Capital flight has not been confined to Latin America. In the Philippines, the government increased foreign borrowing sharply in 1981, anticipating that exports would soon recover and interest rates fall. The expected upturn in the world economy did not occur. Political uncertainty and lagging economic policy adjustment triggered capital flight. The government eventually had to devalue and reschedule. In Nigeria, official

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reluctance to devalue the exchange rate during 1981 83, when inflation was running at 20 percent a year, discouraged foreign direct investment, induced substantial capital flight, and encouraged firms to build up large inventories of imports.^[8]

Compensating or Reinforcing Shocks

The above discussion suggests that it is not always easy to isolate the impact of a specific shock. More often than not major economic shocks are accompanied by either compensating or reinforcing shocks. The two periods 1974 78 and 1979 84 provide a sharp contrast in this regard.

In the period following the oil shock in 1973 there were many "compensating" external shocks for the oil-importing countries. The acceleration of international inflation while interest rates on international lending were fixed meant that real interest rates turned sharply negative. Not only were the interest rates negative, but there was also a very sharp increase in commercial bank lending to developing countries. The sharp rise in migration flows to oil-surplus Middle Eastern countries from neighboring countries like Egypt and Pakistan and, to an extent, India, the Philippines, and Thailand was another positive shock that helped offset the burden on the balance of payments. The availability of much larger concessionary assistance to certain countries, such as Jordan, Morocco, and Egypt, from oil-surplus countries was also a compensatory "shock." In the case of the Philippines, the terms of foreign assistance improved considerably after technocratic economic management introduced in the early 1970s led to the organization of an aid coordinating group under the chairmanship of the World Bank. The enlargement of markets in the Middle East, not only for foreign labor but also for imports and overseas construction services, was also an exogenous development that helped the adjustment process in oil-importing countries, depending on their ability to take advantage of the positive opportunities.

The developments following the 1979 80 oil price increase were strikingly different. The very large real interest rate shock greatly reinforced the terms-of-trade loss from the oil price increase, and generally more than offset the gain enjoyed by most borrowing countries during 1974 79 because of negative real interest rates. International economic activity slowed down even further, and opportunities for increasing worker remittances and overseas construction contracts were not available on the same scale. As the debt burdens grew, many countries found access to commercial banks drying up, and in many cases, there was virtual cessation of voluntary lending.

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Measurement of Shocks

Because of the multiplicity of external shocks and the difficulty of choosing appropriate base periods, precise quantification of external shocks is not easy. Several attempts have been made, however, to measure the impact of oil and related shocks in the period since 1973.^[9] Studies by Bela Balassa and Desmond McCarthy are among the most comprehensive. Their results for the major oil-importing countries are summarized in table 5.3.

These figures show that external shocks were very large indeed for most oil-importing countries. The shocks during 1974 76 and 1979 82 were largely, though not wholly, additive. During 1976 78 (which provides the base for the 1979 82 calculations), the real oil price was somewhat lower than in 1974 75, and the international economy had also recovered from the recession of 1974 75. Balassa's calculations tend to overstate the net shocks during 1974 76, however, because they do not take into account the effect of sharply lower real interest rates, which

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helped to soften the impact of higher oil prices. Inclusion of the other positive shocks, such as larger concessionary assistance and worker remittances, will further modify the calculations at least for some countries, specifically Morocco, Pakistan, and India. On the other hand, the estimates for 1979 82 underestimate the shocks because the focus is on measuring the changes in nominal interest rates rather than real interest rates, which have changed dramatically. For very heavily indebted countries, notably Brazil, Korea, Yugoslavia, Morocco, and the Philippines (which in 1984 had high ratios of total net external debt to GDP; see table 5.4). the large swing in interest rates after 1978 79 meant a massive loss of welfare, ranging perhaps from 8 percent to 12 percent of GDP compared with the base period of 1976 78. Even using the notion of normal real interest rate of, say, 3 percent, the interest-rate shock for Brazil and Yugoslavia during 1981 84 would appear to be over 4 percent of GDP. For Morocco and the Philippines the shock was much greater because of higher ratios of debt to GDP. The Balassa calculations of interest-rate shock equal to 1.9 percent of GDP for Brazil, 1.3 percent for Yugoslavia, 1.7 percent for the Philippines, 2.4 percent for Morocco, and 2.8 percent for Korea clearly understate the impact.

The central point is that the need for adjustment in the initial period (1974 78) was considered less pressing because the external borrowing option was available and sharply negative real interest rates (though relatively short-lived) lulled many countries into complacency. In the second round (1979 84) adjustment became inevitable. In many cases the net external shocks were larger in 1979 84. In any case the shocks were largely cumulative, and the borrowing option was increasingly less available.

Taking the past twelve years together, and accounting not only for oil and interest shocks but for other adverse terms of trade changes (notably in the Philippines) and positive shocks (worker remittances in India and Pakistan), the countries in our study affected most negatively (in terms of percent of GDP) were Korea, the Philippines, and Brazil, while India and Pakistan were probably the least adversely affected. Pakistan, on balance, probably benefited from the secondary effect of oil shocks because of a truly dramatic rise in worker remittances. Also, India and Pakistan suffered little from the rise in real interest rates owing to the highly concessionary nature of their foreign capital inflows.

It should be stressed once again, however, that measurement of external economic shocks in terms of loss of GDP can be misleading. External economic shocks essentially impose a pressure on the balance of

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payments, so the ability of the economy to adjust depends critically on the size of the economic shock in relation to the foreign trade sector.

3
The Meaning of Economic Adjustment

What does adjustment mean? Negative shocks imply a loss of national income and/or import capacity. A rational response to these changes should involve both a reduction in national expenditure and a switching of expenditures to foreign-exchange saving or earning activities with a view to eliminating the deterioration in the current account balance of payments that invariably is the result of negative shocks. This adjustment need not be (indeed often cannot be) very quick, provided the foreign borrowing option is available. Increased net foreign borrowing must be an integral part of the adjustment process unless the country is already very heavily indebted or has been running an unsustainable current account balance-of-payments deficit in the period before the negative shock registers.^[10] Increased foreign borrowing provides the opportunity to maintain imports and growth at a higher level than would otherwise be possible. But, more important, it provides time for orderly adjustment to the change in external economic parameters. If the increased borrowing is used merely to postpone adjustment, to sustain the past levels and pattern of growth, the external debt buildup will be rapid, borrowing capacity will increasingly become a constraint, and growth of the economy will ultimately be disrupted. In contrast, successful economic adjustment to negative shocks can be denned as maintenance (or resumption) of a satisfactory growth rate while keeping (or bringing down) the external debt burden within manageable limits over the medium term of, say, five to seven years. A country that borrows for adjustment must build up its capacity to service the additional debt, while at the same time reducing the initial disequilibrium caused in the balance of payments by negative external shocks.

