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CurrencyConvertibilityin theMiddle EastandNorth Africaeditors

Manuel GuitianSaleh M. Nsouli

International Monetary Fund

Washington • 1996

Papers presented at a seminarheld in Marrakesh, Morocco,December 16-18, 1993


© 1996 International Monetary Fund

Cover design by IMF Graphics Section

Cataloging-in-Publication Data

Currency convertibility in the Middle East and North Africa / editors ManuelGuitian, Saleh M. Nsouli. — Washington, D.C. : International Monetary Fund,1996

p. cm.

"Papers presented at a seminar held in Marrakesh, Morocco, December 16-18,1993."

ISBN 1-55775-564-7

1. Currency convertibility — Middle East. 2. Currency convertibility —Africa, North 3. Foreign exchange — Middle East. 4. Foreign exchange —Africa, North. I. Guitian, Manuel. II. Nsouli, Saleh M.HG3968.2.C97 1996

Price: $19.50

Address orders to:International Monetary Fund, Publication Services

700 19th Street, N.W., Washington D.C. 20431, U.S.A.Telephone: (202) 623-7430

Telefax: (202) 623-7201Internet: [email protected]


Contents

Foreword vii

Acknowledgment ix

1. OverviewManuel Guitian and Saleh M. Nsouli 1

2. Opening RemarksOmar Kabaj 14Osama J. Faquih 16

3. Concepts and Degrees of Currency ConvertibilityManuel Guitian 21

4. Current Account Convertibility:Anachronism or Transition?

Saleh M. Nsouli 34

5. Experience with Exchange Controls in theArab Countries

Mustapha Kara and Salam Hleihel 51

6. Currency Convertibility in TunisiaAbdelmoumen Souayah 95

Appendix: The Move Toward Convertibilityof the Tunisian Dinar for Current Operations

Central Bank of Tunisia 99

7. The Exchange System in MoroccoAli Amor 115

8. Experiences of Morocco, Tunisia, Jordan, and Egyptwith Currency Convertibility

Arfan Al-Azmeh 129

9. The Issue of Capital Account Convertibility:A Gap Between Norms and Reality

Manuel Guitian 169

V


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Foreword

Promoting currency covertibility, mainly as it relates to external currentaccount transactions, has been at the heart of the International

Monetary Fund's mandate since its foundation. As financial markets havegrown and become more globalized, the size and impact of capital move-ments have increased in importance. This was recognized in the 1995communique of the Interim Committee of the IMF's Board ofGovernors, which underscored the benefits of increased freedom of cap-ital movements and emphasized the importance of firm economic policiesto reduce the volatility of capital movements. The Committee encour-aged the Fund to pay increased attention to issues relating to capitalaccount transactions. Consequently, the Fund's advice on convertibilityhas expanded in line with developments in world economic conditions.

The seminar on Currency Covertibility in the Middle East and NorthAfrica that took place in Marrakesh at the end of 1993 coincidedwith the increased momentum toward establishing current account con-vertibility in the region. Most notably, Morocco and Tunisia, followingthe successful implementation of adjustment programs, had accepted theobligations relating to the provisions on current account convertibilityunder the Fund's Articles of Agreement. Lebanon and Jordan followedsuit. Many other countries in the region, which have different degrees ofcurrency convertibility, are moving in the direction of accepting theobligations.

The seminar helped focus the attention of the many participants fromthe region on the benefits and conditions for adopting and sustainingconvertibility. The papers published in this volume attest to the effortsthat these countries are making and to the issues that they must confrontin moving to full convertibility.

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Currency Convertibility in the Middle East and North Africa

This volume will contribute to clarifying the issues and reformsinvolved as the Middle East and North African countries establish bothcurrent and capital account convertibility, thereby further integratingtheir economies into the globalized world economy.

MICHEL CAMDESSUS

Managing DirectorInternational Monetary Fund

viii


Acknowledgment

The papers that are reproduced in this book were presented at the con-ference on Currency Convertibility in the Middle East and North

Africa at the end of 1993. They covered a wide range of general theoret-ical issues and provided empirical information on the progress that thecountries in the region were making in establishing the convertibility oftheir currencies. The seminar came at an appropriate time, shortly fol-lowing Morocco's and Tunisia's introduction of convertibility for currentaccount transactions and as other countries in the region were moving inthat direction.

We would like to thank our colleagues in the Middle EasternDepartment and the Monetary and Exchange Affairs Department of theInternational Monetary Fund (IMF) for their encouragement and sup-port in the preparation of this book. Since the original papers werepresented in different languages (English, Arabic, and French), we wantto express our appreciation to our colleagues in the IMF's Bureau ofLanguage Services, who assisted in the translation into English of thosepapers that were originally in Arabic and French. We would also like tothank Janet Bungay of the African Department, who undertook extensiveediting of the some of the translated papers. Ilse-Marie Fayad providedexcellent research support, and Maureen Burke unstinting assistance inprocessing the various drafts of the manuscript. Particular thanks go toJuanita Roushdy of the External Relations Department for her thoroughediting of the final draft manuscript and for coordinating the publicationof the book.

We are also grateful to the authors, who reviewed the edited and, insome cases, the translated versions of their papers. The papers represent

ix



the personal views of the authors and reproduce the data and informationprovided by the authors at the time of the conference. The affiliations andposition of the authors are those that were in effect when the conferencetook place.

We hope that these papers will provide useful insights to other coun-tries inside and outside the region on the issues involved as they lay thefoundation for establishing the convertibility of their currencies in anincreasingly globalized world economy.

MANUEL GUITIAN AND SALEH M. NSOULI

X


OverviewManuel Guitian and Saleh M. Nsouli

Currency convertibility—defined in the broadest sense as the right toconvert freely and without limit a currency into any other at the pre-

vailing exchange rate—is the linchpin of today's globalized world econ-omy. To assess the importance of convertibility, it is only necessary topoint out that a system of well-managed convertible national currenciesimparts to the international arena advantages analogous to those result-ing from the introduction of money in a national economy, most notably,the elimination of barter (and the need for coincidence of needs) as abasis for international trade and the provision of an instrument for the de-velopment of financial markets.

It is not, therefore, surprising that the founding fathers of the Inter-national Monetary Fund (IMF) saw the promotion of convertibility—al-beit limited mainly to current account transactions—as central to theFund's mandate under Article VIII of the Articles of Agreement. Yet theIMF's limited concept of convertibility has become increasingly anachro-nistic in today's globalized world economy, where current and capital ac-count transactions are at the very least equally important. The logical nextstep was taken at the last meeting of the Interim Committee of the Boardof Governors of the International Monetary Fund. The Committee, in itscommunique of October 8,1995, "stressed that increased freedom of cap-ital movements and globalized markets bring significant benefits to allcountries (p. 2)." It underscored the importance of a "consistent imple-mentation of firm economic policies . . . to help reduce the volatility ofcapital movements," and encouraged the Fund "to pay increased attentionto capital account issues and the soundness of financial systems. . . .(p. 2)"

1

d



The Fund has made significant progress in its original mandate to en-courage members to establish current account convertibility, under Arti-cle VIII, Sections 2, 3, and 4 of the Articles of Agreement. As of Octo-ber 10, 1995, 109 member countries out of a total membership of 180had accepted the obligations under Article VIII. During the twenty yearsfollowing the establishment of the Fund, 1946-65, only 27 countries ac-cepted those obligations. The pace picked up during the following twentyyears, 1966-85, but only marginally, with 33 additional countries accept-ing those obligations. It is only over the last eleven years, 1986-96 (as ofMay 21, 1996), that the pace accelerated significantly, with an additional55 countries accepting those obligations. Interestingly, only 6 countriesin the Middle East had accepted those obligations (Saudi Arabia, Kuwait,Bahrain, Qatar, the United Arab Emirates, and Oman) through 1974,while no North African country had. Remarkably, there was a hiatus untilJanuary 1993, when Tunisia and Morocco accepted those obligations,becoming the first North African countries to do so. Lebanon followedsuit in September 1993, with Jordan being the latest country in the re-gion to accept in February 1995. Many countries, however, both in theMiddle East and North Africa, as well as in the rest of the world, haveachieved in an economic sense de facto current account convertibility,with only some technical issues hindering them from complying with theobligations under Article VIII. Furthermore, many countries that haveaccepted the obligations under Article VIII, as well as many of those thathave not, do have to varying degrees capital account convertibility.

Themes of the Seminar

The seminar in Marrakesh, organized by the Arab Monetary Fund incollaboration with the Government of the Kingdom of Morocco and theInternational Monetary Fund, focused on both the theoretical aspectsand empirical issues relating to the introduction of currency convertibil-ity. It came on the heels of the above-mentioned establishment of currentaccount convertibility in Morocco and Tunisia, an accomplishment thatboth countries considered as evidence of the success of their adjustmentand reform efforts.

The seminar gathered a wide array of government officials and aca-demicians from the Middle East and North Africa. The papers presentedcovered a number of theoretical questions that contrasted the experienceof a number of Middle Eastern and North African countries in movingtoward convertibility, and provided detailed case studies of Morocco'sand Tunisia's efforts to establish current account convertibility. Both of

2


Overview

the speakers who delivered opening remarks—Omar Kabbaj, Morocco'sMinister Delegate to the Prime Minister Responsible for Economic In-centives, and Osama Faquih, Director General and Chairman of theBoard of the Arab Monetary Fund—stressed the importance of convert-ibility for fostering trade and financial linkages among the Arab coun-tries and with the rest of the world, for promoting investment andgrowth, and for enhancing regional economic cooperation. Kabbajpointed to the lessons that could be drawn from the Moroccan experi-ence, while Faquih highlighted the achievements of both Morocco andTunisia in establishing current account convertibility and noted theprogress that Egypt, Jordan, and Mauritania had made toward that ob-jective in recent years. They both encouraged the participants to focuson the theoretical aspects of the move to convertibility and the empiri-cal experience of the region.

Against this background, there were a number of questions that wereaddressed at the seminar:

• What are the various concepts and degrees of convertibility?• What are the costs and benefits of convertibility?• What are the policy preconditions for the successful establishment

and the conditions for sustaining currency convertibility?• What are the considerations involved in the sequencing of policies

and the speed with which convertibility can be introduced?• Should current account convertibility be established before moving

to full convertibility?• What is the status of exchange restrictions in Arab countries, and

what progress has been made in eliminating them?• What have been the specific experiences of Tunisia, Morocco,

Egypt, and Jordan in moving toward convertibility?• In a more general vein, how has the financial code of conduct with

regard to convertibility established nearly five decades ago in theBretton Woods Conference changed?

Concepts and Degrees of Convertibility

Manuel Guitian set the stage for the discussion by reviewing the vari-ous concepts and degrees of convertibility. He provided a broad currentdefinition of the concept of convertibility, namely, as the right to convertfreely a national currency into any other currency. In this context, he differentiated between soft convertibility, which involves a market-deter-mined exchange rate system, and hard convertibility, which involves a

3



fixed exchange rate system. He noted that, in today's world of flexibleexchange arrangements, it was soft convertibility that prevailed. He ex-plained that the move from hard to soft convertibility, associated with theabandonment of the Bretton Woods par value regime, was fostered bythe latter's very success in promoting the integration of nationaleconomies into the world system, which heightened the difficulties en-countered by countries to live within the constraints imposed by the con-sequent interdependence.

Guitian underscored that few currencies adhered to the above defini-tion of full convertibility. He noted that there were limitations or re-strictions that resulted in different degrees of convertibility. He examinedthe degree of convertibility from three angles. First, from the standpointof holders, he differentiated between external and internal convertibility.The former refers to the right of foreign holders of currency to converttheir balances into foreign exchange, while the latter refers to the rightof domestic holders of currency to convert their balances into foreign ex-change. Second, from the standpoint of the purpose, Guitian pointed outthat the degree of convertibility was circumscribed by the nature of thetransaction—with current and capital account convertibility being thetraditional distinction. Third, from a geographical standpoint, the differ-entiation could be made between regional and global convertibility.

Convertibility, in a fundamental sense, was affected by restrictionsother than those on exchange transactions, particularly those on importsof goods and services and of capital exports, Guitian explained. For in-stance, a currency that is convertible because there are no exchange re-strictions could be made practically inconvertible through trade and cap-ital controls. He argued that the interconnections between financial andreal transactions provided the basis for the distinction of real or com-modity convertibility (prevailing when there are no exchange and tradecontrols) and financial convertibility (requiring only the absence of ex-change controls).

Guitian noted that the degree of convertibility in the IMF is assessedby three standards: the currency's usability (the purpose), its exchange-ability (into other currencies), and its exchange value (hard or soft con-vertibility). He explained that the first two standards are conceptuallysubject to well-defined boundaries. A currency can be used either for allpurposes or not at all. Similarly, a currency can be exchanged either forall currencies without limit or for none. The degree of convertibility canbe defined as involving gradations within these boundaries. However, asfar as exchange value is concerned, the standard of relativity is different,with the degree of currency convertibility depending on the extent orscale of oscillations in its exchange value. In this context, Guitian noted

4


Overview

that the focus of convertibility in the IMF's Articles of Agreement on cur-rent account transactions reflected the original concern with restoring thefree flow of international trade in goods and services that had been dis-rupted by World War II.

Preconditions, Sequencing, and Speed

Saleh Nsouli focused on the preconditions to convertibility, the bene-fits and costs associated with the establishment of convertibility, the considerations behind the appropriate speed at which convertibility can beintroduced, and the issues involved in sequencing the reforms to meet thepreconditions.

He explained that currency convertibility was not a policy instrumentper se, but rather a reflection of a policy outcome where a country hadachieved balance between the demand for and supply of foreign ex-change vis-a-vis its currency. As such, currency convertibility could besimply achieved by allowing the exchange rate to float and removing allexchange restrictions. However, if domestic financial policies were tooexpansionary, continuous pressure would then be exerted on the ex-change rate, leading to an inflationary cycle involving depreciation-infla-tion-depreciation—a cycle that would disrupt investment incentives andgrowth. Furthermore, the lack of adequate foreign exchange reserveswould limit the ability of the monetary authorities to smooth fluctua-tions in the exchange rates arising from seasonal or transient factors,with the resulting instability of the currency (in the absence of stabiliz-ing arbitrageurs) undermining confidence in the currency. Finally, if theregulatory environment was such that prices, production, and trade de-cisions were controlled centrally, the benefits of the introduction of con-vertibility would not be passed on to the economy. In this light, henoted that four preconditions needed to be met, namely, achieving in-ternal financial balance through sound fiscal and monetary policies;achieving external financial balance through an appropriate exchangerate; building up adequate international reserves; and liberalizing theincentives system.

The speed with which convertibility is introduced and the sequencingof its introduction were critical to ensure that it generates beneficial ef-fects for the economy, Nsouli explained. He noted that the successfuladoption of convertibility involved a comprehensive set of both macro-economic and structural reforms to achieve financial balance and alloca-tive efficiency. It was, therefore, synonymous with successful adjustment.He argued that the distinction between the fast and gradual approaches

5



to adjustment was somewhat overdrawn. In practice, the speed of adjust-ment—and the concomitant introduction of convertibility—would de-pend on the specific circumstances of each country but could be definedtheoretically as being the optimal adjustment trajectory that will maxi-mize the country's inter temporal welfare function, with an appropriatesocial discount rate, subject to various financial and structural constraints.

With regard to sequencing, he gave high priority to macroeconomicpolicies designed to align aggregate demand with available resources. Buthe emphasized the need to take into account the compatibility of struc-tural reforms with the re-establishment of macroeconomic stability; thecomplementarity of policies in determining the timing of their introduc-tion; the lead time involved in the preparation and the implementation ofpolicies; the gestation period for the reforms to yield results; and the dis-tribution effects to avoid social tensions that would derail the reforms.

Within the above framework, he examined three different approachesto convertibility: front-loaded, preannouncement, and by-product. Ingeneral, he considered that the first approach to convertibility, where theestablishment of convertibility had to lead policy decision making, im-plied a low social discount rate and a binding external financial constraint,with sequencing being governed by the need for rapidly adjusting macro-economic policies and introducing complementary structural measuresup front. In the process, the compatibility, lead time, gestation, and dis-tribution considerations would be constrained. The preannouncementapproach, which involved setting a specific date for eliminating currentaccount restrictions, subordinated all objectives and policies to theachievement of convertibility and implied a higher social discount ratethan the front-loaded approach, with less of an external financial con-straint. It was less binding in terms of macroeconomic compatibility,complementarity, lead time, and gestation considerations, as well as dis-tribution effects. Finally, under the by-product approach, Nsouli ex-plained, convertibility was not an objective of economic policy per se. Itwas, therefore, consistent with either a high or a low social rate of dis-count, with the pace of adjustment and reforms proceeding either slowlyor quickly. The availability of financing would, of course, be an importantconsideration, but issues relating to compatibility, complementarity, leadtime, gestation, and distribution were likely to dominate the process.

Nsouli concluded that, while current account convertibility in today'sworld could be viewed as an anachronism in the sense that it deprived thecountry of the full benefits of convertibility, many countries had movedgradually to establish current account and, subsequently, capital accountconvertibility. In terms of the framework discussed, the establishment ofcurrent account convertibility as a transitional step toward achieving full

6


Overview

convertibility would seem consistent with the "revealed" optimal adjust-ment path that would maximize a country's welfare function.

Reviewing the Arab Experience

Moustapha Kara and Salam Hleihel focused on the reforms in the 12Arab countries with exchange restrictions on current or capital transac-tions, or both (Algeria, Egypt, Iraq, Jordan, Socialist People's LibyanArab Jamahiriya, Mauritania, Morocco, Somalia, Sudan, Syrian Arab Re-public, Tunisia, and the Republic of Yemen), underscoring that 8 otherArab countries (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, UnitedArab Emirates, and Lebanon) had no restrictions. They explained that thereforms of the exchange systems in most of the 12 countries had gainedmomentum in the 1980s.

Kara and Hleihel broke down the 12 Arab countries surveyed into twogroups. Group A was characterized as a set of countries that had or hadhad a dominant public sector and a centrally planned economy, andwhere the government exercised strict control over the volume and allo-cation of foreign exchange. The group comprised Algeria, Egypt, Iraq,Socialist People's Libyan Arab Jamahiriya, Somalia, Sudan, and the Syr-ian Arab Republic. In these countries, exchange controls were part of thesystem of economic management. Group B was defined as consisting ofcountries with market-oriented economies and whose main reason for ex-change controls was the management of the balance of payments. Thesewere Jordan, Mauritania, Morocco, Tunisia, and the Republic of Yemen.In these countries, exchange controls aimed at limiting the balance ofpayments pressures and supporting the exchange rate.

Kara and Hleihel noted that countries in Group A suffered fromhigher distortions than those in Group B. Countries in Group A had gen-erally experienced during the 1980s a more pronounced real effective ap-preciation of their currencies, a greater diversion of domestic resourcesfrom the traded to the nontraded sectors, a more disappointing exportperformance, a wider divergence between official and parallel market ex-change rates, a more acute diversion of foreign exchange to parallel mar-kets, and a higher volume of capital flight. For both groups, howevergrowth performance had been disappointing during the 1980s, as com-pared with the previous decade, and efficiency, as measured by the incre-mental capital output ratio, had remained low.

Countries in group A had pursued the transition to liberalized ex-change systems since 1980 in stages rather than in one step, Kara andHleihel explained. By 1991, Egypt had virtually fully liberalized its ex-

7



change regime and unified its exchange rate. In Sudan, although a uni-fied foreign exchange market was introduced in 1992, the exchange ratehad not been sufficiently flexible and exchange controls had remained inplace, with the result that activity on the parallel market had continued toreflect the pressures on external resources. In spite of periods of progressin re-establishing external financial balance and reducing exchange con-trols, Somalia had continued to experience divergences between the offi-cial and parallel market exchange rates throughout the 1980s. In Algeria,efforts to liberalize exchange restrictions remained constrained to a cer-tain degree in 1992 by external sector difficulties. The Syrian Arab Re-public, which had reduced exchange restrictions somewhat by 1992, con-tinued to have multiple exchange rates. Iraq and the Socialist People'sLibyan Arab Jamahiriya were singled out as the only two countries thatdid not undertake significant exchange reforms. By contrast, considerableprogress in reducing exchange restrictions in group B had been achieved.Both Morocco and Tunisia had made major strides in liberalizing theirexchange controls, particularly for current account transactions, in thecontext of comprehensive adjustment programs. Similarly, Mauritaniaand Jordan had moved forward. The Republic of Yemen's exchange sys-tem, however, had become more restrictive.

Specific Case Studies: Tunisia, Morocco,Egypt, and Jordan

Three studies focused in greater depth on Tunisia, Morocco, Egypt,and Jordan. Abdelmoumen Souayah reviewed Tunisia's experience indecontrolling its exchange system, while Ali Amor traced that ofMorocco. Arfan Al-Azmeh provided a comparative study of the fourcountries.

Souayah placed the move to convertibility in Tunisia in the context ofthe overall reorientation of the country's economic and financial poli-cies. He considered that the revival of interest in a liberal economy inTunisia had followed the failure of the socialist system of development.This revival coincided with the external payments crisis that facedTunisia in 1986, and which had prompted the government to launch aprogram aimed at economic rehabilitation and consolidation. Under theprogram, progress in liberalizing and restructuring the economy hadbeen made in a number of areas, notably the import system, the taxstructure, and the financial system. The pursuit of sound budgetary,monetary, and exchange rate policies had helped reduce inflation andstrengthen the external sector position. This had enabled Tunisia to lib-

8


Overview

eralize exchange restrictions for current account transactions at the endof 1992 and accept in January 1993 the obligations under Article VIII.Souayah foresaw the next phases toward the establishment of full con-vertibility, with the expected establishment in 1994 of a foreign ex-change market and the continued pursuit of coherent macroeconomicpolicies.

Amor traced exchange controls in Morocco to the colonial era, as partof a strategy to promote the Moroccan economy's integration intoFrance's metropolitan economic system. Upon independence, such con-trols were viewed as a means of promoting development. In analyzing de-velopments during the 1970s, he reached the conclusion that the ex-change restrictions had contributed to stifling economic activity andworsening the financial imbalances. Accordingly, the government had de-cided in 1983 to liberalize and open up the economy in the context ofsuccessive structural adjustment programs. A gradual approach to liberal-izing exchange controls had been chosen to allow the banking system toadapt to the new environment and to avoid "jeopardizing the fabric ofthe domestic economic system." Amor saw considerable positive resultsfrom the liberalization measures implemented, including those on ex-change controls. He considered the shift in the structure of imports to-ward capital and semifinished goods as a positive development associatedwith increased investment. Exports had also increased and been diversi-fied, while tourism receipts had expanded. Both remittances and foreigdirect investment had risen sharply. The improvement in the external sec-tor position had contributed to a reduction in the debt-service burdenand the buildup in foreign exchange reserves. At the same time, real GDPgrowth had averaged 3.5 percent a year during 1983-92. Looking ahead,he, like Souayah, foresaw the move to full convertibility and the estab-lishment of a foreign exchange market.

In a comparative study, Arfan Al-Azmeh reviewed the progress madeby Morocco, Tunisia, Jordan, and Egypt in meeting the four major pre-conditions for establishing convertibility. He considered that Morocco,which had made significant strides in reducing its budget deficit, main-taining a realistic exchange rate, building up its foreign exchange re-serves, and substantially decontrolling the incentives system, had satisfiedall four preconditions. However, it needed to remain vigilant in avoidinga resurgence of inflationary pressures and safeguarding its competitive-ness. While Tunisia had also met the preconditions, he considered thatthe progress made had been less than that achieved by Morocco andcalled for completing promptly the envisaged reforms in the secondphase. With regard to Egypt and Jordan, Al-Azmeh explained that theyhad hastened to virtually eliminate the exchange restrictions on current

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transactions as soon as external balance had been re-established and for-eign exchange reserves built up, but that both domestic financial man-agement efforts and structural reforms needed to be pursued.

Al-Azmeh noted a number of similarities and differences in the ap-proaches of these countries to establishing convertibility. First, all fourcountries had embarked on the liberalization of their exchange systems inthe context of comprehensive adjustment and reform programs. Second,the progress in exchange liberalization took place at different rates. In Mo-rocco, the pace was gradual and in tandem with that of trade liberalization.In Egypt, it had also been phased in between 1987 and 1991 in conjunc-tion with the progress made in the reform process. By contrast, in Tunisia,it had been concentrated in the final years of the 1986-92 reform pro-gram. In Jordan, the rapidity with which the move toward convertibilityhad progressed had reflected the limited degree of restrictions already inplace. Third, the timing of the announcement of convertibility had dif-fered. In Morocco, it was announced as an objective a year before it wasachieved, while in Tunisia it was announced at the same time it was im-plemented. In Egypt and Jordan, no announcement had been made (as ofthe end of 1993) as there remained some technical obstacles to officiallyaccepting the obligations under Article VIII. Overall, Al-Azmeh consid-ered that the experience of these four countries showed that convertibil-ity, rather than representing invariably the culmination of adjustment andreform programs, could be viewed as an integral part of the adjustmentand reform process, complementing and reinforcing it.

Capital Account Convertibility

In presenting the last paper at the seminar, Guitian made a strong casefor an up-front move to full convertibility as a means of leading financialpolicies and economic reforms, thereby turning the tables on thepreconditions for establishing convertibility. He stressed that economiclogic advocates the dismantling of capital controls; developments in theworld economy make them undesirable and ineffective; and a strong casecan be made in support of a rapid and decisive liberalization of capitaltransactions. All these conditions underpin strongly a code of conductthat eschews resort to capital controls as an acceptable course of actionfor economic policy.

Guitian argued that, with the growing predominance of capitalmovements in international transactions, the international financial codeof conduct focusing on current account convertibility that was estab-lished nearly five decades ago in the Bretton Woods Conference had be-

10


Overview

come outdated. He explained that there were normative benefits to bederived from updating the code of conduct to include full convertibilitywith the benefits deriving mainly from the provision of faster and clearersignals when inconsistencies arose between national and internationalconsiderations of events. He emphasized that controls could only serve apalliatives to temporarily contain, but not to eliminate, the underlyingpressures, and that, in any event, capital controls could be circumvented.

The case for capital controls, Guitian explained, was based on the im-portance of meeting the necessary preconditions before moving to exter-nal financial liberalization, such as achieving a sustainable fiscal positiona realistic exchange rate, as well as a well-functioning liberal domestic financial system. He feared, however, that waiting to fully meet such pre-conditions to liberalize capital movements could foster the maintenanceof capital controls. He considered that opening the capital account with-out fully meeting the preconditions would exert pressures to adoptquickly the necessary policies to bring about balance and stability to theeconomy. Nonetheless, he cautioned that, while capital account liberal-ization could be undertaken in less-than-optimal domestic economicconditions, it should not be undertaken under circumstances so far fromoptimality that the credibility of the decision to open the economy to in-ternational financial transactions would be so impaired that it could notbe sustained. In this regard, Guitian dismissed the notion that the open-ing of the current account should precede the liberalization of the capi-tal account, arguing that there did not seem to be any a priori reason whythe two accounts could not be opened up simultaneously.

Regarding the speed of liberalization, Guitian acknowledged thatthere was no single, categorical answer but leaned in the direction of fastliberalization. He felt that there was no guarantee that the leeway to ad-just to confront competition in a gradual approach would be, in effect,used, but rather that the tendency of operators would be to continue ex-ploiting the opportunities of a closed or partially closed economy. If agradual opening were to encourage delays in adjustment, he consideredthat its costs would not fall below those resulting from a fast liberaliza-tion. By contrast, a rapid opening of the economy would provide quicklyto economic agents the transparent signals that would generate gains inefficiency and attract international resource flows.

Conclusions

A number of general conclusions can be drawn from the seminar, al-though authors differed in their emphasis. First, currency convertibility is

11



critical to help integrate the Middle East and North Africa into the glob-alized world economy. Apart from the systemic benefits, there are bene-fits to be derived in each country in terms of the resulting allocative effi-ciency, the necessary macroeconomic discipline, the increasedproductivity and competitiveness, the attraction of foreign direct invest-ment, and the importation of technological know-how. The downsiderisks were viewed particularly in terms of the potential for temporary pro-duction dislocations and disruptive capital flows.

Second, the establishment of currency convertibility is part of an over-all adjustment and reform process. The case studies of Tunisia and Mo-rocco, which assumed the obligations under Article VIII in early 1993,and the comparative study with Egypt and Jordan, which had only defacto achieved convertibility by the time of the seminar, illustrated clearlyhow convertibility had progressed in the context of the adjustment andreform programs that these countries had implemented.

Third, the achievement of domestic and external balances, the buildupof reserves, and the liberalization of the incentives system are importantpreconditions for the establishment and the sustenance of convertibility.The theoretical underpinnings of meeting those preconditions were ana-lyzed, and the case studies showed the progress that various Middle East-ern and North African countries had made in this regard. While most au-thors considered that convertibility should follow the establishment ofthe preconditions, at least one author put forward the possibility that theintroduction of convertibility could prompt the authorities to moverapidly to satisfy those preconditions.

Fourth, current account convertibility can be viewed as a transitionalphase toward the establishment of full convertibility. Most participantswere of the view that a gradual approach would minimize the costs andmaximize the benefits of establishing convertibility. The theoreticalframework for analyzing the optimal speed of introducing convertibility,as part of the overall adjustment process, suggested that it was difficultempirically to qualify a process as fast or gradual. Certainly, the casestudies pointed to the "revealed preferences" of the countries consideredto proceed in a phased and gradual manner. The point, however, wasmade that too gradual an approach could result in perpetuatingrestrictions and inefficiencies, while the benefits of full convertibilitycould be reaped earlier if it were introduced rapidly and supported bythe necessary policies.

Fifth, the progress toward officially establishing convertibility in theMiddle East and North Africa needs to be accelerated. Only eight coun-tries in the region had accepted the obligations under Article VIII by thetime of the seminar, and only two additional ones have accepted those

12


Overview

obligations since then. While a number of other countries in the regionhave already de facto virtually full convertibility, some minor restrictionsstill impede them from assuming the obligations under Article VIII anddeprive them of the benefits of the signaling effect of the irreversibility ofassuming such obligations. Still, some other countries in the region re-main far from satisfying the preconditions and need to implement the ad-justment policies and structural reforms needed to lay the foundation forestablishing convertibility.

13


Opening Remarks

Omar Kabbaj*

It is an honor and a genuine pleasure for me to deliver the openingremarks today for this seminar on currency convertibility. I wish, first ofall, to welcome you to Marrakesh, a city with a rich cultural heritage anda wealth of tourist attractions. I also wish to thank the authorities of theArab Monetary Fund and the International Monetary Fund for choosingto hold this seminar in the Kingdom of Morocco. In addition, I wouldlike to express our appreciation to Mr. Osama Faquih, Director Generaland Chairman of the Board of the Arab Monetary Fund, who has hon-ored us by attending and participating personally in this important event,and to congratulate him on his election as President of the IslamicDevelopment Bank. Furthermore, I wish to extend greetings to thesenior officials from the participating countries. Their presence demon-strates the interest and importance that the Arab countries' monetaryauthorities accord to the topics to be discussed during this seminar.

While I will leave to the distinguished experts participating in this con-ference the comprehensive discussion and analysis of the various theoret-ical and practical issues related to currency convertibility, I wish, never-theless, to share with you a few key ideas on the matter, and some lessonsin this regard that can be drawn from the Moroccan experience.

Convertibility represents a far-reaching instrument to facilitate inte-gration into the global economy. The worldwide adoption of marketeconomies, the development of world trade, and the increasing mobility

*Minister Delegate to the Prime Minister, Responsible for Economic Incentives,Kingdom of Morocco.

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Opening Remarks

of capital flows have led to the globalization of the international econo-my and exchange system. In these circumstances, domestic economiescannot play a role in this process and benefit fully from its advantagesunless they introduce the necessary instruments and mechanisms, includ-ing the establishment of the convertibility of their currencies, therebyeliminating all exchange restrictions. Convertibility is also necessary fordomestic economies to achieve an optimal allocation of their resources.

While structural reforms are designed to eliminate sectoral distortionsand to strengthen the rules of the market, they will remain limited inscope if they are not supported by currency convertibility. Indeed, con-vertibility makes it possible for economic transactors to choose freelybetween the domestic market and external markets and promotes priceformation through the free interplay of market forces, which is conduciveto the efficient allocation of resources and the stimulation of competi-tiveness within an economy.

With respect to the Arab world, I must stress the important role thatconvertibility can play in enhancing cooperation among the countries,especially in the commercial, economic, and financial spheres. There is nodoubt that the spread of convertibility within the Arab world can open upnew prospects for the economies through the development of inter-Arabinvestment flows, increased trade among Arab countries, and theenhancement of complementarity in production structures.

It is important to emphasize that convertibility should not be limitedpurely to international current account operations. Rather, it should beintroduced gradually to encompass capital account transactions andshould be accompanied by the establishment of a foreign exchange mar-ket. In my view, full convertibility should be the final objective, support-ed by the required structural reforms and a viable macroeconomicframework.

You will certainly have the opportunity during the seminar to learnmore about the Moroccan experience with convertibility. Let me stress,however, a number of issues related to that experience that I consider ascrucial. The introduction of convertibility in Morocco is the crowningachievement of an economic restructuring and adjustment process thatbegan in 1983. This effort has led to clear progress in correcting domes-tic and external imbalances, liberalizing the economy, notably throughthe development of market mechanisms and the promotion of private ini-tiative, and opening up the Moroccan economy to the outside world.Based on these achievements, Morocco was able, effective January 1993,to introduce the convertibility of the dirham for international currentaccount operations and to end the cycle of rescheduling by resuming reg-ular payments for its external debt service.

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The latter two actions were taken in a particularly unfavorable inter-national environment and in the midst of a two-year drought. The econ-omy, however, had become sufficiently robust and, thus, able to enterinto a new phase of integration into the world economy. At the sametime, an appropriate fiscal and monetary stance was maintained and fur-ther structural reforms were pursued. Capital inflows have continued, theexternal current account deficit has been held to acceptable levels, andnet international reserves are growing. We can, therefore, say that, near-ly one year after its introduction, the impact of convertibility onMorocco's economy has proved to be largely positive. We have clearedthe hurdle of introducing convertibility, while avoiding many of thepotential risks inherent in such an operation.

The widening of the scope of convertibility was pursued in 1993, par-ticularly with the liberalization of access to external financing for eco-nomic operators and the authorization for exporters and Moroccansresiding abroad to hold convertible foreign exchange accounts. Weintend to persevere in this direction and to establish a foreign exchangemarket. This task is already listed among the priorities set by theGovernment of His Majesty, the King, as recently described before theHouse of Representatives within the framework of the government'sprogram.

Before closing, I would like to suggest that the eminent experts fromthe international organizations and representatives of the Arab countries'monetary authorities participating in this seminar provide greater enlight-enment on two factors I consider current and of great interest in con-ducting financial policy. I refer, first, to an analysis of the relationshipbetween convertibility and the modernization of financial systems and thedevelopment of capital markets, and, second, to an examination of theimpact of convertibility on both direct and portfolio foreign investment.Given the significance of the topics to be discussed and the caliber of thespeakers, I feel certain that the deliberations will be rich and extremelyuseful for policymakers in the Arab world.

Osama J. Faquih*

I am delighted to welcome you to this historical and beautiful city ofMarrakesh, well known for its deeply rooted Arab and Islamic back-ground. I am pleased to inaugurate with you today this important and

* Director General and Chairman of the Board, Arab Monetary Fund.

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Opening Remarks

specialized seminar on currency convertibility, which has been placedunder the auspices of the Moroccan Ministry of Finance and jointly spon-sored by the Institute of the International Monetary Fund (IMF) and theArab Monetary Fund's Economic Policy Institute.

The seminar has been designed to address a number of substantiveissues that are both theoretically and empirically related to economicadjustment. In that context, it aims at providing an opportunity for ageneral review of the adjustment efforts in certain Arab countries and aclose assessment of the experiences of Morocco and Tunisia, whichannounced at the beginning of this year the establishment of currentaccount convertibility of their national currencies. Both are considered tobe pioneers in that area.

As many of the papers before you emphasize, currency convertibilityhad been one of the central concepts that the founding fathers of theBretton Woods system had intensively debated and sought to codify inthe wake of World War II. It constituted a key pillar underlying efforts toestablish a multilateral system of payments in respect of current transac-tions among nations and to eliminate foreign exchange restrictions thatimpede the growth of international trade. As a matter of fact, Article VIIIof the IMF's Articles of Agreement sets out in detail the rules and behav-ior to be observed by countries that accept the obligations of itsprovisions.

Five decades have elapsed since then, and the benefits of convertibili-ty for the promotion of free international trade, allocative efficiency, com-petitiveness, savings and investment flows have been clearly establishedand the risks for an individual country well identified. Yet, until recentlymany nations around the world, including some Arab countries, havebeen unable to establish convertibility.

It is against such a background that the Arab Monetary Fund (AMF)and the IMF, which is in charge of surveillance over exchange arrange-ments worldwide, have joined in organizing this seminar. They have invit-ed a distinguished group of eminently qualified experts, practitioners,academicians, and Arab officials to meet and exchange ideas and views onthe various notions of convertibility, the benefits and risks associated withthe concept, the conditions for its successful application, and its role instructural economic adjustment and growth.

