' role-instilling truths and transferring knowl- learning materials are used. edge-should be abandoned, at least during part of the Other changes include the massive use of computers and instruction time (Ellis and Fouts 1993). Basic inputs, class- the development of Escuelas Llderes (Costa Rica), the room activities, and adequate time and materials are also Programa Nacional de Educaci6n Biling#e (Guatemala), the required for students to learn (World Bank 1994b). School Instructores Comunitarios (Mexico), and the Reforma feeding and health programs also may be required for poor Acadimica de Rio Grande do Sul (Brazil). A national innova- students. Still, provision of these and other basic inputs tion network has successfully operated in Colombia (Toro does not guarantee that learning occurs (Chubb and 1993), and common core curriculums have been imple- Hanushek, 1990; Doyle 1994; Tedesco 1994). mented in Argentina (Braslavsky 1995). Research capabil- To ensure that learning occurs, specific activities must be ity and use of findings in education have been developed part of the daily teaching-learning routine. For example, through the REDUC regional exchange network (Oliveira learning occurs when students discuss the proposed task, 1989). Attempts to provide comprehensive funding for when the task is related to their context or expectations, graduate programs include research and doctoral fellow- when sufficient time is available to learn the task, and when 161 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 formative evaluation is given to students that have not fully and excessive bureaucracy are reflected in underinvestment learned the task (Brown 1994; Kamii, Clark, and Dominick in education, inefficient allocation of resources, and use of 1994; Augier 1994; Schiefelbein 1991). These activities are inefficient technologies such as frontal teaching. all simple, but they require well-trained and committed Reforms must be coherent and consensual to efficiently teachers (Lieberman 1995). Poor teaching techniques, tem- improve education. Frequent changes in strategies resulting porary dropping out, and lack of preparation explain why 40 from the personal objectives of newly appointed secretaries of percent of students in Latin America and the Caribbean education rather than from agreement with all concerned par- repeat the first grade. In fact, most teacher training institu- ties or based on successful projects or research findings have tions provide theoretical training-structural grammar, lin- brought education reform to a deadlock and hindered guistic, or learning models-but lack specific strategies for improvement (Tedesco 1994). Fortunately, the biases of edu- teaching (OREALC 1993). Teachers must be provided with cation officials is reflected in the performance of public uni- better skills. versities. Although most officials send their children to pri- Most of the region's teachers are trained to use the frontal vate primary and secondary schools, their children attend free teaching method, in which lessons consist of oral instructions public universities. As a result the performance of public uni- and information is tailored so that the average student can versities is usually much more efficient (Oliveira 1989). memorize and reproduce the content in exams and receive Education planners in Latin America and the Caribbean good evaluation scores. This method is less damaging in pri- usually do not consider current research findings in their vate schools or in universities where students are similar in analyses. This helps explain why inappropriate policies age, culture, family support, and motivation, and where good were implemented during the economic crisis of the 1980s, materials are available for each student. But in classrooms when student/teacher ratios were lowered despite reduced where teachers have insufficient training, materials are scarce, resources (Schiefelbein and Wolff 1995). At a time when and the group of students is heterogeneous-as is the case for high rates of return are estimated for investment in all lev- primary and secondary students from urban-marginal, and els of education, the use of reliable research findings will rural areas-poor learning results. By definition, all students help convince the public, congress people, and officials of below the level of the "average" student (a level subjectively the need for reform (Birdsall 1995; World Bank 1994b; chosen by the teacher) will eventually repeat. Frontal teach- Psacharopoulos 1994). Thus research and development ing seems to be the main cause of repetition and inequity. efforts, which receive so little attention, should be More than half the students who repeat are in the lower half strengthened (Winkler 1990). of the socioeconomic distribution (Amadio 1995; UNESCO In summary, not enough time has been devoted to iden- 1993). Furthermore, the frontal teaching model is especially tifying, understanding, and defining key problems in pri- traumatic for first-grade students, regardless of whether they mary and secondary education classrooms or to developing have attended preschool, since they must sit through classes a tradition of empirical research at the university level. motionless and silent in rows of benches (Landesman and Thus designing an effective strategy for education reform Ramey 1994). will require analyzing the nature and causes of the poor Reforming the traditional role and teaching style of quality observed in the region as well as the sequence of teachers could require far-reaching social changes- events of reform. In most cases reform will require gradual, changes that must be widely understood and accepted to complex changes rather than drastic, simple ones. achieve the national consensus required for long-term edu- Although Latin American and Caribbean countries have cation reform. The region's education systems are rooted in tried myriad approaches to education, the fight for quality a society that developed from colonial and indigenous tra- reform is only just beginning. ditions (Coles 1994; Oliveira 1989). This legacy con- tributes to a highly imperfect education market in which Defining priorities for reform enrollments depend on demographic trends. Market through consensus imperfections such as education brand names, long-term Since reforms should be based on national consensus, they lagged effects, geographical monopolies, supply subsidies, will differ in each country. Consensus can be achieved by 162 EDUCATION REFORM IN LATIN AMERICA AND THE CARIBBEAN: AN AGENDA FOR ACTION convening a representative group, providing relevant back- such schools if one teacher works in the morning with forty- ground information, and then asking the group to discuss two students and another teacher works in the afternoon diagnostic findings and define long-term objectives and with the same group (the Republic of Korea had forty-eight strategies (Connell 1994). The group should include repre- students per class in 1980). This increase, which could be sentatives from different political and religious back- implemented gradually, should increase achievement grounds, various geographical regions, and the many par- (Lockheed and Verspoor 1991; Schiefelbein and Simmon ties concerned with the education system, including teach- 1979). Although these changes would initially benefit the ers, students, parents, policymakers, scholars, and politi- most deprived students, they would eventually reach the cians. Consensus among such a heterogeneous group is fea- entire system. The alternative allocations of resources gen- sible given the widely recognized need for change. In fact, erated by larger class sizes depend on the initial situation. representative groups in Chile, Colombia, the Dominican For example, by expanding class size from twenty-one to Republic, Ecuador, Mexico, and other countries have forty-two students, learning time and teachers' salaries already use consultative mechanisms to build consensus could increase by 50 percent without requiring additional (Tedesco 1994; Oliveira 1989). resources. However, in countries with student/teacher ratios Three types of reform should be discussed during the above 35 and with no excess staff or "ghost" teachers, the process of reaching social consensus: giving preferential increased time for learning implies a substantial increase in treatment to deprived students (Oliveira 1989), developing financing. One additional week represents a 2 percent alternatives to the frontal model, at least during part of the increase in the total cost of the corresponding level. class time (Lieberman 1995; UNESCO 1993), and Extending from four to five hours a day could cost 20-25 strengthening a tradition of empirical research (Winkler percent more. 1990; World Bank 1994a). Specific strategies must eventu- 2. Gradually transform frontal teaching into active and ally be defined by the group that reached consensus or by participatory learning processes using self-learning and group technical advisory task forces. While some strategies (such work. The amount of time teachers spend going over rou- as long-term salary increases) will require additional tine information can be reduced by producing and dis- resources, others (such as the use of self-learning and group tributing well-tested learning guides, like those the materials rather than traditional textbooks) will only Republic of Korea asked Florida State University to pro- require reallocating resources to more efficient uses and duce in the 1960s (Huh 1992). This type of material has changing laws and procedures. Twelve interrelated strate- already been tested in several Latin American and gies for improving learning that are especially relevant to Caribbean and industrial countries and can easily be used Latin American and Caribbean countries are discussed by teachers with limited on-the-job instruction (Castro below (Wolff, Schiefelbein, and Valenzuela 1993; 1995). Successful use of such materials usually leads to MEC-UNICEF-UNESCO 1994). gradual diffusion to neighboring schools. Self-learning 1. Increase the annual amount of time spent in school to raise materials also help reduce the class time wasted on non- achievement levels, By increasing the number of school days learning activities. Such materials can be adapted by each year from 160 to 200 and extending daily schedules bilingual teachers to meet the needs of ethnic groups, from four to six hours the region should reach attendance thus encouraging use of the local context and family tra- levels similar to those in industrial countries (1,200 hours a ditions. Such material also helps teachers prepare for year). As it stands primary and secondary rural students future computer usage as part of the regular learning attend school three hours a day, 100-120 days a year, which process. Moreover, the cost of self-learning and group amounts to 300-400 hours a year (ANEP-CEPAL 1990). work materials is relatively low. The required increase can be partly financed by reallocating 3. Extend preschool education to prepare children for primary resources or eliminating "ghost" teachers from payrolls. For school. This is especially important for urban-marginal and example, in 1994 there were twenty-one students per rural students, who suffer a tremendous shock upon enter- teacher for a half-day of classes in Chile's public primary ing first