This can be achieved only through export expansion and/or import substitution if maintenance of a reasonable rate of economic growth is also an important objective. Some reduction in growth rate, compared to historical levels, may be necessary if the negative external economic shocks are very large, but it is, of course, more desirable to bring about adjustment through a policy of switching national expenditures to

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foreign-exchange saving or earning activities rather than a policy focused chiefly on reduction in national expenditures.

A policy of expenditure switching requires, above all, that the higher scarcity price of foreign exchange, which is inherent in a structural weakening of the balance-of-payments position through a lasting negative external shock, be reflected in domestic prices, if not immediately, at least over time. To the extent domestic prices correctly reflect international prices, higher scarcity prices of foreign exchange, energy, and capital (which have constituted the external shocks faced by oilimporting countries) will be passed on to the consumers and a good deal of the adjustment will be automatic. In a typical situation, however, the government response is critically important. For instance, very few developing countries have market-based exchange rates, and energy prices and interest rates are also often controlled by the government. In heavily energy-dependent oil-importing countries, the 1973 oil price increase fundamentally altered the balance-of-payments position. If the oil price increase was not seen as reversible, the response should have been a depreciation of the exchange rate and the basing of domestic energy prices on the new exchange rate and the new international oil price. Foreign borrowing decisions could be similarly based on the new exchange rate. This kind of market orientation was, however, rare, partly because political constraints clearly limit the reduction in consumption implied by a quick adjustment. The foreign borrowing option provides the possibility of adjustment to reduction in national income and import capacity without requiring a cut in absolute consumption. Instead, the adjustment in the balance of payments takes place in the context of overall growth, but with imports growing less fast than exports. Such an improvement in the balance of payments also implies a narrowing of the domestic savings and domestic investment gap. Indeed, domestic saving must improve relative to domestic investment not only to reduce the resource gap in the balance of payments, but also to accommodate the increase in interest payments abroad.^[11] As the subsequent discussion shows, a persistent balance-of-payments deficit can easily be rooted in a domestic financial imbalance and may have little to do directly with the failure of policies to promote exports or saving foreign exchange.

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Another dimension of the adjustment process is efficiency in the use of economic resources. The above discussion of growth implies that the relationship between economic growth and investment, and economic growth and import capacity, is more or less fixed. In actuality, substantial changes in incremental capital output ratios (ICORs) and import elasticities can and do take place over time.^[12] If an improvement (reduction) in ICOR and/or import elasticity can be achieved, a given growth rate can be achieved with lower investment and/or lower imports. An important object of economic adjustment should be to improve efficiency in the use of scarce economic resources especially foreign exchange, energy, and capital. The efficiency issue is linked with appropriate factor pricing but is broader. For instance, the effectiveness of the use of public investment resources and government efforts to encourage development of human resources and technological change can be important elements in improving the growth response of the economy somewhat, independent of whether severe price distortions exist.

4
A Review of Country Responses, 1974 84

An Overview of Adjustment

Table 5.4 summarizes the growth performance of major oil-importing developing countries over the past two decades and highlights the changes in the burden of their external debt over the past decade.^[13] By any reasonable measure, the burden of external debt has gone up sharply in all major oil-importing countries, with the possible exceptions of India and Pakistan, which have actually been able to contain the burden of debt while maintaining a reasonable growth rate. In all other countries there was heavy reliance on foreign borrowing in the wake of

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external shocks, and consequently the average growth rates remained relatively high during 1973 83. But by the early 1980s the heavy burden of debt was itself seriously inhibiting growth in a number of countries. Among countries heavily affected by both interest-rate and oil shocks, only Korea, and to an extent Thailand, can be deemed to have met our test of maintaining a high rate of growth while keeping the debt-service burden within reasonable limits over the past decade. In Thailand, the fact that net external debt was negative in the early 1970s provided substantial leeway for foreign borrowing. Turkey, neglecting adjustment until 1980, registered the sharpest relative increase in external debt between 1973 and 1980. But then, facing critical economic and political problems, Turkey embarked on a major economic adjustment program that has involved very significant shifts in economic policy and development strategy. By 1984 85 Turkey had succeeded in restoring a reasonable rate of growth of GDP while reducing the real burden of external debt and bringing the current account balance-of-payments deficit to manageable proportions (2 percent of GDP). A large number of major oil-importing countries, especially Brazil, Portugal, the Philippines, Morocco, and Yugoslavia, failed to adjust, or failed to adjust adequately, and are currently facing relative economic stagnation or major external debt problems or both.

Failure to Adjust

The seeds of the serious difficulties being faced in the mid 1980s by a number of oil-importing countries can be traced to an initial failure to take suitable action in 1974 79. Several policy weaknesses were common in their response to the 1973 oil price increase.

Excessive Domestic Expenditures.

Even though oil-importing countries were faced with a decline in income and import capacity after 1973, a large number of them (notably Morocco, Brazil, the Philippines, and Turkey) maintained high rates of expansion of domestic expenditures (especially investment) relying on large foreign borrowing for financing growing current account balance-of-payments deficits (table 5.5). The inability to reduce domestic spending in line with the reduced availability of national resources was reflected in large fiscal deficits and high rates of monetary expansion, and ultimately in the large imbalance between domestic savings and investment.

In Morocco the effects of the oil price increase were initially offset by the ongoing boom in phosphate rock exports. The real price of phos-

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phate in 1975 was 3.4 times the level in 1973. The government miscalculated the longer-term prospects of revenue from phosphate, did not fully take into account the burden imposed by increased engagement in the West Sahara war, and counted heavily on grant and loan assistance from friendly Arab states, especially Saudi Arabia. Thus an extremely expansional policy was followed at least until 1977. Gross investment expanded by 23 percent per annum during 1973 77, rising to 33 percent of GNP. Turkey was another country that expanded gross fixed investment vigorously (nearly 14 percent per annum compared to 8.1 percent per annum during 1972 77).

In Brazil domestic demand was maintained through public-sector deficits and subsidies through the credit system. The interest rate charged on credit programs administered through the Central Bank and Bank of Brazil remained constant, while inflation accelerated from 13 percent in 1973 to 44 percent in 1977.

Brazil, Turkey, Portugal, Morocco, Pakistan, and Yugoslavia all showed substantially worsened investment-saving balances in 1973 78 compared to 1965 72. The deterioration was the largest in Morocco (10 percentage points of GDP) as investment expanded vigorously while the saving rate improved very little. Morocco was followed by Portugal (7 percentage points), Turkey and Pakistan (4 percentage points) and Yugoslavia and Brazil (3 percentage points each). Except for Yugoslavia and Turkey, the situation worsened further during 1979 81.