The importance that the AMF attaches to currency convertibility is amirror image of the high priority accorded to its action program for eco-nomic stabilization and structural adjustment in Arab countries.Alongside this pursuit, the AMF program currently seeks to foster link-ages among Arab economies; to actively contribute to efforts aimed atmobilizing savings and resources and their channeling into productive

17



investments; to enhance the technical capabilities of the staff of officialArab monetary, banking, and financial agencies; and to promote closercooperation with regional and international financial institutions.

Indeed, the early 1980s witnessed a heightened international interestin macroeconomic adjustment policies and their implications. That peri-od was characterized by a rapid deterioration of domestic and externalfinancial imbalances, a dramatic increase of indebtedness and debt servicand poor economic growth performance in many developing nations.These included several Arab countries that courageously initiated andimplemented, at painful costs, comprehensive adjustment programs.

Interest in the adjustment process was not restricted only to indebtedArab countries confronting fiscal and external deficits. In fact, the Araboil producing countries have also realized in the past few years the impor-tance and urgency of timely adjustment in the face of declining terms oftrade associated with falling oil prices. As a result, these countries volun-tarily proceeded to rationalize government budgets and adopted prudentmonetary policies as part of their strategy to contain inflationary pres-sures. They concomitantly sought to diversify the sources of their rev-enues and to actively promote non-oil industries and exports. Reflectingthese endeavors, macroeconomic adjustment efforts and structuralreform programs in many Arab countries began to bear fruit.

In Morocco, substantial progress was achieved as policies pursued con-tributed to the resumption of growth, the diversification of the produc-tive and export base, the containment of inflation, and a considerablestrengthening of the external sector position. These achievementsenabled the country to announce the establishment of current accountconvertibility of the dirham. In this context, I should like to address aspecial tribute to His Majesty King Hassan II and the wise MoroccanGovernment, who should be fully credited for steering the economy ofMorocco in the right direction.

In this connection, a particular word of appreciation is due to HisExcellency Mohamed Barrada, former Minister of Finance, for his relent-less efforts and resolute determination in carrying out over a number ofyears a series of macroeconomic adjustment and reform programs. Theseaimed at enabling Morocco to enter a new era of increased self-reliance.There is no doubt in my mind that his successor, Professor MohamedSaghu, who has contributed significantly to the design and elaboration ofthose programs before assuming his current post, will seek to consolidatethe progress achieved by staying the course. I therefore wish him everysuccess in this pursuit.

In Tunisia, the adjustment efforts deployed and reform programsimplemented during the past eight years have been met with equal suc-

18


Opening Remarks

cess. The policies pursued have led to the revitalization of economic activ-ity, the reduction in the rate of inflation, and the strengthening in theexternal sector position. These achievements enabled Tunisia to establishthe convertibility of the dinar of current account transactions at thebeginning of 1993.

In Egypt, a multiphase reform program was initiated in 1987. Itsimplementation has yielded a number of positive economic develop-ments, including an improvement in the government's financial positionand a strengthening in the balance of payments and international reservepositions. During 1991, the Egyptian authorities canceled the system ofmultiple exchange rates and floated the national currency. Many restric-tions on external trade and exchange were removed, paving the way forfull liberalization of the exchange system. The authorities are currentlyactively engaged in further action in that direction, while concurrentlyendeavoring to expedite the reform, restructuring, and privatization ofpublic sector enterprises.

Since 1989, Jordan has embarked on a major macroeconomic adjust-ment program and geared its policies toward restoring domestic andexternal financial balance. Notwithstanding the detrimental repercussionsof the 1990-91 crisis in the region, Jordan continued its adjustment ef-forts, which included, inter alia, the reduction of exchange restrictions,thereby putting the country close to achieving convertibility of theJordanian dinar for current account transactions.

In Mauritania, the authorities started in 1985 to implement successiveadjustment programs, which included several policy measures aimed atliberalizing the trade and exchange system. In that connection, a series ofactions were taken to review, simplify, and reduce custom tariffs. Importlicensing was dismantled, and some flexibility was introduced in theexchange rate system.

In a number of other Arab countries facing domestic and external dif-ficulties and imbalances, the authorities have been responding to the sit-uation by adopting, in varying degrees, adjustment policies and measures.Broadly, these aim at restoring financial balance, reforming the price sys-tem, and promoting greater private sector participation in economicactivity and growth. The results achieved by these countries are encour-aging. They provide scope for hope and optimism in the willingness andability of the authorities to maintain the adjustment momentum withinthe framework of comprehensive programs geared toward moving theireconomies to the path of sustainable growth, strengthening their balanceof payments position, and improving their creditworthiness.

As you all know, the world economy is becoming increasingly interde-pendent and globalized. In view of this, the ability of developing

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20

nations—including Arab countries—to successfully safeguard the hard-won fruits of their comprehensive economic adjustment programs andfar-reaching liberalization of their trade and payment systems criticallydepends on the openness of markets in industrial countries and theremoval of barriers to international trade and payment restrictions.However, it is to be feared that, as a result of growing protectionist ten-dencies, the expected benefits from the grouping of industrial countriesinto gigantic regional economic and trading blocs might be limited tomember states only. If so, this would constitute a serious blow to theadjustment process in developing countries, which have made majorstrides in the past few years. Indeed, developing countries have complet-ed at a socially painful cost the requisite wide-ranging structural reformsand have thus succeeded in raising the level of the production of com-petitive exportables. Such countries, however, are set to face considerabledifficulties in marketing their exports. It, thus, becomes evident that, if itis incumbent upon developing countries facing imbalances to take timelycorrective action, then industrial countries—both old and new—shouldat the same time expedite the removal of obstacles to the flows of trade.More important, it is the responsibility of industrial countries to endeav-or to establish a more liberal, open, and equitable international econom-ic and trading system. The revitalization of their own economies and theprovision of adequate financial support on appropriate terms remain keyfactors for the success of economic adjustment and growth in developingcountries.

Once again, I would like to welcome you and to reiterate my thanksand appreciation to the officials of the Moroccan Ministry of Finance forhosting this seminar and for the excellent facilities and arrangements theyhave put in place. Special thanks are due to the International MonetaryFund for its instrumental cooperation in the organization and conduct ofthis seminar and for the valuable papers prepared by its staff. I would alsolike to thank the participants for their attendance and willingness to sharewith us and among themselves their knowledge, experience, and views onthe various aspects and issues of the seminar's central theme.


Concepts and Degrees of CurrencyConvertibility

Manuel Guitian*

Currency convertibility has always been a fundamental notion in inter-national economic relations. Yet, since the abandonment of the

Bretton Woods par value regime, a remarkable degree of silence has untilrecently surrounded the subject. Possibly this silence is related to theadvent and prevalence of flexible exchange rate arrangements that fol-lowed the Bretton Woods order. The reason could be that, in theory,flexible exchange rates would make exchange and other restrictionsunnecessary or redundant; and, therefore, under such exchange ratearrangements currencies would be convertible by definition, so to speak.But as is often the case, what can be expected in principle does not alwaysmaterialize in practice; exchange, payments, and other internationalrestrictions have continued to prevail in the period of flexible exchangerates and, therefore, questions of currency convertibility have remainedopen.

Recently, though, the silence has been broken and numerous writingson the subject of convertibility have begun to appear. Two different setsof factors account for the renewed interest. One has been the widespread

* Director, Monetary and Exchange Affairs Department, International Monetary Fund.The views expressed in the paper are those of the author and should not be attributed tothe International Monetary Fund. For the preparation of the paper, I have relied extensiv-ely on the work on convertibility of several of my colleagues or ex-colleagues in the Fund.I would like to mention, in particular, Gold (1971), Polak (1991), Gilman (1990), Greeneand Isard (1991), and Mathieson and Rojas-Suarez (1993).

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process of reform currently under way in the ex-collectivist economies ofcentral and eastern Europe, as well as of the former Soviet Union, thatbegan in the late 1980s. The other has been the process of domesticfinancial sector deregulation and capital market liberalization that eitherde jure or de facto has been carried out during the last decade in theindustrial world at large and in many developing countries.

From the standpoint of the societies in transition from central plan-ning to a market-based system of economic organization, the issue of cur-rency convertibility has become important in that it constitutes a keycomponent of their reform efforts. In this context, it has been pointedout that the concept of convertibility transcends the boundaries of a nar-row monetary question and that it embodies central elements of the strat-egy to transform economic regimes radically and comprehensively.

Developments in domestic financial markets in industrial economiesand in many developing countries and the consequent globalization ofinternational capital markets, in turn, have also stimulated interest in cur-rency convertibility issues. The interest here has focused on the degree,rather than the concept, of convertibility. In this regard, the issuesbrought to the fore have been those concerning currency convertibilityfor capital account transactions, more commonly referred to as capitalaccount convertibility.1

This paper discusses the concept of convertibility in its various modal-ities and degrees. Convertibility, like other related economic concepts,such as liquidity and restrictiveness, is not always amenable to precise def-initions and, therefore, it is worth stating explicitly what it entails, itsscope, which is not invariant in time or in economic usage.

Concept of Convertibility

Traditionally, that is, until early in this century, convertibility generallyreferred to the right to unrestrictedly convert a currency into gold at agiven rate of exchange. This right was an essential component in the func-tioning of the gold standard that prevailed at the end of the nineteenthand the beginning of the twentieth centuries. In this sense, no currency isconvertible today. At present, gold no longer plays a significant monetaryrole and therefore convertibility into it is no longer a relevant concept.Instead, convertibility now refers to the right to convert freely a nationalcurrency at the going exchange rate into any other currency. Clearly, the

1See Mathieson and Rojas-Suarez (1993) and Guitian (1992a).

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Concepts and Degrees of Currency Convertibility

going exchange rate can be either fixed or flexible, in principle, and con-vertibility is a concept that would apply to a currency under either regime.Yet, as hinted in the introduction, the strength of the concept of convert-ibility is not invariant with regard to the existing exchange system.

To the extent that flexibility in exchange rates replaces the need forrestrictions on exchange transactions, it is clear that such flexibility andcurrency convertibility go hand in hand. Deviations between the twoconcepts arise whenever a flexible exchange rate coexists with exchangerestrictions, as is often the case in practice. In theory, though, flexibleexchange rates render such restrictions (and international reserves)unnecessary, or in any event less necessary than otherwise. Convertibilityin this context is a corollary of exchange rate flexibility. A soft concept ofconvertibility, therefore, would be embodied in the ability to engage inunrestricted exchange of currencies at market-determined exchange rates.

Most discussions of convertibility, however, do not envisage such anunconstrained notion. In fact, the general understanding of convertibili-ty is rather the right to engage in unrestricted exchange of currencies ata given exchange rate. This is a hard concept of convertibility and the oneassociated with fixed exchange regimes. To the extent, though, thatexchange restrictions accompany fixed exchange rate systems, the scopeof convertibility is thereby limited.

So far, the discussion has been conducted on the basis that convertibili-ty is a financial, a currency, concept. And it has been argued that the con-cept depends on the nature of the exchange regime, both in terms of theexchange rate system and of the presence or absence of exchange restric-tions. But even when exchange restrictions do not exist, convertibility in afundamental sense is very much affected by restrictions other than those onexchange transactions. This is particularly true with controls on the under-lying transactions, such as those on imports of goods and services and ofcapital exports. That is to say, a currency that is convertible at a givenexchange rate (the hard concept discussed above), because there are noexchange restrictions, can be made practically inconvertible through tradeand capital controls. These interconnections between financial and realtransactions are the basis for the distinction between real or commodityconvertibility (prevailing when there are no exchange and trade controls)and financial convertibility (requiring only absence of exchange controls).

Degrees of Convertibility

Apart from the various definitions of convertibility just discussed,there are a number of other meanings given to the term that, rather than

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reflect additional variations of the concept itself, represent differences indegree. These degrees are derived from various perspectives from whichthe question of convertibility of a currency can be examined. The mostcommon angles have been (a) the holders of the currency balances;(b) the purposes for which convertibility is sought; and (c) the geo-graphical scope of convertibility.

From the standpoint of the holders of currency balances, distinctionshave been made between external convertibility and internal convertibil-ity. External convertibility typically refers to extending to foreign holdersof currency the right to convert their balances into foreign exchange.This form of restricted convertibility becomes relevant in settings wherepromotion of foreign capital inflows is a relevant consideration. Moregenerally, external convertibility will provide incentives for foreigners toengage in economic transactions in the countries that provide this freedom to their currency. Internal convertibility, in turn, typically relates tothe right given to domestic (resident) holders of currency to convert theirbalances into foreign exchange. This modality of restricted convertibility,although it is not inconsistent with the promotion of foreign investment,focuses more on other aspects of an economy's performance. Apart fromproviding incentives to residents to hold domestic cash balances, internalconvertibility exposes domestic economic policies to external competi-tion. As such, it poses risks to the policymaker, but it also contributes tomaking domestic policies internationally competitive. These two forms ofrestricted convertibility are also often referred to as nonresident versusresident convertibility.

From the standpoint of the purposes for which convertibility issought, the criterion to define its scope is the nature of the transactionfor which the foreign exchange is required. The traditional distinctionhere is between current account convertibility and capital account con-vertibility. Current account convertibility is the most common conceptand is defined as the right to convert currency balances into foreign ex-change for making payments for goods and services, or more general-ly, for payments related to current transactions. This is the degree ofconvertibility sought by the Bretton Woods par value regime. During itsexistence, participating countries undertook a commitment to establishfor their currencies convertibility at a fixed exchange rate for paymentsin foreign exchange in respect of current international transactions andtransfers. Capital account convertibility refers to the unrestricted right ofcurrency holders to convert their balances into foreign exchange forpayments in respect of capital transactions and transfers. This type ofconvertibility has been less widespread in practice than the one on cur-rent account. Nevertheless, recent liberalization of capital markets and

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financial sector deregulation trends have developed throughout theworld economy and de jure or de facto capital account convertibility hasbecome more common. In the particular context of the EuropeanMonetary System (EMS), virtually all its participants have lifted capitalcontrols, thereby ensuring capital account convertibility for their cur-rencies. In connection with the variety of incentives that each type ofconvertibility confers, it is clear that current account convertibility (likeinternal convertibility) stresses the competitiveness of an economy, whilecapital account convertibility (like external convertibility) emphasizes aneconomy's ability to attract foreign capital. There are, of course, over-laps in the effects of each type of convertibility, but they do not invali-date the distinction.

From the standpoint of geographical scope, a distinction can be madebetween regional convertibility and global convertibility. Regional con-vertibility denotes the right to convert domestic currencies into the cur-rencies of a given number of countries in a region. This was obtained, forexample, when the participating countries of the European PaymentsUnion (EPU) made their currencies reciprocally convertible but did notextend convertibility to the United States or other countries. More gen-erally, even currencies with broader convertibility typically limit it, forpractical purposes, to the main currencies in the system, that is, those inwhich international transactions are denominated. In the EMS, of course,participating currencies (until recently) exhibited hard convertibilityamong themselves and soft convertibility for outside currencies. Globalconvertibility, in turn, confers the right to currency holders to converttheir balances into any foreign currency. As already noted, convertibilityis only relevant or necessary in relation to the main international curren-cies. As with languages, ability to speak a few of the major ones doesensure capacity for universal communication.

Convertibility in the IMF

In the IMF, there are three essential aspects of the concept ofconvertibility that are traditionally stressed: the usability of a currency, itsexchangeability, and its exchange value. These are the key standards forthe measurement of the convertibility of a currency. From thisstandpoint, a currency would be deemed to be fully convertible if it canbe used for all purposes without restrictions of a financial, or moreprecisely, a currency character; it can be exchanged for any other currencywithout limitations of a financial (or currency) nature; and it can be used

25



or exchanged at a given rate of exchange, be it a par value, central rate,official rate, or some legal exchange rate.

Then, if these three standards are not satisfied, totally or in part, thecurrency in question will fall short of complete convertibility, that is, of afull direct or financial convertibility. Since each of the standards can bemet to a varying extent, it is clear that convertibility will also exhibitdiverse degrees. A currency may be partly usable, that is, usable for somepurposes but not for others, or partly exchangeable and therefore, itsstanding on the convertibility axis cannot be described as either convert-ible or inconvertible.

An analogous relativity arises in connection with the third standard,that is, the currency exchange value, which was the basis for the distinc-tion made earlier between hard and soft convertibility. On the assumptionof unlimited usability and exchangeability, the robustness of the conceptof convertibility will depend on the currency's exchange value. In theextreme, that is, when this exchange value is determined by a freely fluc-tuating exchange rate, in a narrow sense, the currency will fulfill the threestandards and therefore may be considered convertible. But this inter-pretation sets no boundary or constraint on the exchange value of thecurrency. In contrast, the other two standards exhibit well-definedbounds, at least conceptually. A currency can be used either without lim-its, that is, for all purposes, or not at all, that is, for no purpose, or morerealistically, for only a few purposes; these two extremes confine the scopeof relativity of convertibility on this scale. In turn, a currency can beexchanged either for all currencies without limit or for none; here again,this dimension of convertibility is bound by these two outer frontiers. Butas far as exchange value is concerned, the scope of relativity is of a differ-ent nature: there is the possibility of defining convertibility on this scaleas meaning that a currency is usable and exchangeable either at a givenrate of exchange or at any rate of exchange. The former definition guar-antees, so to speak, the currency's exchange value, but the latter offers nosuch guarantee. Clearly, the usefulness of the concept of currency con-vertibility when its exchange value can oscillate without limits is veryreduced, if it exists at all. Currencies can, of course, have varying degreesof convertibility in terms of the standard of their exchange value, whichwill depend on the particular exchange rate regime in place. The essentialissue on this front revolves around where the exchange risk falls. Does theissuer of the currency or do its holders bear such risk? Hard convertibili-ty allocates the risk to the issuer of the currency; soft convertibility pass-es it on to the holders of the currency balances.

The definition of convertibility in the Fund's Articles of Agreementreflected the concern in the membership with restoring the free flows of

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international trade in goods and services that had been disrupted byWorld War II. This concern meant that the commitment in the area ofconvertibility that members undertook extended only to current transac-tions. This commitment is reflected in the Articles of Agreement asfollows:

Subject to the provisions of Article VII, Section 3(b) and Article XIV,Section 2, no member shall, without the approval of the Fund, imposerestrictions on the making of payments and transfers for current interna-tional transactions. (Article VIII, Section 2(a); italics added.)

The reference to Article VII, Section 3(b) concerns an authorizationthat the Fund can provide to members to limit the freedom of exchangeoperations in a currency that has been declared scarce. This scarcity clausewas included in the Articles of Agreement to provide a constraint onunduly persistent balance of payments surpluses. As succinctly put in theKeynes Plan for an International Clearing Union,

. . . a country finding itself in a creditor position against the rest of the woas a whole should enter into an arrangement not to allow this credit balancso long as it chooses to hold it, to exercise a contractionist pressure againstworld economy. . . (Horsefield's italics).2

The concern was with regard to symmetry, that is, with rules thatwould apply to both members with persistent deficits or surpluses in theirbalance of payments. But it also arose, in substance, with the need toavoid contractionist pressures on world trade, as made clear in the abovequotation.

The second proviso, the reference to Article XIV, Section 2, refers totransitional arrangements that members are permitted to maintain untiltheir balance of payments positions allow them to fulfill their convertibil-ity commitment. The proviso states:

A member . . . may . . . maintain and adapt to changing circumstances therestrictions on payments and transfers for current international transactionsthat were in effect on the date on which it became a member. (Article XIV,Section 2)

A third proviso of importance in the context of the Fund's concept ofconvertibility relates to the definition of the meaning and scope of pay-ments for current international transactions, which include

2See Horsefield (1969, Vol. III, p. 5, para. 10). This volume contains the various pro-posals put forth by a number of countries for an institution like the Fund. These includedthe quoted Keynes Plan, a U.S. proposal for an International Stabilization Fund (the WhitePlan), a French Plan on international monetary relations, and a Canadian Plan for anInternational Exchange Union.

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(1) all payments due in connection with foreign trade, other current busi-ness, including services, and normal short-term banking and creditfacilities;

(2) payments due as interest on loans and as net income from other invest-ments;

(3) payments of moderate amount for amortization of loans or for depre-ciation of direct investments; and

(4) moderate remittances for family living expenses.

The Fund may, after consultation with the members concerned, determinewhether certain specific transactions are to be considered current transac-tions or capital transactions. (Article XXX)

Some of these categories are viewed, from an economic standpoint, ascapital transactions. To a large extent, though, their inclusion reflectedconcern with encouraging sound development in current account trans-actions. These transactions typically require normality in the use andrepayment of short-term banking and credit facilities and payments ofregular loan amortization as well as allowance for depreciation of directinvestment.

Clearly, the most important limitation on the scope of the concept ofconvertibility in the Fund is the power that members retain to restrictcapital transactions. The only constraint on this power relates to the pro-viso that members may not exercise controls on capital movements

. . . in a manner which will restrict payments for current transactions orwhich will unduly delay transfers of funds in settlement of commitments,except as provided in Article VII, Section 3(b) and in Article XIV, Section 2.(Article VI, Section 3)

Thus, capital control procedures cannot apply to the transactionsdefined as current for purposes of the Articles of Agreement, and theycannot be used to indirectly restrict current payments or delay currenttransfers. Apart from these caveats, members are free to control capitalmovements, both inflows and outflows, and this freedom is acknowl-edged in the purposes of the Fund, which include

(iv) To assist in the establishment of a multilateral system of payments inrespect of current transactions between members and in the elimina-tion of foreign exchange restrictions which hamper the growth ofworld trade. (Article I; italics added)

The stress in the Articles of Agreement on current accountconvertibility reflects the view that adjustment of external imbalances bythe use of controls on capital movements was appropriate. It is clear thenthat although freedom to engage in current transactions was seen as con-

28



tributing to economic welfare, the same could not be said of freedom ofcapital flows, and to quote again the Keynes's Plan, "it is widely held thatcontrol of capital movements, both inward and outward, should be a per-manent feature of the post-war system."3 This view reflected the state ofaffairs in the world economy at the time of the drafting of the Articles ofAgreement. But it is less clear that the reasons behind this view hold inpresent circumstances.4

The obligation to maintain current account convertibility in the sensedescribed above is subject to two main qualifications (other than the onerelated to the currency scarcity clause described above). The first qualifi-cation is that the Fund is authorized under certain circumstances to ap-prove restrictions imposed by members for balance of payments rea-sons. Such approval may be granted by the Fund only when it is clear thatthe restrictions are necessary to cope with the balance of payments prob-lems and that their use will be temporary. The second qualification is thatthe convertibility commitment applies only to transactions among mem-ber countries.

Apart from this formal definition of convertibility as contained in theArticles of Agreement, there is the concept of de facto convertibility. Thisconcept refers to the status of the currency of those countries that main-tain no restrictions on payments and transfers for current internationaltransactions but have not formally accepted the obligations of ArticleVIII, Section 2, 3, and 4. In general, the Fund has recognized variousforms of convertibility that can be grouped under the general label of defacto convertibility, all of which share the common characteristic that thecurrencies in question have a high degree of convertibility in practice.This is clearly implicit in the use of the term freely usable currency in theArticles of Agreement, which is used for operations with the Fund and isdefined as follows:

(f) A freely usable currency means a member's currency that the Funddetermines (i) is, in fact, widely used to make payments for interna-tional transactions, and (ii) is widely traded in the principal exchangemarkets. (Article XXX)

Then, there is the concept of external convertibility, which refers tothe provision of freedom for nonresidents to convert current earnings ina currency by exchanging them into foreign currencies. This type ofconvertibility, which is the one attained by western European countries inthe late 1950s, also provided that the conversion would be at official

3Horsefield (1969, Vol. III, p. 31, para. 33)4For an elaboration of this point, see Guitian (1992b).

29



(fixed) exchange rates; it was, then, a hard convertibility concept. Theconcept, though, is narrower than that of convertibility under ArticleVIII, Section 2, and also than de facto convertibility because it did notextend an equivalent degree of freedom to residents.

Requirements for Convertibility

There are a number of prerequisites that have been traditionally iden-tified as necessary for an effective establishment of currency convertibili-ty. These are an appropriate exchange rate level; an adequate stock ofinternational reserves; balanced macroeconomic management; and aneffective market environment. The latter prerequisite is one that appliesmainly to those economies in the process of moving from central plan-ning to a market-based system.

The notion that the exchange rate should be at a realistic level when acurrency is to be made convertible is straightforward. If the exchange rateis not consistent with external balance, pressures will build on the econ-omy and soon they will bear on the exchange rate itself, thus threateningthe sustainability of the convertibility commitment, if this is of the hardmodality. The requirement is less binding, of course, under convertibili-ty in the soft version, as the pressures that would develop from an inap-propriate level of the exchange rate would be eased by fluctuations in theexchange rate.

The importance of having an adequate stock of international reservesto establish and maintain currency convertibility is also easy to under-stand. The availability of reserves is essential to cope with shortfalls andother shocks that, on a recurrent basis, always affect balance of paymentsand economies in general. The need for international reserves is mostacute for establishing and maintaining hard convertibility. As the con-vertibility requirement softens, the need for reserves diminishes. In theextreme, soft convertibility interpreted as convertibility with a freelyfloating exchange rate would necessitate no reserves whatsoever.

The third requirement, sound macroeconomic management, is of theutmost importance for all concepts and degrees of convertibility. In sub-stance, credible and appropriate macroeconomic policy is a sine quanon for the effectiveness of convertibility. This entails appropriate fiscaland monetary management, the importance of which cannot be over-stressed in the context of full convertibility, that is, convertibility thatextends to capital transactions. But it is also clearly relevant for softconvertibility concepts, if stability is to be provided to exchange ratedevelopments.

30



The fourth requirement, the existence of an effective market environ-ment, a setting where market forces are allowed to play a role, also hasrelevance for economies where the market is the principle of economicorganization. The sense in which this requirement is important is in theneed for flexibility in product and factor markets so that the domesticcost-price structure can adjust to changes in real or other factors. Suchflexibility is of particular importance in the context of hard convertibility,where wage-price flexibility will be essential to underpin the given fixedexchange rate.

Concluding Remarks

Currency convertibility, in practice, is a relative concept bound by anoutside definition to which few, if any, currencies adhere, that is, the free-dom to convert a currency into foreign exchange for any and all purpos-es at a given rate of exchange. In terms of the ability to conduct interna-tional transactions, much progress has been made in terms of current andcapital account liberalization. In that respect, convertibility of currencieshas been established de jure or de facto to a large extent in many coun-tries. But in essence, it is soft convertibility that prevails, as exchange ratearrangements have moved toward flexibility. Until recently, hard con-vertibility was characteristic of the currencies in the exchange rate mech-anism (ERM) of the European Monetary System, which maintained a vir-tually fixed link among participating countries. But their convertibilitysoftened when a decision was taken to broaden the margin for most cur-rency fluctuations within the ERM from 2.25 percent to 15 percent.

In essence, convertibility of currencies, as liquidity of money, isamenable to many gradations, and in fact, has gone through many of thosegradations in the last half century. Most currencies at the outset of theBretton Woods period were inconvertible, since international transactionswere tightly controlled. Indeed, one of the central purposes of theInternational Monetary Fund was precisely to liberalize the exchange sys-tems of member countries and ensure that a reasonable measure of con-vertibility was attached to their currencies. Much progress has been madein the international economy at large in lifting exchange restrictions andestablishing current account convertibility for many currencies.

This progress helped to strengthen the integration of nationaleconomies into the world system and thereby tightened the constraints ofinterdependence. Difficulty or unwillingness to live with the constraintsled, inter alia, to the abandonment of the Bretton Woods par valueregime in favor of a system of flexible exchange rate arrangements. Hard

31



convertibility was consequently also abandoned, and countries enteredinto a period of soft convertibility of their currencies, the degree of whichvaried depending on the presence and magnitude of exchangerestrictions.

The period since the demise of the Bretton Woods system saw also anenormous growth in the scale of capital movements. These capital flowsaffected currency convertibility in a variety of ways. To the extent that theemergence of capital flows allowed for the financing of current accountimbalances, they lessened the degree of exchange rate adjustments thatwould have been necessary in their absence. Thus, they contributed to ameasure of hardening of currency convertibility. Capital flows also wereinstrumental, together with a trend in governmental policy circles in favorof market prices, in bringing about a de jure or de facto lowering of cap-ital controls. Thus, they also broadened the degree of convertibility bymoving currencies toward capital account convertibility. In this respect,reality has surpassed the aims of the code of conduct embedded in theArticles of Agreement, which still contemplate the use of capital controlsas an available policy option.

In sum, currency convertibility, in its hard modality, is equivalent todomestic price stability as a government aim. The latter will ensure thegovernment's willingness and ability to maintain the internal value ofmoney. The former amounts to the similar principle in the internationaldomain: the government's willingness and ability to maintain the externalvalue of money.

References

Asselain, J.C., "Convertibility and Economic Transformation," in European Economy: Path of Reform in Central and Eastern Europe, Communities of the EuropeaCommission (Paris: CEC, Special Edition No. 2, 1991).

Bofinger, Peter (1991a), "Options for the Payments and Exchange-Rate System inEastern Europe," in European Economy: The Path of Reform in Central and EaEurope, Commission of the European Communities (Paris: CEC, Special EditiNo. 2, 1991).

(1991b), "The Transition to Convertibility in Eastern Europe: A Monetary View,"in Currency Convertibility in Eastern Europe, ed. by John Williamson (WashinInstitute for International Economics, 1991).

Gilman, Martin G., "Heading for Currency Convertibility," Finance & DevelopmenVol. 27 (September 1990), pp. 32-38.

Gold, Sir Joseph, The Fund's Concepts of Convertibility, IMF Pamphlet Series, No. (Washington: International Monetary Fund, 1971).

32



Greene, Joshua E., and Peter I sard, Currency Convertibility and the Transformation ofCentrally Planned Economies, IMF Occasional Paper No. 81 (Washington:International Monetary Fund, 1991).

Guitian, Manuel (1992a), The Unique Nature of the Responsibilities of the InternationalMonetary Fund, IMF Pamphlet Series, No. 46 (Washington: International MonetaryFund, 1992).

(1992b), Rules and Discretion in International Economic Policy, IMF OccasionalPaper No. 97 (Washington: International Monetary Fund, 1992).

"Capital Account Liberalization: Bringing Policy in Line with Reality," in CapitalControls, Exchange Rates and Monetary Policy in the World Economy, ed. by SebastianEdwards (Cambridge, England; New York, NY: Cambridge University Press, 1995).

Haberler, Gottfried, Currency Convertibility (New York: American Enterprise Association,1954).

Horsefield, J. Keith, The International Monetary Fund, 1945-1965: Twenty Tears ofInternational Monetary Cooperation (Washington: International Monetary Fund,1969), 3 vols.

Levcik, Friedrich, "The Place of Convertibility in the Transformation Process," in CurrencyConvertibility in Eastern Europe, ed. by John Williamson (Washington: Institute forInternational Economics, 1991).

Mathieson, Donald J., and Liliana Rojas-Suarez, Liberalization of the Capital Account:Experiences and Issues, IMF Occasional Paper No. 103 (Washington: InternationalMonetary Fund, 1993).

Polak, Jacques J., "Convertibility: An Indispensable Element in the Transition Process inEstern Europe," in Currency Convertibility in Eastern Europe, ed. by John Williamson(Washington: Institute for International Economics, 1991).

van Brabant, Jozef M., "Convertibility in Eastern Europe Through a Payments Union," inCurrency Convertibility in Eastern Europe, ed. by John Williamson (Washington:Institute for International Economics, 1991).

Williamson, John (1991a), ed., Currency Convertibility in Eastern Europe (Washington:Institute for International Economics, 1991).

(1991b), "Convertibility," in Paul Marer and Salvatore Zecchini, eds., TheTransition to a Market Economy, Vol. II (Paris: Organization for EconomicCooperation and Development, 1991).

33


Current Account Convertibility:Anachronism or Transition?

Saleh M. Nsouli*

In a world where goods, services, and financial markets have becomeincreasingly integrated, it is argued that current account convertibility

has become an anachronism.1 Yet, current account convertibility remainsat the center of the mandate of the International Monetary Fund andconstitutes for many countries an important policy objective, which isoften seen as an intermediate step toward the attainment of full convert-ibility. A key unresolved issue is whether countries with inconvertible cur-rencies should move directly to full convertibility or go through a transi-tional period of current account convertibility. While the focus of thispaper will be primarily on current account convertibility, it will attemptto shed some light on the considerations involved in the move to fullconvertibility.

The paper will, first, provide some background on the concept andgradations of convertibility. Second, it will outline the benefits and costsinvolved in the introduction of convertibility, as well as the conditionsthat need to be met and sustained to introduce and maintain convertibil-ity. Third, it will place the issue of convertibility in the wider framework

*Assistant Director, Middle Eastern Department, International Monetary Fund. Theviews expressed are those of the author, and do not necessarily reflect those of the staff orExecutive Board of the International Monetary Fund. The author is grateful to JorgDecressin, Mohamed El-Erian, and Sena Eken for comments on earlier drafts, and to Ilse-Marie Fayad for valuable research assistance.

1See Guitian (1993a).

34

g


Current Account Convertibility: Anachronism or Transition?

of the speed of adjustment and the appropriate sequencing of reformpolicies. Against that framework, it will attempt, fourth, to analyze therelative merits of different approaches to achieving current account con-vertibility. It concludes by highlighting how transitioning through cur-rent account convertibility to achieve full convertibility can be viewed asconsistent with both theoretical welfare and pragmatic considerations.

Gradations of Convertibility

The founding fathers of the International Monetary Fund gave highpriority, in Article I(ii) of the IMF's Articles of Agreement, to the estab-lishment of current account convertibility as a means of facilitating "theexpansion and balanced growth of international trade, and to contributethereby to the promotion and maintenance of high levels of employmentand real income. . . . " As such, a key mandate of the Fund was

[t]o assist in the establishment of a multilateral system of payments inrespect of current transactions between members and in the elimination offoreign exchange restrictions which hamper the growth of world trade(Article I(iv); italics added).

Capital account convertibility was viewed as being important only inso far as its absence hindered current account transactions, as evidencedby the provision in the Articles of Agreement that

[m]embers may exercise such controls as are necessary to regulate interna-tional capital movements, but no member may exercise these controls in amanner which will restrict payments for current transactions or which willunduly delay transfers of funds in settlement of commitments . . . (ArticleVI, Section 3, IMF, 1993; italics added).

From an economic point of view, currency convertibility can bedefined as the ability (1) to exchange one currency for another, at a givenor market-determined rate, and (2) to use the acquired currency for for-eign transactions. There are wide gradations of convertibility. At oneextreme, total convertibility involves the unrestricted exchange of thecurrency of a country into any other currency without limitation on itsuse for any foreign transaction. This would be achieved if the country hadno exchange controls or restrictions vis-a-vis the rest of the world, as wellas no quantitative or financial barriers to external transactions. At theother end, total inconvertibility denotes the complete inability toexchange the currency of a country into any other currency or to use itfor any foreign transaction. This would be the situation in a country thathad instituted exchange controls or restrictions or quantitative or finan-

35



cial barriers that completely cut off all external transactions. Along thisspectrum, the degree of convertibility of a currency can be identified bythe effectiveness of exchange controls and restrictions and of quantitativeor financial barriers to external transactions (Table 1).2

The Fund's concept of convertibility, as provided for under ArticleVIII, Sections 2, 3, and 4, lies in between these two extremes. It involvesthe abolition of exchange restrictions on current account transactions,namely, trade and invisibles. It does not, however, extend to restrictionson trade and invisibles that could, in themselves, limit the usability of thecurrency for some current account transactions or capital transactions. Italso does not provide for internal convertibility, defined as the ability ofresidents to hold and convert the domestic currency into other currencieswithin the country.3

The official establishment of current account convertibility, involvingacceptance of the obligations of Article VIII, Sections 2, 3, and 4, hasproceeded at a relatively slow pace since the establishment of the Fund(see Appendix). In 1946, only four countries accepted those obligations.It was not until the early 1960s that most of the industrial countries haddone so. In the following years, several countries accepted the obliga-tions, although at an average rate of somewhat less than three countriesa year. There was a pickup in 1993, with 8 additional countries accepting,bringing the total to 82 countries (Chart 1). However, weighing thecountries by their importance in world trade in 1990, the most importantprogress was made in the early 1960s, followed by the period 1986-93(Chart 2). It was only in the late 1960s and early 1970s that the majorindustrial countries had gone beyond the requirements of Article VIII,moving for the most part to full convertibility.

Benefits, Risks, and Conditions

The Fund's Articles of Agreement are clear on the systemic benefitsfrom current account convertibility, notably in terms of the promotion ofworld trade, allocative efficiency, growth, and employment.4 From acountry's point of view, the move to current account convertibility car-ries numerous benefits. Establishing current account convertibility helpsto reduce distortions associated with foreign exchange rationing. It con-

2See McLenaghan, Nsouli, Riechel (1982).3See Gold (1971 and 1978), Greene and Isard (1991), Guitian (1993b), and Nsouli,Cornelius, and Georgiou (1992).4See Guitian (1993a).

