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Many countries that pursued import substitution policies in the 60s and 70s did run into severe
difficulties, especially about their balance of payments.
These policies werent responsible for the crises, but they exacerbate the difficulties.
Thats why we saw that many countries, ex. Latin America, have moved away from a regime of import
substitution and embraced other domestic policies instituted as a package of structural adjustment.
We see a new role for international organizations such as the International Monetary Fund (IMF) and
the World Bank, considered no longer as lending and aid organizations, but messengers of a new vision
that countries are pushed to adopt (along with the rescue package).
Since the 70s, the stabilization/structural adjustment package has been used in many countries (Latin
America, Philippines, Turkey), similar ones applied to some African and South Asian countries and in
the 1990s to the last subject of import substitution, India.
Why the failure of inward orientation? It has to do with domestic interests that use protection as a
monopolistic/oligopolistic right, rather than a temporary measure to increase competitiveness
perpetuates inefficiencies.
When economic environment is good, exports can be maintained or increased thanks to a favorable
price change, and the international community is willing to lend large quantities of money NO
problems BUT if this helpful external climate disappears (as at the beginning of 80s in Latin
America) crisis need for economic reforms debt crisis as a prelude to structural adjustment.
N.B. Imports substitution and exports substitution tend to overvalue the exchange rate because they
reduce the demand for foreign currency and they increase the supply of domestic currency. So at the
end of both policies the country may need to devaluate its own currency.

50s and 60s:

The main features were Import Substitution policy for developing countries after WW2.
High tariffs and quotas, strong bias to foster industry, promotion of leading sectors with induced
Countries example: India, Turkey, Iran, Egypt, Argentina and Brazil. For most of them the potential
dynamic gains did not occur, the static efficiency costs remain high. The policies were not effective and
the industries did not manage to become competitive.


A watershed: the change of the international environment that allow the existence of economies with
heavy unbalanced situations. many countries which has applied Import Substitution policy in the 70
ran into very difficult times: internal (inflation) and external (balance of payments). Though protection
is one of the factor that gave rise to the developing countries crisis, some aspects of the inwardoriented policy increased the difficulties.
Latin American countries, Turkey and Philippines failed to set off and exploit the potential comparative
advantage. What was left was a huge allocative inefficiency. A prolonged inward-oriented policy
created a wall for continuous inefficiencies, lobbies and corruption.

Exports were blocked by overvaluation but imports were never replaced by competitive domestic
This state of affair may be viable only if the external economic environment is good and if the
international community is willing to lend large quantities of money to these countries.
The external economic environment in the 70s:
1. The OPEC price shocks of 1973-74 raised prices sharply in the oil-importing countries this
created a growing unbalance on current accounts that had to be foreign funded.
2. Huge petrodollar balances were accumulated into developed countries banks: this induced
banks to boost their lending to developing countries to reap about 2% in excess of the standard
international rate on US government bonds (in other words, rich countries banks were full of
money and they wanted to get even more money by lending loans with higher interest rates to
the developing countries).
3. Interest rates on debt were still low (the dollar value of export was growing) and developing
countries governments were guaranteeing for the loans so it seems there was no concern
about paying back the loans this situation aggravated the balance of some developing
countries year by year.
A viscous circle has been created: increase unbalanced situationincrease the financing from
abroad to foster domestic industry this grew without any concern (countries such as Brazil,
Mexico and Turkey).

80s crisis:

The OPEC price shocks of 1973-74 had several effects on the international economy (see before 70s
external environment).
It is called sovereign debt crisis because governments debt was behind (guaranteeing for) international
loans bankruptcy was the last thing in anyones mind: the dollar value of exports was growing and
interest rates on the debt were low finance existing debt borrowing new funds debt/export ratios
remained steady and even fell (even for Latin America which had an average debt burden at its
The balance of payments states:
exports imports = (private savings - investments) + (taxes - public expenses)



End of 70s sudden transition: inflation relatively high in developed countries (because a second oil
shock had just struck), monetary policies tightened and increase in interest rate recession

The recession also caused a drop in export prices the debt/export ratios sent warnings!
Warnings bells of the crisis: ratio like DEBT/GDP or DEBT/EXPORTS, these two ratios during the 70s
increased too much, for example for some countries (DEBT/GDP)=100%
After years of more imports than exports (E<I), unbalanced situation, the external constraint will be
binding ((S-I)+(T-G)). Binding in the sense that the other countries will think that sooner or later the rest
of the world will stop financing this unbalanced situation. And when this will happen there will be an
explosion; therefore the country will have to change/adapt the other variables (savings, investment,
taxes, etc) to solve the situation. However it is impossible to artificially increase savings, the country
will increase taxes; it will also decrease both investments and public expenses. Eventually the economy
will become more and more depressed, it will lower wages, spending and so on.
An enormous amount of money continued to flow until 1981, especially into Latin America end in
1982 no more lendings by banks debt crisis.
That wasnt the first crisis, but the largest. During the past countries have borrowed and defaulted (and
then renegotiated): Mexico is an example.
The problem is that defaulting countries have not been treated too differently from the non-defaulting
In the 80s crisis, countries did renegotiate the debt under a mixture of concessions and threats: the
larger debtors received better concessions because there was more risk for the creditors themselves.
Several reasons for renegotiations (as opposed to unilateral default) can be given:
1) Countries were worried about the possibility of future bans on credit.
2) Fear that other non-credit avenues would be closed by borrowers and even imposed trade
sanctions lets consider IMF entering the renegotiations by making concessional loans under
stringent conditions that imposed policy changes on the debtor countries (financial support
connected to domestic policies).
3) Domestic forces pushing for change (ex. if governments ties with domestic bankers and exporters
were strong, it was more willing to renegotiate the debt and pursue liberal trade policies
Therefore the debt crisis led to an economic crisis of the debtors massive cuts in investment
especially public one consequence is difficulty in transition to export orientation (the only way to
pay for the debt now).
Interests had to be paid and governments played with a combination of bond finance and money
creation (which raised inflation) higher inflation raised expectations about governments not
controlling the currency capital flights AND enormous loss of efficiency in resource allocation,
increased inequality and failure of relative prices calculations.