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Neglect of Exports.

High rates of growth of investment in Turkey, Yugoslavia, and Morocco during 1974 79 combined with the bias toward capital-intensive investment and import substitution. In Turkey and Yugoslavia the authorities basically decided on an import-substitution strategy of adjustment to external shocks, with emphasis on domestic production of raw materials and basic industrial products. It was felt that export possibilities were limited by high-technology competition and protectionist barriers in the developed market economies and lowwage competition in labor-intensive products from less-developed countries. Relatively little attention was paid to the creation of capacities for exports. At the same time, the exchange rates, instead of being depreciated to reflect the greater scarcities of foreign exchange, were allowed to become overvalued.^[14] It is not surprising, therefore, that export performance during 1973 80 was poor in Yugoslavia and actually negative in Morocco and Turkey (table 5.5), though in the case of Morocco the sluggish demand for phosphate exports was also a major factor. Because export volume growth was slow and external borrowing substantial, the real burden of debt in relation to exports rose even though higher rates of international inflation wiped out a portion of debt. In Turkey net external debt as a proportion of exports rose from a negligible level in

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1973 to 250 percent in 1980. In Morocco the increase in debt was from less than 50 percent of exports to nearly 200 percent over 1973 80. If real interest rates had not been substantially negative, the debt problem in these countries would have emerged even earlier, though it can also be argued that persistence of high negative real interest rates provided a strong disincentive to adjust.

Energy Deficits.

The failure to adjust was also related to less than satisfactory progress in the reduction of energy deficits after the first oil price increase. While the growth rate of energy consumption generally slowed down during 1974 79, the energy intensity of the economies increased in many oil-importing countries (notably Turkey, Portugal, and Morocco), and in a number of countries (notably Turkey and Yugoslavia) domestic energy production expanded at a slower pace than energy consumption (see table 5.7). Korea, India, the Philippines, and Brazil made relatively quick adjustments in domestic energy prices in contrast with Thailand, Pakistan, Turkey, Yugoslavia, Portugal, and Morocco.

Mixed Performance

While poor export performance was a key element in lack of adequate adjustment, good export performance did not guarantee a smooth adjustment. Brazil and the Philippines, for instance, achieved relatively satisfactory rates of growth of exports, but have ended up with very heavy debt burdens and very poor growth prospects. The Philippines

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was able to expand its manufactured exports by 30 percent per annum during the 1970s, and the share of manufactured exports had risen to 38 percent by 1980. The value added in manufactured exports was, however, limited, as the export sector's backward linkages with domestic industry did not develop. Unfortunately, the growth of consumption and investment remained high in the Philippines, and, what is more, a good deal of investment resources were not well directed, owing to heavy protection afforded to domestic industry. Thus pressures on the balance of payment remained high, and large recourse to external borrowing led to a growing burden of debt notwithstanding negative real interest rates and considerable improvement in the terms of foreign assistance.

In the case of Brazil also, export growth during 1973 80 was quite rapid (7.8 percent per annum), but the current balance of payments deficit remained large, as domestic outlays on consumption and investment were not restrained. It is also interesting to note that the rise in the burden of foreign debt in the case of Brazil was already very substantial by 1978 because, unlike the Philippines, all of Brazil's external financing needs were met from borrowing on commercial terms. Furthermore, the bulk of the growth in total external debt after the mid 1970s was on variable interest rates thus greatly limiting the flexibility of debt management and increasing vulnerability to rises in interest rates. In 1984 the net external debt was over 300 percent of exports. This overhang of debt will clearly limit Brazil's room to maneuver in the remaining part of the 1980s. In retrospect, external borrowing was excessive in Brazil in the 1970s. Even though the current account balance-of-payments deficit during 1973 80 was as a percentage of GDP (4.4 percent) lower than in Korea (5.1 percent), the ability to service this debt was much more limited because of the limited size of the foreign-trade sector. Furthermore, Korea's export growth rate was double that of Brazil. Korea's external debt burden thus remained low, in sharp contrast to Brazil's.

The Case of Turkey

The only country that can be considered to have turned around an extremely poor record of economic adjustment during 1974 78 to a rather successful one in 1980 84 is Turkey. Turkey is almost unique among the oil-importing countries, reducing the relative burden of net external debt during 1980 84 from about 250 percent of exports at the end of 1980 to 170 percent at the end of 1984. At the same time its growth rate during 1981 84 (4.7 percent per annum) has been well above the average for other developing countries (2.4 percent per annum).

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A fundamental shift from an inward-looking to an outward-oriented strategy has been the key element in the adjustment process in Turkey since 1980. The rise in Turkey's exports has been phenomenal. Helped by (a) exchange rate adjustments, (b) export incentives, and (c) liberalization of imports and sluggish domestic demand, merchandise exports rose from $2.9 billion in 1980, to $7.4 billion in 1984, an increase in volume terms of 200 percent in four years. The export growth was led by the manufacturing sector and involved a significant diversification of markets. Large exports to Middle Eastern markets have been an important factor in this expansion, but certainly do not tell the whole story. That Turkey, with a strong tradition of inward-looking policies, was able to stage such a major and quick turnaround in its exports  at a time when international economic conditions were sluggish may be an important lesson for other developing countries. Indeed, outside East Asia, there are few cases of recent export performance matching Turkey's.

Other elements in Turkey's adjustment program include the following:

(1) A retrenchment of the public sector. Government consolidated budget expenditures, which stood at 24.2 percent of GNP in 1980, fell to 22.1 percent in 1983. The budget deficit to GNP ratio, which stood at 5.3 percent in 1980, decreased to 2.7 percent in 1981, to 2.1 percent in 1982, and was 3.3 percent in 1983. State Economic Enterprises (SEE) transfers as a percentage of GNP showed a decline from 4.8 percent in 1980 to 2.5 percent in 1983.

(2) Successful efforts to constrain the level of public investment in line with available resources, to limit the number of projects to a manageable level, and to ensure that priority projects received larger allocations in order to speed up their completion. Allocations for the energy, agriculture, and transport sectors were increased, and the share of manufacturing reduced.

(3) Substantial progress in import liberalization through the abolition of quotas, the freeing of a large number of items from licensing, rationalization of tariffs, and a simplification of administrative procedures.

(4) Adjustment of prices in the energy and agriculture sectors closer to economic levels, reduction of input subsidies in a phased manner, and introduction of measures to simplify the regulations surrounding banking operations and improve the performance of money and capital markets. As a result of action on energy prices. Turkish energy consumption expanded only at 3.4 percent per

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annum during 1979 83, as compared to 8 percent per annum during 1974 78.