grade and being exposed to the frontal teaching education system. The daily schedule could be doubled in method (UNESCO 1993). Enrollment at an early age 163 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 together with improved quality tends to reduce the num- teachers and to gradually reform traditional teaching meth- ber of repeaters, particularly in the first grade. Preschool ods (see point 2 above). The use of student guides for active education can initially be delivered with partial assistance learning and regular local workshops for teachers to from the student's mother or another relative. This exchange comments on such materials, for example, could approach helps keep preschool costs-which, because of improve teaching. In addition, better strategies for teach- the need for small classes, can be twice as high as primary ing reading and writing should be included in preservice education-at levels similar to those of primary education. training (UNESCO 1993c), and mentoring should be a key Preschool education should eventually reduce repetition in part of teachers' preservice programs. Selection mechanisms public primary schools and free some of the enormous that raise commitment and incentives for improving pre- resources being wasted in repetition. It should also service training should be coupled with approaches that increase the average number of completed grades. gauge teachers' interest in teaching. Improving the quality Increased preschool coverage usually requires increasing of training and teachers is a matter of reallocating resources education resources, since private supply cannot expand and political will, rather than of securing new resources. unless subsidies are available. 7. Encourage decentralization and local participation. 4. Link learning experiences in high schools to the working world Although these processes in no way guarantee an increase to complement active and participatory education and to ease the in the quality of education-in several countries decentral- transition to the labor market. High schools should give special ization is implemented for political, financial, or adminis- attention to communications, mathematics, and science trative reasons not linked to education-the decentraliza- since these skills are necessary for jobs and further education. tion experiences in Chicago and Kentucky are encouraging The participation of the local business community, opportu- (David 1994; Bryk and others 1994; Walberg and Niemiec nities for dual technical education, and internships should be 1994). Decentralization in Latin America and the actively pursued. Opportunities for work or play with com- Caribbean has yet to prove that education quality can be puters should be encouraged. Detailed analysis of foreign- improved, although poor centralized administration may language instruction, including the pros and cons of a few- benefit from the process (Palma 1995; Malpica 1994; hours per week versus "immersion," should be carried out. Prawda 1991; Winkler 1991; Oliveira 1989; Noah and Strategies that develop higher-level cognitive skills, like Sherman 1979). Thus decentralization is an area that making decisions under uncertainty, pursuing alternative requires further study. approaches to problem-solving, and concentrating on pro- Community involvement is attractive policy, but it is jects for long periods, should also be used. difficult to implement in a class-stratified society. The same 5. Ensure that resources can be reallocated easily and quickly. elements that make decentralization attractive make its Enrollment changes are brought about by higher levels of implementation difficult (Oliveira 1989; Ogawa 1994). economic activity that increase labor mobility and by For example, the 1980 decentralization in Argentina dis- reductions in the number of repeaters, especially in initial mantled the statistical system, and legal norms were only grades. Teaching staff should be reallocated each year in enacted in 1993. Decentralization mainly involves reallo- response to these changes, but their access to work should cating resources, not developing additional ones. be guaranteed. In Rio Grande do Sul (Brazil), for example, 8. Develop better testing and information to monitor the qual- a more efficient allocation of teachers enabled the system to ity of education, inform the public about key education issues, expand enrollments and to increase teacher salaries without build social consensus, and increase accountability of the use of increasing the total budget. The long-term strategy for educational resources (Puryear 1995). However, simple corre- raising salaries must be complemented with a short- or lation analysis between inputs and student achievement medium-term strategy for extending teaching time. Both should be avoided because achievement is a complex func- strategies should be consistent over time. tion reflecting many interrelated factors, including past 6. Restructure and revitalize teacher training. Although achievements, socioeconomic background, level of urban most teachers are trained to use frontal teaching methods, development, and selection at entrance or at the end of each it is possible to improve the selection and training of future school year. For example, private school students usually 164 EDUCATION REFORM IN LATIN AMERICA AND THE CARIBBEAN: AN AGENDA FOR ACTION have higher achievement scores than students from public and start with low-cost changes (Wolff, Schiefelbein, and schools, but the difference can sometimes be explained by Valenzuela 1993). Over the longer term the flow of public different socioeconomic backgrounds or by the fact that resources should be increased gradually as improvements in private schools can expel poor achievers while public education are objectively identified and measured. In addi- schools must accept all applicants. The costs of testing and tion, the private sector should mobilize a larger share of information programs are about 0.1 percent of the annual education resources, and resources should be distributed cost per student. Results should be widely distributed so more eqtuitably. Any increases, public or private, should be that parents and other concerned parties can make tied to improvements in educational quality. At the same informed decisions and so that society can hold authorities time legal norms should be enacted to increase cost sharing accountable for the way education resources are used. to the extent possible and to secure international coopera- 9. Subsidize the production and use of education research find- tion and financing (McMeekin 1995). ings to increase the efficiency of the educational system. 12. Define a new role for the secretary of education, especially Production of research is an important part of graduate within decentralized or private education systems. Six tasks education, but use of research requires the continuous should be highlighted: improving efficiency by identifying development of the regional exchange network (REDUC) promising programs (educational and management), as well national networks. Research findings should be used financing their evaluation, and widely distributing the to diagnose education problems at the national and local results; supporting accountability by financing and moni- level, to identify causes and possible solutions or successful toring testing systems and publishing the results; helping projects, and to design policies (McGinn and Borden individual decisionmaking by launching or strengthening 1995). Otherwise conventional wisdom will continue to accreditation mechanisms, especially at higher education guide decisionmaking in education and inappropriate poli- levels; supporting research by encouraging externally cies will continue. Given that the benefits from education- reviewed project funding; improving equity by collecting al research cannot be appropriated by researchers, public and processing information that helps identify groups subsidies are necessary. About 1 percent of the education needing special attention, subsidies, or incentives to reach budget should be allocated through externally reviewed acceptable education levels; and supporting social consen- project funding. sus by convening consultative mechanisms, supporting 10. Expand graduate education programs to stimulate research their work, and disseminating their reports to encourage and to train future university professors. Less than 20 percent participation from parents and teachers (Tedesco 1989). of university professors have doctoral training; as a result These intellectually and politically challenging tasks university students are usually trained using synthesis of demand a flexible public sector personnel policy that outdated books. Poor training is the result of the low enables recruitment of dynamic leaders into the sector and salaries and limited opportunities that national and inter- continuous professional development of sector staff. national graduate students confront. Even though universi- ty faculty salaries cannot be substantially raised for all fac- Conclusion ulty members in the short term, salaries should be raised The twelve recommendations presented above are not of for the small group of senior researchers who staff graduate equally importance. But to a large extent they are closely programs. This group comprises about 10 percent of uni- linked, and work toward common goals: versity faculty. A program providing research grants to 1. Achieving education reform that is inclusive and supported such a group, including salaries and doctoral fellowships, by the society at large. There is a need for substantive educa- would be equivalent to about 20 percent of the cost of pub- tion reform. Since many stakeholders are affected by and lic undergraduate university financing. interested in reform, the reform process must include all 11. Increase education financing over time to fund increasing important interest groups. This process should result in a salaries, extended school years, preschooling, computer networks, national consensus on strategies that raise the quality of graduate programs, and research. The initial reform strategy schooling, especially for the poor. should implement successfully tested educational strategies 2. Guaranteeing each child a minimum basket of educational 165 DEVELOPMENT IN LATIN AMERICA AND T'HIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 inputs, including materials for group and personal learning, national support for reform, identifying and evaluating textbooks, other instructional materials, and, most impor- innovative programs, and ensuring that school performance tant, a guaranteed number of hours of instruction. The information is widely disseminated to students, parents, length of the school day and the length of the school year and teachers. However, schools should be given incen- must be extended-with important implications for tives-not forced-to improve their performance. teacher salaries and the teaching profession. Of course, the efforts made in each country will differ 3. Targeting extra resources to children of low-income families. because their baselines are different. Therefore reform Improving the income distribution in Latin America will strategies should be tailored to local needs. Each society require significantly higher investments in human capital must decide on the education levels it requires to live for the poor. These investments include increased access to peacefully in a democratic regime and to achieve sustain- preschool, subsidized school lunches and school materials, able economic development through international compe- better teachers, and longer school days. tition. Non scholae, sed vitae discimus-not learning for 4. Changing teachers' education. The teacher is critical to the school, but for life. improving classroom processes. Improving the quality and style of teaching will require improving teacher training, References developing mentoring and group learning approaches, and Amadio, Massimo. 