36



Table 1. Degrees of Currency Convertibility and the Effect on Transactions

Source: McLenaghan, Nsouli, and Riechel (1982).

tributes to a rise in productivity by opening the internal market toincreased competition, improves the access to production inputs and cap-ital equipment; and helps import foreign technology. As internal pricesbecome more aligned with world prices, current account convertibilityalso helps in fostering allocative efficiency and in moving to areas of pro-duction in line with the country's comparative advantage. All these fac-tors also contribute to improving the incentive structure and therebystimulating investment, employment creation, and growth. Apart fromthe resulting positive incidence on real per capita income of currentaccount convertibility, consumer welfare is further improved as a widerrange of consumption items becomes available. Further benefits, howev-er, can be achieved with the move to full convertibility, particularly as theflow of capital can help to attract foreign investment. This, in turn, caccelerate the introduction of improved technology and more efficientproduction methods, while the knowledge of foreign investors of marketopportunities abroad can foster export growth.5

There can, of course, also be negative transitional effects associatedwith the establishment of current account convertibility, as the expansionof foreign competition could prompt the restructuring of domestic pro-

5See Gilman (1990), Greene and Isard (1991), Nsouli, Cornelius, and Georgiou (1992),Williamson (1991), and Villanueva (1993).

37

TotalConvertibility

Article VIIIConvertibility

TotalInconvertibility

Current transactionsTrade

Invisibles

Capital transactions

Convertible intoall currencies

No exchange ortrade restrictions

No exchangeor invisiblesrestrictions

No restrictions

Yes

No exchangerestrictions; possibletrade restrictions

No exchangerestrictions;possible andinvisibles restrictions

Possible restrictions

Not necessarily

Comprehensiveexchange andtrade restrictions

Comprehensiveexchangerestrictions

Comprehensiverestrictions

No



Chart 1. Number of Member Countries That Have Accepted the Obliga-tions of Article VIII, Sections 2, 3, and 4 of the Articles of Agreement(Cumulative, 1946 through 1993)

Source: International Monetary Fund.

duction and lead to temporary output losses. However, these losses haveto be viewed as a necessary cost of restructuring the economy and mov-ing it to a higher growth path. Furthermore, the move to full convert-ibility could result in capital outflows if the macroeconomic policies wereperceived to be inconsistent with a sustainable stable domestic financialenvironment or if there were uncertainties regarding the economic orpolitical prospects of the country. It may be argued, however, that, undersuch circumstances, the incentives for capital outflows are so high thatcapital restrictions will be bypassed through parallel market activities orthe overinvoicing of imports.6

Currency convertibility is not a policy instrument per se, but rather areflection of a policy outcome where a country has achieved balancebetween the demand and supply for foreign exchange vis-a-vis itscurrency. As such, currency convertibility can be simply achieved byallowing the exchange rate to float and removing all exchange restric-tions. However, if domestic financial policies were too expansionary,continuous pressure on the exchange rate would result, leading to aninflationary cycle involving depreciation-inflation-depreciation, a cyclethat would disrupt investment incentives and growth. Furthermore, thelack of an adequate level of foreign exchange reserves would limit the

6See Guitian (1993a) and Williamson (1991).

38

90

80

70

60

50

40

30

20

10

046 50 54 58 62 66 70 74 78 82 86 90 92



Chart 2. Members That Have Accepted the Obligations of Article VIII,Sections 2, 3, 4 of the Articles of Agreement(In billions of U.S. dollars in 1990 trade; cumulative, 1946 through 1993)

6000

5000

4000

3000

2000

1000

0


ability of the monetary authorities to smooth fluctuations in theexchange rates arising from seasonal or transient factors, with the result-ing instability of the currency (in the absence of stabilizing arbitrageurs)undermining confidence in the currency.7 Finally, if the regulatory envi-ronment was such that prices, production, and trade decisions were cen-trally controlled, the benefits of the introduction of convertibility wouldnot be passed on to the economy.

Because of these considerations, the economic literature has generallyfocused on the preconditions that need to be satisfied to successfullyintroduce convertibility.8 The presumption is that these are prior condi-tions. In fact, however, they are conditions that need to be satisfied priorto or concurrently with the introduction of convertibility and are neededto sustain it. Thus, it is more appropriate to refer to the conditions thatare necessary for the successful introduction and maintenance of con-vertibility. There are four conditions that, though interdependent, can beanalytically isolated.

First, internal financial balance needs to be established by adoptingsound fiscal and monetary policies that equilibrate aggregate demand witeavailable resources. Otherwise, excessive inflationary pressures would u

7See Crockett and Nsouli (1977).8See Gilman (1990), Greene and Isard (1991), Nsouli, Cornelius, and Georgiou (1992).

39

46 50 54 58 62 66 70 74 78 82 86 90 92



dermine the competitiveness of the economy and lead to a deteriorationin the balance of payments situation, given the exchange rate.

Second, external financial balance must be achieved. To this end, theexchange rate has to be set or allowed to float to a level that would equi-librate the demand for and supply of foreign exchange without exchangerestrictions, taking into account the demand-management policies. Inprinciple, the achievement of external financial balance is a necessary andsufficient condition for convertibility. Thus, if the exchange rate isallowed to float, the demand for and supply of foreign exchange will beequalized. However, if domestic financial policies remain excessivelyexpansionary, inflationary pressures will build up, resulting in a continu-ous depreciation of the currency. In such an unstable environment,investment and growth would suffer. To prevent that, external and inter-nal financial balance must be achieved simultaneously.

Third, an adequate level of reserves must be maintained to allow thcountry (1) to absorb domestic or exogenous shocks, without reintroduc-ing restrictions, while domestic policies or the exchange rate, or both, areadjusted, and (2) to finance transient or seasonal fluctuations in netexchange receipts so as to avoid large temporary swings in the exchangerate. In general, the level of reserves needed will depend on the exchangerate policy of the authorities. A higher level of reserves will be needed ifthe authorities place a high priority on exchange rate stability over time.Otherwise, movements in the exchange rate could be used to fully absorbtransient or more permanent shocks to the economy. Thus, an adequatelevel of reserves, while not absolutely essential, can provide a buffer againsttemporary shocks, and serve as a cushion that would allow some marginfor introducing policy adjustments to tackle more permanent shocks.

Fourth, the incentives system must be liberalized to allow the positiveeffect of convertibility on resource allocation to be transmitted to theeconomy. It is, therefore, to be seen as a condition not for currency con-vertibility but for deriving the allocative efficiency that would result fromcurrency convertibility. It would require the elimination of trade controls,tariff barriers, internal marketing controls, price controls, interest rateceilings, regulatory monopolies, labor market restrictions, and otheradministrative hindrances to the functioning of the market system.

Issues in Speed and Sequencing

The speed with which convertibility is introduced and the sequencingof its introduction are critical to ensure that it generates beneficial effectsfor the economy. From the discussion above, it is clear that the success-

40



ful adoption of convertibility involves a comprehensive set of bothmacroeconomic and structural reforms to achieve financial balance andallocative efficiency. It is, therefore, synonymous with successful adjust-ment, culminating in a viable balance of payments position.

The views on the appropriate speed of adjustment are divided. Someanalysts argue that a fast adjustment, involving the immediate move toconvertibility, can generate greater benefits than a gradual approach,where convertibility is phased in pari passu with the progress made on theadjustment and reform fronts. Others argue that the benefits of a gradualapproach are greater. In my view, the distinction between the twoapproaches is somewhat overdrawn. In practice, the speed of adjustment,and the concomitant introduction of convertibility, will depend on thespecific circumstances of each country. In a purely theoretical model,however, the problem can be defined as that of finding the optimal adjust-ment trajectory that will maximize the intertemporal welfare function, withan appropriate social discount rate, subject to various financial and struc-tural constraints.

The practical translation of this maximization problem into a real-world adjustment program is virtually impossible. But three generaliza-tions would seem plausible: (1) the higher the social discount rate, otherthings being equal, the lower the optimal speed of adjustment—as therewill be a tendency to defer net costs; (2) the greater the financial con-straints, the faster the speed of adjustment required—whether orderly ordisorderly; and (3) the greater the structural constraints—in terms ofinfrastructure, institutional capacity, administrative capacity, and soforth—the slower the speed of adjustment.

From these, it follows that

• if a program were designed to achieve convertibility at a faster ratethan provided by the social discount rate, other things being equal,social tensions would rise, leading to a disruption of the adjust-ment process;

• if a program were designed to achieve convertibility at a slower ratethan implied by the financial constraints, other things being equal, theadjustment process would break down because of lack of resources;

• if a program were designed to achieve convertibility at a faster pacethan given by the structural constraints, there would also be abreakdown of the process because of the problems that would beencountered in implementation; and

• if a program were designed to achieve convertibility at a slowerspeed than given by the optimization solution, it would follow tau-tologically that there would be welfare losses.

41



The above theoretical discussion of the pace at which convertibilitycan be achieved provides only a broad framework; it is of little use in prac-tically determining the speed at which macroeconomic adjustment shouldtake place or the manner in which reforms should be phased in.Nonetheless, there are a number of interrelated practical considerationsthat are essential in determining the time frame and phasing under anadjustment program leading to the introduction of convertibility.

Regarding the time frame, two practical considerations are critical:

Required financing. The external financing required for adjustmentshould be compatible with a return to a viable balance of paymentsposition; that is, the resulting debt-service ratio should not underminethe external sector position.

Available financing. The overall speed of adjustment cannot be slowerthan that given by the availability of external financing, subject to the firstconsideration above.

As to the sequencing, the following considerations arise:

Macroeconomic policies. Given that the alignment of aggregate demanwith available resources is critical for the establishment of convertibility,the adoption of sound fiscal, credit, and exchange rate policies needs tobe given priority.

Compatibility. There would be a need to phase structural reforms in amanner compatible with the re-establishment of macroeconomic stability.Consider, for example, the rationalization of tariff structures, which wouldbe essential to reinforce the positive effects of convertibility, but whichwould have immediate adverse effects on revenue and the deficit; the intro-duction of tax reforms, which would be essential to reduce financial imbal-ances, but which could take some time to be introduced; or the increasedemphasis on credit to the private sector, which would be essential to financeinvestment associated with the improved incentive structure, but whichcould be incompatible with an acceptable rate of monetary expansion.

Complementarity. The complementarity of policies should determinethe timing of actions. Consider a country with an overvalued exchangerate and price controls. An adjustment in the exchange rate will onlyhave the desired absorption and expenditure-switching effects ifdomestic prices are concurrently deregulated (or adjusted) to reflect theexchange rate change. Similarly, the positive effects of liberalizing traderestrictions would be reaped only if domestic prices were deregulated.However, an ensuing sharp rise in prices can be limited only if restrainedfiscal and monetary policies are put in place.

42



Lead time. Structural reforms should be phased in, taking into accounthe time for the requisite preparatory work, the implementation, and,where applicable, the gestation period. For example, if tax reforms areneeded to improve the fiscal position so as to reduce excess demandpressures and introduce convertibility, the phasing would depend on thetime required to prepare the studies, recruit or train the requisitepersonnel, prepare and adopt the legislation, put in place a functioning-institutional structure, and generate the requisite revenue.

Distribution effects. The phasing of reforms to achieve convertibilishould take into account income distribution effects. Reforms that in theshort run affect adversely and simultaneously large segments of thepopulation or the most vocal and politically influential segment may leadto social tensions that would derail the reforms and lead to higheradjustment costs.

Differing Approaches

The above framework provides a basis for assessing the different speedsat which the introduction of convertibility can be approached. Three dif-ferent approaches—which for illustration can be classified as the front-loaded, the preannouncement, and the by-product approaches—areexamined.9

To analyze these approaches, consider a country with both internaland external financial disequilibria exemplified by a high budget deficit, amonetary overhang, an inadequate exchange rate, widespread exchangeand trade restrictions, as well as price controls, and large parallel marketsfor goods and foreign exchange. What would be the implications of thethree approaches for the country?

Front-Loaded Approach

Under the front-loaded approach, the country would eliminateovernight the exchange restrictions on current account transactions ineffect. This would essentially require the immediate establishment ofexternal balance and would involve a concerted policy push in alleconomic and financial areas. The exchange rate would fall—or need tobe adjusted—to an equilibrium rate. With a concomitant decontrol of

9See Nsouli, Cornelius, and Georgiou (1992) for a practical discussion of these differentapproaches in three North African countries.

43



prices, the authorities would have to tighten fiscal and monetary policiesto support the exchange rate and avoid excessive inflationary pressuresfrom setting in motion a vicious circle of devaluation-inflation-devalua-tion. The inflationary impact of the devaluation could be further damp-ened by the concomitant liberalization of trade restrictions. The mone-tary overhang would be reduced by the opening up of the currentaccount.

Provided the move is viewed as sustainable, investment incentiveswould increase. At the same time, local industries would suffer from theincreased external competition, in view of the loss of protection resultingfrom the removal of exchange and trade restrictions. It is not unlikelythat, in such circumstances, there would be a transitional output andemployment loss. The sustainability of the adjustment policies would crit-ically depend on the ability of the authorities to show the benefits thatwould accrue at the end of the transition period, and on the provision ofappropriate social safety nets to meet the needs of the most vulnerablesegments of the population. That is why it is argued that "countries inwhich initial macroeconomic instability and popular discontent are highmay feel compelled to move more rapidly toward introducing the mainelements of current account convertibility, even with some risk of harm-ing particular sectors and thereby decreasing popular support for thereform program."10 In general, the proponents of a front-loadedapproach to convertibility—where the establishment of convertibilityleads policy decision-making—base their case on four major considera-tions: (1) getting the policies right up front can lead to faster welfaregains, since the distortions and imbalances in the economy are eliminat-ed early on; (2) the credibility effect of a critical mass of policies—supporting current account convertibility and signaling irreversibleaction—can generate a positive atmosphere for investment; (3) thefront-loading of actions at a time of economic crisis can provide the basisfor sustained adjustment and for minimizing adjustment fatigue; and (4)the financing requirements are minimized.

In the context of the framework elaborated in the previous section, thefront-loaded approach implies a low social discount rate and a bindingexternal financial constraint, with sequencing being governed by the needfor rapidly adjusting macroeconomic policies and introducing comple-mentary measures up front. In the process, the compatibility, lead time,and distribution effects considerations would be constrained.

10Greene and Isard (1991), p. 13.

44



Preannouncement Approach

The preannouncement approach would involve setting a specific date foreliminating current account restrictions and the adoption of policies toensure the achievement of current account convertibility by that date. Thepreannouncement approach essentially subordinates all objectives and poli-cies to the achievement of convertibility. With a set date for eliminatingexchange restrictions, the country can select a policy trajectory to achievethat objective. The excess aggregate demand, as evinced by the initial mon-etary overhang, can be programmed to be reduced in a phased manner.Actions to narrow the budget deficit can be taken in time to achieve therequisite reduction, and the pace of credit and monetary expansion can beslowed down. Price and trade controls can be reduced gradually. At thesame time, the elimination of exchange restrictions can proceed pari passuwith the adjustment in the exchange rate. This period can also be used tobuild up foreign exchange reserves and put in place a social safety net.Thus, by the end of the period, the conditions for successfully implement-ing convertibility will have been met and convertibility introduced.

In general, the proponents of such an approach base their case on theimportance of the phasing of policies in an appropriately sequential man-ner to reduce the dangers of premature introduction of policies; providefor flexibility of adjusting policies in mid-course; take into account admin-istrative constraints and the time needed for institution building; and allowthe government to take policies that may affect different groups of thepopulation at different times, thus minimizing the possibility of backlash.

In terms of the framework elaborated in the previous section, the pre-announcement approach implies a higher social discount rate than thefront-loaded approach, with less of an external financial constraint. It isless binding in terms of macroeconomic compatibility, complementarity,and lead time considerations, as well as distribution effects.

By-Product Approach

Under the by-product approach, convertibility is not an objective ofeconomic policy. Other policy objectives take precedence, and convert-ibility becomes a lower priority issue in policy decision making. Undersuch an approach, the country can move at the pace it determines appro-priate to keep in line with other policy objectives, with convertibilitybeing relevant only insofar as it affects the other objectives. The reduc-tion in the budget deficit can be dictated by institutional and politicalconsiderations; the pace of credit expansion by the balance the authori-ties see fit between the provision of resources to finance economic activ-

45



ity and the reduction of the monetary overhang; exchange rate policy bythe trade-offs between absorption, inflation, and reserves; the reductionof price controls by the balance between inflation, investment incentives,and social considerations; and the elimination of trade and exchangerestrictions by the trade-offs between efficiency and the protection ofdomestic industries.

In principle, this approach is similar to the preannouncementapproach but without a prespecified date for introducing convertibility.The risk of this approach is that it may take longer to establish convert-ibility, given that other policy objectives may not provide as clear a pol-icy target.

In terms of the framework elaborated earlier, this approach could becompatible with either a high or a low social rate of discount, with thepace of adjustment and reforms proceeding either slowly or quickly. Theavailability of financing would, of course, be an important consideration,but it is likely that issues relating to compatibility, complementarity, leadtime, and distribution effects would dominate the process and necessarilyslow it down. Thus, convertibility—either as the leading target in thefront-loaded approach or as an explicit target in the preannouncementapproach—can be viewed as an element in speeding up the adjustmentand reform process by providing an explicit focus.

Full Convertibility

There is no question that in today's world—where the financial mar-kets are as important if not more important than the goods markets—current account convertibility can be viewed as an anachronism in thesense that it deprives the country of the full benefits of convertibility.However, historically, many countries have moved gradually to establishcurrent account and, subsequently, capital account convertibility. Interms of the framework set out in this paper, the establishment of currentaccount convertibility as a transitional step toward achieving full convert-ibility would seem consistent with the "revealed" optimal adjustmentpath that would maximize a country's welfare function.

In practical terms, the debate for a move to full convertibility is basedon two major arguments: (1) the conditions required for establishing cur-rent account convertibility are not substantively different from thoserequired to achieve full convertibility; and (2) capital controls are, in anyevent, ineffective and can be circumvented. This position, however, over-looks what may be termed the confidence factor, namely, that even if themacroeconomic and structural conditions for full convertibility are met,

46



a country with a track record of policy reversals needs to change marketexpectations by performing well over a certain period of time. The intro-duction of current account convertibility and its sustenance can increasethe confidence in the currency, minimizing the potential for speculativecapital flows once capital controls are lifted. Although it is possible thatthe confidence factor can be offset at the outset through the adoption ofa high interest rate policy, such a move has to be assessed in terms of itsimplications for some of the country's internal objectives.

Appendix

Members That Have Accepted the Obligations of Article VIII, Sections 2,3, and 4, of the Articles of Agreement (as of December 31, 1993)

MemberEffective Dateof Acceptance

El SalvadorMexicoPanamaUnited States

Guatemala

Honduras

Canada

Dominican RepublicHaiti

BelgiumFranceGermanyIrelandItalyLuxembourgNetherlandsPeruSwedenUnited KingdomSaudi Arabia

Austria

JamaicaKuwait

JapanNicaragua

Costa Rica

November 6, 1946November 12, 1946November 26, 1946December 10, 1946

January 27, 1947

July 1, 1950

March 25, 1952

August 1, 1953December 22, 1953

February 15, 1961February 15, 1961February 15, 1961February 15, 1961February 15, 1961February 15, 1961February 15, 1961February 15, 1961February 15, 1961February 15, 1961March 22, 1961

August 1, 1962

February 22, 1963April 5, 1963

April 1, 1964July 20, 1964

February 1, 1965

47


Cunency Convertibility in the Middle East and North Africa

Members That Have Accepted Article VIII (continued)

MemberEffective Dateof Acceptance

Australia

Guyana

DenmarkNorwayBolivia

ArgentinaSingapore

Malaysia

Ecuador

Fiji

BahrainQatarSouth AfricaBahamas

United Arab EmiratesOman

Papua New Guinea

Venezuela

Chile

SeychellesSuriname

Solomon IslandsFinlandDominica

UruguaySt. LuciaDjibouti

St. Vincent and the Grenadines

New ZealandVanuatu

BelizeIcelandAntigua and Barbuda

St. Kitts and Nevis

SpainKiribati

July 1, 1965

December 27, 1966

May 1, 1967May 11, 1967June 5, 1967

May 14, 1968November 9, 1968

November 11, 1968

August 31, 1970

August 4, 1972

March 20, 1973June 4, 1973September 14, 1973December 5, 1973

February 13, 1974June 19, 1974

December 4, 1975

July 1, 1976

July 27, 1977

January 3, 1978July 29, 1978

July 24, 1979September 25, 1979December 13, 1979

May 2, 1980May 30, 1980September 19, 1980

August 24, 1981

August 5, 1982December 1, 1982

June 14, 1983September 19, 1983November 22, 1983

December 3, 1984

July 15, 1986August 22, 1986

48



Members That Have Accepted Article VIII (concluded)

Effective DateMember of Acceptance

Indonesia May 7, 1988Portugal September 12, 1988Korea November 1, 1988

Swaziland December 11,1989

Turkey March 22, 1990Thailand May 4, 1990

Cyprus January 9, 1991Tonga March 22, 1991

Switzerland May 29, 1992Marshall Islands June 22, 1992Greece July 7, 1992San Marino September 23, 1992

Tunisia January 6, 1993Gambia, The January 21,1993Morocco January 21,1993Micronesia June 23, 1993Lebanon July 1,1993Israel September 21,1993Mauritius September 29, 1993Barbados November 3, 1993Trinidad & Tobago December 13, 1993

References

Crockett, Andrew D., and Saleh M. Nsouli, "Exchange Rate Policies of DevelopingCountries," Journal of Development Studies (January 1977).

Evans Jr., James G., "Current and Capital Transactions: How the Fund Defines Them,"Finance & Development, Vol. 5, No. 3 (September 1968), pp. 30-35.

Gilman, Martin G., "Heading for Currency Convertibility," Finance & DevelopmenVol. 27 (September 1990), pp. 32-38.

(1993b), "Currency Convertibility: Concepts and Degrees" (unpublished,Washington: International Monetary Fund, December 1993).

Gold, Joseph, The Fund's Concepts of Convertibility, IMF Pamphlet Series, No. 1(Washington: International Monetary Fund, 1971).

, Use, Conversion, and Exchange of Currency Under the Second Amendment of theFund's Articles, IMF Pamphlet Series, No. 23 (Washington: International MonetarFund, 1978).

49



Greene, Joshua E., and Peter Isard, Currency Convertibility and the Transformation ofCentrally Planned Economies, IMF Occasional Paper No. 81 (Washington: InternationalMonetary Fund, 1991).

Guitian, Manuel (1993a), "The Issue of Capital Account Convertibility: A Gap BetweenNorms and Reality" (unpublished, Washington: International Monetary Fund,December 1993).

International Monetary Fund, Articles of Agreement (Washington: International MonetaryFund, 1993).

Krueger, Anne O., Foreign Trade Regimes and Economic Development: LiberalizationAttempts and Consequences (Cambridge, Massachusetts: Ballinger Publishing Compan1978).


McLenaghan, John B., Saleh M. Nsouli, and Klaus-Walter Riechel, Currency Convertibilityin the Economic Community of West African States, IMF Occasional Paper No. 13(Washington: International Monetary Fund, 1982).

Nsouli, Saleh M., Peter Cornelius, and Andreas Georgiou, "Striving for CurrencyConvertibility in North Africa," Finance & Development, Vol. 29 (December 1992),pp. 44-47.

Persson, Torsten, and Guido Enrico Tabellini, Macroeconomic Policy, Credibility and Politi(Hur, Switzerland; New York, N.Y.: Harwood Academic Publishers, 1990).

Polak, Jacques J., "Convertibility: An Indispensable Element in the Transition Process inEastern Europe," in Currency Convertibility in Eastern Europe, ed. by John Williamson(Washington: Institute for International Economics, 1991).

Rieffel, Alexis, "Exchange Controls: A Dead-End for Advanced Developing Countries?" inFinance and the International Economy, AMEX Bank Review Prize Essays, ed. by JohnCalverley and Richard O'Brien (Oxford: Oxford University Press, 1987).

Rodrik, Dani, "Promises, Promises: Credible Policy Reform via Signalling," EconomicJournal, Vol. 99 (September 1989), pp. 756-72.

Villanueva, Delano, "Options for Monetary Exchange Arrangements in TransitionEconomies," IMF Paper on Policy Analysis and Assessment 93 /12 (Washington:International Monetary Fund, September 1993).

Williamson, John, ed., Currency Convertibility in Eastern Europe (Washington: Institute forInternational Economics, 1991).

50


Experience with ExchangeControls in the Arab Countries

Mustapha Kara and Salam Hleihel*

R eliance upon exchange controls and restrictions played an impor-tant part in the economic policies of the Arab countries, with the

exception of the Gulf Cooperation Council (GCC) countries, andLebanon, which adopted early on an open trade and payments system.The extent and character of exchange controls, however, varied amongthe countries depending on their economic orientation, resourceendowments, and external sector circumstances. In those countries witha dominant public sector, exchange controls were part of an overall sys-tem of administrative allocation of resources, while balance of paymentsconcerns were the main reason for the use of restrictions in market-ori-ented economies.

This paper briefly surveys the practice of exchange controls in 12 Arabcountries since 1980. The countries experienced widespread distortionsand inefficiencies that resulted in lower economic growth and severeexternal payments difficulties that, in some cases, culminated in the accu-mulation of external payment arrears. The paper supports the view thatthe reliance on exchange controls to maintain an unrealistic exchange rateresults in distortions and inefficiencies as reflected in the overvaluation ofthe exchange rate, the bias against exports, the prevalence of a parallelmarket for foreign exchange, the diversion of workers' remittances from

*Economists, Arab Monetary Fund. The views expressed are those of the authors andshould not be attributed to the Arab Monetary Fund.

51

g



official channels, the fostering of capital flight and currency substitution,as well as the decline in overall productivity.

With the costs of exchange controls becoming more and more pro-hibitive, these countries were under increasing pressures to adjust and lib-eralize their exchange systems. Recently, most of them have taken stepsin that direction, in conjunction with the adoption of comprehensiveadjustment programs. However, the steps undertaken in this context, andtheir effectiveness, have varied considerably among the countriesconcerned.

An Overview of Exchange Controls inthe Arab Countries

Typically, the classical methods of adjustment of a balance of paymentsdeficit consist of allowing flexible exchange rate determination or thepursuit of monetary and fiscal policies consistent with a fixed exchangerate. Apart from these classical methods of adjustment, another methodthat has come to be widely used by developing countries to contain exter-nal imbalances is exchange controls, that is, restricting foreign paymentsto a level consistent with foreign exchange receipts and external borrow-ing.1 Exchange controls can, however, also be imposed for other thanbalance of payments considerations, as part of the economic managementof resources by the public sector.

By imposing exchange controls, the country suppresses the excessdemand for foreign exchange and partly insulates the domestic economy.The immediate implication of such intervention in the foreign exchangemarket is the suspension of the convertibility of the currency; and thedirect outcome is an exchange rate level for the domestic currency thatdiffers from the one determined by the free interplay of market forces.This intervention in the foreign exchange market, under a system of fixedexchange rates, aims at protecting the official external value of thedomestic currency, while, under an adjustable peg, its purpose is to stabi-lize the exchange rate at a desired level.

A survey of exchange rate regimes shows that most Arab countriesdetermine their exchange rates on the basis of a peg, either to a currencyor to a basket of composite currencies related to imports or payments, aswell as to the SDR (Table 1). The exception is Lebanon, which has main-tained a flexible exchange rate system. The exchange rate regimes of these

1Krueger(1983).

52


Experience with Exchange Controls in the Arab Countries

Table 1. Exchange Rate Regimes in the Arab Countries, 1980

Source: IMF, Annual Report on Exchange Arrangements and Exchange Restrictions (1981).1Lebanon has a market-determined exchange rate system.

countries differ in several aspects, and as such can be divided into twomain categories. The GCC countries, which do not impose restrictionson international transactions, fall into the first category. These countriesshare a similar exchange rate policy objective, namely, the stabilization oftheir respective currency in terms of the currencies of their trading part-ners so as to reduce the negative impact of exchange rate variations ondomestic costs, prices, and output. They enjoy substantial external cur-rent account surpluses, resulting from large oil revenues, and they rely onthe market as a system of economic management. They also maintaintheir foreign exchange markets free from restrictions, to facilitate theinvestment of their oil surplus funds in foreign assets. The rest of the Arabcountries, other than Lebanon, had imposed exchange controls on bothcurrent and capital transactions and fall into the second category. Theyare the subject of this paper.

The extent and character of exchange controls among the Arab coun-tries surveyed vary depending on their economic and political systemsand their external payments position. Two reasons seem to justify the im-position of exchange controls, namely, the allocation of resources by thepublic sector and the management of the balance of payments.

53

Group Country Currency Pegged to

No restrictions onpayments for current andcapital transactions

Restrictions onpayments for current andcapital transactions

BahrainKuwaitOmanQatarSaudi ArabiaUnited Arab EmiratesLebanon1

AlgeriaEgyptIraqJordanLibyaMauritaniaMoroccoSomaliaSudanSyrian Arab Rep.TunisiaYemen Arab Rep.

SDRCurrency basketDollarSDRSDRSDR

Currency basketDollarDollarSDRDollarCurrency basketCurrency basketDollarDollarDollarCurrency basketDollar



Accordingly, the countries that had imposed exchange controls can fur-ther be divided into two groups. The first group (group A) consists ofcountries that have, or had, a dominant public sector and a centrallyplanned economy, and where the government exercised strict controlover the volume and allocation of foreign exchange. In these countries,the predominant reason for exchange controls was the direct allocation ofresources. The second group (group B) consists of countries with mar-ket-oriented economies and whose main reason for exchange controlswas the management of the balance of payments.

Direct Allocation of Resources

In their endeavor to achieve the objectives of rapid growth, employ-ment, and income redistribution, the countries in group A followed astrategy of development and an economic philosophy that placedemphasis on industrialization, centered around import substitution,and a dominant public sector role in the economy. To influence themobilization, and allocation of resources, they relied upon a set ofcoherent policies consisting of a state monopoly over production, dis-tribution, and external trade, accompanied by administrative controlsover domestic prices, wages, interest rates, investment, and productiondecisions. Controls were inherent in this system of economic manage-ment, and the use of exchange control's was a normal and consequen-tial by-product of it. Thus, the imposition of exchange controls in suchcases may not have been for balance of payments purposes only, but alsofor allocative purposes as an element of the economic system (irrespec-tive of the state of the balance of payments and foreign exchangereserves).

The type of measures used (referred to here as "administered alloca-tion measures") included the drawing of a yearly import program, with-in which import priorities were set. Priority was usually given in the pro-gram to import requirements of public enterprises and investments, aswell as to basic consumer necessities. In addition, a foreign exchangebudget was also drawn, to allocate foreign exchange proceeds in accor-dance with the import program. Imports within this framework, as wellas exports of the country's major products, were carried out by statemonopolies. Import licenses were required and were issued in accor-dance with the import program or foreign exchange budget. Exportlicenses were also required in certain cases. In some cases, a list of pro-hibited imports was drawn for the protection of domestic production.Along with this, a system of multiple exchange rates was implemented insome countries to discriminate in the allocation of foreign exchange, on

54



the one hand, in favor of official and public sector payments, and on theother, to subsidize basic consumer necessities to discriminate againstexports and private sector imports.

Management of the Balance of Payments

The use of exchange control for management of the balance of pay-ments prevailed among the countries of group B. The proponents ofexchange controls, as opposed to adjustment, harbor the belief thatexchange rate and demand management as mechanisms of adjustment areineffective and have a contractionary and inflationary as well as a distrib-utional impact on the economies concerned. They argue that, in view ofthe structure of these economies and the short-run income and priceinelasticity of their import and export demand,2 devaluation would nothave, at least in the short run, the desired impact on the balance of pay-ments and would only work, through different channels, to exert a con-tractional impact on output and employment. It would also greatlyincrease the cost of imports and of servicing foreign debt. They also referto the lag effect of a devaluation at a time when the scarcity of foreignreserves calls for quick positive results in the balance of payments.Moreover, they point to the inflationary pressures induced by a devalua-tion and its impact on income distribution. The decrease in income andemployment opportunities would occur in the import substitution sector,which is highly protected by the government and where vested interestsare firmly entrenched. Furthermore, they refer to some additional advan-tages of exchange controls over devaluation, in terms of the protection itprovides to the economy concerned. It gives the policymakers a freedomof action in the design and implementation of fiscal and monetary poli-cies to foster domestic economic objectives, with the benefit of a sup-pressed balance of payments constraint. Finally they consider thatexchange controls are effective in preventing capital outflows and in help-ing retain domestic savings in the country.

The type of "restrictive measures" implemented by these countrieswere aimed at restricting and directing the flow of foreign exchange forbalance of payments and exchange rate support. These measures oftenincluded restrictions on the holding and use of foreign exchange accountsfor resident nationals, and restrictions on payment for both current andcapital transactions. In addition, exporters were required to surrendermost (or all) foreign exchange proceeds, at the official exchange rate in

2Cheng(1959).

55



most cases, and import surcharges were added to the cost of imports,over and above existing customs duties. Moreover, importers wererequired to deposit in advance the full or partial value of their imports.Finally, several countries settled a portion of their trade through bilateralpayments agreements.

Features of the Exchange Systems in Arab Countries

As explained previously, the Arab countries under study can be dividedinto two groups, with exchange controls imposed for allocative purposesin group A and for balance of payments considerations in group B.Appendix 1 provides a summary of the exchange controls used in eachcountry under discussion.

Exchange Systems for Allocative Reasons

"Administered allocation measures" were widely prevalent in theexchange control systems adopted by the countries in group A. The sys-tem of foreign exchange rationing and import allocation was strictly ad-hered to by the seven countries in the group with a few variations. Iraqand the Socialist People's Libyan Arab Jamahiriya did not apply a foreignexchange budget, while Somalia and Sudan did not apply an explicitimport program. In Egypt, imports were regulated by exchange budgetallocations rather than by import licenses and prohibited import listing.

Multiple exchange rate systems were widely prevalent in Egypt, theSyrian Arab Republic, Somalia, and Sudan. The official exchange market,where multiple exchange rates prevailed, was generally restricted in thesefour countries (with some variation among the countries and over time)to government current and capital transactions, public sector imports,basic consumer imports, and valuation of surrendered export proceeds.In many cases, other transactions were effected at depreciated, albeitadministratively determined, rates.

Among the countries in this group, multiple exchange rates proliferat-ed the most in the Syrian Arab Republic. In 1987, the Syrian ArabRepublic applied seven official exchange rates: the effective official rate,the parallel rate, the tourist rate, the export rate, the travel rate, the pro-motion rate, and the airline rate. These were reduced to four in 1988,and an additional "rate in neighboring countries" was added in 1989.This last, administratively determined rate was supposed to be flexibleenough to reflect market conditions. It represented an interim measuretoward the intended unification of the exchange rate system.

56



Egypt also applied several rates in 1987, namely, the effective officialrate, the special rate, the official free rate, the bank pool rate, and a newlyintroduced, flexible "new bank market" rate. This last rate was intro-duced to establish a flexible parallel market rate, as an interim measuretoward exchange market unification.

Official rates applied by Sudan in 1988 were the effective official rate,the commercial bank rate (or parallel market rate), the export rate, andthe remittance rate. Thereafter, measures were taken toward unifying theexchange market. Somalia has applied a dual official exchange rate sys-tem, albeit intermittently, since 1980.

Algeria and the Socialist People's Libyan Arab Jamahiriya both applieda separate depreciated official rate, as an incentive, to private remittances,in addition to the effective official rate that applied to all transactionsfinanced through the banking system. Meanwhile, the official exchangesystem in Iraq remained unitary. Furthermore, the countries in this groupeffected a portion of their trade through bilateral payments agreements.In addition to these "administered allocation measures," all countries ingroup A also applied strong restrictive measures.

Exchange Systems for Balance of Payments Reasons

The system of exchange controls in group B relied more on "restric-tive measures" rather than administered allocation measures. The publicsector in these countries did not play as big a role in the economy as wasthe case in group A countries, and allocation of resources relied more onthe market mechanism.

Import listing and licensing by administrative priority and for protec-tion, which was practiced in both Morocco and Tunisia, have been great-ly curtailed since 1980. State trading has also been limited to key miner-al exports: phosphates in Morocco, Tunisia, and Jordan; petroleum inTunisia; and iron in Mauritania.

Multiple exchange rate practices in this group have been very limited:Morocco applied a "premium" exchange rate applicable to remittances ofworkers abroad until 1983. The Yemen Arab Republic had a secondaryexchange market for transactions through commercial banks from 1985until 1987, when it was merged with the official market. Dual marketswere reintroduced in 1990, following the unification of North and SouthYemen.

All countries in this group applied restrictive measures of the samenature as those practiced by group A. The degree of restrictiveness hasvaried between countries and over time. Jordan and the Yemen ArabRepublic, for example, had few restrictions on current transaction pay-

57



ments during the first half of the 1980s but introduced tighter restric-tions in later years.

Degree of Restrictiveness of Exchange Controls

Perhaps the best indicator that differentiates the two groups of coun-tries and reflects the degree of restrictiveness of their exchange controlsystem, and the economic distortions created thereby, is the divergencebetween the official (effective) exchange rate and the free (or parallel)market exchange rate. As indicated in Table 2, this divergence was mostpronounced in group A, where most of the countries (except Somalia)had a ratio of parallel to official exchange rates exceeding 3 during thesecond half of the 1980s. In group B, on the other hand, this ratio waswell below 1.4 for most countries, except Mauritania, for the sameperiod.

Impact of Exchange Controls in Arab Countries

Economists have usually focused their attention on the inefficienciesand distortions introduced by exchange controls in the allocation ofresources and in international trade.3 It is argued that exchange controlshave a number of negative consequences, namely, the creation of a paral-lel market, distortion of the exchange rate (overvaluation of the curren-cy), shortages of goods, corruption, rent seeking, and capital flight. Allthese consequences work together to make exchange controls ineffectiveas a means for protecting the balance of payments.