A high rate of inflation, running close to 40 percent annually, however, remained a major problem. A consequence of the persistence of the high rate of inflation was the sharp drop in real wage rates, which meant that the social cost of adjustment was spread unevenly. It can be argued, however, that costs of nonadjustment for the lower-income groups would have been even higher.

Successful Adjustment

Korea and India, and to an extent Thailand, are other good examples of not only successful, but also sustained adjustment. All three countries have been able to maintain relatively high growth rates during the past decade, have moderate burdens of debt, and have either kept or brought inflationary pressures under control. India's GDP growth rate during 1973 83 at 4 percent per annum was marginally higher than in 1965 73, and its net external debt burden, though it grew rapidly during 1980 84, was still relatively low (about 150 percent of export earnings).

India's case is interesting because, unlike Thailand and Korea, the export sector was much less dynamic. Though exports in India (at 4.9 percent per annum) expanded somewhat faster than did GDP (4 percent per annum) during 1973 83, and clearly faster than export growth in the previous period, 1965 73 (2.3 percent per annum), import substitution, especially in food, capital goods, and energy, has played a major role in reducing the rate of overall import growth (2.8 percent per annum) during 1973 83.

The common factor in adjustment in India and Korea, and to some extent in Thailand, was an exceptional savings performance (see table 5.6). The saving-investment balance improved in Korea (6 points). India (3 points), and Thailand (2 points) during the 1973 78 period compared to 1965 72, as saving expanded at a much faster rate than investment. In the following period (1979 83) there was further improvement in the saving-investment balance in Korea while the saving-investment balance did not deteriorate in Thailand and India. India's ability to restrain growth of investment and consumption following the oil price shock was undoubtedly a major factor in its successful adjustment. The first round of oil price increases in 1973 74 worsened India's already vulnerable external accounts and exacerbated inflation. Although the economy was already in recession, the government decided against borrowing abroad to absorb this new shock. Instead, domestic savings were

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boosted from 14 percent of GDP in 1965 72 to 19 percent in 1973 78 by raising taxes and interest rates, reducing public spending, and tightening monetary policy.^[15]

In Thailand GDP growth during 1973 83 averaged 6.9 percent per annum, compared to 7.8 percent per annum during 1965 73. Though Thailand's external debt grew very rapidly during the past decade, the burden of total debt was still moderate in 1984 (130 percent of exports) because the initial level of debt was very low. Also, a large part of debt was owed to official creditors and was relatively long-term. The total debt-service ratio, including interest on short-term debt, was thus in 1984 not much above 25 percent. Adjustment was undoubtedly delayed in Thailand, as the government maintained a high level of aggregate demand and moved slowly on energy prices until 1979. However, the fact that export growth was strong and that there was not a major waste of investment resources suggests that the lag in adjustment was not too costly.

Adjustment in Korea

Korea is a very open and relatively energy-intensive economy, highly dependent on exports, borrowing, and oil imports, and thus felt the full impact of external shocks, sharply higher oil prices, rising international interest rates, and two international recessions during the past decade. Notwithstanding this, Korea was among the most successful oil-importing countries in terms of adjustment. Korea's case, therefore, deserves special attention.

The adjustment process in Korea falls into two clear phases: 1974 78 and 1980 83. During 1974 78 Korea was actually able to increase its growth rate to 12 percent per annum compared to 9.6 percent per annum during 1969 73, notwithstanding a sharp deterioration in terms of trade. Three factors contributed to these results. First and foremost, Korea maintained an aggressive export growth strategy and expanded exports in real terms by 150 percent between 1973 and 1978, increasing its share of world exports. The export drive was assisted by major efforts to diversify products and markets, a trade regime favorable to exports, and a major expansion of Korea's trading companies. Real wages, which had fallen by 6 percent during 1974, were held in check relative to foreign wages for two years after a 22 percent devaluation of the won in December 1974. This helped maintain the country's competitiveness though the real effective exchange rate actually appreciated after 1976.

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The fact that in the early 1970s the share of manufactured exports (out of the total) was already over 90 percent was a major structural strength of the Korean economy, because world trade in manufactured goods continued to grow rapidly until 1980. Second, the outstanding Korean success in obtaining construction contracts in the Middle East greatly strengthened the invisibles accounts in the balance of payments, and also provided support for export efforts; by 1978 the value of construction contracts stood at $15 billion and workers' remittances helped to swell foreign exchange receipts. Third, Korea borrowed heavily during the 1974 79 period, not to maintain consumption, which grew much less rapidly than GNP, but to sustain a higher level of investment directed at supporting diversification and deepening of industrial structure. Total Korean external debt (including short-term debt) expanded from less than $4 billion at the end of 1973 to $22 billion at the end of 1979. But because of the largely negative real interest rates and the very sharp expansion in exports, the burden of debt increased little.

However, strong economic expansion and the very success in adjusting the balance of payments during 1976 78 generated a number of structural problems. First, the Korean planners, assuming continuing buoyance of the economy and of Korea's export potential, set out after 1976 to induce changes in the country's comparative advantage in order to accelerate its move into the next phase of industrial development.^[16] For that purpose, large amounts of subsidized credits were made available to heavy industries (machinery, steel, shipbuilding, and petrochemicals) by the financial system under the government's direction. Since these industries are more capital-intensive than light industries, and since gestation periods tend to be long, the incremental capital/output ratio nearly doubled in comparison with the first half of the 1970s. Consequently, investment did not translate into rapid expansion in capacity and output, and domestic supply bottlenecks started to emerge  leading to increasing import requirements. Labor markets tightened, particularly for scarce skilled workers, and real wages increased at rates greatly exceeding productivity growth. The accelerating inflation, sharply rising unit labor costs, and a rigid exchange-rate policy resulted in progressively eroding export competitiveness. Real exports, which had grown rapidly for over a decade, fell in 1979. The current account

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balance deteriorated from a virtual equilibrium in 1978 to a deficit of almost 7 percent of GNP in 1979, even before the full impact of the second oil price increase was felt.

At the end of 1979, there was no doubt that Korea faced major adjustment problems. The domestic economy was severely overheated and faced major structural problems, with supply bottlenecks, excess capacities in heavy industries, and a relatively energy-intensive output mix. The difficult situation was greatly compounded by the simultaneous external shocks of doubling of petroleum prices, the shift from negative to highly positive interest rates in international financial markets, and the recession in OECD countries. The severe economic problems from external shocks were compounded by an equally difficult political and social crisis after the assassination of President Park in October 1979. At the outset of 1980, it was evident that in the absence of corrective policies the current account deficit would increase to critical levels during the year and beyond.