1995. "La Repetici6n Escolar en la Ensefianza changing the reputation of the teaching career. University Primaria. Aspectos Relevantes." IBE-UNESCO, Geneve. departments and other teacher training institutes will have ANEP-CEPAL. 1990. "Ensefnanza primaria y ciclo basico de edu- todbeparefomen andoth teacher salaries wi ll have tobeincreased cacion media en el Uruguay." 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"Education Sector Strategy in the Latin America Educacao Basica. MEC-UNICEF-UNESCO, Brasilia. and Caribbean Region." Washington, D.C. UNESCO. 1990. "World Declaration on Education for All. . 1991. World Development Report 1991: The Challenge of Framework for Action to Meet Basic Learning Needs." Paper pre- Development. New York: Oxford University Press. sented at the World Conference on Education for All, Jomtien, . 1993. The East Asian Miracle: Economic Growth and Public Thailand. Policy. New York: Oxford University Press. . 1993a. "The State of Education in Latin America 1980- - . 1994a. "Higher Education. The Lessons of Experience." 1989." OREALC, Santiago. Washington D.C. . 1993b. "Towards a New Era in Educational Development, . 1994b. "Priorities and Strategies for Education." Education Major Project in the Field of Education in Latin America and the and Social Policy Department, Washington D.C. Caribbean." OREALC, Santiago. World Economic Forum. 1994. World Competitiveness Report 14. . 1995. "The State of Education in Latin America, Lausanne, Switzerland. 1980-1991." OREALC, Santiago. 1'69 DEVELOPMENT IN LATIN AMERICA AND TIIE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Comment on "Education Reform in Latin America and the Caribbean," by Ernesto Schiefelbein ROBERTO CARNEIRO Tr_ HE INEFFECTIVENESS OF EDUCATION REFORM IN LATIN AMERICA OVER THE PAST DECADE CAN be attributed to three factors. First, education reform has been confused by administrative success, legislative production, and technocratic projects. Second, there has been too much emphasis on achieving consensus. Reforming and building education policies that last beyond electoral cycles requires political courage and stable government. Third, education reform has not been on the agendas of all members of society. Putting education at the top of the national agenda should be a priority of ministers, politicians, executives, and intellectuals, not just of the ministry of education. Reducing social inequality and eliminating exclusion of * Graduate study support the poor imposes increased demands on education. But in * Improving professional standards, the social status of Latin America the availability of goods is growing at a much teachers, and general teaching conditions slower pace than the increase in demands. What can be done? * Cooperation between local administrations and the pri- First, an education "new deal" involving every democratic vate sector to provide complementary studies and a school- political association should be established. The deal should work exchange so that youth and adults are more profes- work toward approving, in the medium term, a program of sionally qualified. financial support for education. Such support should come Education, including preschool, also needs to be linked from the state and from private groups such as companies, to other programs and activities that seek social promo- families, individuals, and bilateral and multilateral institu- tion. Schools are social institutions; they teach us the tions. This program should last for at least ten years because importance of social cohesion, living together in peace, implementation of sound and lasting education policy will and living in communities. Schools are an indispensable not be sustainable in less time. Second, resources should be part of the social system. effectively and equitably allocated. Distribution of funds Improving the quality of education is a dynamic should be based on the following priorities: process. Schools' effectiveness should not be measured by * Universal basic education, including preschool for students the assets they have accumulated. Instead, an effective under five and primary school for the next nine or ten years school should be considered one that produces an envi- * Gradual development of market and private investment ronment of strong leadership, tradition, service, responsi- mechanisms in college education, with the state responsible bility, community values, and ownership of the education for ensuring access for the poor mission. Schools need to be given back to civil society, Roberto Carneiro is president of the executive board of Televisao Independente, S.A. (TVI) and former minister of education of Portugal. 170 EDUCATION REFORM IN LATIN AMERICA AND THE CARIBBEAN: AN AGENDA FOR ACTION and should not be viewed as state-owned bureaucratic and conformity. Accomplishing this will require strong, terminals. educational communities where education is more than In our society those who will prosper are those who can just a factor of economic growth. Education should be the master new skills and take on risks. Poverty will only fall aim of development. Human potential is Latin America if human development programs are implemented that and the Caribbean's greatest wealth-we must believe in invest in building a culture that can confront adversity this resource and make good use of it. 171 DEVELOPMENT IN LATIN AMERICA ANI) TOEt CARIBBEAN RIO DE JANEIRO CONFERENCE, 1995 Comment on "Education Reform in Latin America and the Caribbean," by Ernesto Schiefelbein EDUARDO AMADEO F ROM AN ECONOMIST'S POINT OF VIEW, THE BENEFITS OF EDUCATION CAN BE MEASURED IN two ways. For the person who receives education, returns are measured by future income; for society, education generates externalities and allows individual agents to perform. Moreover, individual performance is not independent from group performance. Four basic points concerning the relationship between economic development and educa- tion have characterized Latin American economic development. First, Latin America has experienced intensive growth in jobs requiring few qualifications and has used a development strategy in which workers' skills play a minor role. Until a few years ago companies survived without investing in their employees' education. Today, as a result of technological advances and international competition, this sce- nario is changing and companies have begun to invest in their employees. But advances of this sort are taking place only in a small part of the society. Second, the importance of externalities has not been emphasized. Third, no direct strategy for improving the quality of life for the poor has been developed. Any progress in this area has been the natural outcome of economic development-that is, nothing more than a trickle-down effect. Finally, social segregation has resulted in an unequal distribution of political capital. A society cannot finance or commit to education without capital. First, Latin America has experienced intensive growth has been the natural outcome of economic development- in jobs requiring few qualifications and has used a devel- that is, nothing more than a trickle-down effect. Finally, opment strategy in which workers' skills play a minor social segregation has resulted in an unequal distribution role. Until a few years ago companies survived without of political capital. A society cannot finance or commit to investing in their employees' education. Today, as a result education without capital. of technological advances and international competition, What can Brazil and the rest of Latin America do in this scenario is changing and companies have begun to light of new international competition? One option is to invest in their employees. But advances of this sort are participate in the competitive market by producing goods taking place only in a small part of the society. Second, using low-skill workers. But since there is a surplus of the importance of externalities has not been emphasized. low-skill workers throughout the world, including in Third, no direct strategy for improving the quality of life more-developed countries, investments on this front will for the poor has been developed. Any progress in this area result in a no-winners war. Participating in the interna- Eduardo Amadeo is a professor at Pontificia Universidade Cat6lica in Rio de Janeiro, Brazil. 172 EDUCATION REFORM IN LATIN AMERICA AND TIIE CARIBBEAN: AN AGENDA FOR ACTION tional market in this way would be useless. Public education teachers in Brazil have strong politi- A second option for Brazil and Latin America is to pro- cal power through their unions. However, they have not vide some added value to workers that can potentiality been successful in getting the government to increase generate competitive advantages. This kind of action their salaries or improve education. The fundamental requires considerable investment in research and develop- problem in Brazil and other countries is the lack of social ment strategies as well as in education. It also depends on commitment to education. Lack of commitment results in many externalities. Nevertheless, in the long run it is the the immense segregation of poor children, low standards most promising option. in public schools, and lack of sensitivity to the impor- The presentations at this conference have painted real- tance of education among the public school population. istic pictures of education in Latin America. They have Reaching consensus will require agreeing on methods concentrated on a "software" vision of the problem and and on making an honest commitment to changing educa- "how to" approaches to make education work. But is it tion in Latin America. However, as an economist, it is dif- true that our main problem is software? ficult for me to imagine how to generate this consensus Statistics show that the top 10 percent of rich students other than by establishing taxes where the rich pay for the in Latin America perform as well as, or even better than, education of the poor. Consensus on software is not suffi- those in many industrial countries. If the same methods- cient to make education in Latin America work. In this that is, the same software-were provided to everyone in sense I propose the following idealistic but valid sugges- the region, outcomes would obviously be much better. tion: middle-class families could pay a 10 percent tax on Since we already have the software, we must concentrate their children's tuition to improve the education of poor on the other, more difficult, delicate, and frustrating part children in the nearest public school. of the problem: the unequal distribution of education. 