Summing up the problem (17.4.3):

From debt crisis led to economic crisis; the balance of payments: (Exports-Imports)=(S-I)+(T-G)

There cannot be unbalanced situations for decades To solve debt, countries depressed their
economies which led to economic crisis.
The mechanism of the transmission (Dornbush 1988 and Sachs 1989).
The most affected countries by the unbalance of payments were the inward-oriented. How could they
find money to pay back interest rates?
1) Issue of domestic bonds: to sell them they have to offer high interest rates which are costs for
the country.
2) Issue of more money (creation of money): but more money means inflation (in some Ltin
American countries it meant hyperinflation as 200-300% per year and the rise of expectations
of inflation provokes hyperinflation).
These two points bring to capital flights (flow of currency to other countries). In other words the
rich were moving away their money to foreign countries causing devaluation of the domestic
currency It is a vicious circle of worsening the exchange rate of the country and an appreciation
of the dollar in which all debts were denominated so debts became more expensive countries
reacted by issuing more domestic bonds and more money and the circle went on a central bank
cannot deal with that. It means strong depreciation of the currency and this vicious circle of the
mechanics of the transmission destroys the economy.
Different groups of people have different aspirations of what their share of GDP should be.
Problem: when the money demanded is higher than GDP (the money produced by the country), the
only way to distribute more income than what is available domestically, is to borrow it from abroad
(international loans, foreign debt).
If these loans are used to grow infant-industry, then the benefits deriving from the growth of the infant
industry will pay back the international loans (increase in productivity, etc ex. Asian countries).
Latin American countries instead used the international loans to alter artificially the domestic
consumption, also boosting corruption.
So it depends on how money is used, if for productive activities it will work, if for artificially increase the
well-being of people, it will bring the country into an economic crisis. Once this last wrong use of
international money starts, it is really hard to escape the vicious circle, this mechanism is almost
impossible to break bringing to sovereign debt crisis.

Structural adjustment (Conditionality):

The standard position of IMF and World Bank:

fiscal deficits (fiscal excesses funded by money creation) lead to a balance of payment crisis (in
the absence of continuous injection of outside funds);
overvaluation of the exchange rate is a tax on exports and a subsidy for domestic lobbies that
benefit from protectionism (inward-orientation: thanks to overvaluation the country can
import at cheaper prices, but it is bad for exports);
domestic prices, imports prices and wages should reflect free-market supply and demand.
A typical reform package is a mixture of domestic and international policies; there are two parts to the
adjustment package:

1) Stabilization: consist of short-term measures to deal with current crisis. It typically involves:
- immediate and large devaluation of the exchange rate to bring the domestic currency into line
with international reality; the idea is to expand exports: with a devaluated currency, foreign
currency export earnings will now translate into a larger quantity of domestic currency BUT
other side is that prices of non-tradable goods must fall;
- restrictive monetary policy (to push interest rate and to decrease inflation); if devaluation is
not followed by appropriate monetary restraint, the effect of devaluation are lost);
- restrictive fiscal policy (first, social spending programs are inevitably cut ex. health and
education the poor are affected far more than the nonpoor; second, public investment
projects are abandoned and this slows down capital accumulation and widens inequality);
- inflationary policies and the subsequent stabilization reactions (adjustment of prices and
wages) involve asymmetric effects among different groups of people (there is a psychological
aspect: people feel that they are restoration of status quo real income (in this case, the policy is
likely to fail because it will perpetuates demand for adjustment) or an aggressive move to
compensate in advance for future inflation);
- moreover, as consequences of debt crisis, the primary goal was to make sure that developing
countries would repay their debts paying debts to banks was more important than
conditions of people in developing countries and the striking aspect is that multilateral
organizations as IMF as well were involved in such a way of thinking because they had
pressures by the banks.
2) Structural adjustment: it is the step beyond stabilization. It involves lifting all controls that
make for inward orientation and a greater reliance on market prices.

The main elements of a structural adjustment program (SAP) are:

import liberalization: trade controls should be lifted. If there are quotas or other quantitative
restrictions on imports, these should be replaced by tariffs and these should be reduced or put
N.B. It is more an ideological issue, it represents a direction, rather than a component that
must be adopted with no exceptions (ex. many Latin American countries imposed further
import restrictions even after their devaluations occurred and IMF supported these steps
because it recognized that generating a trade surplus (impossible after the debt crisis if imports
arent curtailed) was the only way to service the debt.
export liberalization (or keeping the exchange rate competitive): give free rein to exports by
making sure that the initial devaluation that accompanies stabilization is not eroded by
inflation policies. This is the key element of SAP in order to move away from import
The exchange rate devaluation serves another purpose as well: it switches away expenditure
from imports (that now are more expensive) to domestic non-tradable control the balance
of payments situation can be costly!
fiscal and monetary discipline: under this topic come a whole group of domestic policies.
Typically, different components of public expenditure are reduced or deleted ex. India in 1991
remove fertilizer subsidy. Another issue is the push toward privatization of public-sector
activities, the only question is the doubt about the consequences for health care, mass
transportation, education, etc

_____________________HO FATTO FINO A QUI (PAG. 696 ESCLUSO BOX MEXICO)_______________