Early in 1980 the government started implementing a wide-ranging stabilization and adjustment program in response to the deterioration in economic conditions. The magnitude of the imbalances, which were partially rooted in the economic structure, left no doubt that the adjustment process would take concerted efforts over several years. The highest priorities were given to (a) wringing out structural inflation and (b) restoring a viable external position as the prerequisites for sustained growth. The government faced the challenges with a bold and resolute course of action. It involved the coordinated and flexible application of fiscal, monetary, credit, exchange-rate, and wage and price policies. Sharp depreciation of the real exchange rate in 1980, strict control of credit expansion, positive real interest rates, and wage restraint were important elements in the adjustment program.

The government used its considerable influence to moderate wage increases and to educate the public about Korea's economic problems. Real wages in manufacturing fell by 8 percent during 1980 81, though a part of this decline must be viewed as a correction to a very rapid growth in real wages during 1975 80.

Demand management policies were supplemented by measures designed to correct structural weaknesses in the economy. A major financial sector reform was initiated in 1980 to improve financial intermediation by relying more on market signals to alleviate financial resources. In 1982 83 the government denationalized all nationwide commercial

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banks, eliminated preferential interest rates, replaced direct credit controls through credit ceilings on individual banks by indirect controls through reserve money management, and authorized two nearcommercial banks and numerous financial intermediaries.

A number of measures were also taken to rationalize the existing heavy machinery industry, including temporary protection and marketsharing agreements for some firms. The government committed itself to withholding special support for further investment in heavy industries, and to avoiding the excesses of the later 1970s. The extensive system of directed and subsidized credit was being phased out as part of the financial-sector liberalization, and the system of industry-specific fiscal incentives was abolished. Investment decisions were increasingly in the hands of private industry and autonomous banks.

The government also committed itself to a stepwise increase of the liberalization ratio to that of the industrialized countries (or about 90 percent) by the late 1980s. The liberalization ratio already had been increased from 54 percent in 1977 to 76 percent in 1982, and a further significant increase to 80.4 percent took effect July 1, 1983.

By 1983 Korea had once again succeeded in making a remarkable adjustment to the changed international economic environment. GNP growth averaged over 8 percent during 1983 84, inflation was negligible (3 percent compared to 18 percent in 1979) and the current account deficit was less than 2 percent of GNP. Declining oil and raw material prices helped the balance-of-payments position, but the burden of high real interest rates remained considerable. In quantitative terms, the expansion in merchandise exports from $14.7 billion in 1979 to $23.2 billion in 1983 was a major factor in overcoming the balance-of-payments disequilibrium. Korea was able to expand export volume by 12 percent per annum during 1980 84, notwithstanding the general sluggishness in world trade and the international economy at least until early 1983. In contrast, import growth in 1979 83 averaged only 3.5 percent per annum. This reflected slow growth of energy demand, only a modest growth in fixed capital formation, and considerable import substitution in industry. The ratio of net external debt to export (120 percent in 1983) was only moderately higher than in the early 1970s and compared favorably with other major oil-importing countries.

Positive Shocks

Oil exporters enjoyed large windfall gains during the decade following the oil price increase in 1973. Oil income became very sizable not only

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for capital-surplus oil-exporting countries (Saudi Arabia, Kuwait, U.A.E.) but also for a number of middle-income developing countries. In 1982 Mexico, Egypt, Indonesia, and Nigeria had net exports of oil ranging from 9 percent to over 12 percent of GDP and from 36 percent to 66 percent of total exports. In the early 1970s the volumes of oil exports were relatively small in the above countries, so much of the growth in oil revenues, representing both price and quantity factors, has come since 1973. The primary effect of the increase in oil income has been reinforced by increased ability to borrow abroad. This large increment of resources has, however, been a mixed blessing. Higher oil revenues have generally led to higher levels of public and private consumption. But it is not clear whether the positive shocks have helped to further the objectives of increasing the long-term growth rate of the nonoil economy or have increased the general viability of the development process, except perhaps in Indonesia. There is much to be said for the argument that sharp growth in petroleum revenues led to waste, corruption, consumption, and excessive debt. Indeed, of the four countries mentioned above, only Indonesia was able to avoid a serious debt problem. What is more, the growth in these countries had slowed down very considerably even before the dramatic fall in oil prices in early 1986. The factors that appear to have helped or hindered the effective use of windfall resources can best be illustrated by a comparative look at the experiences of Egypt and Indonesia since 1973.

Egypt gained large revenues not only from oil but also from very large worker remittances and concessionary aid flows. Total foreign exchange earnings in Egypt increased over fivefold between 1974 and 1983, implying an increase in real import capacity threefold higher than the relative increase in the case of Indonesia. Indonesia and Egypt, countries with roughly similar levels of per capita income, have responded very differently to the shifting economic circumstances. Egypt has been less successful than Indonesia in using its windfall gains to promote the nonoil sector and in avoiding heavy debt burden, even though its access to additional resources was somewhat greater than Indonesia's.

Both Egypt and Indonesia have enjoyed very high growth rates of GDP, consumption, and investment during the past decade (see table 5.8). Both face prospects of much slower growth in the second half of the 1980s owing to reduction in oil revenues and (in the case of Egypt) uncertain prospects about workers' remittances. But while by 1985 Indonesia had already achieved a degree of success in adjusting to the reduction in oil revenues after 1982, the adjustment process in Egypt had

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barely begun. Egypt's current account balance-of-payments deficit averaged about 7 percent of GDP in 1984 85, while Indonesia was able to limit the deficit to around 3 percent of GDP. Partly as a consequence of only moderate balance-of-payments deficits in 1973 84. Indonesia's external debt burden in relation to foreign-exchange earnings was not, in fact, excessive in 1984. In Egypt the debt burden has grown much faster than in Indonesia, notwithstanding a more rapid growth in foreign-exchange earnings, because current account balance-of-payments deficits have been large. With the reduction in oil prices in early 1986, Egypt's ability to borrow abroad is likely to be even more constrained than Indonesia's, in part because Egypt's initial debt burden is higher and in part because Indonesia has had at least modest success in expanding nonoil exports. Nonoil exports from Indonesia have nearly doubled in volume over the past decade, while in Egypt they have essentially stagnated.

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Several factors can be singled out for the relatively greater success Indonesia has had in coping with both the positive external shocks and with the subsequent deterioration of the external exogenous economic situation.

Management of Investment Resources.

In both Indonesia and Egypt gross domestic investment expanded rapidly over 1973 83. In both countries a substantial part of the expansion was concentrated in the public sector. The overall capital/output ratios, the relative growth rates in the agricultural sector, and the performance of nonoil exports suggest that Indonesia has, on the whole, been able to make more effective use of investment resources. Indonesia achieved an agricultural growth rate of 3.7 percent per annum during 1973 83, compared to less than 2.5 percent in Egypt; the rate of growth of domestic demand for agricultural products and rate of agricultural investments in relation to agriculture was actually higher in Egypt. Irrigation investments in Indonesia were a key factor in its ability to rapidly expand rice output and attain self-sufficiency in rice. Egypt's investments in land reclamation, in contrast, yielded low economic returns.