173 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Floor Discussion of "Education Reform in Latin America and the Caribbean," by Ernesto Schiefelbein N AUDIENCE MEMBER NOTED THAT LOW DEVELOPMENT INDICATORS AND POOR-QUALITY education were often used to explain social and economic inequalities and fragile democra- cies in Latin America. However, the opposite is true. Authoritarian governments are not A interested in improving the quality of education because education develops the critical rea- sonin s that can turn against those in power. Another speaker observed that effeciticea-on that makes democracy grow precedes effective action that leads to a national pact on education. Another audience member said that the education and increased resources to the sector. This was a result of model presented in the second part of the session intro- their understanding that there were possibilities to con- duces a type of education that is both participative and front and resolve the problem. liberating and that helps develop self-awareness. Education in Latin America is not on the forefront of A fourth person noted that education is a unique tool technological progress; it is applying nineteenth-century because it simultaneously strengthens democratic institu- techniques. Bearing this in mind, Schiefelbein said, there tions and increases productivity and equity through eco- is immense possibility for progress. Using the same nomic development. The direct contribution of education resources, it is possible to increase results by 20-30 per- to growth means a higher quality of education for all. cent. This does not mean, however, that the current Contributing to equity does not consist of reducing income resources dedicated to education are sufficient. inequality, however. Instead, education should generate There is a paradox between the expectations placed on equal opportunity where no one is prohibited from climb- teachers, the importance of their role, and their low ing the social ladder. Equal quality of education implies a salaries. However, the paradox can be partly explained by system of incentives and compensation in which teachers societies' awareness of poor results in the education sys- are enticed into working in rural area schools. With persis- tem. Society is unwilling to pay teachers high salaries tence and commitment, the problem of poverty can be when only half of today's students can read. And although resolved and equal opportunities achieved. salaries historically increase after teachers strike, they Schiefelbein responded to the questions and points, eventually fall again because of the poor quality of the noting first that consensus implies an understanding of education system. the problem-which few countries in Latin America When we talk about education in Latin America, it is have. Chile is an interesting example of a country that is important to note that few parents send their children to aware of its education problem. The government decided public schools. Thus when we talk about education prob- in a relatively short period that education was a priority lems we are often talking about the education and problems 174 EDUCATION REFORM IN LATIN AMERICA AND THE CARIBBEAN: AN AGENDA FOR ACTION of others, not our own. If decisions concerning the education Schiefelbein concluded, the absence of thinking is all too systems affected the people who make those decisions, edu- evident in Latin American schools today. cation in Latin America would be much better. Schwartzman (chair) summed up by noting that educa- Textbooks used in Latin American schools contain tion today is being looked at in a radically new light; it is many shortcomings. For example, they do not relate what now considered a strategic and vital part of economic devel- occurs in the classroom to the family. In addition, they do opment and social survival. Also, we now realize that the not present the students with options or permit them to discussion on quantitative expansion and financial invest- make decisions. Group work is not encouraged. Finally, ment has to be extended to examine why education systems they do not require students to write. Without writing it that have been receiving funding have not improved. is difficult to ensure that thinking is taking place. And, 175 SPECIAL SESSION Capital Markets after the Mexican Peso Crisis WILLIAM CLINE S IX MONTHS AFTER THE COLLAPSE OF THE MEXICO PESO, INVESTORS AND POLICYMAKERS ARE asking which mistakes led to the crisis, cautiously reexamining their responses, and identifyin the systemic reforms necessary to avoid such disruptions in the future. After a brief diagnosis, this paper critically reviews the list of alternative prescriptions currently being discussed. Renaissance of the early 1990s Even so, once-burned banks stayed on the sidelines and To understand what happened in December 1994 it is the capital boom of the early 1990s came in the form of helpful to review what occurred in the previous four years. direct investment, purchases of stocks, and floating bonds. The 1990-94 period marked the most recent internation- An important part of the resurgence represented capital al capital market swing between bust and boom. Net cap- repatriation by Latin American investors. As such, the ital flows to Latin America, which had peaked at about $40 resurgence should have been recognized as a one-time read- billion in 1981 at the end of the 1970s petrodollars boom, justment of portfolio allocation between foreign and fell to an average of $10 billion a year in 1983-89. Later, domestic assets that could subsequently imply more mod- with the favorable conjunction of the Brady and Greenspan erate inflows. As the smart money came back and pushed Plans, net flows averaged about $50 billion a year in up domestic equity markets, institutional money from 1991-93 (Cline 1995). abroad, in search of an alternative to low returns, joined in. Dramatic reforms in economic policies and structures This resulted in capital flows too large for comfort in coun- were a prerequisite to this revival. Major Latin American tries such as Chile and Colombia that were not keen on the debtors had reduced fiscal deficits, liberalized trade, priva- resulting pressures for exchange rate appreciation and mon- tized state firms, and deregulated in a continent-wide shift etary expansion. from an inward-looking, populist economic model toward In February of 1994 the U.S. Federal Reserve began a the Washington consensus of market-oriented reform. long series of increases in interest rates in efforts to cool an Debt, and especially interest burdens, relative to exports overheating U.S. economy. The stage was set for a serious and GDP had improved markedly since the early 1980s. chill on the capital market, precisely as some had warned The Brady Plan forgave about one-third of long-term bank (Calvo, Leiderman, and Reinhart 1993). Even so, net cap- debt and thus about one-sixth of total debt-a technically ital flows to Latin America in 1994 were still more than modest alleviation but a decisive lancing of the debt $50 billion and only 10 percent below the 1993 peak boil. (ECLAC 1994). William Cline is deputy managing director and chief economist of the Institute of International Finance. 177 DEVELOPMENT IN LATIN AMERICA AND T'HE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Mexican miscalculations tions were ripe for a peso crisis when investors realized in The capital inflows were most buoyant in Mexico, where late December that Mexico owed approximately $20 bil- the added capital market euphoria associated with NAFTA lion of these short-term instruments to foreigners while provided Mexico with more than enough rope to hang having only about $6 billion in reserves. itself. Net capital inflows to Mexico reached $98 billion in The lessons from Mexico are at least threefold. First, safe 1991-94, about half of the Latin American total (ECLAC limits to external current account deficits should be 1993, 1994). The counterpart of the large inflow was a observed regardless of their origin. Second, a prudent bal- large current account deficit reaching approximately $30 ance between use of the exchange rate as an anchor against billion, or 8 percent of GDP in 1994. inflation and maintenance of a realistic real exchange rate With the benefit of hindsight, most analysts-includ- should be achieved.4 Third, short-term debt, especially ing President Ernesto Zedillo and Finance Minister short-term government debt held by foreigners (whether in Guillermo Ortiz, both PhD economists-agree that the domestic or foreign currency) should be minimized. principal policy mistake was that of holding on to the quasi-fixed exchange rate too long.1 While this "anchor" Spillover and aftermath against inflation was highly successful in the late 1980s, its The initial spillover from the peso crisis was widespread excessive rigidity and the resulting overvaluation eventual- and ranged from more obvious victims such as Argentina ly brought Mexico's external imbalance to dangerously and Brazil to much less likely ones such as Sweden and high levels. If most of the deficit had represented invest- Thailand. One can even argue that the spillover con- ment in production capacity for tradables, this strategy tributed to the sharp decline of the U.S. dollar against the might have worked. However, much of the deficit repre- yen and deutsche mark. First, markets rediscovered the sented consumption, as the share of investment in GDP risks of large current account deficits (such as that in the rose by much less than that of the current account deficit. United States). Second, there was a technically incorrect An investment-oriented strategy would also have been perception that the Mexico bailout by the United States risky with an external deficit this large. In Mexico political tied up resources otherwise available to defend the dollar shocks such as the Chiapas rebellion and Colosio assassina- (Exchange Stabilization Fund). Third, the crisis meant a tion removed room for adventurous economic policy. likely deterioration in the U.S.