Exchange controls are accompanied by a parallel market for foreignexchange, which constitutes a means for the diversion of foreignexchange inflows from official channels, denying the country additionalforeign reserves. The partial insulation of the economy, afforded byexchange controls, encourages the adoption of expansionary financiapolicies, contributing further to the overvaluation of the domestic cur-rency. As domestic prices rise above foreign prices, the officially peggedexchange rate diverges further from the equilibrium exchange rate thatwould have prevailed in the absence of exchange controls. The overvalu-ation of the currency in the official market tends to encourage imports atthe expense of exports and their diversification. It is also conducive to areallocation of resources in favor of nontradables, resulting in a decline of

3For a detailed survey of the cost of exchange controls, see Yeager (1976).

58



Table 2. Exchange Rate Divergence Between Official and Parallel Markets

Source: International Currency Analysis, Inc., World Currency Yearbook, various issues.1Prior to unification.

the agricultural sector, the mainstay of a large segment of the population.Moreover, it also encourages the choice of capital-intensive projects,which is incompatible with the labor surplus characterizing the countriesunder consideration and exposes the economy to distorted price signalsfor long-run allocation decisions.

The shortage of foreign exchange resulting from lower exports leadsto import restrictions, which tend to create some production bottleneckson the supply side and favor the emergence of a parallel economy, as wellas rent-seeking activities, which divert real resources from productive usesto quick profit-making activities.4 Finally, the existence of exchange con-trols tends to be undermined through capital flight and underinvoicingof exports or overinvoicing of imports.

This section will point out the distortions induced by exchange con-trols and their negative impact on the balance of payments and growth inthe respective countries. Countries in group A with overregulatedeconomies have experienced higher distortions than those in group B.

4Krueger(1974).

59

Ratio of Parallel Market Exchange Rate toEffective Official Exchange Rate

1980 1986 1988 1991

(end of period)Group AAlgeriaEgyptIraqLibyaSomaliaSudanSyrian Arab Republic

Group BJordanMauritaniaMoroccoTunisiaYemen Arab Republic1

3.501.951.381.751.581.721.35

1.001.411.001.181.33

3.402.904.504.301.622.206.90

1.032.301.011.181.35

5.203.504.303.101.703.704.50

1.103.001.041.121.23

5.501.03

16.102.00n.a.

2.503.80

2.00n.a.

1.101.102.40



Currency Overvaluation

Several of the countries surveyed experienced highly expansionary fis-cal and monetary policies, together with a pegged exchange rate system,during the 1970s and a large part of the 1980s. These two factors com-bined led to an open appreciation of the real effective exchange rates formany countries during that period. The real appreciation was more pro-nounced in the countries of group A.

Countries in group A, for which data are available, namely, the SyrianArab Republic, Egypt, Algeria, and Sudan, experienced a more protractedappreciation of the real effective exchange rates. In Sudan, Egypt, and theSyrian Arab Republic, real effective exchange rates rose steadily and sub-stantially over the period 1980-90 (Appendix Table A13). Relative to thelevel in 1980, the Syrian Arab Republic's real exchange rate reached a peakof 191 percent in 1987, before declining to 43 percent in 1990, while inSudan it reached 160 percent in 1990. Egypt's real effective exchange raterose by 98 percent by 1989. Algeria's real effective exchange rate, as well,rose until 1986, but then reversed in the latter half of the 1980s. The rel-atively limited flexibility in the nominal exchange rates of Sudan, Egypt,Algeria, the Syrian Arab Republic, and Somalia, in the face of higherdomestic inflation rates than in their trading partner countries, resulted inserious distortions in their real effective exchange rate. Although data forIraq and the Socialist People's Libyan Arab Jamahiriya are not available,the rigidity in the exchange rate policy pursued by these two countries inthe face of changing economic conditions would certainly suggest a highreal effective appreciation of their respective exchange rates as well.5

In contrast, among the countries of group B, the real effectiveexchange rates in Morocco and Tunisia have been kept on a steady down-ward trend over the entire period 1980-90. The trend has been suffi-ciently pronounced in both countries, with real effective exchange ratesfalling by 33 percent and 35 percent, respectively. In Jordan andMauritania, the real effective exchange rates rose by less than 20 percentduring the first half of the 1980s, but the trend was reversed in bothcountries in the second half.

Reduction in Exports

The real increase of the effective exchange rate for countries in groupA, and to a lesser extent in group B, contributed to the diversion of

5Iraq and the Socialist People's Libyan Arab Jamahiriya adopted a very passive exchangerate policy, keeping their nominal exchange rate constant over the entire period 1980-90.

60



domestic resources from the production of traded to nontraded goods, aswell as to an erosion of competitiveness that discouraged export growth.

The export performance of the countries in group A during the peri-od 1980-90 was very disappointing. Exports at constant prices exhibiteda steady declining trend for the majority of countries. Measured at con-stant prices, exports in 1990 were lower than they had been in 1980 forAlgeria, Iraq, the Socialist People's Libyan Arab Jamahiriya, Somalia, andSudan (Appendix Table A14). In Egypt and the Syrian Arab Republic,real exports declined significantly between 1980-88 before recoveringduring 1989-90. The real appreciation of the exchange rate hamperedthe production of exportable goods through its negative impact onincentives and served to increase the relative profitability of the nontrad-ables sector.

In Iraq, Algeria, and the Socialist People's Libyan Arab Jamahiriya,where oil is the main export item, the price and level of production of oilplayed a major role in the decline in the value of their exports.Nevertheless, the real appreciation of their exchange rate and the diver-sion of exportable goods to domestic consumption as a result of highlyexpansionary policies contributed to the creation of an unconducive envi-ronment for diversifying the export base. Traditional agricultural andmanufactured exports (mainly in the Syrian Arab Republic and Egypt)declined in the face of foreign competition. In Somalia, the appreciationof the real exchange rate prevented the diversification of markets duringa period when its traditional exports faced a ban from its main tradingpartner.

Faced with a shortage of foreign exchange during the period 1980-90,these countries resorted to further trade restrictions, which resulted in asharp contraction of imports. In most countries, real imports were muchlower in 1990 than they were in 1980 (Appendix Table A15). The reduc-tion in imports had a negative impact on output, growth, and employ-ment. In turn, the shortage of imported goods led to the emergence of aparallel economy, rent-seeking activities, and a loss of revenues by thegovernment.

Parallel Market for Foreign Exchange

The expansionary financial policies adopted by countries in group A,together with the pegged exchange rate, led to an excess demand for for-eign exchange. This excess demand suppressed by exchange controlsresulted in the proliferation of parallel markets for foreign exchange, witha marked divergence between the official and parallel market rates for for-eign exchange. In countries of group A, parallel market premiums rose

61



rapidly from low levels during the early 1980s to relatively higher levelstoward the end of the decade. The parallel market rate in Algeria, thatstood at 250 percent above the official rate in 1980, rose to 420 percentby 1988. In Egypt, the Syrian Arab Republic, and Sudan, the rateincreased from 95 percent, 35 percent, and 72 percent to 250 percent,350 percent, and 270 percent, respectively, over the same period.

On the other hand, in the countries in group B, the foreign exchangepremium was relatively low, as the parallel market rate remained fairlyclose to the official rate (Table 2), except for Mauritania, whose parallelmarket rate in 1988 exceeded the official rate by 200 percent.

Diversion of Foreign Exchange

The high foreign exchange premium in group A countries encouragedthe diversion of foreign exchange inflows, particularly workers' remit-tances, away from the banking system toward the parallel market. It alsocontributed to capital flight and the substitution of domestic currency byforeign currency. This exacerbated these countries' balance of paymentsproblems and eroded foreign reserves.

Data on workers' remittances, derived from balance of payments sta-tistics, show that some countries in group A experienced a substantial de-cline in these receipts over the period 1980-90 ranging from 13 per-cent in Algeria to 76 percent in Sudan (Appendix Table A16). Thisdecline occurred despite efforts made by the recipient countries to cap-ture part of these flows, by providing depreciated preferential exchangerates (Egypt, Algeria, Somalia, the Syrian Arab Republic, and Sudan).The effect of the overvaluation of the exchange rate on the flows ofremittances through the banking system can be illustrated by comparingthe receipts of workers' remittances in Algeria and Morocco. AlthoughAlgeria had a larger population working abroad, Morocco's receiptsstood at $2 billion in 1990 while Algeria's amounted to only $350 mil-lion. One of the main reasons behind this difference was the high paral-lel market premium in Algeria, while in Morocco the parallel market wasvery limited and the premium marginal.

With regard to capital flight, the countries surveyed experienced a sit-uation similar to that prevailing in some Latin American countries. Theovervaluation of their currencies, combined with negative real interestrates and inflationary pressures, encouraged capital flight and discouragedthe holding of domestic currencies. A recent study by the World Bankestimated capital flight over the period 1980-89 at 21.7 percent of GDPin Egypt, 15.9 percent in Jordan, 15.1 percent in the Syrian Arab

62



Republic, 3.0 percent in Algeria, and 1.6 percent of GDP in the YemenArab Republic.

Meanwhile, with the exception of direct investment related to thedevelopment of the oil sector, these countries did not benefit much fromthe inflow of foreign capital. In general, because of the policies pursued,these countries could not attract foreign direct investment.

As for currency substitution, the overvaluation of the domestic cur-rency combined with negative real interest rates provided incentives tothe private sector to increase its holding of foreign assets in an attempt toprotect its wealth. This process is similar to the process of "dollarization"prevailing in some Latin American countries. Available data for Egypt,Algeria, and the Yemen Arab Republic show that currency substitutionwas rising. Taking foreign currency deposit holdings by the private sectoras a partial indicator of this process, these deposits (benefiting from theliberalization of the exchange system) rose in Egypt from $9.5 billion in1986 to $16 billion in 1991, and in the Yemen Arab Republic from $200million to $310 million over the same period.

Growth and Productivity

During the 1980s, real economic growth declined steadily from thehigher levels achieved during the second half of the 1970s. Real outputin most countries surveyed grew on average less rapidly than the increasein population, despite relatively high investment rates, suggesting that theproductivity and capacity utilization declines contributed to lowergrowth. Indeed, the incremental capital output ratios (ICOR) in thesecountries (Appendix Table A17) were high, suggesting a relatively highlevel of inefficiency and a deterioration in the quality of investment. Thiscould be accounted for by the impact of the protection provided throughtrade policy measures (tariffs and quantitative restrictions) and the over-valued exchange rate, which allowed the import of capital goods at pricesbelow their true cost to the economy. The distortions resulted in ineffi-cient domestic production techniques and a high level of capital intensi-ty (as demonstrated by the high ICOR) inconsistent with the rapidlygrowing labor force. This bias toward capital intensity was also reinforcedby the import licensing system, which gave priority to capital imports.

Thus, the relatively high level of investment in these countries did notcontribute to the solution of their growing unemployment problem. Itcomes as no surprise, therefore, that unemployment in these countriesincreased rapidly to reach 26 percent in the Yemen Arab Republic, 25percent in Jordan, 24 percent in Algeria, 20 percent in the Syrian ArabRepublic, and 15 percent in Egypt in 1992.

63



Reform of the Exchange Systems in Arab Countries

The costs of exchange controls in the Arab countries surveyed, as wehave seen, were reflected in the emergence of a parallel market, lowerexport growth, diversion of foreign exchange, particularly workers'remittances, capital flight, currency substitution, and declining overallproductivity. Moreover, in a world characterized by a high degree ofinternational economic interdependence and increasing interpenetrationbetween national economies through trade, capital, labor, and techno-logical flows, the partial insulation provided by exchange controls isgreatly reduced, in particular in those economies that rely heavily on theexternal sector. All these factors, along with the awareness of the limita-tions of the import-substitution strategy pursued, have led to a shift inpolicy orientation with the adoption of market-oriented policies and anoutward-looking strategy.

Many Arab countries have carried out adjustment programs during the1980s with the aim of redressing the macroeconomic disequilibria andthe structural distortions in their economies. However, adjustment mea-sures were often implemented piecemeal and failed to deal with theunderlying structural misallocations effectively and tended to exacerbaterather than solve the problems. Faced with currency overvaluation andexcess demand, for example, some countries implemented partial devalu-ations that, in conjunction with insufficient stabilization measures, trig-gered an endless vicious circle of inflation and devaluation. This was mostpronounced in Sudan, Somalia, and Egypt.

In an attempt to deal with the overvaluation of their currency, theauthorities in Sudan, Egypt, the Syrian Arab Republic, and Somalia, aspreviously mentioned, resorted to the segmentation of the foreignexchange market, with the application of multiple depreciated exchangerates that discriminated against some sectors of the economy. In so doing,they not only complicated the exchange rate structure but also failed tonarrow the gap between the official and the parallel market rates. Thus,it became increasingly clear that reform and adjustment should be imple-mented within a comprehensive framework of economic restructuringand stabilization, including the liberalization of the exchange system toachieve a realistic and unitary exchange rate, to abolish most "adminis-tered allocation measures," and to ease the "restrictive measures."

As the experience of several Arab countries shows, the liberalization ofthe exchange system cannot be successfully carried out or sustained with-out a stabilized macroeconomic environment and a favorable externalsector position. A stable macroeconomic environment entails sound non-inflationary fiscal and monetary policies to avoid the loss of competitive-

64



ness caused by inflation and real exchange rate appreciation discussed ear-lier. The authorities can help achieve external balance by following a real-istic exchange rate policy, maintaining an adequate level of reserves, andliberalizing the incentive system to promote exports. A further precondi-tion is the credibility of reform, where the government's commitment tothe reform process is firm and evident.

Pattern of Reform in Group A

Given the external sector difficulties that countries in group A havefaced since 1980, and the complexity of the exchange systems they haveadopted, the transition to a liberalized exchange system was attempted instages rather than in a one-step correction. These general stages are out-lined below without implying a necessary sequence for implementation.

• A dual exchange market is introduced. External private sector trans-actions are directed to the free segment of the dual market. Underthis situation, the exchange rate in the free segment of the marketis flexible enough to reflect market conditions. Resident nationalsare free to hold foreign exchange accounts in domiciled banks,whereby the sale of balances in those accounts is not restricted.Transfers abroad of these balances, however, are still restricted.Introducing a parallel market, with a free or flexible exchange ratemechanism, aims at incorporating the flow of remittances and the"own resource" import financing into the domestic banking system.

• Flexibility of the official rate is introduced to avoid large marginsbetween the official and parallel rates.

• Most administered allocation measures that apply to the parallelmarket are abolished.

• Official market transactions are gradually shifted to the parallelmarket.

• Transactions in the official market are discontinued, and other mul-tiple fixed exchange rates are abolished.

Egypt introduced a "free bank market" for foreign exchange in 1987,where the exchange rate was adjusted daily to reflect market conditions.This market operated in parallel with the official or primary market,where the exchange rate was still pegged to the U.S. dollar. The opera-tion of the system in the period 1987-90 faced difficulties reflecting theworsening condition of the external sector and the mounting foreigndebt problem. The dichotomy between a rigid official rate and a flexibleparallel rate added to these difficulties, and eventually the free bank mar-ket was unable to meet the demand for foreign exchange. Consequently,

65



the parallel market re-emerged and the use of dollar notes in circulationbecame widespread. However, Egypt's external sector position improvedgreatly as a result of the debt relief and external assistance it received in1990 and 1991. Adjustment policies also succeeded in reducing the bud-get deficit from 24 percent of GDP in 1988 to 9 percent of GDP in1991. The current economic programs aim at virtually eliminating thisdeficit by the mid-1990s.

As a result of these improvements, it became feasible to carry out adrastic exchange reform. During 1991, Egypt introduced a free foreignexchange market parallel to a "central bank pool market" with a set max-imum rate of divergence between the two markets. Resident nationalswere also allowed to maintain foreign currency accounts with domiciledbanks without limitations. Balances in those accounts could be used tosettle authorized transactions or sold in the parallel market. Later in theyear, Egypt merged all transactions into the free market, thus unifying theexchange system under a floating regime. These measures abolished, ineffect, the bulk of the administered allocation measures that were in prac-tice before. Other liberalizing measures during 1991 included abolishingthe foreign exchange budget system for public enterprises, reducingimport deposit requirements, and abolishing surrender requirements ofexport proceeds.

In Sudan, multiple exchange rates and dual exchange markets wereoperational throughout the 1980s and up to 1992. Efforts were oftenmade to reform the exchange system, and several administered allocationmeasures were abolished in the early 1980s, including some state tradingmonopolies. A parallel market with a flexible exchange rate mechanismwas introduced in 1985. This market was terminated in 1987 and re-established in 1988. However, the exchange system was not flexibleenough, nor were external sector conditions favorable enough to ensurethe efficient operation of the system. Thus, shortages of foreign exchangepersisted. The authorities had to resort in several intervals to the "ownresources" import-financing system, which was supposed to have beensuperseded by the parallel market.

In 1992, and in spite of persisting external sector difficulties, Sudanintroduced a unified foreign exchange market with a flexible exchangerate determined in an interbank market by the association of commercialbanks. However, unlike in Egypt, these reforms did not introduce suffi-cient flexibility into the exchange system, nor were they accompanied bysufficient measures to relieve the country of the massive debt crisis itfaces.

External debt arrears in Sudan accumulated throughout the 1980s toreach 1,652 percent of exports of goods and services by the end of 1991.

66



Efforts to achieve internal equilibrium were not very successful. In theperiod 1989-91, the budget deficit averaged around 11 percent of GDP.Consequently, parallel market activity persisted, casting doubt over thesustainability of the 1992 reforms.

Similarly, Somalia introduced a dual exchange system with fixed ratesin 1981, where the official rate applied to a limited number of officialtransactions and basic imports, while the bulk of transactions were effect-ed at a depreciated parallel rate. Concurrently, import licensing under theown resources (franca valuta) system was suspended. In the same year,several state trading monopolies were also abolished. In 1982, the dualexchange system was unified, and the exchange system was switched froma dollar- to an SDR-pegged one.

Here again, the reforms proved insufficient, as the exchange systemremained too rigid and the stabilization effort was inadequate. Parallelmarket transactions grew, and the authorities reinstituted the franca valu-ta system. Further reforms were introduced in 1985 whereby the francavaluta system was reabolished, and a dual exchange system was reintro-duced, albeit with more flexibility. The official exchange market wasbased on a managed floating system, while the parallel market rate wasfreely floating. Somalia then abolished the parallel (or secondary) marketin 1987, thereby unifying the exchange system. However, external sectorconditions remained unfavorable (as indicated by the ratio of accumulat-ed arrears to exports of goods and services that reached 881 percent bythe end of 1991) and hampered the sustainability of the exchange systemreforms.

Although a "free" foreign exchange market is still operational amongauthorized holders of foreign currency accounts (mainly nonresidentnationals and exporters), Somalia implemented a system of proportionalforeign exchange rationing among licensed importers. This was replacedin 1990 by a foreign exchange auctioning procedure. It is difficult to say,at present, how successful these reforms would have been in the absenceof the current political situation and the massive external debt burdenthat the country is suffering from.

During 1990 and 1991, Algeria implemented several liberalizing mea-sures with the aim of introducing more flexibility into the exchange ratesystem, and channeling foreign exchange resources from the parallel mar-ket and the own resources import finance to the banking system, therebysetting the stage for the introduction of a parallel foreign exchange mar-ket in the near future. The measures implemented included allowingAlgerian nationals (resident or nonresident) in 1990 to maintain foreignexchange accounts with domiciled banks. Balances in these accountscould be used to pay for licensed foreign transactions or could be sold at

67



a freely negotiated exchange rate, but could not be freely transferredabroad. Furthermore, in 1991 all regulations requiring prior authoriza-tion to import and those controlling foreign exchange payments forimports were abolished.

In effect, imports and import payments could now be effectedthrough the banking system without restrictions, provided the importerprocessed the necessary financial resources. The official exchange marketremained restricted to priority transactions as defined by the state. At thesame time, other liberalizing measures introduced in 1991 were expand-ing the scope of permitted foreign investment in nonpublic sector activi-ties and introducing forward foreign exchange facilities. While the officialexchange rate remained pegged, frequent adjustment relative to the peghad been effected since 1987. Algeria's efforts to liberalize the exchangesystem are still constrained to a certain degree by the external sector dif-ficulties that it faces. The presence of these difficulties has resulted in thereinstitution of some import restrictions in 1992.

The Syrian Arab Republic has also carried out several reforms recentlywith the stated objective of unifying its exchange rate system by 1994.The Syrian Arab Republic applied seven administratively determinedexchange rates in 1987, in addition to the unofficial market (the "Beirutmarket rate") that financed a large portion of private imports under theown resources system. By 1991, the applicable rates numbered four: theofficial rate, the airline rate, the promotion rate, and the rate in neigh-boring countries. It is significant that, although these rates are adminis-tratively determined, the last (rate in neighboring countries) was incor-porated into the official exchange system in 1989, with a frequentadjustment arrangement, whereby the rate is to be reviewed when it devi-ates by more than 5 percent from the unofficial market rate. The inflexi-bility of the other rates, however, still creates wide divergences in the ex-change rates. At the beginning of 1992 the rate in neighboring coun-tries was almost four times the official rate per U.S. dollar.

The Syrian Arab Republic proceeded to shift transactions toward themore depreciated of the four rates, such that, by mid-1992 the rate inneighboring countries covered a significant number of transactionsincluding: 25 percent of surrendered private sector export proceeds, pri-vate remittances from abroad, textile exports, and allowances for invisi-bles. The official rate, by then, applied mainly to oil exports, governmenttransactions and loans, and valuation of private exports under the bilat-eral agreement with the former U.S.S.R. Other reforms in the Syrian ArabRepublic during 1991 included introducing (in May 1991) a new invest-ment law that offered private and foreign investors exemptions from taxand exchange limitations, terminating one out of three active bilateral

68



agreements, with the remaining two to be phased out in the near future,eliminating import deposit requirements, and increasing foreign currencyallowances for travel abroad.

The economic environment has been rather favorable to continuingthis process of exchange reforms. During the period 1988-90, the SyrianArab Republic managed to maintain its budget deficit (excluding grants)within 2 percent of GDP. Its balance of payments has also been improv-ing, mainly as a result of increasing oil exports. During 1989-91, the bal-ance of payments recorded consecutive surpluses exceeding $1 billionannually. Nevertheless, the approach to adjustment continues to be piece-meal, at a time when the measures undertaken need to be formulatedwithin a comprehensive adjustment program.

The Socialist People's Libyan Arab Jamahiriya and Iraq, on the otherhand, did not introduce any significant changes to their exchange systemsduring the 1980s and up to the present time. It is worth noting, howev-er, that the Socialist People's Libyan Arab Jamahiriya allowed privateimports under the own resources system in 1988 after having bannedthem in 1983. Since 1988, the Socialist People's Libyan Arab Jamahiriyahas also waived the surrender requirement for export proceeds, providedsuch proceeds were used to finance imports.

Table 3 summarizes the developments in the exchange rate systems ofgroup A countries. Algeria, Iraq, the Socialist People's Libyan ArabJamahiriya, and the Syrian Arab Republic still peg their official rates.

Reforms in Group B

Among the countries in group B, Morocco and Tunisia revised radical-ly their external sector policies within the framework of comprehensiveadjustment programs initiated in 1983 and 1986. The protectionist tradepolicy was overhauled, quantitative restrictions were eliminated, and mostlicensing requirements were abolished. The system of high and variabletariffs resulting in distorting effective rates of protection was replaced bya low and simple tariff structure. Overall, the measures taken since 1983in Morocco and 1986 in Tunisia resulted in a more realistic exchange ratesupported by restrictive fiscal and monetary policies, a nearly completeelimination of trade policy-induced distortions, and, as a result, a reduc-tion in distorting differentials between domestic and international prices.This process culminated in these two countries announcing in 1993 theiracceptance of Article VIII of the IMF's Articles of Agreement, therebyestablishing the convertibility of their currencies for current transactions.

Mauritania implemented in 1985 a comprehensive adjustment pro-gram with a view to liberalizing the economy. In this context, the author-

69



Table 3. Exchange Rate Developments in Group A Countries

1Frequent adjustment with respect to the peg.2Frequent devaluations in both rates took place during the period.3Rate in neighboring countries.

ities adopted a flexible exchange rate policy in an attempt to depreciatethe currency through a series of small devaluations. This policy was to bsupported by restrictive financial policies and by domestic price liberal-ization, as well as the removal of all import licensing and quotas oimports. Given the economy's extreme vulnerability to external shocks(drought, commodity prices, a heavy debt burden, foreign exchange con-straint) the implementation of structural reforms has been slow, and fis-cal restraint has proved to be difficult. The authorities, however, remaincommitted to pursuing the adjustment of the economy and liberalizingof the exchange system.

The exchange control system in Jordan had been mildly restrictive andstable throughout the 1980s. In 1989, some tightening measures weretaken, including mainly the introduction of an advance import depositrequirement. Thereafter, during the period 1990-92, the changes thattook place were mostly toward the liberalization of the system within theframework of a comprehensive adjustment program. These included theeasing of the surrender requirement of export proceeds, increasing thelimits on foreign currency deposits allowed for resident nationals, increas-ing the payment allowances for some categories of invisibles (twice dur-ing the period), and revoking the advance import deposit requirement,leaving it to the discretion of individual banks. Continuing on this trend,

70

CurrencyPegged to

OfficialExchange Rate

Flexibility(Year introduced)

FlexibleParallel Marketin the Period(From-until)

FlexibleUnitary Rate

(Year realized)

Algeria

Egypt

Iraq

Libya

Somalia

Sudan

Syrian Arab Rep.

Basket

U.S. dollar(until 1991)

U.S. dollar

SDR (since 1986)

SDR (since 1982)

U.S. dollar

U.S. dollar

19871

1991

1985

1992

Expected innear future

1987-91

1985-87

1985-922

19893

1991(floating)

1987

1992



Table 4. Exchange Rate Developments in Group B Countries

1Frequent adjustment with respect to the peg.

Jordan is presently in the process of evaluating the elimination of allrestrictions on current account transactions.

The Yemen Arab Republic faced a period of economic difficulty flowing the unification of the country on May 22, 1990. Foreignexchange shortages led to a widening of the gap between the official ex-change rate and the unofficial rate in the "gray" market that is operat-ed by money changers. The ratio of official to unofficial exchange rate in-creased to around 2.4 during 1990-91 (Table 2). The situationprompted the authorities to legitimize an own-resources finance system,whereby commercial banks were authorized in August 1990 to open let-ters of credits for most self-financing imports. The Yemen ArabRepublic's external sector difficulties could be attributed, in large part, toits substantial fiscal deficit (18 percent of GDP in 1991). In December1992, regulations that legalize the parallel market and the status andactivities of money changers were promulgated. Although most non-governmental transactions now take place at the market-based parallelrate, a unification of exchange rates at a market-clearing level supportedby an adequate fiscal policy to ensure external competitiveness and theremoval of distortions in the economy is still needed.

Developments in the exchange rate systems of countries in group B aresummarized in Table 4, which shows that exchange rate flexibility wasintroduced by most countries during the 1980s.

Conclusion

Considerable efforts to reform the exchange systems in the Arab coun-tries were made during the 1980s. The reform process gathered momen-tum in recent years, with most countries in both groups A and B sub-stantially liberalizing their exchange systems. Countries that introducedexchange reforms since 1980 did so in conjunction with, or subsequent

71

Official Rates Pegged toFlexibility with Respect to

Peg or Managed Floating Since

JordanMauritaniaMoroccoTunisiaYemen Arab Republic

SDRBasket of currenciesBasket of currenciesBasket of currenciesU.S. dollar

19891

198519841

1986



to, more general economic reform efforts toward structural liberalizationof the economic system and stabilization of the domestic economy andthe external sector.

In group A, both Egypt and Sudan abolished their respective multipleexchange rate systems by 1992 and introduced a unitary and flexibleexchange arrangement. The two countries also abolished several of theadministered allocation measures that were in practice previously. TheSyrian Arab Republic and Algeria introduced liberalizing measures; theSyrian Arab Republic's reforms, in recent years, aim to achieve a unitaryand flexible exchange system, while Algeria's exchange liberalization mea-sures during 1991 were within the context of the intended introductionof a liberal foreign exchange market.

Most countries in group B introduced exchange reforms since 1980,abolishing quantitative trade restrictions and introducing flexibility intothe exchange rate mechanism. Liberalization in Morocco and Tunisia cul-minated in their accepting Article VIII of the IMF's Articles ofAgreement. Jordan is currently considering the removal of all restrictionson current transactions.

Of the 12 countries under study, only the Islamic Republic of Iran andthe Socialist People's Libyan Arab Jamahiriya have not attempted to lib-eralize their exchange systems since 1980, while the Yemen ArabRepublic's originally open exchange and trade system became morerestrictive in recent years as a result of a deterioration in the balance ofpayments caused in large part by large and growing fiscal deficits.Countries that attempted to liberalize the exchange system but still facefinancial disequilibria, especially in the external sector, have been unableto complete or sustain the reform process.

In recent years, the implementation of stabilization programs, as wellas favorable exogenous factors, has resulted in improvements of therespective external sector positions of Egypt, the Syrian Arab Republic,Morocco, and Tunisia. The improvements should make it possible for thefour countries to carry through and sustain the exchange system reformsthat they have been implementing.

72



Appendix

Exchange Controls in Arab Countries

Sources: International Monetary Fund, Annual Report on ExchangeArrangements and Exchange Restrictions, various issues, andDevelopments in International Exchange and Payments Systems (June1992); International Currency Analysis, Inc., World Currency Yearbookvarious issues; World Bank, World Debt Tables, various issues; and reportfrom central banks of member countries.

73

CountryAlgeriaEgyptIraqJordanLibyaMauritaniaMoroccoSomaliaSudanSyrian Arab RepublicTunisiaYemen Arab RepublicReal Effective Exchange RatesReal Merchandise ExportsReal Merchandise ImportsWorkers' RemittancesIncremental Capital Output Ratio

TableAlA2A3A4A5A6A7A8A9A10AllA12A13A14A15A16A17



Table A1. Algeria: Summary of Exchange Controls

End of Period

1980 1985 1991

74

A. Administered allocation measuresImport/export/exchange licensingGeneral import program/quotasList of prohibited/restricted imports for protectionTotal/selective trade monopoly by state agencies1

Own exchange import systemForeign exchange budget/restricted official

exchange rate transactionsMultiple exchange rates applied to

Imports/exportsInvisibles/capital transactions

B. Exchange rate systemExchange rate pegged to

U.S. dollarBasket of currencies

Frequent adjustment with respect to pegMargin of variation with respect to peg/

managed floatingFloating

C. Restrictive measuresRestriction on payment for

Current transactionsCapital transactions

Import surchargesAdvance import depositsSurrender (total or partial) of export proceedsBilateral payment agreements

IndicatorsRatio of debt to exports of goods

and services (in percent)Ratio of arrears to exports of goods

and services (in percent)

Black/free market exchange rate ~ official/effectiverate (national currency units per U.S. dollar)

n.a.

1983

3.1

131

1986

3.4

*2

199

1991

5.510ther than basic mineral exports.21987.

Recent ChangesSeveral liberalizing measures were taken since 1990, mainly:

1990• Allowing nationals (residents and nonresidents) to open foreign exchange accounts with domestic

banks.• Expanding the scope of permitted foreign investment in the private sector.• Increasing the proportion of foreign exchange that can be retained by the exporter.• Revoking a regulation that requires nonresident nationals to repatriate foreign exchange amounts.

1991• Abolishing all regulations requiring prior authorization to import and those controlling foreign

exchange payments for imports. Traders can import freely through the banking system, provided



Table A1 (concluded)

that they have the necessary foreign exchange. This measure is supposed to regularize the trade sec-tor and set the stage for the intended introduction of a "parallel foreign exchange market."

• Allowing the introduction of forward foreign exchange facilities.• Allowing foreign residents to open foreign exchange accounts.• Allowing foreign borrowing to finance imports through the banking system.

1992• Allowing foreign exchange purchases to finance categories of current transactions.• Entering into effect of multilateral payments agreement with the other Maghreb countries.

75



Table A2. Egypt: Summary of Exchange Controls

End of Period

1980 1985 1991







Frequent adjustment with respect to pegMargin of variation with respect to peg/managed floatingFloating

1Other than basic mineral exports.

Recent ChangesLiberalizing measures were taken in recent years starting with the introduction of the "new bank for-

eign exchange market" in 1987, which operated as a limited scope free exchange market parallel to theofficial exchange market (or central bank pool).

During 1991, an expanded "free foreign exchange market" was introduced, while the official exchangemarket was phased out, such that, by the end of the year, the free market exchange rate became applic-able to all transactions.

This in effect abolished the pegged exchange rate systems, as well as most measurers in category(A) above.

Other measures during 1991 included:• Abolishing the foreign exchange budget system for public enterprises.• Reducing the import deposit requirement.• Abolishing the surrender of export proceeds requirements.

76

**

*







Black/free market exchange rate - official/effectiverate (national currency units per U.S. dollar)

n.a.

n.a.

1983

1.66

386

43

1986

2.9

280

12

1991

1.09



Table A3. Iraq: Summary of Exchange Controls

End of Period

1980 1985 1991







Frequent adjustment with respect to pegMargin of variation with respect to peg/managed

floatingFloating








10ther than basic mineral exports.

Recent and Expected ChangesNo significant changes took place in recent years.

77

*

n.a.

n.a.

1983

2.0

n.a.

n.a.

1986

4.5

n.a.

n.a.

1991

16.1



Table A4. Jordan: Summary of Exchange Controls

End of Period

1980 1985 1991







Frequent adjustment with reference to pegMargin of variation with reference to peg/managed

floatingFloating








n.a.

1983

1.08

134

1986

1.03

*2

283

37.2

19913

2.0

10ther than basic mineral exports.21989.3This ratio improved to around 1.0 in 1992.

Recent ChangesJordan tightened its exchange control restrictions in late 1989:

• Advance import deposit requirements were introduced.• Financing of free zone imports through the banking system was prohibited.• Foreign exchange deposits with the central bank were imposed on banks with such deposits.• Surrender of export proceeds requirement was reduced.

Since then the trend has been toward the liberalization of the exchange system:

1991• The approval requirement for loans to foreign currency depositors was partially removed.

78




• Foreign exchange limits for categories of travel abroad were doubled.• Advance import deposit requirements were halved.• Reserve requirements were introduced on Jordanian-owned offshore banks.

1992• The limit on Jordanian currency that can be taken out of the country was increased.• The advance import deposit requirement was revoked, to become a discretionary requirement of

individual banks.• Export credit limits were increased.• Limits on transfers abroad to finance invisibles were doubled.• The central bank issued certificates of deposits denominated in U.S. dollars at the London inter-

bank offered rate plus interest rates.

79



Table A5. Libyan Arab Jamahiriya: Summary of Exchange Controls

End of Period

1980 1985 1991

A. Administered allocation measuresImport/export/exchange licensing *General import program/quotasList of prohibited/restricted imports for protectionTotal/selective trade monopoly by state agencies1






Frequent adjustment with reference to peg *2

Margin of variation with reference to peg/managedfloating

Floating



Import surchargesAdvance import depositsSurrender (total or partial) of export proceeds *Bilateral payment agreements


and services (in percent) n.a. n.a. n.a.Ratio of arrears to exports of goods

and services (in percent) n.a. n.a. n.a.

1983 1986 1991Black/free market exchange rate - official/effective

rate (national currency units per U.S. dollar) 1.9 4.3 2.0

10ther than basic mineral exports.21986.

Recent and Expected ChangesNo significant changes took place in recent years.

80

*

*

*2



Table A6. Mauritania: Summary of Exchange Controls

End of Period

1980 1985 1991








floatingFloating







Black/free market exchange rate - official/effectiverate (national currency units per U.S. dollar) 2.6 2.3 n.a.


Recent Changes

1989• New investment code that allows transfer of profits was introduced.• Surrender requirement for export proceeds was reduced.• System of import licensing was abolished.

1991• Some tariffs were reduced.

81

n.a.

n.a.

1983

*2

373

16

1986

458

67

1991



Table A7. Morocco: Summary of Exchange Controls

End of Period

1980 1985 1991






U.S. dollarBasket of currencies *

Frequent adjustment with respect to peg *2

Margin of variation with respect to peg/managed floatingFloating


Current transactions *Capital transactions



and services (in percent) n.a. 400 256Ratio of arrears to exports of goods

and services (in percent) n.a. 15 9

1983 1986 1991

Black/free market exchange rate -r official/effectiverate (national currency units per U.S. dollar) 1.09 1.01 1.10


Recent Changes

1989• Advance dirham deposits against requests to purchase foreign exchange were abolished.

1990• Foreign exchange allowed for tourism abroad was increased.• The minimum requirement for nonresident convertible dirham accounts was reduced.• Limits on foreign investors' share in Moroccan enterprises were abolished.

1991• Exporters were allowed to retain more of their foreign exchange proceeds.• Nonresidents were allowed to transfer more of their earnings.• Foreign exchange allowances for business travel and study abroad were increased.• Foreign exchange arbitrage operations by authorized banks were allowed.

82

*

*2

*



Table A8. Somalia: Summary of Exchange Controls

End of Period

1980 1985 1991







Frequent adjustment with respect to pegMargin of variation with respect to peg/managed floating *2

Floating


Current transactions *Capital transactions *

Import surchargesAdvance import depositsSurrender (total or partial) of export proceedsBilateral payment agreements * *


and services (in percent) n.a. 1,285 2,595Ratio of arrears to exports of goods


1983 1986 1991

Black/free market exchange rate - official/effectiverate (national currency units per U.S. dollar) 1.26 1.62 n.a.