Price Distortions.

The performance of the nonoil economy has also been related to the effectiveness of price signals. In both Indonesia and Egypt a large influx of foreign-exchange resources after 1973 enabled the real effective exchange rate to appreciate. Indonesia, however, followed an active exchange rate policy after 1977. The weakening of the underlying balance-of-payments situation triggered large devaluations in November 1978 and March 1983. The real effective exchange rate (which had appreciated by 14 percent between 1980 and 1982) declined by over 20 percent between 1982 and 1984. In Egypt, on the other hand, the real effective exchange rate appreciated by 40 percent between 1980 and 1984. The exchange-rate movement, in turn, had major disincentive effects on agricultural and industrial production.

Energy price policy provides another source of contrast between Egypt and Indonesia. In oil-exporting countries with ample government revenues, the pressures for keeping domestic energy prices low are strong. In Indonesia petroleum product (except gasoline) prices were kept low in the 1970s; consequently, the economic subsidy on energy sales was growing, and volume of domestic consumption doubled over 1973 78. Since 1982, however, Indonesia has raised energy prices

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sharply. Between the end of 1981 and 1984, domestic fuel oil prices increased more than fourfold, while the general price level increased less than 50 percent. This has had the effect of cutting the economic subsidy on oil products sharply (to less than 1 percent of GNP) and has also slowed down the growth of domestic petroleum consumption. Since 1981 domestic oil consumption in Indonesia has risen little, even though GDP has grown by over 12 percent. In Egypt real energy prices have actually declined by at least 40 percent over the past decade; in 1985 they were on average less than 20 percent of international prices. Consequently the economic subsidy on domestic sales of oil has grown enormously; it probably amounted, at prevailing world oil prices, to about 10 percent of GDP in 1985. This has had a very unfavorable impact on both the fiscal position and the balance of payments. The direct effects of cheap energy prices were compounded by the increased domestic and foreign-exchange costs of the large power investment program required to meet rapidly growing power demand.

Public-Sector Savings.

Because economic subsidies on energy and other goods and services supplied by the public sector were very much smaller in Indonesia than in Egypt, government savings remained large (6 7 percent of GDP) in Indonesia. In Egypt government savings were actually substantially negative in the early 1980s. The fact that a large part of the oil revenue accruing to the government was saved was a major reason why the domestic saving-investment gap remained relatively small in Indonesia and external borrowing was kept within reasonable limits. On the other hand, in Egypt not only were government savings negative, but public investment was very high, so that public-sector deficits became very large indeed. It is these large public-sector deficits that were at the root of excessive external borrowing.

Quick Policy Response.

Not only were Indonesian policies more prudent, but the government was also generally quick to act. In 1981 82 Indonesia's commitment to economic energy prices was relatively weak, the exchange rate was appreciating, and a very ambitious program of capital-intensive and foreign-exchange-intensive investment projects, based on large external borrowing, was planned. By early 1983 a weaker demand for oil, a reduction in oil prices, and a sharp decline in nonoil exports as a result of the deep international recession produced a fundamentally changed resource outlook. Within months the government allowed sharp increases in the prices of domestic oil and fertilizer, deval-

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ued the currency, and undertook a comprehensive reassessment of the public investment program. The major rephasing of large projects was aimed at an expected foreign-exchange saving of $10 billion. In addition to devaluation, longer-term structural improvements were initiated through a drastic overhaul of the tax system and a major reform of the financial sector that freed up deposit and lending rates of the state banks and removed credit ceilings. As a result of these concerted actions and the stimulus provided by international recovery, the current account balance-of-payments deficit, which had reached a peak of $7.1 billion in 1982 83, had dropped to $2.1 billion by 1984. The recent remarkable success of Indonesian decision makers in tackling adjustment issues might be related to unhappy experience immediately after the first oil price increase, when the Pertamina (state oil company) crisis erupted. In 1973 74 Pertamina, in the wake of an enormously expanded oil income base and growth in borrowing capacity, committed itself to a large number of uneconomic or marginal investments without proper government authority or approval. In the wake of the scandal, restructuring of a majority of Pertamina projects was undertaken, and the powers and influence of technocrats and economic coordination ministries were considerably strengthened.

5
The Lessons of Experience

Several major themes emerge from the foregoing discussion of external shocks. First and foremost, the ability to adjust successfully to external economic shocks depends on the quality of macroeconomic management. It is not very surprising that countries in East Asia (which had developed a tradition of good economic management in the 1960s) have by and large been able to survive the turbulent period of 1973 better than many other developing countries.^[17] Second, the magnitude of external shocks generally has had only a limited relationship with the ability to adjust. Among oil-importing countries, Korea and Brazil have been amongst the most seriously affected by oil and interest-rate shocks  with Korea suffering larger GDP loss than Brazil over the past twelve years, though in relation to the foreign-trade sector the impact of shocks has been about the same in Brazil. Korea, however, has been able to adjust much more successfully to terms of trade deterioration and higher real interest rates. Korea's recent growth rate has been much higher than Brazil's, its current account balance-of-payments deficit has been

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brought down to modest levels, and its external debt burden is much more manageable than Brazil's. Third, the extreme swings in real interest rates of 20 percent between 1978 79 and 1981 84 have made adjustment difficult not only for a number of heavily indebted oil-importing countries (notably the Philippines, Yugoslavia, and Morocco) but also for a number of oil-exporting countries (notably Mexico and Nigeria). To the extent ex post real interest rates on private borrowings were, at nearly 10 11 percent, still very high in 1985, a part of the adjustment in heavily indebted countries must come through relief in the form of a decline in real interest rates to more normal levels. The expected further reduction in the value of U.S. dollar, some recovery in commodity prices, and further decline in U.S. nominal interest rates will, it may be hoped, bring about a much needed reduction ex post in real interest rates. But because, among other things, oil prices and interest rates may remain quite volatile during the next decade, reduction in real interest rates and the recent decline in oil prices must not be used by oil-importing countries to delay domestic economic policy adjustments and/ or to substitute for improvements in macroeconomic management.

Another theme of this chapter is that economic shocks and crises can prove a blessing. Turkey's case after 1980 suggests the value of alarming deterioration in the economic situation for forcing a fundamental change in economic strategy. It is an interesting question whether Turkey would have taken its economic problems so seriously and made such a major shift toward an outward-oriented growth strategy it adjustment had not been so greatly neglected during 1974 79 and if the external shocks after 1979 had not been so great. On the other hand, there is clearly a downside to positive economic shocks. Large unexpected gains in GDP or foreign exchange earnings often create a lax altitude toward economic management and resource use, or at the very least lead to a postponement of effort to deal with underlying structural and developmental issues. Indonesia's experience with Pertamina in 1974 and the external debt difficulties now being experienced by Egypt, Mexico, and Nigeria illustrate this point.