-Mexico trade balance of Mexico should have devalued in the second quarter of 1994 about $20 billion.5 while its reserves were still relatively high instead of wait- Financial contagion in Mexico occurred in part due to ing until being forced to do so at the end of the year, when the fact that much of the short-term portfolio investment reserves were down to six weeks' imports. was made by investors with little experience in Latin Most of Mexico's policies have been commendable and America. Later, there was a tendency toward binary reac- were widely seen as a prototype of the Washington consen- tion, as large mutual funds sold off Latin American holdings sus model. Mexico's willingness to run a large external when Mexico reneged on its pledge not to devalue. High deficit was based on the "consenting adults" thesis (associat- levels of short-term debt, low reserves, an exchange rate ed with former U.K. chancellor Nigel Lawson), which anchor, political shocks, and a current account deficit rela- assumes that large current account deficits financed by pri- tive to GDP unmatched by any other major country except vate capital are not problematic for policy as long as the Hungary also contributed to the contagion. The character- they do not stem from fiscal deficits.2 This theory, which istics of the Mexican situation were in sharp contrast to the made optimistic assumptions about the speed and auto- debt crisis of 1982 when Mexico's problems of large exter- maticity of adjustment, was proven wrong in Chile in 1981, nal and fiscal deficits were typical of Latin America. in the United Kingdom in 1986, and now in Mexico.3 In 1994 Argentina was the closest possible policy-clone Mexico's risk-taking strategy was also evident in its of Mexico. Like Mexico, Argentina had a fixed exchange heavy reliance on treasury bills (CETES) and tesobonos rate anchor as well as a large current account deficit. (peso obligations indexed to dollars). The short-term inter- However, the current account deficit relative to GDP was est savings were penny-wise and pound-foolish. The condi- less than half as large as Mexico's. The fixed exchange rate 178 CAPITAL MARKETS AFTER THE MEXICAN PESO CRISIS in Argentina was part of a currency board that dictated 47 cents in December 1994 to 32 cents in early March of contraction of the money supply in the event of declining 1995, was back up to 50 cents by early June. Venezuelan reserves. In Mexico the impact of falling reserves on the Brady bonds similarly had fallen from 50 cents to 39 cents money supply was sterilized. Argentina's 1989 Bonex Plan, and rebounded to 50 cents; a similar pattern held for the an extreme measure that froze bank accounts and convert- Brazilian equivalents (Salomon Brothers 1995a). Stock mar- ed short-term claims to ten-year maturities, left the legacy kets, after severe declines through early March, had approx- of minimal short-term government debt; in contrast to the imately returned to or even surpassed their December 1994 Damocles' sword of tesobonos, Argentine foreign exchange levels in Argentina, Brazil, Chile, and Peru by late May reserves remained high. (Salmon Brothers 1995b). The rest of Latin America was even more different from The level of reserves is a key indicator of capital market Mexico and automatic contagion was therefore even more contagion. By the second quarter of 1995, reserves stood unfounded. In Chile there had been limits on short-term close to or higher than their December 1994 levels in capital inflows. In Colombia the external deficit was strict- Chile, Colombia, Peru, and Venezuela. Although Brazil ly linked to direct investment in the oil sector. Neither lost one-tenth of its reserves in March when it announced a country had a fixed exchange rate anchor. In Brazil there possible devaluation, its reserves remained high by the sec- was a massive accumulation of reserves even though some ond quarter. For Latin America as a whole, non-gold problems were beginning to surface with the fixed reserves fell from $113 billion in September of 1994 to exchange rate overvaluation problem associated with the $101 billion in March of 1995 (IMF 1995) . However, Real Plan. almost $10 billion of this decline was in Mexico alone. The spillover, which temporarily put particular pressure Therefore, reserves in the rest of Latin America fall by less on equity and secondary debt markets, may have actually than 3 percent as a consequence of the tequila effect. benefited several Latin American countries. Temporarily, it took some of the pressure off of excessive capital inflows in Testing Argentina and Mexico Chile and Colombia. The threat of a Mexican outcome Contagion has been most severe in Argentina, followed by strengthened the hand of finance ministers and presidents Mexico. In Argentina international reserves fell from about in obtaining fiscal adjustment from legislatures in $16 billion in December of 1994 to $12 billion in April of Argentina and, to some extent, in Brazil. The events in 1995. Despite the currency board, the government soft- Mexico likely influenced Brazil to devalue sooner than ened the corresponding decline in money supply by reduc- expected, thereby putting a stop to its widening external ing bank reserve requirements and by using the cushion of deficit. Even a major policy adjustment in Hungary appears the limited permissible coverage of the money base by gov- to have been facilitated by the scare. This pattern tempts ernment dollar-denominated bonds. Yet the fear of bank one to conclude that the "tequila effect" really amounted to difficulties (in a system with no deposit insurance and a "tequila vaccine" against more severe policy mishaps. extremely limited lender of last resort capacity) led to Six months after the eruption of the Mexican peso crisis major withdrawals. Overall checking and savings deposits the initial fright of the tequila effect seems to have largely in pesos fell by about 15 percent (by some 4 billion pesos), dissipated. At the outset, it was questioned whether the and dollar-deposits in Argentine banks fell by 15 percent Mexican crisis meant that the Latin American debt crisis (by $3 billion). Although reserves remained comfortable was back with full force and whether the Brady Plan results relative to imports, the nation entered into a classic gold- only papered over a fundamentally unresolved debt prob- standard adjustment through monetary contraction, the lem. However, these were never very likely possibilities logical consequence of a currency board under stress with given the major structural and policy reforms in the region concerns about soundness of the banking system. and the improved debt ratios.6 The government of Argentina needed to come up with By June 1995 the above interpretation looked even less cash for $5 billion in 1995 amortizations of external debt valid. The temporary financial runs had reversed in most that under normal circumstances would have been rolled cases. Argentina's Brady (par) bond, which had fallen from over. Extraordinary fiscal measures were needed in a context 179 DEVELOPMENT IN LATIN AMERICA AND TIiE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 in which revenues were already likely to be under pressure parts sought to err on the side of high interest rates and from an economic slowdown. Yet the reelection of tight money to attract capital. This explanation is consis- President Menem showed that the public endorsed auster- tent with the fact that by June CETES auctions were over- ity to preserve the newly found stability. In terms of subscribed. However, this theory may fail to recognize the inflation-phobia, Argentina seems to have become the attention investors pay to the real economy. Surely Mexico's Germany of Latin America. top priority now is to reduce interest rates to nominal lev- Mexico is by no means out of the woods. The solution to els consistent with moderate real rates given forward-look- the peso crisis had to assure that the short-term tesobonos ing inflation.7 (and dollar obligations of banks) would be honored (hence the need for the $20 billion U.S. package with maturities Institutional reform of up to ten years) as well as a perception that Mexico's Six months after the peso crisis, a number of lessons can be vaunted fiscal and monetary discipline was back on track. learned; some elements in the new catechism are valid, oth- Toward this end, the government has reduced the money ers questionable: supply and (though with too much initial delay reformu- * International institutions must be reformed to deal with "the lated fiscal and external targets for 1995. next Mexico" because the $20 billion deal with the United States If the above holds true, a virtuous circle could arise. and $17 billion from the International Monetary Fund (IMF) First, the peso would stabilize enough to give investors the cannot be repeated. The problem with this conclusion is that perception that dollars placed in Mexico would not lose in a meaningful sense, there won't be a "next Mexico"- value from still further devaluation (beyond the move from there cannot be. Consider the "systemic risk" of Mexico, 3.5 pesos to the dollar in early December 1994 to about 7 which lies in the fact that this was the first shock to the by the first quarter of 1995). Then, in the face of high nom- newly-revived capital market of the early 1990s; if handled inal peso interest rates (over 70 percent on CETES), foreign badly, the result might be a shutdown of that market. But capital would return in pursuit of high-risk, high-return now, that market has been chastened. It is impossible to assets. As the money enters, the peso would stabilize, repeat a "first major shock" because it has already hap- putting downward pressure on domestic interest rates. pened. Additionally, the dimensions of short-term govern- Interest rates would decline sharply and exchange market ment debt involved in the Mexican case greatly exceeded conditions would be normalized. corresponding obligations elsewhere in Latin America. No By early June 1995 this scenario was arguably working. other country managed to convince foreigners to hold large The exchange rate had stabilized to approximately 6 pesos short-term government debt denominated in domestic cur- to the dollar. CETES rates fell from an average of about 75 rency (albeit indexed to the dollar). percent in March and April to 50 percent by late May. But * It is necessary to establish an emergency mechanism to provide the real economy was in severe recession. High interest short-term financing to countries with goodpolicies so they can deal rates were provoking bankruptcies, putting pressure on the with waves of private market speculation. There may be merit banking system. It was questionable whether a mechanism in this proposition, but it cannot be justified by the to convert loans and deposits to an indexed basis (modeled Mexican experience. Mexico probably would not have qual- on Chile's experience in the early 1980s) would work as ified for good policy status because of its exchange rate borrowers resisted open-ended indexation obligations. The problem and excessive current account deficit. In any event, minimum wage increase was limited to 17 percent in the Mexico could not have been bailed out by short-term context of expected 1995 inflation of over 40 percent. This money because the essence of the problem was converting had unfavorable implications for social stability, equity dis- short-term to long-term obligations by refinancing. Yet in tribution, and poverty. international discourse, the Mexican events have been An atmosphere of doubt resulting from economic and invoked to revive proposals originally conceived to deal social strains could explain why 50 percent on CETES was with problems such as those experienced in the 1993 required to attract capital despite a stable peso. Or, it could breakdown of the European Exchange Rate Mechanism. be that Mexican authorities prodded by their U.S. counter- * An international bankruptcy procedure comparable to U.S. 180 CAPITAL MARKETS AFTER THE MEXICAN PESO CRISIS domestic "chapter 11 " treatment is necessary. This conclusion generally on a basis of quota shares. cannot be justified by Mexican experience. Tesobonos were With the larger GAB resources available, the IMF could denominated in pesos subject to adjudication by Mexican then open an "emergency" window for lending beyond the (not New York) courts and thus could have been suspend- normal quota multiples. High policy standards for country ed by Mexico if the issue were institutional. But, the issue access would be required to minimize the "moral hazard" was one of reputation. Mexico had invested far too much in problem of inducing