Recent Changes

1989• A new law allowing residents and nonresidents to establish commercial banks was introduced.• The state monopoly on some exports was abolished.• Exemption from approval requirement to import some items.

1990• The surrender requirement for some exports was reduced.

83

*

*

*2

**



Table A9. Sudan: Summary of Exchange Controls

End of Period

1980 1985 1991








floating *2

Floating


Current transactionsCapita! transactions

Import surchargesAdvance import depositsSurrender (total or partial) of export proceedsBilateral payment agreements *


and services (in percent) n.a. 733 2,743Ratio of arrears to exports of goods

and services (in percent) n.a. 169 1,659

1983 1986 1991

Black/free market exchange rate + official/effectiverate (national currency units per U.S. dollar) 1.28 2.2 2.5

1Other than basic mineral exports.21992.

Recent Changes

1989• Ban on own exchange imports was generalized.• Holders of foreign exchange accounts were permitted to finance certain imports through them.• Foreign exchange allowance for travel to Egypt was reduced.• Possession of foreign currency was prohibited.• Withdrawal of bank notes from foreign currency accounts was prohibited.• Transfers of workers' remittances were moved from official to commercial exchange rate.

1990• Export procedures were simplified and regulated.

84

*2

**




1991• Official exchange rate was devalued from LSd 4.5 to LSd 15 per U.S. dollar.• One hundred percent of export proceeds for irrigated cotton and gum arabic was to be surren-

dered at official rate.• Commercial exchange rate was devalued from LSd 12.3 to LSd 30 per U.S. dollar.

1992• A unified foreign exchange market, with a flexible exchange rate, was introduced. The exchange

rate is determined in an interbank market.

85



Table A10. Syrian Arab Republic: Summary of Exchange Controls

End of Period

1980 1985 1991




Imports/exports *Invisibles/capital transactions



Frequent adjustment with respect to pegMargin of variation with respect to peg/managed floatingFloating


Current transactions *Capital transactions

Import surcharges *Advance import depositsSurrender (total or partial) of export proceedsBilateral payment agreements




1983 1986 1991


10ther than basic mineral exports.

Recent ChangesDuring 1991 and 1992, the Syrian Arab Republic took several liberalizing measures:• Moving several transactions to depreciated rates of exchange,• Expanding the list of imports allowed by the private sector.• Eliminating the import deposit requirement.• Depreciating one of the key exchange rates (the airline rate) by 50 percent.• Increasing foreign currency allowances for travel abroad.• Terminating one bilateral payments agreements (with Vietnam).• Introducing a new investment law (May 1991) that offers private and foreign investors tax exemp-

tions, as well as reduced controls on their necessary imports, their holdings and transfer of foreigncurrency earnings, and repatriation of profits, salaries, and capital.

86

*

*



Table A11. Tunisia: Summary of Exchange Controls

End of Period

1980 1985 1991








floating *2

Floating


Current transactionsCapital transactions *




and services (in percent) — — 1.3

1983 1986 1991



Recent ChangesSeveral liberalizing measures were taken since 1989, mainly:

1989• Foreign exchange earnings allowed to be retained by exporters were increased.

1991• Reductions in import duties, especially on semifinished goods and raw materials.• Foreign exchange allowed for certain categories of invisibles was specified.

1993• Most restrictions on current payments were eliminated.

87

*2

**



Table A12. Yemen Arab Republic: Summary of Exchange Controls

End of Period

19801 19851 1991








floatingFloating



Import surchargesAdvance import deposits *Surrender (total or partial) of export proceedsBilateral payment agreements


and services (in percent) n.a. n.a. 293Ratio of arrears to exports of goods

and services (in percent) n.a. n.a. 72

1983 1986 1991


1Data applicable to the Yemen Arab Republic prior to unification.2Other than basic mineral exports.

Recent Changes

1990• Commercial banks were authorized to open letters of credit for most imports, provided such

imports were self-financed.1991• Foreign exchange purchased domestically (that commercial banks can retain to finance imports)

was doubled (to 100 percent).• Financing certain imports was moved to official rate.• Foreigners were required to settle air tickets and hotel bills in foreign exchange only.

88

*


Table

A1

3.

Real

Effect

ive

Exc

hange

Rate

s(1

980

= 10

0)

Sou

rce:

Int

erna

tiona

l Mon

etar

y F

und.

Country

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

89

Gro

up A

Alg

eria

Egy

ptIra

qLi

bya

Som

alia

Sud

anS

yria

n A

rab

Rep

.

Gro

up B

Jord

anM

aurit

ania

Mor

occo

Tuni

sia

Yem

en A

rab

Rep

.

100.

010

0.0

100.

010

0.0

100.

010

0.0

100.

010

0.0

103.

211

3.3

65.2

126.

3

110.

611

0.6

96.9

96.9

107.

313

6.3

66.7

143.

6

119.

011

8.1

92.1

98.6

122.

516

6.5

90.8

158.

3

113.

611

6.7

86.9

95.9

136.

621

0.3

140.

919

6.2

118.

811

5.0

84.1

94.8

131.

919

7.8

83.0

201.

3

110.

597

.175

.491

.6

119.

921

7.7

88.2

253.

7

103.

994

.374

.172

.0

100.

620

6.5

55.5

290.

7

89.2

84.0

70.8

67.5

82.6

247.

0

97.5

130.

9

70.2

80.7

69.9

66.6

72.1

198.

2

160.

115

1.6

65.7

77.8

71.5

65.4

51.4

99

.5

259.

414

2.9

60.5

79.8

66.7

64.7

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

Tab

le A

14

. R

eal

Mer

chan

dis

e E

xpo

rts

(In

mill

ions

of U

.S.

dolla

rs)

Cou

ntry

19

80

1981

19

82

1983

19

84

1985

19

86

1987

19

88

1989

19

90

90

Gro

up

AA

lger

iaE

gypt

Iraq

Liby

aS

omal

iaS

udan

Syr

ian

Ara

b R

ep.

Gro

up

BJo

rdan

Mau

ritan

iaM

oroc

coTu

nisi

aY

emen

Ara

b R

ep.

15,6

72.8

4,42

3.7

32,1

20.4

25,1

64.2

153.

079

1.4

2,42

4.8

660.

422

5.4

2,77

1.5

2,47

4.2

82.9

14,8

60.0

4,20

9.5

10,6

73.3

15,5

07.4

184.

583

4.4

2,32

7.4

771.

828

4.1

2,40

2.1

2,57

6.8

62.0

13,9

41.2

4,14

6.5

10,3

54.3

14,1

39.3

176.

341

3.7

2,06

6.0

775.

624

7.7

2,10

8.4

2,04

0.2

44.1

12,9

88.8

3,76

4.5

8,31

9.2

12,5

87.2

100.

452

4.3

1,95

5.1

591.

232

1.5

2,09

7.9

1,88

5.8

50.8

12,7

28.4

3,84

4.8

9,27

0.4

10,9

73.1

54.5

516.

41,

824.

9

748.

229

2.3

2,15

0.2

1,76

7.2

38.9

13,0

34.0

3,83

5.0

10,4

09.4

10,3

53.0

90.6

444.

31,

856.

0

788.

937

1.5

2,14

5.0

1,70

0.0

50.7

8,30

4.8

2,71

0.6

7,68

7.4

5,98

7.6

97.5

336.

61,

068.

0

753.

943

1.3

2,48

2.0

1,81

5.7

47.9

9,05

6.2

3,12

4.4

9,73

4.4

5,84

6.5

94.3

266.

51,

361.

1

935.

940

3.6

2,78

9.4

2,10

7.3

119.

5

7,34

9.1

2,67

1.2

9,34

2.3

5,44

2.6

56.3

411.

81,

299.

9

971.

542

2.1

3,47

9.3

2,31

3.4

510.

3

8,76

2.9

2,67

1.9

11,2

55.9

6,69

3.9

62.2

500.

42,

769.

3

1,01

9.7

439.

23,

044.

12,

693.

966

7.5

11,5

03.1

3,19

7.9

9,22

8.5

10,0

81.6

289.

73,

687.

7

944.

137

4.5

3,73

5.6

3,11

8.9

616.

2

Sou

rce:

Int

erna

tiona

l M

onet

ary

Fun

d. ©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

Table

A1

5.

Real

Merc

handis

e I

mport

s1

(In

mill

ions

of U

.S.

dolla

rs)

Sou

rce:

Ara

b M

onet

ary

Fun

d.1N

omin

al m

erch

andi

se im

port

s de

flate

d by

U.S

. P

rodu

cer's

Pric

e In

dex

(198

5 =

100

).

Cou

ntry

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1

99

0

91

Gro

up A

Alg

eria

Egy

ptIra

qLi

bya

Som

alia

Sud

anS

yria

n A

rab

Rep

.

Gro

up B

Jord

anM

aurit

ania

Mor

occo

Tuni

sia

Yem

en A

rab

Rep

.

11,0

17.2

7,82

2.0

15,1

05.1

11,9

02.4

461.

01,

294.

84,

602.

8

2,45

2.5

368.

84,

328.

43,

592.

42,

832.

8

10,6

18.9

8,33

4.7

21,4

32.6

15,3

30.5

390.

01,

719.

64,

634.

7

2,96

3.4

406.

54,

041.

13,

597.

92,

499.

4

10,2

05.4

7,98

0.4

21,9

13.5

11,3

27.1

486.

477

4.3

3,75

2.3

2,97

0.7

440.

23,

938.

13,

237.

42,

700.

2

9,70

0.3

8,41

0.8

10,1

20.5

9,15

1.9

369.

171

6.8

4,10

1.9

2,75

2.4

385.

63,

364.

92,

979.

62,

496.

3

9,18

9.1

10,0

29.9

9,70

6.5

8,42

1.9

463.

459

6.8

3,66

8.7

2,46

0.3

300.

63,

551.

22,

913.

42,

124.

7

8,81

1.0

9,05

0.0

10,5

39.5

5,75

4.0

330.

758

3.4

3,94

6.0

2,42

6.8

333.

93,

513.

02,

566.

01,

702.

5

8,1

14.3

7,38

4.1

9,18

6.7

4,56

6.4

352.

365

2.6

2,43

3.6

2,22

2.9

413.

23,

580.

82,

777.

51,

281.

7

6,63

5.9

8,11

9.4

7,36

3.9

5,40

7.2

359.

669

8.7

2,23

2.7

2,40

7.3

360.

33,

861.

62,

837.

51,

651.

2

6,43

7.8

9,04

3.4

8,99

9.5

5,54

7.7

208.

391

4.7

1,91

5.1

2,33

2.4

336.

54,

204.

43,3

71.3

1,83

7.5

7,69

4.9

8,12

5.9

9,05

5.9

5,98

9.9

318.

396

6.0

1,67

3.7

1,73

0.2

348.

64,

587.

33,

804.

21,

656.

6

7,78

7.9

9,14

2.0

5,81

0.2

6,72

7.6

575.

71,

829.

6

2,29

2.6

359.

45,

574.

14,

607.

81,

541.

3

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion

Tab

le A

16.

Wor

kers

' Rem

ittan

ces

(In

mill

ions

of

U.S

. do

llars

)

Sou

rce:

Ara

b M

onet

ary

Fun

d.

92

Gro

up

AA

lger

iaE

gypt

Iraq Liby

aS

omal

iaS

udan

Syr

ia A

rab

Rep

.

Gro

up

BJo

rdan

Mau

ritan

iaM

oroc

coTu

nisi

aY

emen

Ara

b R

ep.

406.

02,

695.

0

256.

077

3.0

794.

45.

61,

055.

031

9.0

1,06

7.7

447.

02,

182.

0

365.

343

6.0

1,03

2.5

3.7

1,01

3.0

357.

01,

336.

0

507.

02,

431.

0

131.

941

1.0

1,08

2.3

2.3

849.

037

2.0

1,59

0.8

392.

03,

666.

0

274.

538

7.0

1,10

9.6

1.2

916.

035

9.0

1,65

2.4

329.

03,

963.

0

284.

832

1.0

1,23

6.7

0.9

872.

031

7.0

1,52

1.3

313.

03,

211.

0

260.

835

0.0

1,02

2.2

0.8

967.

027

1.0

1,21

4.1

358.

02,

506.

0

113.

332

3.0

1,18

3.8

2.0

1,39

9.0

362.

086

3.9

487.

03,

604.

0

137.

833

4.0

938.

16.

71,

587.

048

6.0

1,01

8.6

379.

03,

770.

0

217.

836

0.0

895.

09.

31,

304.

054

6.0

580.

8

345.

03,

293.

5

416.

743

0.0

627.

14.

81,

336.

048

8.0

438.

0

352.

04,

305.

8

61.9

385.

0

611.

5

2,00

6.0

599.

0

Cou

ntry

19

80

1981

19

82

1983

19

84

1985

19

86

1987

19

88

1989

19

90

©In

tern

atio

nal M

onet

ary

Fund

. Not

for R

edis

tribu

tion


Table A17. Incremental Capital Output Ratio(In percent)

Source: The World Bank.

93

Country 1970-74 1975-79 1980-84 1985-89 1988-91

AlgeriaMoroccoTunisia

Maghreb

EgyptJordanSyrian Arab Rep.

Region

6.394.253.88

5.63

2.836.47n.a.

3.65

8.064.825.19

7.08

2.554.794.21

5.54

8.717.427.71

8.44

3.66-7.819.57

7.59

-589.345.146.49

25.92

7.01-13.26

5.65

11.22

24.0110.683.81

14.33

8.78-4.882.19

9.43



References

Agarwala, R., Price Distortion and Growth in Developing Countries, World Bank StaffWorking Papers 575 (Washington: The World Bank, 1983).

Balassa, Bela, "Disequilibrium Analysis in Developing Economies: An Overview," WorldDevelopment, Vol. 10 (December 1982), pp. 1027-38.

Caves, Richard E., Jeffrey A. Frankel, and Ronald Winthrop Jones, World Trade andPayments: An Introduction (New York, N.Y.: Harper Collins College Publishers, 6thed., 1992).

Cheng, Hang Sheng, "Statistical Estimates of Elasticities and Propensities in InternationalTrade: A Survey of Published Studies," Staff Papers, International Monetary Fund,Vol. 7 (April 1959), pp. 107-58.

Cottani, Joaquin A., Domingo F. Cavallo, and M. Shahbaz Khan, "Real Exchange RateBehavior and Economic Performance in LDCs," Economic Development and CulturalChange, Vol. 39 (October 1990), pp. 61-72.

Krueger, A.O., "The Political Economy of the Rent-Seeking Society," American EconomicReview, Vol. 64 (March 1974).

— , Exchange Rate Determination (New York: Cambridge University Press, 1983).

Nsouli, Saleh, Peter Cornelius, and Andreas Georgiou, "Striving for CurrencyConvertibility in North Africa," Finance & Development, Vol. 29 (December 1992),pp. 44-47.

Sheikh, Mounir A., "Black Market for Foreign Exchange, Capital Flows and Smuggling,"Journal of Development Economics, Vol. 3 (March 1976), pp. 9-26.

Yeager, Leland.B., International Monetary Relations, Theory, History, and Policy (New YorHarper & Row Publishers, 2d ed., 1976).

94


Currency Convertibility in TunisiaAbdelmoumen Souayah*

This paper reviews the experience of Tunisia in liberalizing itsexchange system and highlights the steps envisaged for the future in

decontrolling further the exchange system. The appendix provides addi-tional background information.

Generally speaking, exchange control in Tunisia was inherited fromthe colonial era. Following independence, it was strengthened and evenvalidated by the good press enjoyed by the prevailing socialist ideology inTunisia and the other former French colonies. According to that ideol-ogy, the quickest way to reduce the existing disparity with the industrialcountries and to raise living standards for the people of the new nationswas to entrust all economic power to the administration. This would cre-ate the industrial fabric required to ensure full employment and the wel-fare of all. The problem of how these economies fitted in with the worldeconomy was secondary.

As time passed, the agencies responsible for supervision of the econ-omy became increasingly important while the economic distortions andthe social cost of adjustment became more and more acute. The govern-ment hesitated to take the unpopular reforms necessary, especially sinceseveral years would be required for any adjustment to show positiveeffects. It generally takes special circumstances, notably an external pay-ments crisis, for a government to recognize that it has no alternative butto rehabilitate the national economy.

*Deputy Governor, Central Bank of Tunisia.

95

g



In Tunisia, such awareness was also facilitated by the development ofthought on the issue, especially following the failure of the socialist sys-tem of development. This contributed to the strong revival of the bene-fits of a liberal economy. In this context, following the external paymentscrisis of 1986, Tunisia introduced a comprehensive adjustment programaimed at economic rehabilitation and consolidation.

Economic Restructuring and Liberalization

Before reviewing the major orientations of the adjustment program, itmust be stressed that the economic policy implemented until the early1980s had positive effects on the scope of diversification achieved and onthe reduction of the economy's degree of vulnerability. In addition to thesubstantial development of the tourism sector, the share of manufacturingindustries in gross domestic product (GDP) rose from 7 percent in 1960to 28 percent in 1993. Over the same period, the share of agriculture fellfrom 23 percent to 16 percent.

For its part, the restructuring program was aimed at removing therigidity that hampered the operation of the market mechanism in order toincrease the competitiveness of enterprises. This restructuring wasdesigned to facilitate the integration of Tunisia's economic activity into theworld economy. The major elements of this program were as follows.

Laws governing importers were liberalized. The share of free importsincreased to 90 percent of total imports in 1993, compared with only33 percent in 1986. Over the same period, 87 percent of producer pricesand 70 percent of supplier profits were liberalized.

Tax legislation was completely revised. With the introduction of a valuadded tax (VAT), a large number of indirect taxes were abolished. Incometax was simplified, and the rates were reduced from more than50 percent to a maximum of 35 percent. Taxation on savings was stream-lined; all interest on financial investment, whatever the volume or thecapacity of the issuer, became subject to a 15 percent withholding tax. Asan incentive for risk-bearing savings, dividends were exempt from all taxes.

Financial reforms were adopted. They included (1) liberalizing lendingand borrowing rates; (2) eliminating the requirement for banks to obtainprior authorization from the Central Bank of Tunisia to extend loans;(3) creating a money market; (4) financing budget deficits by issuing trea-sury securities under market terms, which made it possible for subscrip-tions to come mainly from the public, rather than from banks as before;and (5) creating savings collection agencies, such as mutual funds, invest-ment trusts, and open-end investment companies.

96


Currency Convertibility in Tunisia

It is noteworthy that the liberalization of banking activity was accom-panied by a tightening of retroactive supervision by the central bank, par-ticularly of banks' financial structure. To this end, prudential ratios wereintroduced as of 1987. All of these reforms were achieved in the sound-est possible context of financial stability and were supported by policiesof monetary austerity and exchange rate stability in real terms.

The control of domestic demand and the recovery of exports pro-duced encouraging results in the external payments position. The currentaccount deficit fell from about 8 percent of GDP in 1986 to 5.3 percentin 1992. Debt parameters improved markedly, with the ratio of debt ser-vice to exports of goods and services declining to 19.5 percent in 1992,compared with 28 percent on average between 1981 and 1986. In turn,the annual average inflation rate declined from 9.5 percent in 1981 to 5.5percent in 1992 and to 4.5 percent in 1993.

Move to Convertibility

This process of economic liberalization led to the December 1992decision to make the dinar convertible for current account operations, incompliance with the obligations under Article VIII of the IMF's Articlesof Agreement. It must be stressed that Tunisia's relatively limitedreserves—covering 55 days of imports, compared with the international-ly accepted minimum of three months—might have seemed inadequateto justify the removal of all foreign exchange restrictions. Tunisia enjoys,however, a good credit standing on the international financial marketsand has ready access to drawings of up to TD 300 million (covering 20days of imports) in the event of exogenous shocks.

This convertibility implied a major relaxation of the administrative proce-dures relating to the settlement of current transactions in foreign exchangeby economic operators. Such a relaxation could enhance the performance ofthese operators, making them more competitive in foreign markets.

The liberalization measures affected such a large range of transactionsthat it is easier to mention the remaining restrictions on the freedom ofcapital flows than to list all of the transactions that were liberalized.Practically the only flows still restricted relate to Tunisians' investmentsabroad, which are subject to the central bank's prior approval.

The impact of the convertibility on expenditure in foreign exchangewill barely exceed TD 40 million (6 percent of the current accountdeficit). This justifies the convertibility decision, which simply confirmeda de facto situation. Indeed, declaring the currency convertible has atleast two advantages: (1) In itself, convertibility involves a certain stan-

97



dard of liberalism in an economy. There is no longer a need to take stockrepeatedly of the degree of liberalization reached by each economic sec-tor. (2) Such a declaration represents a commitment by the governmentto pursue restrained macroeconomic policies in preparation for fullconvertibility.

Prospects

The next phases in establishing full convertibility are the establishmentof an exchange market and the planned authorization of residents to openaccounts denominated in foreign exchange. The exchange market thatwill be introduced in the first quarter of 1994 is essentially a market forapproved resident intermediaries. Foreign exchange operations conduct-ed on the market would be spot purchases and sales involving two foreigncurrencies or a foreign currency and Tunisian dinars.

Banks will be authorized to manage foreign exchange positions, forwhich the relevant amounts and administrative rules will be defined in acentral bank circular on prudential rules for monitoring foreign exchangepositions. According to these rules, the ratio of each foreign currency'sposition to a bank's net capital and reserves must not exceed 5 percent,while the ratio of the bank's overall foreign exchange position to such netcapital and reserves must not exceed 20 percent.

Such foreign exchange positions will enable banks to manage approx-imately 20 percent of the country's foreign exchange reserves. As a result,the banks will become used to the prospect of full convertibility. Similarly,the foreign exchange market will make rate fixing more transparent andwill ensure consistency among all monetary policy instruments, especial-ly interest and exchange rates.

It must also be noted that the central bank will monitor trends in mar-ket rates without the need for it to publish its own rates; indeed, suchpublication could hamper the smooth functioning of the market. Thecentral bank will influence the market in two ways: (1) by fixing its ownrates for repurchasing from banks at the close of business any foreignexchange in excess of the authorized position; and (2) by publishing onthe following day the average buying and selling rates applied by banksthe previous day only as a guide.

The accounts denominated in foreign exchange that residents wouldbe authorized to open would be transferable among residents on the for-eign exchange market. This transferability will gradually make it possibleto meet all residents' foreign exchange requirements, without having toseek the central bank's authorization each time.

98



Prudence should continue to be the order of the day, however, sincemajor challenges remain. Indeed, while the pace of Tunisia's economicgrowth has been considerable, it is not yet possible to deal decisively with theunemployment problem. The balance of payments is a further source of con-cern, given the persistence of a small but significant current account deficit(4 percent of GDP in 1993, 3.2 percent estimated in 1994). Despite a favor-able climate, the trade balance is under pressure as a result of the slowdownin the export growth rate owing to the ongoing crises of Tunisia's majortrading partners. In addition, Tunisia should seek new outlets. For such anobjective to be met, the sectors involved must continue to improve productquality and to enhance the competitiveness of production units.

On the external front, there are profound changes under way in theinternational environment, given the reorientation of financial flowstoward the countries of eastern Europe. Yet it remains our objective topursue a coherent, stringent macroeconomic policy, which is vital if thebasic equilibria are to be maintained and inflation controlled. Thus, socialpeace—and consequently political stability—can be ensured.

Appendix

The Move Toward Convertibility of the TunisianDinar for Current Operations

Central Bank of Tunisia

The decision to establish the current account convertibility of theTunisian dinar in 1993, in conformity with the obligations under ArticleVIII of the Articles of Agreement of the IMF, represented the culminationof efforts by the Tunisian authorities to open up the nation's economy,promote its international competitiveness, and strengthen its ability toface the challenges of development. This decision complemented andreinforced the many revisions of the Exchange and External Trade Codeand its implementing provisions since the mid-1980s. These revisionswere intended to simplify the procedures for economic operators and toimprove the investment climate and working conditions for enterpriseswithin the framework of a policy to liberalize the national economy.

This paper reviews the original and revised versions of the Exchangeand Foreign Trade Law of 1976 and discusses the future orientation offoreign exchange policy. By way of background, it provides an overviewof the main features of the Tunisian economy, traces important domestic

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and external financial developments, and outlines the main elements ofTunisia's reform program.

Main Features of the Tunisian Economy

During the 1970s, Tunisia intensified its development activities. GDPgrew by 7.5 percent a year, and investment, as a percentage of GDP, dou-bled, resulting in a fundamental change in the structure of the economyand an increase in the role of the manufacturing and tourism sectors.National saving increased, the current account deficit was limited to 4 or5 percent of GDP, and the debt ratio declined. Contributing to the suc-cess of these efforts was a significant improvement in the terms of traderesulting from higher prices for oil, phosphates, and other exports.

The economic policy envisaged during the period was characterized bythe substitution of domestic products for imports in the domestic market.This policy was based on the provision of assistance and various incentivesto boost investment and production and to protect Tunisian industry,while continuing administrative management of the economy in areas suchas investment, pricing, foreign trade, and finance. The main objective wasto create the maximum possible number of jobs to meet a constantlyincreasing labor force. This policy had several negative results: (1) the ori-entation of production units toward the domestic market, with weak ex-port growth; (2) a low overall factor productivity and an underutiliza-tion of productive capacity owing to excessive and sustained protection ofdomestic industries; and (3) a limited degree of industrial integration anda resulting increase in the demand for imported intermediate goods.

Important Domestic and External Financial Developments

In the early 1980s, the combined effects of falling oil prices, contract-ing external demand, appreciation of certain foreign currencies, andincreasing domestic demand resulted in domestic and external financialimbalances. The budget deficit, which amounted to 6 percent of GDP,rose to 8.1 percent of GDP in 1983. The external current account deficitrose from 8.7 percent of GDP annually to 10.8 percent of GDP in 1984.Concurrently, the external debt position deteriorated and the debt-to-GDP ratio reached an unacceptable level.

These developments led to a crisis in 1986 that was characterized by(1) a marked drop in real GDP (-1.6 percent); (2) a deteriorating bal-ance of payments position, with a current account deficit of 8 percent ofGDP; (3) a rise in the debt ratio to 60 percent of GDP; (4) an increasein the debt-service ratio to 28 percent of current receipts; and (5) a rise

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in the government budget deficit to 5.5 percent of GDP, despite thestrict measures enacted in the supplementary budget law for that year.

Analyses and scenarios formulated at that time showed that anyattempt to simultaneously increase production and decrease the currentaccount deficit while improving the debt ratios would require the ratio-nalization of domestic demand, the promotion of exports, and the effi-cient use of available resources through market mechanisms. Such a plancould not ignore the investment and consumption components ofdomestic demand, because consumption growth and the provision ofinfrastructure are the most important objectives of any developmentactivity, provided they are achieved within the framework of sound financial balances. Therefore, exports were targeted to grow faster thandomestic demand, and national savings to outpace external borrowing inview of the limited and scarce resources of the economy. A strategy of thistype depends in large measure on the efficient use of resources throughenhanced national competitiveness, resulting in an export-oriented econ-omy. In light of these circumstances, Tunisia adopted a comprehensivestructural adjustment program that coincided with the Seventh Five-YearPlan (1987-91).

The Reform Program

The structural adjustment program included short-term measuresaimed at halting the economic deterioration and creating conditionsconducive to production and employment. It also included medium-term measures to address any obstacles that might impede economicdevelopment.

Among the short-term measures taken was a 10 percent devaluation ofthe Tunisian dinar in August 1986 to correct the overvaluation of thecurrency that had taken place between 1980 and 1985 and therebyimprove the competitiveness of Tunisian products and facilitate access tonew markets. Another measure was the adoption of a bold policy to cutpublic expenditure and increase revenues to correct the balance of pay-ments position and decrease the budget deficit. The authorities alsomobilized external loans on concessional terms to fill the financial gapresulting from the deterioration of the economic situation; they signedsizable loan agreements with the IMF, the World Bank, and certainfriendly countries.

Medium-term measures were aimed at removing the obstacles to eco-nomic development, enhancing the role of market mechanisms, encour-aging initiative, and activating the self-correcting mechanisms of thenational economy. To achieve these objectives, the structural adjustment

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program envisaged fundamental reforms such as the liberalization ofinvestment and prices, the privatization and restructuring of public enter-prises, the reform of tax administration and of the financial and monetarysystems, the liberalization of foreign trade, and the abolition of priorauthorization for foreign exchange transactions.

The main results of the Seventh Five-Year Plan, which constituted adecisive turning point in the development process, were as follows.

• Overall factor productivity improved. This indicator, reflecting thereturn on capital and labor, registered for the first time a positiveannual increase of 2.2 percent, compared with an annual drop of1.1 percent during the Fourth Plan (1972-76), no change duringthe Fifth Plan (1977-81), and an annual decline of 2.6 percentduring the Sixth Plan (1982-86). This improvement was reflectedin a better use of productive capacity. The economy grew at anannual rate of 4.2 percent while investment increased by only 0.5percent a year (in constant prices) and consumption rose by notmore than 2.7 percent a year in the absence of a pronouncedgrowth in GDP.

• Exports increased annually by about 10.8 percent in constant pricesduring the period, compared with an ambitious initial target of a 5.3percent annual increase. Export promotion activities encompassedtraditional sectors, for example, agricultural and food products,phosphates and derivatives, textiles, tourism, as well as new sectorsthat were not previously exporting, for example, building materialsand certain mechanical and electrical products. The flexibleexchange rate policy, along with efforts to enhance market mecha-nisms and to improve the overall economic environment, helped inachieving these objectives. The growth in output relied mainly onexports, rather than on inward-oriented sectors as in the past.

• Domestic and external financial balances improved markedly. Thecurrent account deficit did not exceed 2.9 percent of GDP, com-pared with a target of 4.8 percent of GDP in the plan and a deficitof 8 percent of GDP in 1986. The budget deficit fell from about 6percent of GDP during the Sixth Plan to 3.8 percent of GDP dur-ing the Seventh Plan. The discipline on the expenditure sidereversed the previous trend, which had been characterized by afaster rate of growth of expenditure than that of revenue. Althoughthis result exceeded the deficit foreseen in the plan (2.1 percent ofGDP), it was nevertheless encouraging in view of the pressure onthe budget caused by such adverse factors as drought, locusts,floods, and the Persian Gulf war.

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• The debt structure showed continuous improvement, accompa-nied by a sustained decline in the debt-to-GDP ratio. The share oflong-term loans in the debt stock increased from about 60 percentin 1986 to about 77.5 percent in 1991, as foreign resources madeavailable in the context of structural or sectoral adjustment pro-grams helped reduce the share of medium-term loans at commer-cial terms. More important, the debt-to-GDP ratio fell by about 7points of GDP (from 59.5 percent of GDP in 1986 to 52.6 per-cent of GDP in 1991) and the debt-service ratio decreased from27.9 percent to 21.8 percent of current revenues during the sameperiod.

Despite these positive results, and because the reform process was notcompleted, a number of weaknesses became apparent during the last yearof the plan, given the adverse impact of the Persian Gulf war. The result-ing financial imbalances required immediate action. Investment perfor-mance was uneven during the period of the Seventh Plan. After a con-traction in the first two years of the plan (by 10.1 percent in 1987 and by4 percent in 1988 in constant prices), the authorities took measures toincrease and promote investment by easing the social burden on enter-prises and by simplifying procedures and administrative regulations. Inaddition to improving the overall economic conditions, these measureshelped restore investors' confidence, resulting in a recovery in investmentduring 1989 and 1990 (with a 12.4 percent increase in 1989 and 19.1percent in 1990). This rate of increase dropped, however, in 1991 to only3 percent because of the adverse effects of the Persian Gulf war.

Regarding the fiscal balance, the pressure on the fiscal position wasmore severe than expected because of an increase in some public expen-diture items (e.g., the wage bill) that exceeded earlier estimates becauseof higher world prices and product subsidies. Nonbudgeted expendituresalso rose because of the adverse effects of two years of drought in 1988and 1989, damage caused by floods, and the Persian Gulf war. Immediatemeasures were, therefore, required in the context of supplementary bud-get laws to preserve fiscal balance. With these constraints, the objective ofnarrowing the budget deficit from 5.5 percent of GDP in 1986 to 1.5percent in 1991 could not be achieved. The budget deficit was at 3.9 per-cent of GDP in 1991.

The results of the structural adjustment program seem mixed, but theyclearly reflect the positive aspects of steady and courageous reform efforts.Despite the severe circumstances surrounding the implementation of theprogram, the authorities were able to exceed expectations by achieving anannual growth rate of 4.2 percent. Investment recovered during the final

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years of the Seventh Plan after following a relatively lengthy decline, thefinancial crisis faced by the country in the mid-1980s was reversed, and aimprovement in debt ratios was achieved. These gains formed a soundbasis for launching the Eighth Five-Year Plan (1992-96). The volatileinternational environment made consolidation of these gains imperative.

The turning point in the development process was 1992, when thePersian Gulf crisis was over. Economic activity picked up, and the reformprocess was intensified at all levels. Accordingly, good results wereachieved in 1992 with respect to growth, price decontrol, and budgetaryadjustment. The balance of payments came under pressure owing to adecline in exports and an increase in imports in the last months of theyear.

Real GDP grew by 8.1 percent in 1992, as compared with 3.9 percentin 1991. The authorities adopted a fiscal policy stance aimed at mobiliz-ing resources and rationalizing expenditures and were thus able to limitthe budget deficit to 2.8 percent of GDP. The authorities also pursued arestrictive financial policy and carried out many monetary and financisector reforms. This policy yielded generally positive results. The moneystock grew at moderate rate of 8.2 percent in 1992 and remained at14.3 percent of GDP. This helped control inflation; prices increased by5.5 percent in 1992, compared with 7.8 percent in 1991.

Constraints on external payments were more severe than expected.The current account deficit rose to 4.8 percent of GDP in 1992, com-pared with 4.4 percent of GDP in 1991. The deterioration in the termsof trade alone increased the current account deficit by 1.1 percent ofGDP. Nevertheless, debt ratios continued to improve. The debt-serviceratio declined to 19.1 percent of current receipts, compared with20.1 percent in 1991, and the debt ratio dropped to 49.4 percent ofGDP, compared with 52.9 percent in 1991.

The improvement in these indicators allowed the authorities toannounce the convertibility of the dinar for current account operations.The announcement of this decision at the beginning of the plan demon-strated the authorities' intention to liberalize and open up the economyand to strengthen its structure.

Main Areas of Economic Reform and Liberalization

The reform and liberalization measures of the Eighth Five-Year Plan(1993-96) covered many areas, including the following.

(1) The requirement for prior approval for obtaining foreignexchange was removed. Administrative procedures were simplified, and

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investment in agriculture, industry, services, tourism, and other sectorswere liberalized.

(2) Various concessions were granted to boost private sector invest-ment. The system of concessions and incentives was revised, and a unifiedlaw on investment was drafted that took into account national priorities,in terms of selectivity and proper use of resources.

(3) A comprehensive reform of the tax system and of the tax admin-istration was initiated using a new, modern system characterized by sim-plicity, transparency, and lower tax rates. A value-added tax was intro-duced with only three rates (6 percent, 17 percent, and 29 percent)along with a unified income tax return, a single corporate income taxreturn, and a maximum profit tax rate of about 35 percent. Capital gainswere exempt from income taxation to avoid tax duplication. Customduties were adjusted downward from a maximum rate of 200 percent to41 percent to ensure reasonably effective protection. A law was drafted toincorporate all tax provisions and thus ensure greater harmony andconsistency.

(4) The gradual liberalization of prices was initiated at the levels ofproduction and distribution. This was done in recognition of the role ofprices in enhancing competition and efficiency.

Prices of agricultural products were revised and significantly increasedon a number of occasions. This prevented the artificial freezing of theseprices, while concurrently providing a minimum degree of protection fordomestic products. The legal framework was also revised, and two lawswere adopted: one on free competition and prices and the other on mar-keting and trade. The authorities made extensive efforts to control thecosts of subsidies, either by adjusting prices or by taking specific andstructural measures to contain them within reasonable limits.

The percentage of free prices in terms of production reached 87 per-cent by the end of January 1993. The only exceptions were subsidizedgoods and monopoly products. Free prices constituted 70 percent of thegoods and services distributed. It will continue to apply fully to unsubsi-dized goods and services or to goods and services that are insufficientlycompetitive by the end of 1994.

Parallel to price liberalization, under Law No. 91 /64 of July 1991, thenumber of price-fixing mechanisms has declined since January 1992 fromfive to three (involving absolute freedom, self-determination, and admin-istrative determination).

(5) A program was introduced to privatize and restructure publicenterprises. This took place in the context of a review of the state's rolein the economy. This review concluded that government interventionshould be limited to the infrastructure and strategic sectors. Under the

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previous plan (1987-91), provisions were made to reduce state control ofpublic enterprises by expanding their boards of directors, substituting aposteriori supervision for a priori supervision, and ensuring flexibility inthe conclusion of agreements that determine relations between the stateand enterprises. The authorities reviewed the structure of public enter-prises. Out of 95 enterprises studied by the end of 1991, 28 were totallyprivatized and 11 were partially privatized. This process dealt primarilywith the tourism and textile sectors. In addition to safeguarding jobs asfar as possible, it provided the state with additional resources and helpedreform a number of public enterprises.