A real problem in dealing with external shocks is the inability to predict further shocks. Both at national and international levels, it was very difficult during the past decade to correctly forecast developments such as growth in international trade and interest-rate and oil price changes. Failure of reasonable assumptions about the international economy to materialize was a significant source of economic difficulty in a number of countries. But the ability to handle economic uncertainty, short of a

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major breakdown of the international economic system, must be considered an integral part of broad macroeconomic management at the national level. It is the quality of this management that is fundamental to successful adjustment.

Quality of Economic Management

But what is good economic management? Some of the key elements of economic policy that have enabled countries to adjust successfully to major and unforeseen changes in external economic circumstances are (a) outward orientation of development strategies, (b) a liberal economic framework, with reliance on market signals, including international economic parameters, (c) selectivity and effectiveness in the quality of public-sector interventions, (d) encouragement of high domestic savings in both public and private sectors, and (e) a high degree of flexibility and quick policy responses within the framework of stability and predictability of basic policy objectives. A high degree of political commitment to economic development, continuity of political and economic leadership, and societal consensus are, however, the essential prerequisites for sound economic policies.

Foreign-Trade Orientation.

The past three decades constituted a period of unprecedented growth in world trade, and world trade grew substantially faster than world output. The growth of world trade was particularly rapid in manufactured goods. Even with the slowing down of OECD growth, world trade in manufactured goods doubled in volume during 1970 80 and manufactured exports of developing countries expanded by 12 percent per annum. World trade growth slowed down in 1980 84, but manufactured exports from developing countries held up reasonably well, growing at 9.7 percent per annum.^[18] In this setting, countries that emphasized exports of manufactured goods, like Korea, Thailand, the Philippines, and Brazil, were able to expand their foreign-exchange earnings sharply. Others, notably Morocco and Yugoslavia, and, until 1980, Portugal and Turkey, neglected export development and thus faced an increasing scarcity of foreign exchange.

The economic rationale for the emphasis on manufactured goods exports lies in their potential for providing employment opportunities and foreign-exchange earnings at low capital cost. Import substitution, except in energy, foodgrains, and other natural-resource-based sectors, can conversely be quite capital-intensive. Notwithstanding growth in

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protectionist pressures in developed countries, low real wages in a large number of developing countries (compared to OECD countries) will continue to provide an important economic lever for increased international trade. Although the developing countries have increased their share of industrial countries' markets in manufactured goods, it still remains small; in 1980 the share of developing countries' exports in consumption of manufactured goods was only 3.4 percent up from 1.7 percent in 1970 but the import penetration by developing countries was, at 7.6 percent in 1977 80, actually lower than it was in 1970 77.^[19] Finally, the potential for increased trade among developing countries is growing.

The maintenance of realistic exchange rates, avoidance of discrimination against exports, and relatively low levels of effective protection are central for a policy of effective export promotion. While it is not easy to establish a direct and close relationship between export performance and the real effective exchange rate in the short run except in a few circumstances, realistic exchange rates are perhaps the most important instrument of export promotion.^[20] There is no doubt that a realistic exchange rate was a fundamental factor in the success of export-promotion policies in East Asian countries, especially Korea. In Yugoslavia, Turkey, and Pakistan, appreciation of the exchange rate was a negative factor in export performance during 1973 79. In contrast, the export performance of Thailand, India, and the Philippines during this period was helped by depreciation of the real exchange rate. Over 1980 84 Turkey depreciated the real exchange rate substantially, and this was a powerful factor in export expansion. Though Brazil's real exchange rate has shown wide variation, the net depreciation after 1980 was significant. This perhaps accounted for Brazil's impressive, though erratic, export performance.

Liberal Economic Framework.

Outward orientation of the economy itself forces the need for market orientation. The effect of international price signals is transmitted quickly, particularly if exchange-rate flexibility is maintained. There is a growing belief, not only in market economies but also in socialist countries such as China, Hungary, and Yugoslavia, that price distortions are inimical to growth. The issue of price distortions has been widely researched and was a special focus of the World Bank's 1983 World Development Report. In the context of dealing

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with external shocks, it is important to stress that oil and interest-rate shocks changed the scarcity value of energy, foreign exchange, and capital for oil-importing countries. The countries that maintained realistic exchange rates and were largely successful in reflecting these increased costs in their domestic price structures were able to adjust relatively quickly. On the other extreme, countries that enjoyed windfall gains from oil but were slow in adjusting domestic energy prices to international levels dissipated a part of the increased income subsidies to consumption.

Effectiveness of Investment.

Price signals also have great relevance for both the making and the effectiveness of investment decisions. In a number of countries that did not adjust, misdirection of investment resources and overinvestment were at the root of excessive domestic expansion. Overprotected industry and overvalued exchange rates encouraged allocation of resources to uses with low or marginal economic returns. Wasteful investment in the public sector was not, however, merely a question of price signals. In the 1960s and 1970s growth became synonymous with investment, and governments rushed to expand public-sector commitment to industry. The public-sector capacity to do economic analysis of large capital-and foreign-exchange-intensive projects was weak even in countries like Korea. Thus public-sector support for these projects often did not take into account the opportunity cost of these investments. Admittedly, many large industrial projects (fertilizer, cement, and steel plants; copper and aluminum smelters; heavy machinery complexes) have a role to play in the evolving pattern of industrial development. But economic justification, priority, and timing of major industrial investments require careful consideration, even in normal circumstances. In the sharply changed circumstances after 1973, many governments were not quick enough to adjust investment programs. The pressures for deepening industrial structure were strong and led to excesses even in Korea, where the broad shift toward the heavy industry and machinery sectors was generally well conceived. But in Korea and elsewhere sharp cutbacks in investment became inevitable after 1980. The ratio of gross investment to GDP in the middle-income countries dropped from 27 percent in 1980 to 22 percent in 1983 and probably fell further over the next two years. The cut involved an absolute decline in public investment and a sharp reappraisal of the public-sector role in industry and other productive sectors in countries such as Turkey, Morocco, and Portugal.