reckless borrowing due to foreknowl- preserving its credit reputation in the previous decade to edge of bailout facilities. jeopardize the record with a unilateral bond rescheduling. Beyond such measures, Cline (1995) proposes the cre- * The IMF should provide early warning whistle-blowing on ation of a joint private-public international bondholders countries with bad policies and immediate country disclosure of insurance corporation. For a given fee of 50 basis points reserves and other key information. Full disclosure within two this entity would insure against default on sovereign months would be laudable, though much shorter times bonds-just as private insurers cover U.S. municipal could feed destabilizing bandwagons. IMF whistle-blow- bonds. The corporation could vary its coinsurance rate from ing (Goldstein 1995) probably makes sense, although it 80 percent of losses for countries following good policies to assumes an accuracy of IMF staff judgment not necessarily 20 percent for those with less adequate policies. The insur- present in the Mexican case. However, the basic notions of ance could substantially widen the class of investors in curbing problems before they get too large and of magni- developing country bonds (for example, to include insur- fying the IMF's impact by using the leverage of its signal- ance and pension funds) while at the same time providing ing effect on the private market are correct. an important signaling role about the quality of country * Double IMF quotas. Some propose that the IMF quotas policy, thereby contributing to the "early warning" func- should be doubled from their present level of $220 billion. tion. Simulations of plausible scenarios suggest that the However, the IMF already has a large amount of unused liq- entity would usually make a profit, and hence could draw uidity (about $80 billion in 1994). Against a usable curren- on private capital. cy base of about 80 billion SDR ($120 billion), outstanding At some point the international community may face credits in the past few years have not exceeded 30 billion the question of how to reschedule sovereign bonds. The SDR (IMF 1994). Although the resulting liquidity excess of transition from syndicated bank lending to equity and about $75 billion was narrowed by $17 billion for Mexico bond instruments means that rescheduling would be more in 1995, the cushion remains significant. complicated in the future due to numerous atomistic bond- The most likely near-term reform will be a substantial holders rather than a few dozen international banks that increase, perhaps a doubling, in the General Arrangements can be mobilized by "advisory committees." Fear of the to Borrow (GAB). This mechanism, now at about $26 bil- consequences of this shift has been one reason for the dis- lion, amounts to an arrangement whereby the G-10 indus- cussion of international bankruptcy arrangements, typical- trial countries, plus Saudi Arabia, stand ready to lend to the ly premised on the notion that the IMF could invoke its IMF if it needs additional liquidity to deal with a crisis in authority (under its Article 8) to approve exchange restric- the international financial system. The United States and tions for a country in trouble.9 other authorities appear to be seeking to enlist cash-rich The cleanest way to establish a rescheduling mechanism newly industrialized countries such as Singapore and would be to require bonds issued by sovereign states to Taiwan into this club (although it is unclear under what incorporate a clause providing for majority bondholder voting conditions). By pursuing enlargement of emergency approval of rescheduling without recourse to default claims funds through the GAB, the major industrial countries by dissenting minority bondholders."0 This step would retain greater control than under a comparable increase of overcome the free-rider problem, although it might come IMF liquidity through quota expansion.8 Similarly, the only at the expense of a significant delay in development of GAB mechanism limits the additional funds for systemic the bond market. It would seem ill-advised to pursue the crisis use, whereas quota expansion tends to be viewed as an issue of potential bond rescheduling by a more heavy- increase in resources available to developing countries, more handed approach emphasizing unilateral public declaration 181 DEVELOPMENT IN LA'I'IN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 of rescheduling or bankruptcy reorganization, even where to this argument is that incomplete capital account con- the bondholders had not previously agreed to such a con- vertibility can be a proper response to a run, rather than tingency. The latter approach would be much more likely "one, two, many" Mexico-type packages through enlarged to stunt the growth of the emerging sovereign bond mar- international emergency windows. Such limits imply the ket for developing countries. possible appearance of spreads between official and parallel exchange markets. But as a temporary shock absorber, such Changing the model? an arrangement may have merit.11 An assessment of whether the Mexican experience has set If a nod in the direction of reasonable capital controls is the stage for a rejection of the Washington consensus a sensible model refinement after Mexico, the slide toward model of economic policy and development strategy leads protection is a much more unfavorable development. to both positive and negative conclusions. On the positive Brazil's decision to raise tariffs on consumer durables to 70 side is the growing acknowledgment of the role of capital percent and to move toward quotas on auto imports is a controls. Chile has emerged as the savvy player in this much more fundamental departure from the market-ori- episode because its restrictions on short-term inflows, such ented Washington consensus model. It is a symptom that as a 30 percent deposit requirement on funds under one the real is becoming overvalued and there is a temptation year, meant that the country was not vulnerable to rapid to use protection as a substitute for real depreciation. outflows when market sentiment shifted. There is a risk that the political economy of protection A proper reading of the market-oriented Washington con- may become entrenched even if initially introduced in a sensus model (Williamson 1990) shows that it did not place temporary emergency. Backing away from the proliferation the same priority on free capital movements as it did on other of trade liberalization that emerged from the debt crisis of central elements of the strategy (fiscal balance, trade liberal- the 1980s would signify a serious retrogression in Latin ization, privatization, exchange rate realism, and deregula- American economic policy. Free trade projects certainly tion). The literature on policy sequencing stresses that capi- could be placed on the shelf indefinitely if the economic tal market liberalization comes after, not before or simulta- model in the region were to move in this direction. neously with, trade liberalization. The final removal of capi- Because the Mexican mistake was rooted in an excessive tal controls did not occur in Europe until the early 1990s. external current account deficit, it is important to consider Limits on short-term capital inflows to reduce vulnera- what constitutes a safe deficit level. The annex sets forth a bility have earned new respect and legitimacy since the simple mathematical relationship suggesting that a safe Mexico crisis. It is less clear whether this has been the case level is likely to be in the vicinity of 3 to 4 percent of GDP for limits on currency convertibility for capital outflows. if the deficit is to be sustained for a long time."2 At this Although controls on outflows were always considered level, the ratio of external debt (including the debt equiva- anathema in Mexico, in large part because of the argument lent of net foreign investment) will stabilize at about 40 that the long U.S. border meant they would not work, percent of GDP if the economy is growing at 5 percent and Brazil has never had the same compunction; even under the world inflation is 3 percent. An external debt of 40 percent Real Plan the holder of local currency has no guarantee of of GDP has in the past represented a threshold beyond access to dollars. A currency board arrangement (as in which countries have tended to get into debt difficulties. Argentina) grants this right, but for countries on the crawl- ing peg or otherwise flexible rates, it is possible to distin- Conclusion guish between current and capital account convertibility. The preliminary verdict is that the Mexican peso crisis of Indeed, some might challenge that "Mexico was unique" 1994 was a minor aftershock of the debt crisis of the 1980s -that its short-term government debt is irrelevant- rather than a precursor of another comparable or worse because of its large tesobono obligations. A country can get international financial quake. If the promising signs are to into trouble to the extent of its entire money supply when be consolidated it will be necessary to achieve sustainable there is a rush toward the exchange rate exit. The response adjustment in Mexico and in the spillover case of Argentina. 182 CAPITAL MARKETS AFTER THE MEXICAN PESO CRISIS In the instance that success is achieved, it is likely that equation 3 means that the safe upper limit on the exter- the capital market for emerging economies will continue to nal deficit as a fraction of GDP is 3.2 percent recover from the panic and indiscriminate cutoffs that char- (0.4 = oa/[0.05 +0.03]; cc = 0.032). acterized the initial reactions to the Mexican crisis; there will be a move back towards more discriminating behavior Notes that rewards good policy.13 1. As for foresight, Dornbusch (1994) issued the most prominent early warning. Cline (1991) warned about an excessive external The stock of financial assets of industrial country mar- deficit even earlier. kets stands in the vicinity of $20 trillion. Annual capital 2. Lawson (personal communication) now argues that he meant flows to developing countries are about $120 billion, half the theory to apply only to industrial countries, and moreover, that of which has gone to Latin America. Thus, only small port- he did not promise painless adjustment. folio shifts toward the emerging markets are required to 3. Fiscal balance in 1994 was not quite as clear-cut as it might permitlaeproportionate growth in these flows. Despite be, considering an expansion of about 2 percent of GDP in lending permit large ~~~~~~~~~~through development banks. the Mexican peso crisis, countries that pursue appropriate truhdvlpetbns the Mexicapesocrisi,coutriesthatursueapproriat 4. Defenders of Mexico's exchange rate level in 1994 point to economic policies should expect to have ample access to brisk export growth. However, they do not mention the spectacular international credit. The crisis, by serving as a lesson, may growth in imports in response not only to real appreciation but also help assure that policies are appropriate; Mexico has shown to trade liberalization. us what can happen when they are not. 5. The third consideration technically would be neutral if there were a corresponding decline in U.S. capital flows to Mexico. Appendix 6. For Latin America as a whole, interest payments (accrual basis) relative to exports of goods and services fell from 38.7 percent in The steady state current account deficit 1982-83 to 28 percent in 1988-89, 20 percent in 1992-93, and Let cc be the constant ratio of the external current account 19.1 percent in 1994 (ECLAC 1994). deficit to GDP. Let Y be nominal GDP, g the real growth 7. Much of the 40 percent inflation expected for 1995 will have rate of GDP, and . the rate of international inflation. Let been concentrated in the first part of the year because of the one-time D be effective external debt (including the debt equivalent effects of a 100 percent exchange rate movement. 