(6) Foreign trade liberalization was treated as a priority, with importliberalization seen as a prerequisite to the creation of favorable condi-tions for competition and efficiency. Emphasis was also placed onincreasing exports to achieve the objectives of growth and employment.Under the previous plan (1987-91) restrictions on more than two thirdsof imports of raw materials and semiprocessed goods had already beenremoved and the organizational and promotional framework for exportsenhanced. These actions enabled exporters to face increasing foreigncompetition and to enter new markets, but the pace of removal ofrestrictions on imports during that period slowed down as a result ofunfavorable external factors. Hence the Eighth Plan sought to liftrestrictions on all imports by 1994, except on some essential items orluxury goods. By the end of 1992, 87 percent of the items in questionhad been liberalized. Accompanying measures such as the adjustment ofcustoms tariffs and the harmonization of the various rates, includingduties on raw materials and finished products, were enacted to restrictunfair competition. A compensatory rate was introduced to discourageillegal import transactions.

(7) The monetary and financial systems were reformed to promotecompetition and to give financial institutions more freedom in resourcemobilization and investment. The reform process entailed a variety ofmeasures to strengthen the financial market including (1) liberalizinginterest rates; (2) liberalizing the money market by eliminating therequirement of prior central bank authorization for its lending opera-tions; (3) creating new negotiable financial instruments, such as certifi-cates of deposit, shares, and treasury bonds; and (4) frequent changes inthe system of preferential loans. The procedures for foreign exchangetransactions were also improved.

(8) The value of the Tunisian dinar was adjusted, insofar as some flexibility with respect to the fixing of its exchange rate was introduced in1986. In their monitoring of changes in the exchange rate of the dinaragainst the currencies of trading partners, the monetary authorities relied

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on an indicator of real and nominal effective exchange rates weighted bycurrent receipts from the export of goods and services. Between the timeof the adjustment in the value of the dinar in 1986 and the end of 1987,this indicator moved downward, as intended by the monetary authorities,to reverse the appreciation of the dinar. The authorities have since thenmaintained the stability of the real exchange rate of the dinar at the levelrecorded at the end of 1987.

(9) The 1989 formula for covering term payments for importers andexporters of goods and services was adjusted. The maximum period ofcoverage was increased from 8 to 12 months for importers (comparedwith 6 to 8 months in 1986) and from 6 to 9 months for exporters(compared with 3 to 6 months in 1986), to eliminate related exchangerisks. This system was extended to include nonresidents among all serviceproviders.

A system was established to protect borrowers against exchange risksresulting from the repayment of loans and interest in foreign currency.This system gives the borrower the option of purchasing the currencyfrom the central bank, which guarantees, for purchase on a specific date,a predetermined exchange rate called a "stipulated rate." Benefits may bedrawn from any positive movement of exchange rates.

Call option securities are available through authorized intermediariesfor periods of 3 to 12 months. The purchaser pays a premium, to bedetermined on the basis of the central bank's rate, which is based on theexpected rates of the U.S. dollar, the French franc, and the deutsche markon the date of the option contract.

Exchange and Foreign Trade System, 1976-93

The Exchange and Foreign Trade Law was enacted in 1976, and theExecutive Order No. 608-77 governing its implementation was issued onJuly 27, 1977. This Executive Order was revised in 1987, and thefollowing two important modifications were made.

• Residents were no longer required to transfer from abroad theirincome and earnings in foreign exchange not derived from exportoperations or from the provision of services. They would be allowedto deposit such resources in special accounts denominated in for-eign exchange or convertible dinars.

• Residents with foreign exchange resources would be allowed toopen professional accounts, denominated in foreign exchange orconvertible dinars, in which they could deposit all or part of suchresources to cover their professional foreign exchange expenses.

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Exchange Regime

Payments for Current Account Transactions

The general principle is that no current transaction should be made with-out prior authorization of the central bank, through its branches, on the basisof proper documentation. As an exception to this principle, authorized inter-mediaries are allowed to make transfers in the following categories:

• Subscriptions to scientific, professional, charitable, and culturalassociations.

• Subscriptions to magazines and periodicals.• Savings of nonresidents working in the private sector equal to 50

percent of their net wages and salaries. For other workers, amountsthat may be transferred are usually specified in their employmentcontracts in the context of bilateral agreements for technical, cul-tural, and scientific cooperation.

• Reinsurance surpluses registered between resident and nonresidentinsurance companies.

• Repayment of the principal and interest on foreign debt and allrelated expenses, with the exception of suppliers' credits (which arerepaid through commercial arrangements).

• Bank expenses and interest payable by banks to nonresident banksthat are not their correspondents.

• Interest and dividends, compensation of board members, andbonus shares.

• Expenses for business and tourist travel and for scholarships abroad,within a range to be determined from the disbursement authoriza-tion issued by the Ministry of Finance.

In addition, exporting institutions in the industrial, trade, and servicesectors are free to transfer all expenses in currencies related to their exportactivities. Institutions that are partial exporters of goods and services mayfreely use 10 percent of their foreign exchange revenues to cover theirexpenses.

Opening of Nonresident Accounts

According to an Exchange Order issued in 1982 and modified by twoOrders issued in 1983 and 1984, nonresidents may open the followingaccounts and books.

• Foreign accounts in convertible dinars may be opened freely atauthorized intermediaries and used without prior authorization to

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purchase foreign exchange from the central bank, to transfer funds(in convertible dinars) to another foreign account or to make pay-ments in Tunisia.

• Foreign accounts in convertible currencies may be opened freely atauthorized intermediaries and used without prior authorizationfrom the central bank to transfer such convertible currencies to thelatter or abroad, or to provide currencies to the account holders orany other beneficiary, resident, or nonresident for the purpose ofbusiness travel abroad if that person is a permanent representativeor employee of an account holder. Such accounts may also be usedto transfer funds to other foreign accounts.

• Special accounts in Tunisian dinars for deposits in dinars may beopened by nonresident institutions doing business in Tunisia. Theseaccounts may be opened automatically once the central bank hasapproved any transactions for which they were opened.

• Domestic accounts may be opened at authorized intermediaries,without prior authorization of the central bank for individuals resid-ing temporarily in Tunisia. These accounts may be freely funded byconvertible currencies from abroad or by revenue accruing toaccount holders in Tunisia for services rendered locally. Theseaccounts may also be credited with (1) funds reimbursed on orbefore the dates specified in contracts for Tunisian or foreign mov-able assets, recorded on domestic books opened in the name of theaccount holder; (2) payments for purchases of Tunisian movableassets in the Tunisian stock exchange; (3) repayments of loans pre-viously extended in dinars from the domestic nonresident accountsin question; and (4) transfers from other nonresident domesticaccounts opened in the name of the account holder.

These nonresident domestic accounts may be debited, without priorauthorization of the central bank, with amounts necessary to cover theexpenses of the account holders and their families in Tunisia and theexpenses of maintaining any properties they may have in Tunisia. Theseaccounts may also be debited to subscribe to short-term Tunisian bondsand notes provided these bonds and notes are placed on domestic booksfor nonresidents opened or to be opened in the name of the accountholder. These accounts may be debited if the holder wishes to extendloans in dinars to Tunisian residents or to provide funds to other domes-tic nonresident accounts opened in the name of the account holder.

• Pending accounts and books may be opened for the recording offunds in Tunisian dinars and movable assets whose status has not yetbeen determined by the central bank. These accounts and books

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may be opened without the prior authorization of the central bankof Tunisia. The funds may be used freely, but authorized interme-diaries should not pay interest on them. These pending accountsmay be used without prior authorization of the central bank to carryout transactions, the most important of which are purchases ofmovable assets and payments on behalf of Tunisian public enter-prises and departments.

• Capital accounts may be opened in the name of foreign nonresidentindividuals or corporations, without prior authorization of the cen-tral bank, to accept funds in nonconvertible dinars. These accountsmay be used without the central bank's authorization to coverexpenses related to the management of profits accruing to nonresi-dents from the sale of Tunisian movable assets or real estate.

Accounts and Books in Foreign Currencies and Convertible Dinars

Resident individuals and corporations working in Tunisian institutions,whether Tunisians or foreigners, may open the following accounts.

• Professional accounts in convertible dinars may be opened with thecentral bank's authorization in the names of income earners. Theseaccounts may be used according to conditions stipulated in therespective authorizations for their opening.

• Professional accounts in convertible currencies may be opened withprior authorization for exporters whose export earnings exceed15 percent of their sales and whose activities are subject to the invest-ment law governing such sectors as manufacturing, agriculture, fish-eries, foreign trade, and services. These accounts may be funded by20 percent of revenues in convertible currencies, so that exportinginstitutions may deal with exchange risks. Without prior autho-rization, these accounts may be used for payments under exchangeand foreign trade arrangements, for importation of goods and ser-vices, and for other expenses such as repayment of loan principal andinterest in foreign exchange. These funds may also be used for invest-ment operations in hard currencies in Tunisian money markets.

• Professional books may be opened freely by any exporter, includinghotel owners and travel agencies, with the right to transfer 10 per-cent of their foreign exchange income. These books cover expensesrelated to the economic activity for which they were opened, espe-cially business travel expenses, without limits specified in the dis-bursement order and ranging from TD 10,000 to TD 60,000 ayear.

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Special Accounts

According to a circular issued by the central bank in 1987, residentsmay open special accounts in convertible dinars or foreign currencies inorder to receive revenues accruing to them legitimately from abroad thatthey are not required to sell to the central bank, provided such revenuesare covered by the Exchange and Foreign Trade Law.

Hard Currency Money Market

A hard currency money market was established and organized in 1991between resident and nonresident banks in Tunisia. Exchanges on thismarket between authorized intermediaries are made from the above-mentioned accounts in either convertible dinars or foreign currencies.

Trade Regime

Imports

Import operations are carried out in conformity with trade agreementsbetween Tunisia and other countries, government procurement plans,and measures taken to free or ban some products. Goods that may beimported are published in the official gazette, with the exception notedbelow. Any individual or corporation whose job entails the use or sale ofimported products and is registered as an importer may import the prod-ucts in question, subject to the above-mentioned stipulations. Importoperations can be classified as follows:

• Import operations that may be carried out under exchange and for-eign trade arrangements. These include mainly goods importedfreely by exporting industrial enterprises that are necessary for theirproduction.

• Liberalized goods that are imported on the basis of import certifi-cates. These goods, announced in the official gazette, may beimported without prior authorization upon submission of animport certificate, valid for six months, with invoices to the autho-rized intermediary.

• Banned goods or goods subject to quotas that may be imported onthe basis of import licenses. These include all goods not in the pub-lished liberalized goods list. The books on these operations areexamined by the Ministry of National Economy and are thenreferred to the central bank for approval.

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• Imports subject to special systems. These imports can be classifiedeither as duty-free imports (authorized by the Ministry of NationalEconomy and approved by the central bank) or as imports subjectto an administrative system and to duties.

Exports

Products not subject to any bans or restrictions are exported with priorauthorization, either without any formal procedure or according to pro-cedures whereby the return of export proceeds to Tunisia is monitored.The following exports are not subject to any formal procedure withrespect to foreign exchange and trade arrangements:

• Exports on a list issued by the Ministry of National Economy.• Exports purchased by mail that are not subject to bans or quantita-

tive restrictions and whose costs do not exceed TD 1,800.

Banned goods or those subject to quantitative restrictions may not beexported without an export certificate issued by the Ministry of NationalEconomy and approved by the central bank. The certificate is valid forthree months after approval.

Investment Operations

All laws promoting foreign investment in Tunisia guarantee the trans-fer of foreign exchange capital invested in Tunisia and capital income.This guarantee covers the net revenues and the full proceeds of sales evenif they exceed the capital initially invested. Investment laws emphasize theimportance of the export sectors and grant them financial and customsincentives and a number of exchange and trade privileges, as follows.

• Resident individuals and corporations that engage only in exportactivities subject to Laws No. 51-87 and 100-89 may freely trans-fer funds to their export activities through authorized intermedi-aries. They may freely import any goods necessary for theirproductive operations, provided they are approved by customsauthorities.

• Resident institutions exporting services may provide services forresident institutions within the framework of international tendersor bids.

• Foreign trading companies may transfer funds related to trade orexport through approved intermediaries in conformity with condi-tions set by the central bank.

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In carrying out their activities in the field of foreign trade, exportersmay clear their revenues and expenditures in hard currency and may bor-row hard currency according to conditions set by the central bank.

Investment by Tunisians Abroad

Investment by Tunisians abroad is subject to the prior authorization ofthe Central Bank. According to Law No. 110-88, resident foreign tradecompanies may open liaison offices, affiliates, or branches abroad to pro-mote their activities in exports, intermediation, and foreign trade. Theseagencies are financed by a percentage of their export proceeds, as specifiedin Circular No. 26-88 of November 10, 1988, issued by the central bank.

Exchange and Foreign Trade System Since 1993

Following the decision on the convertibility of the Tunisian dinar forcurrent account operations, the authorities reviewed exchange controlprovisions with the aim of removing the requirements for prior autho-rization of transfers for current account operations by public and privateenterprises and centralized agencies. In this context, Law No. 48-93 ofMay 3, 1993 was issued, modifying the Exchange and Foreign TradeLaw of 1976. Under the revised law, any transfers may be made of pay-ments related to the realized net revenues, proceeds of sales, or investedcapital income in convertible currencies.

The central bank now permits authorized intermediaries to make therequired transfers for economic transactions, based on the necessarydocumentation proving the intended expenses. In this context, privatesector enterprises are allowed to transfer expenses related to currentaccount operations.

The current convertibility of the Tunisian dinar was accompanied byother measures that (1) raised the travel allowance for residents fromTD 200 to TD 500; (2) increased the education allowance for studentsabroad from TD 500 to TD 1,000 annually, starting in academicyearl993-94; and (3) standardized the monthly allowance at TD 600,in any host country, as of January 1, 1993.

To facilitate business travel for entrepreneurs seeking markets orpartnerships, the annual business travel allowance was expanded to applyto all institutions, whether importers or nonimporters, in addition toexporters.

With respect to current account operations, maximum allowanceswere raised, to promote the activities of enterprises and to protect the

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national economy against capital flight. Importers enjoy an annualallowance ranging between TD 5,000 and TD 30,000, depending ontheir turnover, and exporters enjoy an annual allowance ranging betweenTD 10,000 and TD 80,000, also depending on their turnover. New pro-ject investors are allowed TD 5,000. For other enterprises, including theself-employed, the allowance ranges between TD 2,000 and TD 20,000,depending on approved turnover.

To boost investment, the revised Exchange and Foreign Trade Lawabolished the requirement for prior authorization for actual transfers bynonresidents of realized net income from the investment of foreigncapital in convertible currencies in Tunisia.

In addition, the following decisions were made.

• Tunisians living abroad are now to combine the rights and dutiesof both residents and nonresidents, so that they may perform anyoperations related to their money and real properties in Tunisia.

• The capital required to open branches, agencies, or liaison officescan now be transferred abroad. This change is intended to liberal-ize Tunisian investment abroad and promote the presence ofexport enterprises at distribution points in foreign markets.

• To enable exporters to avoid exchange risks, the portion of bal-ances allowed in professional accounts in convertible currencieswas increased from 20 percent to 40 percent of income in thosecurrencies.

• Banks and enterprises are now able to borrow abroad without priorapproval.

Outlook and Future Orientations of Exchange Control Policy

Tunisia's program of exchange control removal is aimed at enablingenterprises and resident economic transactors to operate in a progressiveeconomic environment that promotes competition and stabilizes the basicbalance of payments. In conformity with Article VIII of the IMF's Articlesof Agreement, Tunisia's decisions—especially those regarding the con-vertibility of the dinar for current account operations—constitute majorsteps in this program. Tunisia has now approved full convertibility for for-eign investors and Tunisians living abroad, paving the way for the estab-lishment of an exchange market in the near future. Continuing structuralreforms and successful economic performances will enable the govern-ment to extend the currency's convertibility to include other operations.The aim is to achieve full convertibility of the dinar in the long term.

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The Exchange System in MoroccoAli Amor*

The recent changes in the world economy have led most countries toseek growth and development for their economies through interna-

tional trade. These changes, which have also affected economic doctrine,have shown, particularly for developing countries, that, in an increasing-ly globalized economy, growth cannot result from inward-oriented poli-cies. The need to integrate domestic economies in the global world econ-omy and to remove all restrictions to international trade in goods andservices has moved to the forefront of present concerns a notion virtual-ly forgotten in the economic literature: currency convertibility.

Currency convertibility, in an environment where restrictions arebecoming increasingly inoperable and ineffective, is now a vital issue inmanaging economic relations with the rest of the world for both the for-merly planned economies and the developing economies; all are con-cerned with increasing and diversifying their foreign trade. In both cases,many questions arise: How can currency convertibility be achieved? Whatis the first step? In what coherent economic policy framework should thiseffort be situated? Morocco's experience can offer certain enlighteninglessons in this connection.

Morocco's experience with convertibility is actually quite recent; itaccepted the obligations of Article VIII of the IMF's Articles ofAgreement in January 1993. It provides a very interesting case of a coun-try that moved to convertibility under specific economic conditions. TheMoroccan experience is an example of a non-oil developing economy, fac-

* Director, Foreign Exchange Office, Morocco.

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ing an external debt-financing constraint, as do most developing coun-tries. It can be traced back to the structural adjustment programs thatembodied its liberal choices in re-establishing domestic and externalequilibria.

To present the Moroccan experience, the following approach will betaken. Following a brief overview of different definitions for convertibil-ity, the origin and development of exchange controls in Morocco arereviewed first, focusing on the role they played during the 1960s and1970s. Second, the reasons underlying the liberalization process areexamined, notably the extent of the domestic and external disequilibriathat emerged during 1981-82. Third, the current status of exchange con-trols is examined, then the results of the liberalization efforts with respectto Morocco's external transactions.

Definitions of Convertibility

In the Moroccan case, convertibility has always been defined as unre-stricted access to foreign exchange reserves in order to obtain the for-eign exchange required to settle transactions with foreign entities. Thisdefinition reflects the situation of developing countries that would liketo give their economic agents sufficient freedom to enter into interna-tional transactions, without intending to hold their currency up as aninternational exchange standard.

In addition, several categories of convertibility can be identified accord-ing to the limits set for obtaining foreign exchange: full and unlimitedconvertibility, domestic and external convertibility, and convertibility forcapital and current account operations. The latter form of convertibility,which is adopted by the IMF's Articles of Agreement, is considered as pro-viding a minimum degree of convertibility. According to the authors ofthe Bretton Woods agreements, multilateral trade could not develop with-out a sound international monetary system. Such a system cannot exist,however, unless its participant countries have currency convertibility. Theissue, therefore, was to establish a lowest common denominator for con-vertibility. Accordingly, under Article VIII each member is bound by thefollowing general obligations, inter alia: (1) avoidance of restrictions oncurrent account payments, (2) avoidance of discriminatory currency prac-tices, and (3) convertibility of foreign-held balances. The third obligationmeans that each member shall buy its own currency held by another mem-ber if the latter requests the purchase. It entails a number of conditions(cases involving scarce currency, and so forth), and seems to be decreas-ingly relevant, although it still appears in the Articles of Agreement.

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The Exchange System in Morocco

The first two obligations embody in essence the concept of convert-ibility according to the IMF. In fact, currency convertibility exists fromthe time all restrictions are removed from payments on current accounttransactions and there is no discrimination in external transactions.

Regarding convertibility pursuant to Article VIII, two specific charac-teristics can be observed: convertibility pursuant to Article VIII is a lim-ited form of convertibility, since its scope of application does not extendbeyond current account transactions. In addition, such convertibility isplaced within the context of exchange controls, as it constitutes a phasein the liberalization process.

Origin and Evolution of Exchange Controls

Exchange controls were instituted in Morocco as the result of exter-nally imposed circumstances. Exchange controls were in fact establishedin 1939 by France, as a colonial power, in preparation for its war effort.They applied only to relations with countries outside of the franc area.The purpose was to promote the Moroccan economy's integration intoMetropolitan France's economic systems. The aim was not protectionist;on the contrary, it was exclusivity, which also happened to be at odds withMorocco's own interests. The 1939 measures indeed appeared to be theresult of a process that France had undertaken since the protectorate sys-tem began, with a view to turning the open-door system imposed onMorocco to its own advantage. This system had originally placed all west-ern nations on an equal footing in their economic, commercial, andfinancial relations with Morocco.

In the aftermath of its independence, Morocco recovered its authorityover exchange controls to use them as an instrument to promotedevelopment. It started by applying exchange controls to all countriesacross the board, including those in the franc area. Through exchangecontrols, Morocco was able to stem the capital flight that followed itsindependence, protect nascent industrial activities, and preserve itsexternal equilibria and the value of its currency, while fosteringdevelopment of a substantial financial sector. Thus, during the 1960s and1970s, exchange controls took on a restrictive nature, in the form ofrestrictions on commercial transactions, service transactions, and capitaltransfers.

The process of dismantling these restrictions began under the expan-sionist policies pursued during the period 1974-77. These policies madeit possible to achieve substantial economic growth objectives, but it hadadverse effects on domestic and external imbalances.

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(1) The ratio of exports to imports fell from almost 90 percent in 1974to 40 percent in 1977. At the same time, the trade deficit more than dou-bled between 1975 and 1977 from DH 4.1 billion to DH 8.5 billion.Imports nearly doubled from DH 8.3 billion to DH 14.4 billion between1974 and 1977, while exports declined from DH 7.4 billion toDH 5.8 billion during the same period.

(2) The external current account deficit exceeded DH 8 billion in1977, nearly 17 percent of gross domestic product (GDP).

(3) The external public debt, which stood at only 22 percent of GDPin 1973, rose to 34 percent in 1977.

The worsening of external imbalances was accompanied by a seriousdeterioration in the monetary, financial, and budgetary disequilibria.Faced with this situation, the government launched a three-year plan cov-ering the period 1978-80 with a view to restoring the economy's funda-mental equilibria and growth momentum. Restrictive measures wereimplemented under this plan, particularly as regards the exchange system:(1) restrictions were placed on imports by establishing lists of productswhose import was subject to a priori authorization and instituting advancedeposits for imports; (2) restrictions were applied to services, such as travelabroad and technical assistance; and (3) restrictions on capital transferswere not only maintained but also increased. At the same time, measuresintroduced to attract foreign investment and promote exports had a lim-ited effect as a priori administrative controls were maintained.

Regarding the results, the restrictions, far from helping to restore eco-nomic stability and promote economic growth, instead worsened theimbalances and stifled the Moroccan economy, which could not regain anygrowth momentum under these conditions. Thus, the restrictive exchangecontrols maintained until 1982 led to the following.

(1) A trade deficit that increased by 60 percent between 1977 and1982, rising from DH 8.5 billion to DH 13.6 billion. Similarly, there waslittle improvement in the ratio of exports to imports, which rose from40.7 percent in 1977 to 47.9 percent in 1982, considering that 57 per-cent of the imports in 1982 came from the list of products subject to priorauthorization and only 42.3 percent from the list of products that couldbe freely imported.

(2) An increase in the current account deficit from DH 8.2 billion in1977, or 16.5 percent of GDP, to DH 11.4 billion in 1982, or 12.3 per-cent of GDP. The current account deficit thus remained substantial despiteall of the restrictions that were applied.

(3) A reduction in the central bank's foreign exchange reserves, whichfell from to DH 1.8 billion at the end of 1977 to DH 743,000 at the endof 1982, representing just under ten days of imports.

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It was, therefore, becoming increasingly evident that the restrictionswere not effective in dealing with the external imbalances: imports, com-posed primarily of energy and food products, could not be furtherreduced, and export growth remained sluggish. Real growth was stillconstrained by various restrictions and by (1) an increased debt burden,as the result of the rise in interest rates and the exchange rate for the U.S.dollar following the second oil crisis, and (2) poor weather. Accordingly,the Moroccan economy achieved only fairly modest growth rates. RealGDP grew at an average annual rate of 3.2 percent between 1978 and1982, and even declined in 1981.

Accordingly, it was decided in 1983 under the structural adjustmentprograms that new economic policy options—based on liberalizing andopening up the Moroccan economy—should be adopted. To this end, aconsiderable effort to liberalize exchange controls was initiated in 1983,paving the way for the establishment of the convertibility of the dirhamin January 1993. The process of liberalizing exchange controls wasundertaken in the context of the structural adjustment programs, whichalso aimed at liberalizing other areas of the Moroccan economy, such asthe tariff system, foreign trade, prices, and credit.

Morocco chose a gradual approach for liberalizing exchange controlsfor two basic reasons. The first related to the banking system's ability toadapt to the new tasks it would be required to perform. Indeed, one ofthe main liberalization measures involved the elimination of prior autho-rization for foreign exchange operations and the delegation to bankinginstitutions of the authority to execute such operations on an unrestrict-ed basis. The liberalization aimed at enabling authorized intermediariesto adapt progressively to their new tasks. The second reflected the con-cern that eliminating protective measures and aligning the domestic eco-nomic and financial systems with the international ones should not beenacted so suddenly as to risk jeopardizing the fabric of the domesticeconomic system. Accordingly, a gradual and phased approach wasrequired.

In the final analysis, Morocco's acceptance of the obligations underArticle VIII and the institution of the convertibility of the dirham stemfrom Morocco's belief that exchange restrictions can neither restore norpreserve an economy's fundamental equilibria, nor ensure the mainte-nance of a satisfactory growth rate, particularly in view of the growingglobalization of the world economy, which is making economies interde-pendent and linking an economy's growth rate with those of its partners.Thus, it is becoming increasingly obvious that the multilateralization oftrade and the removal of restrictions to international flows of goods, ser-vices, and capital are important sources of growth for all countries.

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Current Status of Exchange Controls

Establishing convertibility involves providing unrestricted access tooperators of foreign exchange reserves with a view to settling their foreignexchange transactions. Accordingly, settlements for operations benefitingfrom convertibility can take place freely with banks authorized to carry outsuch operations, without any prior administrative formalities. Nonetheless,to avoid any potential abuse of the system, two conditions are required forthe execution of such settlements.

(1) Operations must be carried out through the intermediary of bank-ing institutions. In practice, the settlement system between Morocco andforeign entities is based on a foreign exchange fund centralized within thecentral bank, where foreign exchange drawings and transfers must bemade. This principle, however, is becoming outmoded with the recentestablishment of an interbank foreign exchange market and the wideningof the scope of foreign currency accounts for exporters and Moroccan cit-izens living abroad.

(2) Supporting documentation must be presented for each foreignexchange operation. Indeed, under exchange control regulations, the sup-porting documents to be presented for each payment order abroad arespecified. They include invoices, statements, contracts, import certificates,and shipping documents for goods going to Morocco. These documents,which specify the type of operation and consequently the pertinent mea-sures, also enable the bank executing the settlement to verify that thetransaction is actually carried out. The documentation, however, does notapply to the obtainment of certain bank note allowances for travel abroad.

Let me, now, examine the transactions that have benefited from the lib-eralization of exchange restrictions.

Current Account Operations

Commercial transactions head the list of current account operations.Imports of goods are not subject to any exchange restrictions. Even whenprior authorization to import a product is required from the departmentresponsible for foreign trade, this authorization cannot be interpreted as aforeign exchange restriction. It is actually a foreign trade restriction,because, as far as settlement is concerned, there are no payment obstaclesapplicable to duly established import certificates. In addition, ancillaryimport fees are paid freely through the intermediary of banks, and importinsurance for certain goods can be obtained abroad.

Exports of goods and services benefit from a completely liberalizedregime and are not subject to any prior formalities by the Foreign

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Exchange Office. Exporters are required, however, to repatriate exportproceeds. Failure to do so would constitute the establishment of assetsabroad, corresponding to a capital account operation. Expenses related toexport promotion (business travel, trade shows, fairs, advertising, and soon) can be freely transferred by debiting convertible accounts or foreignexchange accounts, which are generally credited with 20 percent of theforeign exchange repatriated for exports of goods and with 10 percent forexports of services. International transportation operations, by sea orland, or any ancillary fees, can be discharged freely and the related chargescan be paid directly through banks.

As regards air transport, foreign companies established in Moroccomay freely transfer the net revenue resulting from the sale of travel tick-ets and collection of freight charges, less locally incurred expenditure. Itshould be pointed out in this connection that the issuance of transporta-tion tickets is not subject to any restriction. For insurance, the authorityto transfer to nonresidents in unlimited amounts indemnities for claims,annuities, and capital allocated under life insurance contracts has beendelegated to the banks. Authority for all transfers for reinsurance, accep-tance, and retrocession operations has also been delegated.

In matters concerning technical assistance, Moroccan enterprises mayfreely enter into technical assistance contracts with foreign partners andmay transfer remunerations owed for this assistance through the inter-mediary of banks. In this connection, no limits are applied to remunera-tion rates or the total amount paid. The same applies to the transfer ofthe fees for the contracts for foreign films.

For travel operations, business travel expenses for exporters of goodsand services are not subject to any limitation and may be settled withoutprior authorization by debiting convertible dirham accounts or foreignexchange accounts. For nonexporters, annual allowances granted by theForeign Exchange Office can be renewed directly with banks. Theseallowances can be used for travel with no limit per trip, although withinthe limit of DH 2,000 a day.

Banks are authorized to grant economic operators not receivingannual allowances advances in the amount of DH 40,000 for small- andmedium-scale enterprises, and of DH 20,000 for other socioprofessionalcategories. Of course, these amounts are advances rather than limits andmay be increased on presentation of the appropriate supporting docu-mentation. In addition, international credit cards may be issued freely tocover travel expenditure for exporters of goods and services and for allother holders of convertible dirham accounts or foreign exchangeaccounts, such as foreign nationals, individuals or corporations,Moroccan citizens living abroad, and international organizations. The

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issuance of such credit cards is beginning to expand to other economicoperators.

For tourism and religious travel, the allowance, which was onlyDH 100 a year, and subsequently DH 1,000, was increased to DH 5,000a year and can be secured directly from the banking system. An additionalallowance of DH 1,500 is provided for minor children appearing on theapplicant's passport. In addition, travel agencies may freely organizetourist travel abroad on behalf of residents and may pay travel expensesdirectly using their available funds in convertible dirham or foreignexchange accounts. In matters concerning travel for academic purposes,exchange regulations now allow students to transfer tuition paid to for-eign academic institutions freely and without limitation.

To cover subsistence expenses abroad, students receive a departureallowance equivalent to DH 10,000; students not receiving stipends maytransfer DH 6,000 a month and those receiving stipends may transferDH 4,000 a month, plus rent and related costs. For medical care abroad,banks are now authorized to transfer without limits expenses owed to for-eign hospital institutions. In addition, the patient may obtain a departureallowance of DH 20,000 directly from the banking system for each trip.

The establishment of limits for travel operations, primarily allowancesprovided in the form of bank notes, is justified by the requirement tolimit the aspect of such operations to current transactions. In any event,these limits are not fixed in stone; they are regularly re-evaluated andlarger amounts can be obtained with proper justification.

There are no exchange controls on transfers of all types of revenuefrom investments, such as dividends, profits, allocated portions of profit,and interest on loans. These transfers are, therefore, free under the con-vertibility regime applicable to foreign investors and the liberalized exter-nal finance operations. For transfer payments, foreign residents, includingforeign spouses of Moroccan citizens, are authorized in general to trans-fer 50 percent of their savings from income over and above contributionsto retirement or social security funds abroad. Similarly, retirement pen-sions owed by Moroccan funds to nonresidents are freely transferable.

Finally, authority for payments corresponding to other current accountoperations that cannot be classified in one of the above categories has alsobeen delegated. These include payments for advertising; charges for sub-scriptions to foreign publications; translation; correspondence courses;purchases of technical and scientific books, works, and documentation;payments to foreign publishing houses for amounts owed by Moroccanshipping services; registration fees with academic institutions abroad andfor competitive examinations for admission into the professional acade-mies; fees for issuance of diplomas and participation in conferences, sem-

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inars, or internships abroad; payments, contributions, and fees owed toregional or international organizations; membership fees and dues toprofessional associations; fees for participation in regional or interna-tional sporting events; court costs and attorneys' fees; family expensesand alimony; costs for the editing of films, acquisition or rental of filmdocumentaries, and televised programs; fees for foreign registration ofpatents and other trademarks, analysis and expert appraisal, and partici-pation in competitive bidding abroad; and copyrights. All such fees, theremaining list of which is long, can be paid directly through the bankingsystem without limit.

Capital Account Operations

Transfers for capital account operations, which can be carried outdirectly through banks without prior authorization involve the following:

(1) Proceeds from the liquidation or transfer of foreign investmentsin Morocco financed by foreign exchange or using other similarmethods. The possibility of retransferring such funds involves the prin-cipal investment and capital gains, with no limits. Similarly, theinvestments involved have been made by foreign individuals orcorporations, whether or not they are residents, or by Moroccan citizensliving abroad. There is no difference in treatment in this regard.

(2) Amortization of external financing contracted by economicoperators, directly or through the intermediary of the banking system.Such financing no longer requires prior authorization for obtaining thefinancing or for the repayment of principal and interest.

(3) Funds repatriated by foreign enterprises holding contracts inMorocco.

(4) Holdings in dirhams generated by the liquidation of movable orimmovable property belonging to nonresident foreign nationals and notsubject to the re transfer guarantee as provided by the old system. Theseassets, which were restricted in Morocco, may now be transferred on astaggered basis or spent in Morocco. Accordingly, any notion ofrestricted funds has been eliminated.

In addition, foreign tourists and Moroccan citizens living outside ofMorocco may freely import and re-export any foreign means of payment(foreign bank notes, international credit cards, and so on.) Foreign banknotes surrendered by foreign tourists may be bought up to the total sur-rendered, upon presentation of the pertinent supporting documenta-tion, regardless of the length of stay in Morocco.

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With a view to simplifying the system of settlements betweenMorocco and foreign entities, and to maintaining the freely convertiblenature of certain assets, Moroccan banks are also allowed to openforeign exchange accounts or convertible dirham accounts freely in thename of resident or nonresident foreign individuals or corporations.

Finally, the possibility of holding foreign exchange accounts, inaddition to convertible dirham accounts, was extended to Moroccannationals living abroad and to exporters of goods and services. Availablefunds in these accounts plus those in foreign nationals' foreign exchangeaccounts will accordingly constitute a special reserve of foreign exchangeassets not obligatorily transferrable to the central bank, Bank Al Maghrib,and which Moroccan banks may arbitrate among themselves, use togrant loans or advances among themselves, to finance foreign trade oper-ations, to make placements with Bank Al Maghrib or with foreigncorrespondents. They may also use such funds to develop instruments forMoroccan operations to hedge against exchange risks.

This action makes it possible to lay the groundwork for a foreignexchange market in Morocco and to begin decentralizing the holding offoreign exchange accounts, which had been the monopoly of the centralbank. The goal is to acquaint the banking system with internationalforeign exchange procedures with a view to preparing it for theestablishment of the foreign exchange market and enable it to develop,for operators and particularly exporters, the full array of financialinstruments that are available in the major international markets and arebecoming important factors in international competitiveness.

Results of Liberalization of Exchange System

The question arises whether the liberalization measures implementedhave made it possible to reach objectives that were not accessible whilerestrictions were in place, particularly as regards external equilibria andeconomic growth. In this connection, although Morocco's acceptance ofthe obligations under Article VIII is quite recent and the analysis of theresults should await a longer time perspective, the fact remains that thisachievement can be seen as the crowning touch of the process ofliberalization that began in 1983.

The effects of the process can be evaluated by examining Morocco'sexternal sector developments, and particularly those relating to foreigntrade, tourism, transfers from Moroccan nationals living abroad, foreigninvestment, foreign exchange reserves, and external debt, in addition tothe economic growth performance.

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Imports

It was evident that imports would be affected by the liberalizing andopening of the economy. Actually, imports more than doubled fromDH 25.6 billion in 1983 to DH 62.8 billion in 1992; however, theincreased share of capital goods in the total, which reached 26.4 percentin 1993 against 18.9 percent in 1983, is noteworthy. Capital goods have,thus, become the most important group of imported goods. This devel-opment is indicative of the investment effort that both the public and pri-vate sectors have made over the past few years. The second most impor-tant group of products, semifinished goods, accounted for 22 percent in1993, against 19.3 percent in 1983. These two groups of products nowrepresent more than half of Morocco's imports, compared with 38.3 per-cent in 1983. This is a positive development, insofar as such imports areconnected with the investment effort.

Exports

Export promotion measures, the removal of prior approval procedures,and the establishment of facilities for financing export promotion expen-ditures abroad have all had clear positive effects on Moroccan sales abroad,which more than doubled between 1983 and 1992 from DH 15 billion toDH 34 billion. Concurrently, the structure of exports has been improving,with an increasing share of manufactured goods, which reached 64.3 per-cent in 1993 compared with 47.4 percent in 1983, with a commensuratedecline in mining and agricultural products. The manufactured goodsinvolve finished and semifinished goods, with new export products appear-ing over time, such as medicine and automobile spare parts.

Ratio of Exports to Imports

Despite a highly unfavorable external economic environment, aggra-vated domestically in some years by the negative effects of the drought, theratio of exports to imports has oscillated around 60 percent. It had riseto 66.3 percent in 1987, peaked at 76 percent in 1988, and stabilized atapproximately 60 percent between 1989 and 1991.