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The share of public-sector investment to total investment cannot, however, in itself be considered an indicator of efficiency. It is the quality of public-sector investments that is relevant. In the Philippines in the early 1970s, public investment was at a very low level (2 3 percent) of GDP, and much of the increase during the decade was well directed. Important investments in rural infrastructure were responsible for the achievement of a high growth rate of 5 percent per annum in agriculture during the 1980s. Public-sector investment outlays in agriculture in India, Pakistan, Thailand, and Indonesia also had a high payoff. The very remarkable progress made in these countries toward attaining food self-sufficiency would not have been possible without these major investments.^[21] The record of the large public-enterprise sectors was, however, less convincing. If price distortions are limited, and if there is no privileged access to credit, the reliance on a large state-enterprise sector need not be harmful. But in a typical situation where price adjustments are difficult and painful and access to public funds is relatively easy, the existence of a large public-enterprise sector becomes a drag on adjustment.

Fiscal Deficits and Savings Effort.

This is, in fact, what happened in the 1970s. The largely uncontrolled growth of public-sector spending led to large fiscal deficits in a number of countries (Mexico, Morocco, Turkey, and the Philippines). In Mexico, public spending grew from 17.6 percent of GDP in 1968 70 to nearly 26 percent in 1974 76. After oil revenues became available and foreign borrowing possibilities expanded, public spending in Mexico exploded from 30 percent of GDP in 1978 to 35 percent in 1980 and to 48 percent in 1982.^[22] Consequently, the budget deficit rose steadily from 3 percent of GDP in the early 1970s to 18 percent in 1982. The large accumulation of external debt in Mexico, Morocco, and Egypt was closely linked to fiscal imbalances. In contrast, large public savings in India, Korea, Indonesia, and Thailand (until the late 1970s) helped to moderate the balance-of-payments deficits and the growth of debt.

An overall increase in the domestic saving rate is an essential element of economic adjustment. Initially the loss of income from, say, a termsof-trade loss can be met at least in part from foreign borrowing, but this external borrowing must be serviced at least by making interest pay-

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ments. This involves an improving trade balance (excess of exports over imports) on the one hand and an increasing domestic saving-investment balance (excess of domestic output over domestic expenditures) on the other. Merely increasing exports is not enough, as the experiences of Brazil and the Philippines have shown. If domestic savings are not increasing, the trade balance will not improve, notwithstanding the increase in exports. An important goal of the adjustment process should be for the public sector to contribute to the goal of improving domestic savings.

Handling Uncertainty:
A Suggested Rule.

By their very definition, external shocks cannot be predicted. But once a shock materializes, the judgment of governments as to its durability becomes critically important. Is the shock seen as lasting or temporary? Unfortunately, one observes an asymmetry in reaction to external shocks. Positive external shocks are often seen as permanent, whereas it is generally expected, or hoped, that negative shocks will be transient. Actually, countries that handled positive shocks well were those that treated them as essentially windfall gains and not as permanent changes in economic circumstances. For those countries that have suffered negative shocks, the opposite has been true. The very few oil-importing countries (notably Korea and India) that dealt decisively with the first oil shock were in much better positions to deal with a second round of shocks after 1979. A large number of countries basically neglected adjustment because they did not face up to the logical consequences of a fundamental change in the real price of oil. In designing a policy response to external shock, it is necessary first and foremost that change should be taken seriously and at least conceptually dealt with in the context of a medium-and longterm framework. But even in countries where the planning process is well established and macroeconomic management is stressed, this cannot be expected to take place automatically especially as political constraints often tend to limit the ability to adjust consumption and investment and change relative prices. But if short-term adjustment is approached in a medium-term context, some of the short-term conflicts can be minimized, especially if foreign borrowing is available.

Flexibility and Speed of Response.

The essential meaning of flexibility is that countries should be willing to review the assumptions of their development strategies and planning frameworks. In the case of Korea, a considered response to the first oil price increase was both an acceptance

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of the need for domestic energy price adjustments, and a further stepping up of export efforts and a drive to make full use of construction contract opportunities that opened up in the Middle East. In India the emphasis was placed on energy price adjustments, domestic savings, and import substitution. In both cases adjustment was given a high priority. In many other countries emphasis was placed on sustaining aggregate demand or stimulating investment, without a clear view of the longterm consequences of the high borrowing strategy for the balance of payments. For instance, in Turkey the risks inherent in continuation of the import-substitution strategy were apparently never seriously questioned, though the country launched a massive expansion of external debt in 1973. In Thailand also the external debt was allowed to expand from a very low level without articulation of a medium-term debtmanagement framework, and domestic adjustments were consequently delayed.

Flexibility also involves relatively quick policy response to changing economic circumstances. Korea, facing the crises of 1973 and 1979, acted not only decisively, but also quickly. Again in 1982 when stabilization was in danger of overcorrecting the balance of payments and the sharp drop in inflation threatened a very steep rise in real interest rates, monetary and fiscal policies were adjusted to allow for reasonable economic expansion. Indonesian policies in the early 1980s provide another good example of quick policy response. It is often the case that as sensible economic policies work, the confidence of the policymakers in their own effectiveness increases and they are more willing to take risks attendant on policy changes and are less and less wedded to the status quo. In economic reform, as in other things, the first steps are often the most difficult.

Conclusions

Large oil and interest-rate shocks after 1979 found most oil-importing countries ill prepared to deal with adjustment issues. The shocks were very great, and adjustment had generally been neglected after the first oil price increase in 1973. Many compensating shocks, like negative real interest rates, worker remittances, and aid flows from OPEC countries, had helped to mitigate the impact of higher oil prices in the first round. Even so, most countries, with the exception of Korea and India, borrowed to postpone adjustment. India borrowed very little and relied mainly on restraints on consumption and investment, and Korea bor-

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rowed to reinforce and strengthen adjustment policies. In all other countries borrowing, in retrospect, was excessive. This delay in adjustment proved costly. Either exports were neglected, and a base for additional debt service was not created, or domestic savings were inadequate and balance-of-payments deficits continued to be fed by large domestic imbalances, especially public-sector deficits. Adjustment was forced on a number of countries in the period after 1980. But the turnaround in international economic circumstances was too sudden and too drastic for many countries to cope with in an orderly fashion. Nonetheless, three major corrections to the course charted by developing countries in the 1970s appear to be under way. First, there is much less preoccupation with the level of investment and much more attention to quality of investment, its composition and effectiveness. By the same token, as factors in economic growth, policy framework and institutional capabilities are being stressed much more than the size of investment programs. Second, there is a general shift from inward-oriented strategies to outwardlooking growth.^[23] Third, a much needed reappraisal is going on in a large number of countries of the role of the public sector, and especially public-sector industry, in economic growth. As a result of these "corrections," economic policy in developing countries is likely to emerge stronger, and long-term growth will become more viable, provided growth in industrial countries recovers from the sluggish level of the first half of the 1980s, access of developing countries to markets in developed countries is not further restricted, and the international monetary system is able to deal satisfactorily with the problem of the debt-overhang.

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