8. This greater control is also the reason why the industrial coun- of foreign direct investment). Let CA be the current tries are unlikely to simply grant the IMF the right to borrow in pri- account deficit. Then in a given year t: vate capital markets. 9. It is unclear that such designation could in fact preclude court 1) CA, = aY, = aYeg+Pt challenges to a country's suspension of payment. 10. Although this arrangement would have been irrelevant for Mexican tesobonos, as they were not issued in foreign markets. External debt is the cumulation of all past current account 11. Unfortunately, the principal present case of controls on capi- deficits, or: tal outflows is that of Venezuela, which may closer approximate their g1pt g.pt use to mask severe policy distortions rather than in an optimal way. 2) D = f CA = aYf e aY, .e 12. Authorities in Argentina and Chile seem to have arrived at g + " about the same estimate of the safe ceiling, although using different approaches from the analysis here. Defining Z as the ratio of external debt to GDP, we have: 13. A statistical examination of bond yields in the early 1990s in Cline (1995) finds support for the notion of rational lending, as spreads D above U.S. treasury bonds vary rationally with differing country perfor- aYD a ey +Pt mance on such measures as inflation and export growth. There is even 3) z = D, = g+p = a an empirical pattern of a reputational penalty of about 85 basis points t Eyt Y eg+pt g + P for those countries that engaged in Brady debt forgiveness rather than honoring their full original debts. From past experience, a safe ceiling for the ratio of exter- References nal debt to GDP might be on the order of Z = 0.4. If real Calvo, Guillermo, Leonardo Leiderman, and Carmen M. Reinhart. growth is 5 percent and world inflation is 3 percent, 1993. "Capital Inflows and Real Exchange Rate Appreciation in 183 DEVELOPMENT IN LATIN AMERICA AND THE (.ARIBBEAN: RIO DF JANEIRO CONFERENCE, 1995 Latin America." International Monetary Fuend Staff Papers 40 (1): Goldstein, Morris. 1995. The Exchange Rate System and the IMF: A 108-51. Modest Agenda. Washington, D.C.: Institute for International Cline, William R. 1991. "Mexico: Economic Reform and Economics. Development Strategy." EXIM Review (fall). IMF (International Monetary Fund). 1994. Annual Report. - 1993. International Debt Reexamined, Washington, D.C.: Washington, D.C. Institute for International Economics. . 1995. International Financial Statistics. Washington, D.C. Dornsbusch, Rudiger, and Alejandro Werner. 1994. "Mexico: Salomon Brothers. 1995a. Emerging Markets Biweekly 1 (June). Stabilization, Reform, and No Growth." Brookings Papers on - . 1995b. Equity Strategy Biweekly 24 (May). Economic Activity 1. Washington, D.C.: The Brookings Williamson, John, ed. 1990. Latin American Adjustment: How Much Institution. Has Happened? Washington, D.C.: Institute for International ECLAC (Economic Commission for Latin America). 1994. Preliminary Economics. Overview of the Latin American and Caribbean Economy. Santiago. 184 CAPITAL MARKETS AFTER THE MEXICAN PESO CRISIS Comment on the "Capital Markets After the Mexican Peso Crisis," by William Cline MARCI LIO MARQUES MOREI RA UX ' NTIL THE 1994 MEXICO CRISIS IT WAS ARGUED THAT ECONOMIC REFORM SHOULD PRECEDE political reform, since political reform was much easier to implement with a stable economy in place. But the Mexico crisis taught us to challenge the logic of that strategy as well as to stress the link between political democratization and market reform. The link is freedom and creativ- ity, which are at the center of democracy and market economies. Reform of the state requires a strong government, a tified as the cause. By reacting to the trigger (Colosio) more profound engagement of citizen participation, and instead of the cause (the Greenspan Plan), Mexico financed strong governance where all actors work together toward the flight of $30 billion in just a few months. greater participation of the social community. Although some analysts argue for capital flow control, The potential incompatibility between the political and the destination and the matching of long- and short-term economic cycles in a presidential regime can prove problem- uses of these flows are more important. For example, atic. The political cycle is typically one in which the first year Brazil's current account deficit stayed at zero from 1990 to is spent settling in, the second year on savings, the third on 1994 without controls. This was accomplished by putting taking action, and the fourth on spending. This pattern may 100 percent of the flows into reserves as assurance against be contrary to appropriate economic policy at the time. In the unexpected. In this way capital flow quotas were avoid- Mexico sound economic policy was sacrificed to political con- ed. Short-term capital should be used as working capital siderations as the government tried to counteract the lack of and not for investment. foreign inflows by increasing credit, the monetary base, and The Mexico crisis emphasizes the importance of polit- money supply. Contradictions between the economic and ical democratization, ethical evolution, and social devel- political cycles are sometimes made worse by the internation- opment. It also highlights the importance of an indepen- al financial institutions when, at the end of the political cycle, dent and efficient judiciary, open political debate, effi- they refuse to negotiate with the current government. cient governments with citizen participation, and full, When analyzing crises, it is common to identify politi- timely, and reliable production, disclosure, and trans- cal triggers. But it is important not to confuse triggers parency of statistics. Finally, Mexico has taught us that with causes. For example, the assassination of Colosio, a the unexpected should always be factored in as part of the political trigger of the Mexican crisis, was incorrectly iden- equation. Marcilio Marques Moreira is former minister of finance of Brazil. 185 DEVELOPMENT IN LATIN AMERICA AND T-F CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 Comment on the "Capital Markets After the Mexican Peso Crisis," by William Cline SU M AN BERY A LTERNATIVE FACTORS, UNRELATED TO CAPITAL FLOWS, SHOULD BE CONSIDERED WHEN looking for explanations for what went wrong in Mexico. In 1994 Mexico experienced fixed exchange rates, substantial credit expansion, and loss of federal reserves. Such events are likely to produce difficulties under any circumstances. Moreover, in 1994 Mexico was undergoing stabilization. As history has shown, consumption booms are a likely outcome of stabilization periods. Developing countries are small relative to the capital developing countries should consider nondiscretionary, that is being channeled their way. Instead of trying to countercyclical instruments that do not interfere with keep current account deficits under control by segregat- their right to absorb the capital that the rest of the world ing and controlling capital inflows-a strategy that intro- wants to send to them. duces a great number of distortions into the economy- Suman Bery is economic adviser to the Latin America and the Caribbean Regional Office at the World Bank. 186 CAPITAL MARKETS AFTER THE MEXICAN PESO CRISIS Floor Discussion of "Capital Markets After the Mexican Peso Crisis," by William Cline MEMBER OF THE AUDIENCE POINTED OUT THAT THE INABILITY TO EMPIRICALLY PROVE that the Mexican crisis was caused by factors related to financial management leads us to search for other, political explanations. As a result the basic causes of the crisis have not been clearly identified. However, we should not resort to alternative explanations related to Mexico's polit- 6 ^ ~ical or democratic structure to explain why and how the crisis occurred. Instead we should rec- ognize that the Mexico crisis was rooted in the financial management of internal public debt. At the end of 1987, the speaker continued, most of and balance of payments. For this reason, rules for manag- Mexico's credit portfolio was assigned to the public sector. ing the current account should not be enforced. Instead the As a result internal debt was significantly amortized and capital account should be managed based on the natural elevated. Debt then took the form of short-term public evolution of fundamental economic variables such as debt through the sale of CETES. The sale of these instru- investment behavior and internal savings. Fixing rules to ments, in essence, led to a substitution of public for private manage debt goes against the basic orientation of market debt. economies. The quasi-automatic way in which the denomination Others speakers believed that Mexico provides an addi- of this debt changed from national currency to indexed tional valuable lesson: the models we -use today can be bad dollars (with the change from CETES to tesobonos) nega- examples tomorrow. Still others thought that the crisis in tively influenced the reserves of the Bank of Mexico. Mexico resulted from financial mismanagement of debt. Their reserves, converted to short-term debt in dollars, Before the crisis, an audience member noted, the eco- reached extremely low levels simply because of the change nomic team in Mexico was considered to be one of the best to tesobonos and the abuse of CETES. The International in the world. After the crisis it is said that they made mis- Monetary Fund and the Treasury provided sufficient takes. Before the crisis the international financial institu- resources to convert the tesobonos and short-term debt to tions considered the Mexican economy to be a model in longer-term debt, thus helping to resolve the crisis. terms of reforms and processes. After the crisis it is viewed An economy that enters into a free trade agreement such as a model to avoid. Something should be done at the inter- as NAFTA needs freedom in managing its capital account national level to avoid similar events in other economies. 