Tourism Receipts

Between 1983 and 1992, the number of tourists, not includingMoroccans residing abroad, rose from 1,357,000 to 3,367,000, a148 percent increase. During this period, tourism receipts more than

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quadrupled, rising from DH 2.9 billion ($0.4 billion) to DH 11.7 billion($1.5 billion).

In this connection, it is noteworthy that foreign tourists are no longerrequired to declare the foreign exchange on their person when enteringand leaving Morocco, and that the share of foreign bank notes in receiptshas been continuously declining with a commensurate increase in banktransfers.

Receipts from Nationals Living Abroad

The measures taken in favor of Moroccan nationals residing abroad,particularly as regards their right to open convertible dirham accountsand foreign exchange accounts, receive initial departure allowances, andbenefit from convertibility for investments financed in foreign exchange,contributed to nearly tripling the transfer by Moroccan nationals livingabroad during the period 1983-92, from DH 6.5 billion to DH 18.5 bil-lion ($2.2 billion).

Foreign Private Investment

During 1983-87, foreign private investment remained at betweenDH 600,000 and DH 800,000, or approximately $100,000. Since 1988,the measures to liberalize exchange controls, under which prior autho-rizations were eliminated and authority to transfer receipts from foreigninvestments was delegated to banks, had a significant impact on foreigninvestment flows into Morocco, which increased from DH 1.9 billion in1989 to DH 3.3 billion in 1991. They reached DH 4.3 billion (more than$500,000) in 1992. In 1993, foreign investment is projected at approxi-mately DH 6 billion (nearly $700,000), reflecting primarily the participa-tion of foreign private groups in privatization operations.

Current Account Balance

The external current account deficit was cut in half during the periodunder review, from DH 5.41 billion in 1983 to DH 3.75 million in 1992.As a share of GDP, the decline was even more significant, from 6.5 per-cent in 1983 to 1.5 percent in 1992.

Debt Outstanding

Approximately twenty years ago, the overall outstanding external debtamounted to $1.2 billion, representing only 22 percent of GDP at that

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time. In 1983, the year the implementation of the structural adjustmentprograms began, the outstanding debt amounted to approximately$14 billion, equivalent to Morocco's total GDP. After peaking at 123percent of GDP in 1985, the ratio began to decline (despite the growthin outstanding debt). The outstanding external debt, which nowamounts to $21.6 billion, represents currently only 74 percent of GDP.

Foreign Exchange Reserves

From negligible levels in 1983, Morocco's foreign exchange reservesstrengthened continuously during this period to reach DH 35 billion in1993, equivalent to more than seven months of imports of goods, ormore than five months of imports of goods and services. This resultreflects the positive effects of the process of achieving a viable balance ofpayments position. In fact, without direct intervention from the publicauthorities, the changes in different components of the balance of pay-ments were such as to generate an overall balance of payments surplus, asreflected in Morocco's improved foreign exchange reserve position.

The improvement in the structure of the balance of payments is alsonoteworthy, with the current account deficit being financed entirely byforeign private investment flows in 1992. This will certainly be again thecase in 1993.

Economic Growth

The Moroccan economy achieved an average annual growth rate of3.5 percent during the period 1983-92. However, the growth rate,which amounted to 10.4 percent in 1988, 8.9 percent in 1986, and6.3 percent in 1984, would have been even higher had the weather beenmore favorable. Nonetheless, the progress made has contributed to adiversification of production and exports, limiting somewhat the negativeeffects of the droughts that Morocco experienced.

Conclusion

Morocco's future efforts will involve the consolidation of the externalconvertibility of the dirham and the establishment of a foreign exchangemarket. This will entail (1) the liberalization of certain capital operationsfor residents, primarily with regard to investments abroad; these invest-ments are now authorized almost automatically, when they are within theframework of foreign investment in Morocco, particularly with regard to

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the fostering of exports of goods and services and the expansion of theMoroccan financial system abroad; and (2) the move in due coursetoward market determination of the exchange rate for the dirham, withthe establishment of a foreign exchange market.

To conclude, the liberalization process, which has led to the currentconvertibility of the dirham, aims at improving Morocco's chances ofattracting foreign investment, promoting and diversifying production andexports, and achieving and maintaining a viable balance of payments position. The process, on the one hand, should foster the attainment of a sufficiently high growth rate for the Moroccan economy to meet the chalenges of generating employment opportunities and improving thepopulation's standard of living and, on the other hand, should help inconsolidating and strengthening the foundations of the economy suffi-ciently to envisage the establishment of full convertibility.

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Experiences of Morocco, Tunisia,Jordan, and Egypt with CurrencyConvertibility

Arfan Al-Azmeh*

In recent years, the issue of currency convertibility has received increas-ing attention in the economic literature, especially in articles from the

staff of the International Monetary Fund (IMF). This has taken place inspite of the fact that the concept of convertibility and the provisions gov-erning it in the IMF's Articles of Agreement have been widely known formany years. A possible source of the renewed interest in convertibilitymay have been the transformation process now under way in theeconomies of many countries that once were part of the Soviet Union orhad a centrally planned economic system and their increased interactionin international trade and the world economy.

Because one of the main objectives stipulated by Article I of theArticles of Agreement is to assist in establishing a multilateral system ofpayments between members and in eliminating the exchange restrictionsthat impede the growth of international trade, Article VIII calls for spe-cific obligations to be met by member states. The obligations stipulatedin Sections 2, 3, and 4 of Article VIII call for avoiding restrictions on cur-rent payments, unless IMF approval is granted or the country is subject

* Director, Economic Policy Institute, Arab Monetary Fund. The opinions expressed inthis paper are those of the author and do not necessarily reflect those of the managementor staff of the Arab Monetary Fund.

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to the provisional arrangements under Article XIV; for avoiding discrim-inatory currency practices and promoting their elimination; and foradhering to the convertibility of assets owned by external parties, if theyhave emanated from recent current transactions or if there is a need toconvert the assets in order to make current payments.

Article XIV of the Articles of Agreement permits a member state toavail itself of transitional arrangements if the state's conditions prevent itfrom fulfilling the obligations under Sections 2, 3, and 4 of Article VIII,provided that (1) the member maintains and adapts to changing circum-stances the restrictions on payments and transfers for current interna-tional transactions that were in effect when it joined the IMF and (2) themember takes all possible steps to develop commercial and financialarrangements with the other member states so as to facilitate interna-tional payments and to achieve a stable exchange system. Article XIVactually requires each member state to suspend the enforcement of itsexchange restrictions when it feels assured that it can make its externalpayments without the need for these restrictions and without resorting tothe use of IMF resources.

To implement these obligations, many countries have announcedtheir acceptance of the obligations regarding the convertibility of thecurrency for external current account transactions. In the past decade(1983 until the beginning of 1993), the number of countries thataccepted the obli-gations under Article VIII rose from 57 to 80. As IMFmembership rose during the same period from 146 to 178 members, thepercentage of countries that accepted these obligations rose from 39percent to nearly 45 percent. The additional countries that acceptedthese obligations during this period included Indonesia, Korea,Thailand, New Zealand, Spain, Portugal, Iceland, Cyprus, Greece,Turkey, Tunisia, and Morocco. Both Tunisia and Morocco declared theconvertibility of their currencies for current account transactions duringJanuary 1993.

In most of these countries, the announcement of currency convert-ibility for current account transactions was the crowning achievement oftheir adjustment and economic liberalization programs. The duration ofthe programs was a function of the depth and complexity of these coun-tries' economic and external payment problems and the speed with whichthey developed and implemented successful solutions.

At the present time, numerous other countries continue to carry onwith economic and financial programs that seek to restore their domesticand external financial balances. They seek to reach a phase in which theycan declare their acceptance of the obligations under Article VIII on theconvertibility of their currencies for current account transactions. These

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Experiences of Morocco, Tunisia, Jordan, and Egypt

countries include Jordan and Egypt, two Arab countries that have madelong strides toward achieving the convertibility of their currencies.

This paper compares the experiences of four Arab countries—Tunisia,Morocco, Jordan, and Egypt—in their efforts to achieve convertibility.

Benefits of Currency Convertibility for CurrentAccount Transactions

Generally, currency convertibility means the freedom of individuals,companies, and public establishments to buy and sell foreign exchangeand to remit it to the outside world to meet external payments obliga-tions resulting from the movement of goods, services, and capitalbetween countries. The IMF's Articles of Agreement make a distinctionbetween convertibility for current account transactions and convertibilityfor capital account transactions in the balance of payments, mainlybecause the former is strongly linked to the goal of developing interna-tional trade and world prosperity.

Calls for trade liberalization are often coupled with calls for currencyconvertibility because liberalization of trade and liberalization of pay-ments have similar and complementary effects on the creation of a com-petitive climate between countries. These effects promote improved pro-duction efficiency and encourage investment consistent with thecomparative advantages of the countries concerned. This is fosteredthrough competition with the outside world in consumer goods and ser-vices and through increased opportunities for reaching diverse and com-peting sources of imported production inputs.

Convertibility, and the absence of discriminatory treatment in theexchange rates for producers and consumers, enables producers to basedecisions on the relative international prices of semiprocessed and finishedgoods. This competitive environment encourages producers to useresources efficiently. It thus leads to increased production and reducedcosts as producers satisfy consumers' quality and price demands. The pos-itive effect of competition, especially insofar as improving productionquality and matching international standards are concerned, may be real-ized only in the long run. In the initial phases, loss of employment andproduction is a frequent consequence, followed by a process of acclimati-zation, reallocation, and development of the resources required to operatein an increasingly competitive climate. A drop in real wage levels can alsooccur if the competition entails a depreciation of the domestic currency.

The exchange rate level plays a vital role. A depreciation, however, toprotect national production and the competitiveness of locally produced

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goods needs to be approached with caution. This is so because if thedepreciation is too large, it can hurt the national economy's developmentand growth, as the domestic prices of imported production inputs, suchas raw materials, semiprocessed goods, services, and perhaps even capital,could be affected (Green and Isard, 1991). Many governments have,therefore, chosen a policy of gradualism in liberalizing the exchange andthe trade systems, while fostering a competitive climate through adjust-ments in the exchange rate, thus sparing their economies the shocksresulting from sudden changes.

Preconditions for Currency Convertibility forCurrent Account Transactions

The idea of the gradual move to establish a given currency's convert-ibility for the purpose of current account transactions, in accordance withthe requirements of Article VIII, raises questions about the considera-tions that govern the timing of the establishment of such convertibility.In other words, what are the conditions that must be met before a deci-sion is made to declare a currency convertible in accordance with theobligations required under Article VIII? The literature on the subjectsuggests that the following specific conditions should be satisfied for theestablishment of the convertibility of a country's currency for currentaccount transactions: (1) appropriate macroeconomic policies to achieveinternal balance; (2) an appropriate exchange rate to preserve externalbalance; (3) the availability of an adequate level of external liquidity; and(4) an incentives system involving flexibility in domestic prices (Gilman,1990, and Mathieson and Rojas-Suarez, 1993). If one of these conditionsis not satisfied, the probability that convertibility will not be sustained isincreased. In such a case, there could be a loss of credibility, with nega-tive consequences rather than the expected positive results.

Appropriate Macroeconomic Policies

The first condition, appropriate macroeconomic policies, calls for theestablishment of internal financial stability through appropriate fiscal andmonetary policies that reduce inflation, absorb excess liquidity, narrowthe budget deficit, introduce noninflationary means to finance the bud-get deficit (if any), and streamline spending and taxes in ways that limitdistortions and enhance productivity. The reform of public enterprises ortheir privatization would also help to reduce their reliance on the budgetand to enhance their efficiency and productivity. Macroeconomic policies

132



should seek to establish a balance between aggregate demand and thecountry's production capabilities so as to safeguard the stability of thereal exchange rate.

An Appropriate Exchange Rate

The second condition is establishing an appropriate exchange rate tomaintain a viable balance of payments position. In this regard, it is impor-tant that the real exchange rate safeguard the production sector's com-petitiveness vis-a-vis the outside world. This would require the introduc-tion of flexibility in exchange rate determination. The real value of theexchange rate must not be so low that it increases the cost of importedproduction inputs unjustifiably and distorts the distribution of resourcesin favor of focusing investment on export industries to the exclusion ofother industries (Green and Isard, 1991).

An Adequate Level of External Liquidity

The third condition is achieving of an adequate level of external liq-uidity, defined as the international reserves at the disposal of the mone-tary authorities, as well as any other external financing available to themto meet any sudden or anticipated shortages in foreign exchange andmaintain a stable exchange rate in the short run. The adequate level ofinternational liquidity varies from country to country, depending on themagnitude of potential sudden disturbances and on the degree of flexi-bility permitted in the exchange rate. This is because there is an inverserelationship between exchange rate flexibility and the needed volume ofreserves. Generally, reserves that are enough to cover imports for a peri-od of three to five months are considered adequate.

Incentives System

The fourth condition is liberalizing domestic prices to ensure appro-priate incentives for producers. The fulfillment of this condition createsthe climate necessary for moving factors of production between varioussectors and for adapting and increasing production according to marketdemands. This requires the elimination of distortions in the use ofresources so that prices will reflect not only production costs but also therelative scarcity and marginal returns of the factors of production.Domestic price liberalization should also be accompanied by the lifting ofrestrictions that shackle competition between producers and restrain freemovement of the factors of production. This would help ensure that both

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consumers and producers respond to price incentives and that productionadapts to the demands of the market.

Economic Adjustment and Currency Convertibilityfor Current Account Transactions

The economies of Morocco, Tunisia, Jordan, and Egypt experienceddifficulties in their balances of payments in the 1980s and were thus com-pelled to apply (or to continue applying) some form of exchange controlthat varied in degree according to each country's circumstances. Theyadopted adjustment programs and took numerous domestic and externalsteps to restore balance to their economies. They also took steps to elim-inate certain restrictions previously imposed on domestic prices, externaltrade, and foreign exchange transactions. By the beginning of 1993, thesesteps enabled Morocco and Tunisia to declare their currencies convertiblefor current account transactions. They also led to the nearly completepractical application of convertibility in Jordan and Egypt, thus making itpossible to consider their currencies de facto convertible for external cur-rent account purposes; there are, however, still some legal and economicobstacles that hinder the official announcement of convertibility.

Morocco

In Morocco, expansionary financial policies—often involving externalborrowing—were pursued as of the mid-1970s. But the rise in oil pricesfor a second time, and the rise in interest on external loans in the early1980s, together with the recurrent droughts experienced by Morocco,contributed to the emergence of a severe balance of payments crisis in1983. The crisis drained the official foreign exchange reserves, and itbecame impossible to service the heavy foreign debt that Morocco hadincurred. Consequently, the authorities restricted imports severely, tight-ened restrictions on external payments, and reduced government expen-ditures—especially capital expenditures—in order to limit the large bud-get deficit.

These steps reflected negatively on the performance of the productionsectors, and it became necessary to launch between 1983 and 1992 aseries of stabilization programs with the support of international financialinstitutions, Arab national and regional funds, and a number of friendlycountries. These programs sought to (1) achieve fiscal stability by con-trolling the budget deficit; (2) contain inflationary pressures throughstrict fiscal and monetary policies; (3) develop and reform the tax system

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by establishing a modern one consisting of a value-added tax, a corporateprofit tax, and a unified personal income tax; (4) reform or privatize pub-lic sector enterprises; (5) gradually phase out price subsidies; and (6) raisepublic utility prices so that prices would better reflect the costs.

These policies gradually reduced Morocco's budget deficit from7.7 percent of GDP in 1983 to 3.1 percent of GDP in 1991 and 2.1 per-cent of GDP in 1992. Morocco also achieved one of the lowest inflationrates in the developing countries during this period. Its inflation rate, asmeasured by the change in the consumer price index, dropped from12.3 percent in 1984 to 4.9 percent in 1992. Real GDP growth wasmoderate, amounting to an average annual rate of 3.8 percent between1983 and 1992, even though Morocco experienced extensive fluctua-tions from time to time—especially in 1987 and 1988, and again in1992—often caused by the effects of severe weather on agricultural pro-duction (Chart 1).

The policies pursued were thus successful in achieving domestic finan-cial stability—satisfying a condition for declaring the convertibility ofMorocco's dirham for external commercial transactions. But the fiscal sit-uation continues to be fragile. Constant caution is required to preservefinancial balances in the face of various threatening factors and pressureson the budget.

The programs implemented have also involved structural reforms,including liberalization measures, aimed at improving the balance of pay-ments structure and fostering external balance. These reforms wereintended to strengthen the private sector's role, to increase its competi-tive ability by opening up to external markets, and (whenever possible) tolet market mechanisms replace administrative controls on prices. Withinthis context, the structural programs involved the gradual liberalizationof external trade, by reducing the high tariff protection (which amount-ed to a maximum of 400 percent in 1982) to a reasonable level thatallowed for effective external competition (a maximum of 35 percent in1993), eliminating quantitative restrictions, abolishing the requirementof advance permits for 90 percent of all imports, liberalizing exports andexempting them from restrictions and fees, and following a flexibleexchange rate policy. This supplemented other domestic reforms relatedto incentives, prices, taxes, and so on.

Exchange rate flexibility played a significant role in maintaining orimproving the competitiveness of Moroccan exports. The Bank ofMorocco sets the dirham's exchange rate against the French franc daily,depending on the developments in the value of a currency basket ofMorocco's main trading partners. Their weights are based on develop-ments in the geographical distribution of Morocco's external trade and in

135


136


Chart 1. Morocco: Selected Economic Indicators

Sources: IMF, International Financial Statistics; and IBRD, World Debt Tables.

1984 1985 1986 1987 1988 1989 1990 1991 1992

12

6

0

12

8

4

0

-4

-2

-4

-6

-81983 1984 1985 1986 1987 1988 1989 1990 1991 1992

1984 1985 1986 1987 1988 1989 1990 1991 1992

Inflation

Real GDP Growth

Ratio of Budget Deficit to GDP


137


the percentage of the currencies used to settle external payments. Theexchange rate against other currencies is determined on the basis of theirexchange rate against the French franc in the Paris exchange market. Theexchange rate was adjusted several times in the mid-1980s and was lastadjusted downward by 9.25 percent in May 1990.

Chart 2 shows that the Moroccan dirham's real effective exchange ratehad a downward trend throughout the 1980s. This reflected the fact thatMorocco's inflation rate was lower than in the other countries whose cur-rencies were included in the basket. As such, the competitiveness ofMoroccan exports was maintained. The slight tendency toward higherinflation in Morocco in the past three years may not be in the interest ofits competitiveness, but the developments in the exchange rate generallythroughout the period undoubtedly assisted in achieving an improve-ment in the external condition. The future stability of the real exchangerate is essential to prevent a deterioration of the situation.

The establishment of the proper climate for the success of the reformsundertaken was facilitated by the reduced pressure on the balance of pay-ments through the rescheduling of external debt and a number ofarrangements from the IMF. These arrangements culminated in theannouncement of the dirham's convertibility for current account transac-tions in 1993.

Chart 2. Morocco: Real and Nominal Effective Exchange Rates(1980 = 100)


120

100

80

601980 1984 1988 1992

Nominal effective exchange rate

Real effective exchange ra



The improved external situation is clearly reflected in the reductionachieved in the external current account deficit. This deficit was reducedfrom 7.7 percent of GDP in 1984 to 1.6 percent of GDP in 1992 and toan annual average of 1 percent of GDP in the past three years. Theimprovement is also reflected in the reduction of external debt, from128.4 percent of GDP in 1985 to 76.1 percent of GDP in 1992, and thereduction in external debt service as a ratio of exports of goods and ser-vices from 38.9 percent in 1982 to an average of 25.7 percent in the pastthree years (Chart 3). With the improvement in conditions of the balanceof payments and the signs of success of the corrective measures and poli-cies implemented, including exchange rate policy, it can be consideredthat Morocco has achieved the second condition for establishing curren-cy convertibility.

The authorities began to reduce restrictions on external payments aspart of the process of the gradual liberalization of trade transactions andinvisible current payments—a process that was completed in 1992. Theliberalization has also included the restrictions on capital transactions fornonresidents. Residents have been permitted to borrow from abroad andto repay their loans without advance authorization; however, invisiblecurrent remittances by residents have been kept subject to preset ceilings,depending on the objectives, but at limits that are considered adequateand reasonable. These limits prevent the fraudulent and illegal expatria-tion of capital.

The reduced current account deficit and the improved position of thecapital account, as well as the rescheduling of external debt, have enabledthe monetary authorities to build up the international reserves over thepast three years from less than $0.5 billion in 1989 to more than $3.5 bil-lion by the end of 1992. This is equivalent to more than six months of1992 imports, a level that is considered appropriate and adequate to meetany likely external shocks, thereby safeguarding the dirham's convertibil-ity for current account transactions and the regular servicing of externaldebt. Hence, the third condition for establishing convertibility in accor-dance with Article VIII can be considered to have also been met.

Finally, in addition to the measures taken to liberalize external trade soas to increase external competition and to enhance the productivity ofnational industries, other areas of the domestic economy have also beenliberalized in the context of the adjustment programs adopted byMorocco. As a result, market mechanisms have replaced administrativecontrols. Both domestic trade and the agricultural sector have been lib-eralized, and remaining producer prices increased. The government hasfollowed a process of gradually abolishing subsidies for basic goods andfor agricultural inputs and has increased the prices of services provided by

138


139


Chart 3. Morocco: Selected Economic Indicators


1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

3

0

-4

-8

140

120

100

80

60

40

35

30

25

20

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

Ratio of Current Account to GDP

Ratio of Total External Debt to GDP

Ratio of Debt Service to Exports of Goods and Services



public utilities and those of other goods and services subject to monop-olies to better reflect the costs. Interest rates have also been partially lib-eralized within the framework of financial sector reforms. Thus, it can beconcluded that the domestic price liberalization process and the improve-ment in the incentive system have increased the flexibility of theMoroccan economy, enhanced its capability to adapt to exogenous devel-opment, and fostered a more efficient use of scarce resources. As such,the fourth condition of convertibility can be considered to have beenmet.

Tunisia

After the 1970s, which were characterized by relatively rapid growthand domestic and external financial balance, Tunisia experienced an eco-nomic decline in the mid-1980s. The reasons for this decline included(1) the drop in oil production, prices, and revenues; (2) a major deterio-ration in Tunisia's terms of trade; (3) reduced savings, reflectingincreased government and private consumption; (4) a recession intourism; and (5) bad weather that affected agricultural production andexports. The government's fiscal deficit increased to 8.3 percent of GDPin 1983 and the current account deficit to 9.6 percent of GDP in 1984.Inflation picked up to reach 8.4 percent in 1983.

The gap in external resources led to increased foreign debt, amount-ing to 70 percent of GDP in 1987 and to a decrease in internationalreserves, which amounted to the equivalent of one month of imports bythe end of 1985. The increased external debt and the drop in exports ledto a rise in the debt-service ratio from 19.2 percent in 1983 to 28.7 per-cent in 1987. To stem this deterioration, the Tunisian authorities stiff-ened the controls on imports, prices, and investment. This led to furtherdistortions in relative prices, a misallocation of resources, and a furthererosion of Tunisian export competitiveness.

Supported by international and regional financial institutions, theTunisian authorities implemented stabilization policies from 1986 to1992 that sought to restore domestic and external financial stability andfundamental structural reforms to improve competitiveness and fosterexports.

These programs included a tight aggregate demand management pol-icy involving the reduction of the budget deficit as a ratio of GDP, theadoption of tax reforms, the liberalization of interest rates, the contain-ment of domestic credit expansion, and the reforming of the financial sys-tem to create a modern financial market. The policies implemented alsoincluded the liberalization of a large percentage of domestic prices, the

140



reduction of subsidies for consumer goods, the privatization of a numberof public sector enterprises, and the deregulation of investment.

The strict demand-management measures and the structural reformscontributed to restoring domestic financial stability. The government bud-get deficit declined from 8.3 percent of GDP in 1983 to 7.3 percent ofGDP in 1986 and 2.5 percent of GDP in 1992. These reforms also helpedreduce the inflation rate as measured by the consumer price index from8.4 percent in 1983 to 5.4 percent in 1992. This rate was the lowest infla-tion rate witnessed by Tunisia during the decade and was significantlylower than the average annual inflation rate for the whole decade (7.1 per-cent). The reforms also contributed to an increase in the real averageannual GDP growth rate from 1 percent in 1986 to 8.6 percent in 1992.During the period, the average annual real growth rate amounted to about5.0 percent (Chart 4). Based on these indicators and on the flexibilityintroduced into the management of the Tunisian economy, it can be saidthat Tunisia has been able to regain a satisfactory degree of domestic finan-cial stability consistent with a noninflationary economic growth rate.

Because of the importance of enhancing the Tunisian industries' com-petitiveness and production efficiency, and because merchandise exportsand service receipts account for 40 percent of GDP, Tunisia worked toachieve a gradual liberalization of its external trade and payments system.Imports free of quantitative restrictions now amount to nearly 87 percentof total imports. High customs tariff rates, which were as high as 236 per-cent at their peak in 1986, were reduced three years later to a 10-45 per-cent range, averaging about 26 percent.

The exchange rate of the Tunisian dinar is set by the central bank dailyon the basis of a basket of currencies, using weights that reflect the impor-tance of these currencies in Tunisia's external trade. The central bank alsosets forward exchange rates. The exchange rate was devalued in 1986 toenhance the competitiveness of Tunisian exports. Subsequently, the realeffective exchange rate remained almost stable, with a tendency toward aslight depreciation, thus safeguarding the stability of the competitivenessof Tunisian exports. The real effective exchange rate, however, rose slight-ly in 1992 but was adjusted in the first half of 1993 (Chart 5).

The reform policies led to an increase in both the percentage ofexports to GDP since 1986, with a noticeable improvement in the cur-rent account deficit between 1986 and 1991. However, the deficitincreased in 1992 to 6.2 percent of GDP, reflecting the appreciation inthe real and nominal effective exchange rates and other exogenous factorsaffecting the demand for certain exports. The external debt droppedfrom 70 percent of GDP in 1987 to 54.7 percent in 1992. The externaldebt service as a percent of the exports of goods and services also

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Chart 4. Tunisia: Selected Economic Indicators

10

8

6

41984 1985 1986 1987 1988 1989 1990 1991 1992

0

-2

-2

-4

-6

-8

1984 1985 1986 1987 1988 1989 1990 1991 1992

-101984 1985 1986 1987 1988 1989 1990 1991 1992


142

8

6

4

2

Inflation

Real GDP Growth




Chart 5. Tunisia: Real and Nominal Effective Exchange Rates(1980=100)

120

100

80

60

40 1980 1984


1988 1992

dropped from 28.7 percent in 1987 to 23.1 percent in 1992 (Chart 6).However, the increase in international reserves achieved in 1987 and1988, the equivalent of three months of imports, was subsequentlyreversed, with reserves dropping to the equivalent of 1.7 months ofimports in 1992. Despite the improvement in the external position andthe lack of further recourse to use of Fund resources, there continues tobe a need to bolster exports through continued structural adjustment.

Generally, however, the policies pursued have contributed to theachievement of domestic and external financial balances that enabled theTunisian authorities to undertake the obligations under Article VIII ofthe IMF's Articles of Agreement on currency convertibility for currentaccount purposes.

Jordan

Jordan's small economy relies heavily for its prosperity and growth oneconomic conditions in the Arab region. The country's geographic posi-tion and its limited resources play a major part in its fate. As regards pro-duction, the service sector has accounted in recent years for nearly twothirds of GDP. The balance is accounted for by the small and varied agri-cultural, industrial, and mining sectors. Jordan's external resources relylargely on Arab countries, as evidenced by the importance of remittances

143

Real effective exchange rate

Nominal effective exchange r



Chart 6. Tunisia: Selected Economic Indicators

4

0

-4

-8

-10

80

70

60

50

30

25

20

151983 1984 1985 1986 1987 1988 1989 1990 1991 1992

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992


144

Ratio of Debt Service to Exports of Goods and Serviceshjhjkj





of Jordanian expatriates in neighboring countries and the official grantsfrom Arab countries to support the budget and the balance of payments.Receipts from Jordanian agricultural and industrial exports to neighbor-ing countries and from services exported to these countries (e.g., trans-port, transit, and tourism services) constitute a large share of the totalexternal receipts.

In the 1970s and through the mid-1980s, Jordan's economy achievedrapid growth, greatly influenced by the economic prosperity of theregion. The climate of economic prosperity in the neighboring Arabcountries, particularly the oil producing countries, led to increaseddemand for Jordan's exports and for skilled labor. This was reflected inthe accelerating pace of private investment at home and in the flow of pri-vate remittances. Moreover, official Arab grants bolstered Jordan's bud-get and strengthened its balance of payments. The fiscal grants also facil-itated increased capital outlays in the social sectors and infrastructuralprojects, while contributing to the increase in the central bank's interna-tional reserves.

The economic recession that has spread throughout the region sincethe sharp drop in oil prices in the mid-1980s has, however, reversed thedirection of all of the factors responsible for this period of prosperity inJordan. This has led to a fall in private remittances from expatriateJordanians, a weakening in demand for Jordan's exports, and a decline inofficial grants from the oil producing countries. As a result, Jordan's eco-nomic activity has slowed down and the unemployment rate has grown.The structural weakness in the budget and in the balance of payments,both of which rely on external resources, has come to the surface.

Initially, the authorities tried to deal with the situation by continuingto pursue expansionary fiscal policy, subsidizing the agricultural andindustrial sectors, and resorting to foreign borrowing on commercialterms, thereby increasing the country's foreign indebtedness. As of 1987,the government resorted to increased borrowing from domestic banks;this led to a sharp increase in domestic liquidity, to mounting inflationarypressures, and to pressures on the Jordanian dinar's exchange rate. Thesurplus in the balance of payments in 1985 and 1986, resulting from for-eign borrowing, turned rapidly into a deficit in 1987 and 1988, as for-eign debt rose. The deficit was financed by a major drawdown of officialexternal reserves. In 1988, these developments were reflected in a nega-tive real GDP growth, a further increase in inflationary pressures and inunemployment, an increase in the budget deficit, the virtual exhaustionof international reserves, and extreme pressure on the exchange rate.

In light of the seriousness and unsustainability of the situation, theJordanian authorities adopted in 1989 a series of measures and policies to

145



restore domestic and external financial stability within the framework ofa medium-term adjustment program supported by international andregional financial institutions. Jordan was able to stem the deteriorationin the situation rapidly, following the rescheduling of some of its com-mercial and official bilateral debts and receiving support in the form ofofficial grants and bilateral loans.

The negative impact of the region's 1990-91 crisis on the Jordanianeconomy, however, posed temporary problems for the adjustment andreform program and prompted a re-examination of the program andtimetable. As a result, a new program covering the period 1992-98 wasadopted. The program aims at raising the real growth rate to more than4 percent annually, reducing the inflation rate to less than 5 percent, nar-rowing the budget deficit (excluding external grants) to 5 percent ofGDP, and eliminating the external current account deficit and the needfor exceptional financing.

To accomplish these goals, the budget deficit needs to be addressed andexternal balance restored promptly. Efforts must be made to(1) increase tax revenue; (2) streamline, reduce, and restructure budgetexpenditure; (3) focus attention on promoting savings and productiveinvestment; (4) continue the sectoral structural reforms that seek toenhance and develop the production sectors; (5) enhance the efficiency ofpublic enterprises; (6) improve competitiveness and increase exports; (7)streamline imports and develop adequate alternatives to some imports;and (8) reduce the burden of foreign debt on the budget and the balanceof payments. This will require the encouragement of the private sector, theenhancement of the role of the market mechanism in determining prices(including interest rates), and the maintenance of flexibility in theexchange rate to preserve the competitiveness of Jordanian exports.

Even though foreign exchange transactions have historically been sub-ject to fewer restrictions than in many other countries, the Jordanianauthorities have abolished most of the restrictions on current transac-tions. Only three elements remain: (1) some unrepaid external paymentsarrears; (2) two bilateral trade and payments agreements with IMF mem-ber states; and (3) ceilings on some invisible payments, even though theseceilings have been loosened and have become reasonable, thus constitut-ing no obstacle to the free conversion of the currency in practice. Jordanplans to accept the obligations under Article VIII as soon as possible.

Jordan's investment and reform program has received the support andbacking of international financial institutions and has benefited from debtrescheduling. Along with the measures taken, the rescheduling hashelped to ease the immediate pressure on Jordan's budget and balance of

146



payments and to restore the confidence necessary to resume reforms andfoster growth.

Significant progress has been made in establishing the conditionsrequired to establish currency convertibility for current account transac-tions, especially in the area of domestic financial stability. The measurestaken to increase tax revenue and reduce expenditure, and the reschedul-ing of some of Jordan's debts, have contributed to an improved fiscalposition. The fiscal position also benefited from the impact of a goodgrowth performance (particularly in 1992) on revenue. The total budgetdeficit, including foreign grants, dropped from 9.3 percent of GDP in1987 to 2.4 percent of GDP in 1991 and turned into a surplus of 7.3 per-cent of GDP in 1992. Excluding foreign grants, the total fiscal deficit nar-rowed from 21 percent of GDP in 1989 to 17.8 percent of GDP in 1991and to nearly 4 percent of GDP in 1992.

The improved fiscal position contributed to a lower growth in bankcredit and domestic liquidity, and to a drop in the inflation rate from 25.8percent in 1989 to 4 percent in 1992. Real GDP, which had declined by10.6 percent in 1989, recorded a growth of 4.8 percent in 1992. Duringthe period from 1983 to 1992, real GDP growth had been relatively low(an annual 1.8 percent increase on average) and characterized by sharpfluctuations (Chart 7).

The fiscal position still needs to be reinforced, the improvement hasdepended on exceptional factors and measures. There is no doubt thatthe implementation of the medium-term structural adjustment programwill affect the structure of both revenue and expenditure and will demon-strate the extent of the government's ability to reduce its reliance onexternal grants. It will then be easy to judge the sustainability of theimprovement in the government's fiscal position.

The liberalization of domestic prices and incentives, as a main condi-tion for convertibility, does not seem to have received much attention inthe case of Jordan. This is because Jordan's economy is fundamentally afree economy in which the market mechanism is the main determinant ofprices. However, the government's program envisages that public utilityprices be revised and the subsidy element reduced.

Since 1989, the Jordanian dinar's exchange rate has been set daily bythe central bank based on a basket of currencies. The bank uses criteriathat reflect the importance of each of these currencies in Jordan's foreigntransactions. Previously, the dinar was tied to the SDR. The dinar has fall-en in value since the mid-1980s. A parallel exchange rate for the dinaremerged for a short time when the central bank refrained from supplyingthe market with foreign exchange during a period of extraordinary, polit-ically motivated pressures, but rates were unified again at the beginning

147



Chart 7. Jordan: Selected Economic Indicators(In percent)


148

30

20

10

0

-5

12

6

0

-6

-12

8

4

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-8

-10

1984 1985 1986 1987 1988 1989 1990 1991 1992

1984 1985 1986 1987 1988 1989 1990 1991 1992

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

Inflation

Real GDP Growth




of 1989. The exchange rate has been flexible, as evidenced by the move-ments in the nominal and real effective exchange rates since 1989(Chart 8). These movements have reflected the corrections in theexchange rate that have occurred since 1989 to safeguard the competi-tiveness of the economy.

The balance of payments continues to be unstable, even though thedeficit narrowed in 1989 and 1990. If foreign grants and the specialremittances of expatriate Jordanian workers are excluded, the deficit hasdropped from 19 percent of GDP to nearly 15 percent of GDP in 1992.This is still a high percentage and cannot be considered acceptable. Itmust be reduced by improving the structure of the current account of thebalance of payments. Such an improvement will depend on the imple-mentation of Jordan's structural adjustment program. Moreover,Jordan's foreign debt in 1990 remained high, amounting to more thantwice the GDP; however, this debt has been dropping since then. Theratio of foreign debt service to exports of goods and services has declinedfrom 31.3 percent in 1988 to 14.7 percent in 1992, reflecting therescheduling agreements (Chart 9).

External reserves dropped continuously from the equivalent of3.7 months of imports in 1983 to only 0.5 month in 1988. In responseto the adopted steps and measures, these reserves rebounded to2.8 months of imports in 1992. Taking into consideration the severeshocks to which Jordan may be subjected, a further increase in reserveswill bolster confidence in Jordan's ability to meet its external paymentsand defend the exchange rate.

Egypt

Egypt's economy achieved high growth rates in the late 1970s andearly 1980s. This growth was greatly helped by increased revenue fromoil exports and from increased foreign exchange receipts from the remit-tances of expatriate Egyptians, the proceeds of the reopened Suez Canal,and foreign aid. The achievement of these growth rates was also sup-ported by a considerable increase in commercial foreign debt. The inter-national economic stagnation and the drop in oil prices in the mid-1980s,however, played a major role in ending Egypt's economic prosperity atthat time. By 1985, economic growth had slowed, while aggregatedemand had increased. In 1986, the budget deficit rose to nearly 20 per-cent of GDP, the inflation rate climbed to nearly 24 percent, the currentaccount deficit (excluding official remittances) reached nearly 20 percentof GDP, and the overall balance of payments position deterioratedbecause of increased foreign debt-servicing obligations. The increasing

149



Chart 8. Jordan: Real and Nominal Effective Exchange Rates(1980=100)

1980 1984 1988 1992


chronic foreign exchange shortage led to reduced imports (includingindustrial inputs) and to the accumulation of external payments arrears.