187 ROUNDTABLE DISCUSSION Latin America and the Caribbean in the Postadjustment Era T HIS SESSION WAS CHAIRED BY SHAHID JAVED BURKI. CARLOS LANGONI IS DIRECTOR OF THE Getulio Vargas Foundation and former president of the Central Bank of Brazil. Marta Mauras Perez is regional director of the United Nations Children's Fund (UNICEF) in Colombia. Brian Stewart is deputy director of the Western Hemisphere Department at the International Monetary Fund. Carlos Langoni reforms took place at the height of an authoritarian regime. Four fundamental questions should be asked with respect In Argentina and Mexico, where conditions seemed to indi- to the themes of this conference: Is it possible to speak of cate advances toward stability, reforms have faltered. Now Latin America's development in both a quantitative and these countries face the difficult task of restoring expecta- qualitative sense? How successful has the region's new tions and correcting course. In Venezuela reforms have wave of reform been? What are the prospects and chal- failed because of political crises. In Bolivia, despite success lenges for the near future? And is there reason for optimism in controlling hyperinflation, growth has not taken place. when looking toward the region's future? Finally, there are countries like Brazil, where the political The answer to the first question is clearly yes. A cultur- situation precluded effective structural reforms until al revolution is taking place, not just isolated events. In recently. most countries reform is taking place in a democratic set- The least progress has been achieved in social reform. In ting-or at least in a setting in transition to democracy. In many countries modernization has worsened income distri- any event the current development process is qualitatively bution, increased the number of low-level jobs, and in distinct from anything the region has experienced so far. some cases led to the emergence of absolute poverty. Few The answer to the second question depends on how suc- creative changes have been implemented in terms of social cess is defined. If success means the ability to implement and political reform. reform then the results are positive, despite the different Answering the third question requires careful attention pace of development in each country. But concrete results to the relevance and impact of political factors. in achieving sustained development have been small, even Unpredictable political factors can quickly destabilize disappointing. And in some cases economic retrocession reform. Also, small macroeconomic mistakes have serious has occurred. consequences in today's international market and can result The divide between implementation efforts and con- in a reversal of capital flows. Thus the management of crete results shows that reform is a complex process in Latin external accounts, exchange rates, and fiscal and monetary America. For example, Chile is the only country in Latin policies is also a challenge. In a broader sense, the challenge America that has achieved sustained growth with democra- is to create and maintain conditions for sustained expansion cy. But, strangely enough, most of its structural economic of exports and direct investments as well as macroeconom- 189 DEVELOPMENT IN LATIN AMERICA AND THE CARIBBEAN: RIO DE JANEIRO CONFERENCE, 1995 ic stability. Increasing domestic savings is another chal- their wealth (wealth being determined by household assets lenge, and one that will require broad fiscal reforms. In minus liabilities) could generate sufficient resources to pay addition, conditions for continuous expansion of private for the subsidies being cut. savings need to be created. On social spending, the social reform needed to com- Social reform is the biggest challenge, however. plement economic reform has not occurred. For the social Investment in human capital and education is the sector to grow, more needs to be done to empower people. fundamental variable that will reduce growth conflicts, Transforming a culture from one that satisfies needs to one inequality, and poverty. But this challenge will not be that guarantees rights is also critical to achieving social resolved through quantitative expansion. Instead, qualita- reform. tive improvement of the education system is required. National performance as measured by under-five mor- Finally, in answering the fourth question, it is impor- tality rates and per capita income and by children reaching tant to take a realistic view of reform. But there is reason to fifth grade and per capita income is low throughout Latin be optimistic about Latin America's future. Social progress America. In 1993 the region's national performance in has moved ahead of political progress, indicating that there terms of under-five mortality rates and per capita income is social demand for change. These forces will allow reforms was negative in nine of twenty-two countries. That is, in to advance and make them more difficult to reverse. nine countries there was less improvement in under-five Moreover, sources of growth are more sustainable than in mortality rates than expected, given their per capita the past. Growth will result from productivity gains gen- incomes. By comparison, in Southeast Asia only one of thir- erated by the private sector. teen countries had a negative performance gap. For chil- Reducing inequalities is a long-term process, and dis- dren reaching fifth grade, fourteen of twenty countries in tortions and inequalities will be with us for some time. In Latin America and the Caribbean showed negative perfor- the meantime attaining social harmony will require ensur- mance. In Southeast Asia only one of eleven countries for ing political stability until income inequalities are which data were available recorded negative figures. resolved. The virtuous cycle that is the region's goal should Although economic reforms in Latin America and the be thought of as a process that sustains growth, increases Caribbean in recent years have caused nearly 4 percent savings, and gradually improves income distribution. If growth in production, the region has not been successful in this can be achieved, the words "the new Latin America" generating employment, especially for women and young will change from rhetoric to reality. people. This gap accentuates the complexity of disparities among regions and ethnic groups and between the sexes and Marta Mauras Perez age groups. The discussions of the past two days evoked three impor- Productive institutional transformation needs to be tant issues: social equity, the timing of reforms, and educa- guided by human concerns, and human concerns are not tion, democracy, and children. met by economic adjustment and growth. For example, Although fiscal reforms are being implemented controlling inflation does not necessarily lead women to throughout Latin America, social and political reforms deliver healthier babies, nor do children go to better have not been sufficiently developed. As a result Latin schools or receive better education. Cultural transformation American societies are having a hard time getting on their is required to make reform sustainable in the hearts and feet. Poor national performance, low levels of employment minds of people. Within this framework, disparate inter- (especially among women and youth), and poor distribu- ests need to converge and local participation and democra- tion of income contribute to this problem. tization of information for decisionmaking must be In modern societies poor income distribution can be cor- developed. rected by improving tax collections and by targeting social Human capital formation is related to competitiveness expenditures. One suggestion in terms of tax collection can as well as to productivity. It is related to the need to instill be found in Edward Wolf's book Top Heavy. Wolf suggests values such as cooperation, solidarity, altruism, citizenship, that, in the United States, taxing a few at 10 percent of innovation, and creativity from early ages. If we focus on 190 LATIN AMERICA AND THE CARIBBEAN IN THE POSTADJUSTMENT ERA human capital formation in that way, if schools can teach us Today's world is much riskier and more intertwined to live together and instill knowledge in their students, than we recognized even six months ago. Events in one and if education is put at the center of integrated social country can affect events in another much more quickly policies, then the countries of Latin America and the and severely than we thought-regardless of the distance Caribbean will be able to participate as equal partners in between them. Thus the Fund's role in the new postadjust- the opening of global economies. ment era must be more active than was originally thought. There is reason to be optimistic about the future. The Fund will play a more active role in supporting adjust- Mexico has sent a wake-up call to the world about the ment programs, helping countries identify and address importance of implementing the first phase of reforms and problemns, and surveying the exchange rates and other beginning the second phase. This second phase will require macroeconomic policies of its member countries. careful attention to poverty and inequality. The Mexico crisis has uncovered the Fund's need to adapt surveillance procedures to minimize the risk of Brian Stewart crises in the new global economic environment. Pro- Three areas of consensus have emerged at this conference. cedural changes will involve stricter requirements for the First, we must maintain the fiscal controls and macro- regular and timely communication of key economic indi- economic balance that have been achieved in most of the cators; the establishment of standards for timely publica- region's economies over the past five years. Second, we can- tion of economic data that enable markets to work more not solve the problems that remain in Latin America sim- efficiently; continuous policy dialogue with all member ply by throwing more money at them. No one has claimed countries, including adjusting internal procedures to that the countries in the region need to run larger current bring country matters to the attention of the executive account deficits or that they need to borrow more to deal board; more regular visits to member countries; and more with the problems that remain. Third, we must improve board meetings. More pointed and candid surveillance the quality of public administration, social programs, and procedures also imply more critical dialogue than in the social spending. past. More generally, though, we need to change the way we The Fund will review its quotas and explore ways to think about the problems facing Latin America. There is a borrow money from its members. Consideration will also difference between the political support needed for the be given to the use of Special Drawing Rights, interna- remaining reforms and that needed for the macroeconomic tional reserves that the Fund can draw on to support strong adjustment and structural reforms that have already taken policy programs, and to making permanent the concession- place. Although the practical implications of this distinc- al fund facility available to the poorest member countries. tion are not clear, political leadership and education have Preliminary work, similar to an international bankruptcy taken on greater importance than in the past. proceeding, has started on the development of a system to The International Monetary Fund will continue to pro- work out country debt. vide policy advice, technical assistance, and financing for The postadjustment era looks different than it did six countries as well as continue to collaborate with the World months ago. But the objectives and policy framework for Bank and the Inter-American Development Bank in their achieving lasting and equitable growth are basically the support for the social and structural reforms in Latin same. American and the Caribbean. 191 Distributors of COLOMBIA HAITI ITALY NEW ZEALAND ROMANIA SWITZERLAND ln/oenlace Ltda. Cuhure Dfflusion Licosa Commissionada Sansoni SPA EBSCO NZ Ltd. 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