In light of these developments, the structural flaws in the Egyptianeconomy became apparent. They were characterized by (1) the publicsector's domination of economic activity; (2) widespread administrativecontrols; and (3) restrictions on prices, trade, exchange, and investment.These restrictions, lasting for many years and affecting the public and pri-vate sectors, interfered with the determination of relative prices and theefficient distribution of economic resources, even though some of therestrictions were justified by the achievement of noble social goals.

The structural flaws in the Egyptian economy were manifested in anumber of ways, including price and cost distortions, resulting from strictprice controls; negative real interest rates; multiple exchange rates; weak-nesses in the budget structure, reflected clearly in a narrow and relative-ly inelastic tax base and in an excessive reliance on customs revenue;weaknesses in the balance of payments, emanating from the narrow non-oil export base and from the heavy reliance on workers' remittances; anincreased foreign debt-servicing burden; and the extremely complexexchange and trade laws.

As of 1987, the government implemented a number of measures andpolicies that sought to stem the deterioration in the situation and torestore domestic and external financial stability. The government alsosought to address the structural problems confronting the economy. To

150

150

120

90

60


Real effective exchange rate



Chart 9. Jordan: Selected Economic Indicators(In percent)


151

10

0

-10

-20

220

180

140

100

60

30

20

10

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992



Ratio of Debt Service to Exports o



this end, it adopted a phased comprehensive economic reform program.One of this program's broad objectives was the development of a decen-tralized economic system that is open to the outside world and relies onmarket mechanisms to set prices, rather than on administrative decrees.This would enable the private sector, encouraged by a stable competitiveclimate, to play a major role in economic activity alongside the reducedand reorganized public sector.

Egypt's reform program has received the support of international insti-tutions and the world community. Egypt has benefited from debt reduc-tion, forgiveness, and rescheduling. Efforts to achieve further debtrestructuring are under way.

In addition to the stabilization policies that have been embraced since1987 and that have sought to reduce the budget deficit throughincreased revenue and reduced expenditure, the reform program alsocovers the exchange system. The program's goals are to (1) unify theexchange rate system; (2) liberalize current external transactions;(3) decontrol domestic prices in a gradual and comprehensive manner;(4) increase fuel, electricity, and transportation prices; (5) eliminate sub-sidization of final goods and production inputs; (6) raise the prices ofmajor agricultural commodities; and (7) reform public sector enterprisesand privatize a large part of the public sector. The program further pro-vides for (1) gradually liberalizing imports and abolishing restrictions onexports; (2) restructuring and gradually reducing customs tariffs; (3) lib-eralizing bank interest rates, as well as reforming the banking system,bank supervision, and the financial system in general; (4) freeing themovement of labor between sectors; and (5) establishing a social fund tocover the social costs of the adjustment process.

Long strides have been made in implementing this program. Mostexchange restrictions have been abolished, and the remaining restrictions

are of no practical significance. The Egyptian currency has become virtu-ally convertible, even if it is not yet legally convertible because of somearrears in external obligations, a bilateral payments agreement withSudan, and old payments agreements that have been suspended but notyet liquidated.

To what extent has the Egyptian economy met the four conditions forintroducing current account convertibility? Regarding domestic financialbalance, a review of the indicators shows that a reduction has beenachieved in the budget deficit as a percentage of GDP, including foreigngrants. The deficit dropped from 10.9 percent of GDP in 1986 to6.7 percent of GDP in 1992. Moreover, the inflation rate, as measuredby the consumer price index, which was at 23.9 percent in 1986, droppedto 13.6 percent in 1992. In 1986, the real GDP growth rates were at

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about 5.5 percent, but dropped in the past two years, amounting to4.4 percent in 1992 (Chart 10).

These developments, however, especially the inflation rate and thebudget deficit, suggest that domestic financial stability has not yet beenachieved and that further steps are needed to improve the government'sfinancial position within the framework of the adjustment program.

Regarding domestic price liberalization and the introduction of incen-tives to make the production process dynamic, noticeable progress hasbeen made. More needs to be done, however, to reform public enter-prises or privatize them, liberalize prices, and reduce subsidies to ensurethe necessary flexibility in the distribution of resources and the continuedcompetitiveness of Egyptian exports.

Regarding the exchange rate, Egypt has followed a long and difficultpath to rid itself of a complex multiple exchange rate system and to estab-lish a free exchange market (Central Bank of Egypt, 1992). The first stepin this direction was taken in 1976, when the law permitted the free pur-chase and sale of foreign exchange through accredited banks. It also per-mitted imports to be financed from the importer's private foreignexchange resources. This was followed by the establishment in 1987 of afree foreign currency exchange market. This step sought to establish anexchange rate based on market mechanisms. The free bank exchange ratewas set daily by a committee from the banking system. In 1991, a primarymarket was established alongside the free banking market to handlegovernment and public sector transactions. Hence, the primary marketrate was determined by a committee similar to the free market commit-tee. The committee worked to prevent the difference between the tworates from exceeding 5 percent and to take into account the prevailinginflation rate. In October, the two markets were merged into a single freemarket, in which the rate was set on the basis of the interaction of supplyand demand. Banks thus became free to determine and post the exchangerate at which they dealt. The widening gap between the real effectiveexchange rate and the nominal effective exchange rate from 1985 to1989 reflects the rising inflation rate and the declining competitiveness ofEgyptian products in world markets (Chart 11). However, after thedevaluations introduced in 1989 and 1991 and after the establishment ofthe unified exchange market, the real and nominal effective exchangerates tended to become stable, and more likely to safeguard Egypt's com-petitiveness.

In addition to this significant development in the exchange rate sys-tem, the external sector position improved considerably, as indicated bythe decrease in the current account deficit. Expressed as a percentage ofGDP, the external current account moved gradually from a deficit of

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Chart 10. Egypt: Selected Economic Indicators(In percent)


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25

20

15

10

12

6

0

-4

-6

-8

-10

-121983 1984 1985 1986 1987 1988 1989 1990 1991 1992

1984 1985 1986 1987 1988 1989 1990 1991 1992

1984 1985 1986 1987 1988 1989 1990 1991 1992


Real GDP Growth

Inflation



Chart 11. Egypt: Real and Nominal Effective Exchange Rates(1980 = 100)

200

150

100

50

01980 1985


1990 1995

7.6 percent of GDP in 1985 to a surplus in 1989-91 that reached8.7 percent of GDP in 1992. Imports as a percentage of GDP also fell.As a result of the debt restructuring since 1991, the foreign debt droppedfrom 189.4 percent of GDP in 1988 to 99.5 percent in 1992. The ratioof foreign debt service to exports of goods and services declined by onethird between 1986 and 1992, reaching 20.4 percent. Thus, domesticreforms, a reduced foreign debt burden, the reform of exchange and pay-ments system, and the open door policy have all contributed to the im-provement in the external sector position (Chart 12).

The movements in international reserves reflect the improvement inthe external sector position. In the past few years, these reserves havebeen increasing steadily, growing from the equivalent of one month ofimports in 1983-85 to the equivalent of 14.5 months in 1992. Thisachievement can be viewed as one of the main factors that allowed for areduction in exchange restrictions. Against this background, it can beconcluded that the second and third conditions for convertibility (thosepertaining to the exchange rate and the reserves) have also been met.

Comparison of the Four Countries' Experiences

Several difficulties are inherent in the comparison of different coun-tries' experiences in achieving currency convertibility. In the case of the

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Real effective exchange ratekjk




Chart 12. Egypt: Selected Economic Indicators(In percent)


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8

4

0

-4

-8

200

150

100

50

35

30

25

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15

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992



Ratio of Debt Services to Exports of Goods and Services



four countries discussed above, as already noted, Morocco and Tunisiahave already declared recently their acceptance of the obligations underArticle VIII of the IMF's Articles of Agreement on convertibility for cur-rent account transactions, while Jordan and Egypt have attained whatcould be considered de facto convertibility. A comparison based solely onthese recent developments entails the difficulty, however, of isolating anddefining the results that stem from convertibility, not only because oftheir similarity to those that arise from trade liberalization but alsobecause the overall performance of the economy examined reflects alsothe effects of other liberalization measures, reforms, and policies.

It may be possible, however, to make a comparison based on the tim-ing of the liberalization of the exchange system (or the declaration ofconvertibility) and the implementation of other aspects of the adjustmentprograms implemented by the four countries. This comparison demon-strates the following similarities and differences.

First, each of these countries embarked on the liberalization of exchangerestrictions—to reach the stage of establishing currency convertibility forcurrent account transactions legally or de facto—within the context ofcomprehensive reform programs. These programs have not merely provid-ed for restoring domestic and external financial stability and achieving flexibility in the exchange rate but have also encompassed structural reformsaimed at enhancing the growth rate, curtailing inflation, increasing invest-ment, and improving the production and export structure, the governmentbudget, and the balance of payments—to achieve and maintain domesticand external stability over the medium and long term.

Second, with respect to the four conditions for convertibility, each ofthe four countries has made tangible progress toward restoring domesticand external stability, attaining an appropriate exchange rate, building upreserves, and liberalizing domestic prices. The degree of progress towardmeeting each of these conditions, however, varies among the countries.

Morocco has achieved acceptable levels in all four conditions. It estab-lished convertibility when it finished implementing its reform programsand dispensed with the use of IMF resources. The establishment of con-vertibility represented the culmination of Morocco's decade-long adjust-ment efforts; however, to make its efforts completely successful, Moroccomust continue to be vigilant, must prevent an increase in inflationarypressures, and must improve the real effective exchange rate to safeguardits export competitiveness.

Tunisia accepted the obligations under Article VIII at the end of oneadjustment phase, supported by the IMF, and the start of a second one,coinciding with the launching of the fourth development plan. However,the progress Tunisia had achieved by the end of 1992 in each of the four

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conditions, as measured by the magnitude of the fiscal deficit, the level ofthe current account deficit, the level of reserves, and the extent of domes-tic price liberalization, was less than that achieved by Morocco. The sus-tainability of convertibility will therefore depend on the prompt comple-tion of the envisaged reforms and on their success in achieving the desiredresults in the second phase. In this case, convertibility can be consideredas one of the complementary elements of the structural adjustment pro-gram for the second phase.

Egypt and Jordan hastened to eliminate the exchange restrictions oncurrent transactions as soon as an external balance was achieved andenough reserves had been accumulated, but before structural reformswere completed, which would guarantee a continued improvement in thedomestic and external financial positions. The elimination of restrictionscan be considered a complementary and facilitating element of theirreform programs for future years. Egypt must still reduce its inflation rateand budget deficit as a percentage of GDP by improving its revenue andexpenditure structure, by continuing the privatization process andreforming the remaining public sector enterprises, by liberalizing domes-tic prices, and by increasing labor mobility. Jordan is still at the beginningof its adjustment program, which seeks to increase the growth rate, toimprove the production structure, and to increase exports.

Third, the liberalization of exchange restrictions occurred at differentrates. In Morocco, the process took place gradually, and with a degree oftardiness, because it proceeded in tandem with the foreign trade liberal-ization process, which lasted nearly seven years. In Tunisia, the liberaliza-tion took place during the final years of the reform program that wasimplemented between 1986 and 1992; it also proceeded in conjunctionwith the release of trade from quantitative restrictions and advance per-mits. The difference in the two rates reflects a difference in assessing theimportance of the socioeconomic consequences of this liberalization inboth countries, and the degree to which convertibility complementsfuture programs. In Jordan, the speed with which de facto convertibilityfor current account transactions and foreign investment transactions wasattained resulted from Jordan's characteristically limited control and eco-nomic openness. As the restrictions in effect were few and superficial, thecost of this step was relatively small. Moreover, convertibility will beimportant for completing the ongoing structural reforms, which willnecessitate (among other things) an inflow of foreign investment tofinance the development process and help overcome the structural con-straints that hinder the economy.

In Egypt, the attainment of de facto convertibility has been the grad-ual result of policies adopted since 1987 to reform its exchange rate sys-

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tern and complete the establishment of the free exchange market and theunified exchange rate in 1991. It has also been facilitated by abundantreserves and foreign resources that have flowed into Egypt as a conse-quence of economic openness and liberalization, higher interest rates,and recent political conditions. The improvement in the external positionalone is not likely to stabilize the situation unless it is supported byimprovement in domestic financial stability.

Fourth, with regard to the timing of the announcement, Moroccoannounced one year before accepting the obligations under Article VIIIthat it would achieve convertibility at the beginning of 1993. It made thisannouncement in the wake of the tangible progress it had made in adjust-ment and reform, and the announcement became a public commitmentthat had to be fulfilled and could not be postponed. In effect, thisannouncement inspired confidence in the success of the adjustment effortand in the government's determination to continue with the program toachieve its objectives. By contrast, in Tunisia, no advance announcementon the acceptance of the obligations under Article VIII was made. Suchan announcement was considered a step to be implemented at a certainphase of the reform program to lay the ground for entering anotherphase. In Egypt and Jordan, such an announced commitment would havebeen premature for the technical reasons noted above. However, Jordanhas expressed its intention to declare convertibility as early as possible.This could be accomplished when the current technical obstacles areovercome. These obstacles involve the presence of some arrears and abilateral payments agreement with a member state. In Egypt, there is apossibility that a new foreign exchange law will be enacted that wouldprovide greater freedom and abolish the few existing restrictions in theareas of recovering proceeds from tourism and exports and making for-eign exchange payments remitted to the outside world dependent on thepresence of imports.

Conclusions

From the preceding review and the comparison of the four countries'experiences in their movement to achieve currency convertibility for cur-rent account transactions, the following conclusions can be drawn.

• Actual convertibility need not always represent the culmination orcompletion of adjustment and reform programs. It can also consti-tute a part of the adjustment and reform process, because it con-tributes to improved competitiveness, reduces differences between

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domestic and international prices, enhances the efficient use ofdomestic resources, and facilitates trade and production.

• A free exchange system contributes to confidence that bolstersreforms, attracts capital, revitalizes economic activity, boosts invest-ment and growth, and increases available resources, thus helpingachieve the reform objectives.

• Convertibility and a free exchange rate alone are insufficient toreform the economy and achieve the desired external balance, par-ticularly over the medium term. They can, however, help to achievethe goals of structural reforms by eliminating price distortions,enhancing the efficient distribution of resources, increasing theincentives for and mobility of factors of production, and improvingthe competitiveness of exports.

• The attainment of convertibility, especially legal convertibilityaccording to the obligations under Article VIII, presumes that therecan be no reinstatement of restrictions. Therefore, a constant mon-itoring of comprehensive fiscal and economic developments and theobservance of fiscal discipline become essential for maintaining con-tinued domestic and external financial stability, exchange rate flexi-bility, and export competitiveness. Thus, the conditions for achiev-ing convertibility are also conditions for its sustainability.

• The achievement of currency convertibility should be preceded bya thorough preparation that takes into account the circumstances ofthe country concerned and the difficulties it faces. Generally,achievement of the four conditions can precede or coincide with theachievement of convertibility. An official commitment to convert-ibility need not occur before the experimental phases are comple-ted and before a balance is achieved in the external financial condi-tions—a balance that gives the assurance that this convertibility willbe sustained.

• The prolonged coexistence of balance of payments problems andexchange restrictions is likely to complicate and prolong the reformprocess. Extraordinary political courage may be required to tacklethese problems because the social costs of adjustment are high. Ifthe problems are tackled promptly, however, there will be positiveresults and lower social costs.

• The gradual liberalization of the payments and exchange system,particularly in countries that have lived with strict controls for along time, will prevent sudden changes and will provide all sectorsof the economy with an opportunity to adapt gradually to thechanges. On the other hand, an excessively lengthy process cansometimes result in prolonged hardship, retard the positive results

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of reform and liberalization, and run the risk of eroding some ofthese results.Eliminating exchange restrictions and establishing convertibility,together with liberalizing trade, could help countries to enhancecompetitiveness and to allocate domestic resources more efficiently.However, in view of the protectionist tendencies of the advanceindustrial countries and the different dimensions of these countries'economic and technological resources and their negotiating capa-bilities, it is unclear whether eliminating exchange and trade restric-tions will give the small countries an equal opportunity to benefit intheir dealings and to trade with the giant countries and blocs fromtheir comparative advantage. Moreover, the development of anycountry's comparative advantage under these unequal conditionsrequires reliance on improved productivity, increased growth rates,a fundamental change in the import and export structures, and theintroduction of modern technologies. All these changes requireintensive foreign financing, which raises the question of whethersuch financing—particularly for small countries—can be securedwithout an exorbitant cost to national sovereignty.

Appendix

Steps to Free Exchange and Current Positions onCurrency Convertibility

We have reviewed in the body of this paper the progress toward achiev-ing the conditions necessary to attain and perpetuate currency convert-ibility in Morocco, Tunisia, Jordan, and Egypt. We have also noted thedegree of liberalization achieved in current foreign transactions, but thedetails of the current situation or the steps taken in recent years regard-ing convertibility (IMF, 1993) were not to be considered. To make thepicture complete, this appendix deals with and compares the most impor-tant features of the liberalization of payments introduced by these coun-tries in recent years.

Morocco

On January 2 1 , 1993, the Moroccan authorities announcedMorocco's acceptance of the obligations of Article VIII of the IMF; thatis, they accepted the dirham's convertibility for the purposes of current

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•



account transactions. From 1987 until that date, Morocco had graduallyreduced the restrictions imposed on conversion (or remittance) througha gradual shift from the system of quantitative restriction and advanceimport permits to the system of unrestricted importation. This system isimplemented by the submission of a bond or guaranty to a licensed bank,which then remits the value when the necessary documents are received.In 1992, the authorities agreed to establish the rule of importation with-out quantitative or value restrictions, except for three commodities thatrequire an advance permit: pharmaceuticals, textiles, and energy (fuels).Customs protection was noticeably reduced. Hence most differencesfrom international prices were eliminated. All exports were also liberal-ized, except for subsidized goods, antiquities, and live animals. Theauthorities also permitted the maintenance of a part of the value of exportproceeds in special accounts to finance imports connected with exports.

The authorities also liberalized in the past three years most invisiblepayments through current account transactions. However, they main-tained some reasonable and well-studied limits in light of the need fortourist travel expenses, business travel expenses, and personal expenses forcitizens and students residing abroad.

With respect to capital, foreign investment has been liberalized, andinvested capital enters freely and is recouped freely. Income generated bythis capital is also remitted freely. This aspect is controlled through spe-cial accounts that can be opened with licensed banks. Moreover, the oldaccounts that froze foreign capital have been abolished and replaced byconvertible dirham accounts with five-year terms. Remittances fromthese accounts are subject to annual limits, but domestic use of theaccounts is unrestricted. Citizens residing abroad continue to berequired to obtain a permit from the Exchange Bureau to remit capitalto the outside world and to pledge that the income will be returned toMorocco. Morocco has established a unified exchange rate that has ade-quate flexibility. Transactions are conducted in any of a long list of cur-rencies whose prices are set by the Bank of Morocco, which deals in allthese currencies. The most distinguishing feature of convertibility inMorocco is that its attainment has been coupled with the full liberaliza-tion of trade (with emphasis on liberalizing most invisible payments inthe past two years) and with the near attainment of the previously men-tioned preconditions.

Tunisia

The authorities announced their adherence to the provisions of ArticleVIII of the IMF agreement on January 6, 1993. Thus, the Tunisian dinar

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legally became a currency convertible for current account transactions.However, unlike the experience in Morocco, this convertibility was notcoupled with a large degree of progress toward import liberalization.Tunisia's import system continues to include a segment that is liberalizedand a part that is governed by a number of quantitative restrictions andvarious measures, depending on the import identity, the nature of theimport transaction and its connection with exports, and whether theprocess is financed by official foreign exchange. Tunisia has the system ofimport with an import license (quotas for certain goods), the annuallicensing system (annual sums), and the import card system for some pro-duction sectors. This system permits the importation of certain goodswithin certain limits. These goods are exchangeable within the same com-prehensive ceiling. This system makes it possible to benefit from the sys-tem of importation with remittance from resources outside Tunisia; itencompasses the state trade establishments, which import nearly 25 per-cent of all imported goods. Each of these import systems has its own spe-cial payment procedures. Some of the liberalization measures adopted inrecent years are tantamount to a series of reductions of customs tariffs orimport taxes.

Invisible payments must be licensed by the central bank, with excep-tions. Recent exceptions have included (1) interest payments and originalloans; (2) reinsurance; (3) subscriptions to magazines and periodicals; (4)net profits and revenues of companies headquartered abroad;(5) expenditures connected with the activities of exporters; (6) 50 per-cent of the income of foreign experts and technical assistants employedby the public sector; (7) certain limited amounts of travel expenses forseveral purposes, such as tourism and business travel; (8) cost of livingand settlement for students; and (9) pensions of nonresident citizens.These limits were increased or doubled at the beginning of the year andthus moved closer to the limits of adequacy for reasonable requirements.

Most exports (90 percent, excluding energy) have been liberalized,but their proceeds must be returned to licensed banks within ten days ofthe date of payment. Residents with foreign resources may benefit fromconvertible dinar accounts within certain limits.

With regard to capital, foreign investment laws issued since the mid-1980s offer foreign investors incentives that include the right to remitprofits without restriction and to remit capital with a permit, plus otherincentives.

Convertibility for the purposes of current account transactions hasbecome actually and legally valid, but it is still tainted by some limitationson personal transactions and expenses. Significant restrictions continue toexist for capital account transactions.

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Jordan

Even though its resources are limited and it is greatly exposed to for-eign influences, Jordan has always had an exchange system closer to free-dom than restriction. Jordan has taken advantage of its central location inthe Arab East, on trade routes going in all directions and adjacent to theoil producing countries. Perhaps Jordan's openness has been one of thereasons for the dinar's strength and stability for a long period extendinguntil the 1980s and for the speed with which it regained the confidenceand balance it achieved last year. Another reason was perhaps theexchange rate flexibility and a reunified exchange rate, plus Jordan'squick retreat from the few restrictions (primarily involving the require-ment of advance deposits for importation) it had imposed to confront the1987-88 crisis. The Jordanian exchange system can be summarized asfollows.

The central bank exercises control over exchange and is entrusted togrant exchange permits. However, licensed commercial banks areentrusted to issue exchange permits for remittance of the value of importsand, within the permitted annual limits, remittances for invisible person-al expenses. Meanwhile, the Ministry of Industry and Commerce draftsthe import policy in cooperation with the other ministries concerned.

Foreign exchange permits are granted automatically to people whohave import licenses. An importer is entitled to open a documentarycredit or to pay in return for documents. However, the advance approvalof the central bank is required to use suppliers' credit.

Invisible payments are unrestricted if they pertain to licensed imports.Other expenses that are remitted freely and without discriminationinclude personal payments, such as the expenses of a family living abroad;educational, medical, and tourism expenses; pilgrimage expenses; andsubscriptions to scientific magazines. The limits of these remittances (upto 20,000 Jordanian dinars) are high and comfortable by all criteria, andthey greatly exceed the limits applied in Morocco and Tunisia. A com-fortable ceiling is also established for cash sums that a traveler can takeout of the country. Moreover, nonresidents working in Jordan are enti-tled to remit 70 percent of their wages if they have nonresident accounts.

Exporters are required to return the proceeds of their exports and sellthem to licensed banks. They may retain 10 percent of the value of theseproceeds in the form of foreign exchange deposits for the importation ofproduction inputs. They are also required to cede the proceeds of invisi-ble transactions. Expatriate Jordanians are entitled to deposit their savingsat licensed banks in foreign exchange, regardless of their value. Upontheir return from abroad, they may retain unlimited sums in this account

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for five years, after which they must cede any amount over JD 500,000,the maximum resident Jordanians are permitted to maintain in foreignexchange accounts.

Gold may be imported without central bank approval, but its exportrequires prior approval. The entry of capital is unrestricted, but its depar-ture requires central bank approval. Investment in Arab countries is per-mitted if there is a bilateral agreement that deals with the provisions ofsuch investment. The investment promotion law permits the remittanceof profits and interest belonging to licensed foreign investments.Moreover, it permits capital to be re-exported after two years of invest-ment. The law also permits foreign firms planning to invest outsideJordan to be accorded in Jordan the same treatment as nonresidents forthe purpose of exchange control.

It is evident from the above that, practically speaking, Jordan is apply-ing all that is required for free conversion for the purpose of currentexternal transactions. But because of the presence of arrears in certainobligations as a result of the severe crisis to which Jordan was exposedrecently and the presence of a payment agreement with Iraq, Jordan hasnot announced its legal adherence to currency convertibility for suchtransactions. Perhaps there is another reason, namely, the need to bedeliberate and to make certain of continued improvement in the externalfinancial position and of completion of the structural reforms alreadyinitiated.

Egypt

The establishment in 1991 of a free exchange market in Egypt notablydistinguishes it from the other three countries. In Morocco, Tunisia, andJordan, the central bank sets the exchange rate on the basis of a currencybasket whose makeup and weights reflect the importance of the currenciesin the country's international dealings. In contrast, the Egyptian exchangemarket was created in response to an existing system of multiple exchangerates that had historically failed to deal with the chronic problem of short-age of resources, even though the rates were frequently amended.Establishment of the unified free exchange market and the full liberationof the exchange rate have helped to accelerate the liberation of exchangetransactions from restrictions. The gradual and partial application of liber-alization, initially through the system of importation with private resourcesand then through release of the freedom of acquisition and disposal in1976 and the creation of a free banking market in 1987, constituted thebeginnings of the creation of an operational exchange market.

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In 1991, after the problem of the shortage of foreign exchangeresources and the balance of payments deficit was overcome, twoexchange markets were established: a free market for most transactionsand a primary market for government and public sector resources andinvestments. The two markets were unified in the same year in what hascome to be known as the free exchange market. Through this market, theexchange rate is determined in accordance with the forces of supply anddemand. Every bank determines foreign exchange purchase and saleprices freely, provided that it publicizes them explicitly. In 1992, money-changing companies were permitted to sell and purchase foreignexchange for their own benefit through licensed active banks. Thus thecomponents and elements of market and price unification became com-plete (Central Bank of Egypt, 1992).1

The current exchange system can be summarized as follows.

• Government imports and public sector imports are made at the freeprice within the bounds of the foreign exchange budget establishedat the central bank.

• Private sector imports are made freely for all goods, excluding somebanned commodities, also at the free price.

• Banks are permitted to make the remittances necessary to pay thevalue of imports. The system of advance deposits for imports hasbeen scrapped.

• With respect to invisible payments, banks are empowered to supplyforeign currency to the government and the public sector within theframework of the foreign exchange budget.

• Banks sell foreign currency to establishments licensed to deal in for-eign exchange without any restrictions when this is for the purposeof invisible payments concerning individuals, corporations, publicsector corporations, and corporations founded in accordance withthe current investment law.

• Travelers are permitted to take unlimited amounts of foreign cur-rency and other means of payment out of the country.

• Nonresidents are excluded from the right to purchase flight ticketsin local currency; this right is available to citizens and foreignersresiding in the country for more than five years.

• No license is needed for exports, excluding certain goods. Oil, cot-ton, and rice exports are no longer confined to the public sector,

1There are still two other exchange rates. One equals LE 0.30 per U.S. dollar and isapplied to transactions concluded within the framework of the valid payments agreementswith Sudan. The other is a historical rate equaling LE 0.03913 per U.S. dollar, used to set-tle balances in old and terminated payment agreements.

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but their proceeds must be returned to the country. The sameapplies to books and printed materials. It is permitted to retain theproceeds of other exports in a special account at a licensed bank, tobe used for imports or invisible payments or to be sold in the freemarket. But these proceeds cannot be transferred to a free account.

• Invisible proceeds can be maintained abroad or deposited in a freeaccount indefinitely, excluding tourism proceeds that must be cededto licensed banks. However, hotels may retain 25 percent of theseproceeds in special accounts, and invisible public sector corpora-tions may keep 10 percent of their invisible proceeds.

• Travelers may bring in and dispose of unlimited amounts of foreignexchange, but not more than LE 100 in Egyptian currency may bebrought in or taken out of the country.

• With respect to capital, no restrictions apply to capital transfers byemigrants or foreigners leaving the country permanently. Transfersof legal alimony to divorced wives are also unrestricted.

• Transfers in return for imports and the export of securities must bedone through licensed banks that act as brokers.

• Investment abroad by government units or public sector agencies orcorporations is subject to advance licensing and to compatibilitywith the laws in force.

• Cash assets of inheritances reverting to nonresident foreigners mustbe placed in an untransferable capital account at a licensed bank.The same applies to the net shares of nonresident foreign heirs. Theaccount will be used to meet the government's dues, legal expens-es, and supplements within annual limits.

• The value of real estate purchased by foreigners in Egypt is paid inconvertible currencies. The proceeds of foreigners' sale of their realestate in Egypt are transferred within the limits of the sum convert-ed originally into Egyptian pounds when the real estate was pur-chased, plus a sum calculated according to a formula that is sup-posed to reflect a moderate capital gain.

• The control system restricts the ability of banks to engage in foreignborrowing by tying this borrowing to the size of their foreign assetsand their capital.

It is evident from the above that Egypt actually applies convertibilityfor current transactions. It also permits a broad space for convertibility forcapital transactions, all within the framework of a free and unifiedexchange rate. The only factors that separate Egypt from legal convert-ibility are (1) its maintenance of a payments agreement with Sudan andthe remnants of the balances of past agreements, considered to constitute

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multiplicity in the exchange rates, and (2) the presence of some arrears inrepayments owed for past bilateral debts.

References

Central Bank of Egypt, "Development of Regulation of Egypt's Exchange Market," paperpresented to the meeting of governors of the Arab central banks and currency estab-lishments, Abu Dhabi, September 1992; in Arabic.

Gilman, Martin G., "Heading for Currency Convertibility," Finance & Development, d27 (September 1990), pp. 32-38.

Green, Joshua, and Peter. Isard, Currency Convertibility and the Transformation oCentrally Planned Economies, IMF Occasional Paper No. 81 (Washington:International Monetary Fund, 1991).

International Monetary Fund, Annual Report on Exchange Arrangements and ExchaRestrictions (Washington, 1993).

Mathieson, Donald J., and Liliana Rojas-Suarez, Liberalization of the Capital AccouExperiences and Issues, IMF Occasional Paper No. 103 (Washington: InternatioMonetary Fund, 1993).

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The Issue of Capital AccountConvertibility: A Gap BetweenNorms and Reality

Manuel Guitian*

An important feature of the international financial code of conductestablished at the Bretton Woods Conference toward the end of

World War II was the acceptability of controls and restrictions on inter-national capital flows. Specifically, the Articles of Agreement of theInternational Monetary Fund, which contain such a code of conduct,prescribe that

Members may exercise such controls as are necessary to regulate interna-tional capital movements, but no member may exercise these controls in amanner which will restrict payments for current transactions or which willunduly delay transfers of funds in settlement of commitments, except as

* Director, Monetary and Exchange Affairs Department, International Monetary FundThe opinions expressed in this paper are those of the author and should not be attributedto the International Monetary Fund. In a previous incarnation, the paper was presented atan International Conference on "Money and Finance in the Open Economy" sponsored bythe Institute of Economic Research of Korea University and the Bank of Korea and held inSeoul on November 6-7, 1992 and at a Georgetown University Workshop on Monetaryand Exchange Rate Regimes in Transitioning Economies held in Washington on April 231993 (Guitian 1992a). The general issue of international capital flows and the particularsubject of capital account liberalization have been extensively studied in the InternationalMonetary Fund. In the preparation of this paper, I have relied heavily on recent studies inthe institution; these include: International Monetary Fund (1991); Mathieson and Rojas-Suarez (1993); and Calvo, Leiderman, and Reinhart (1993).

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(9)



provided in Article VII, Section 3(b) and in Article XIV, Section 2. (ArticleVI, Section 3)

There was a logic at the time of the drafting and acceptance of theArticles of Agreement for the inclusion of this feature in the rules of thegame that were to govern international transactions for approximately aquarter of a century. The flow of trade and current and capital accountexchanges among countries had been disrupted prior to and during thewar; capital movements had not yet become a predominant force in theinternational transaction network; and, for reconstruction and resump-tion of normality in the world economy, encouragement of free interna-tional trade and exchange of goods and services was essential.Consequently, the attention was concentrated on liberalizing trade andother current account flows, an aim that became enshrined in theArticles. But it is also worth mentioning that an additional considerationfor capital controls was a belief in their ability to preserve theindependence of domestic policies. Apart from the limited character suchability is likely to exhibit, it warrants noting at the outset that capital con-trols, by allowing countries to pursue inconsistent policies (at least forsome time), may have been an obstacle to the aims of international policycoordination.

Since the Bretton Woods era, however, international capital move-ments have acquired increasing importance in the world economy.Undoubtedly, the growing relevance of capital flows in the internationaleconomy during the last two decades, although it can be traced tonumerous other factors, owes much to the opening of trade and currentaccounts that characterized the evolution of the international economyduring the period of prevalence of the Bretton Woods order.1 This spanof time, which extended through the early 1970s, witnessed a progressiveliberalization of current international transactions in the industrial coun-tries, as well as the corresponding integration of their national economiesand those of an increasing number of developing countries into the inter-national system. Establishment of current account convertibility had beenbroadly attained in the industrial world by the late 1950s or early 1960s.2

With it, the importance and pervasiveness of international trade and other

1The Bretton Woods period encompasses the time during which the international econ-omy operated under a fixed exchange rate regime, the par value system adopted at theBretton Woods Conference that established the International Monetary Fund and theWorld Bank. See Horsefield (1969), de Vries (1976), and Guitian (1992b) for examinationsof the period.

2For an exposition of issues related to currency convertibility, see Polak (1991),Williamson (1991) and Guitian (1992c), and Greene and Isard (1991).

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Issue of Capital Account Convertibility: A Gap Between Norms and Reality

current account flows became structural features of the world economicsetting, which grew increasingly interdependent as a result.

In what might well be termed as a revolt against economic interde-pendence, the Bretton Woods par value system collapsed in the early1970s, when countries decided to move away from such a system andadopt instead a regime of flexible exchange rate arrangements. The shiftin focus in world financial relations from an international standpoint(which is a central feature of a par value or fixed exchange rate setting)to a national perspective (which is typical of a flexible exchange rateframework) augured the emergence of a preference for the relativeclosing of national economies, that is, for an international environmentcomposed of basically isolated and insulated national components.

Paradoxically, however, the strength of the preference was to animportant extent weakened by the surge of growing international capitalflows, which contributed to keeping the fabric of the international eco-nomic system closely woven. The reality of developments in the worldeconomy began to surpass the prescriptions of the code of conduct, andcapital flows became a predominant aspect of international economicrelations, even though the use of capital controls remained acceptable.The importance of the capital account continued growing into the1980s, a period when the subject of liberalization of capital movementsbegan to attract attention and elicit policy action, both in the develop-ing and the industrial worlds.3

This paper examines the reasons why the code of conduct forinternational economic policy should catch up with the reality of worldeconomic affairs. As such, the standpoint of the analysis is basically nor-mative, that is, it deals with what ought to be, rather than positive, avantage point that would stress instead what it is. Examined first is theevolution of international capital flows and the consequent divergencebetween the reality of the international economy and the code ofconduct that is supposed to guide it. Subsequently, the analysis focuseson the logic of capital account liberalization, both from the perspectiveof its costs and benefits and from the viewpoint of its practical inevitabil-ity. Examined next is the interaction of free capital movements withnational macroeconomic policies, in general, and with monetary andexchange rate policies, in particular. A discussion of the systemic impli-cations of the liberalization of international capital flows follows; in thiscontext, the issues that arise whenever capital account freedom is accom-panied by a regime of fixed exchange rates are also discussed. The main

3See, for example, Lenain (1992), Mathieson and Rojas-Suarez (1993), and Guitian(1993), and International Monetary Fund (1991).

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points, issues for discussion, and conclusions of the analysis are in thefinal section.

Economic Reality and the Code of Conduct

An essential development in the international economy in the periodsince the abandonment of the Bretton Woods order has been the expan-sion in the scale of gross and net capital flows and the resulting integra-tion of national financial markets, particularly those in the industrialcountries. A number of features have accompanied this expansion. Notonly has it exceeded the growth of international trade flows over thesame period, but it has led to and reflected the presence of foreigninvestors in the domestic capital markets of the main industrial countries,a presence that is there to stay, barring major upheavals in the worldeconomy. An important proportion of the scale of expansion of capitalflows has been private rather than official, with commercial bank lend-ing and security flows as predominant modalities. As for the developingcountries, heavy borrowing from international banking sources in thelate 1970s was followed, as is well known, by the virtual halt in bankingand other related flows in the early 1980s. The process changed thecomposition of capital movements from private to official as well as theirnature from voluntary to involuntary in the period of resolution of theinternational debt crisis.

Possibly the most critical feature of the recent evolution of capitalmovements has been the relaxation of capital controls, the bulk of whichtook place in the context of a broad liberalization and deregulation ofdomestic financial markets in industrial countries. These events couldnot but lead to a growing integration of national and international finan-cial markets, which has been made evident not only by the scale of cap-ital flows but also by developments in yield differentials. Thus, capitalmovements not only have expanded markedly in magnitude but alsohave led to arbitrage transactions that have significantly narrowed themargin for national yield differentials.4 In effect, the globalization offinancial markets has outstripped the integration of goods markets,which are often hampered by recurrent protectionist pressures. This is,in itself, somewhat paradoxical when viewed from the standpoint of theinternational code of conduct. The bulk of international efforts towarda liberal system has been channeled to the flow of trade in goods and ser-

4For further discussion of the evolution of yield differentials, see International MonetaryFund (1991) and Frankel (1991).

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vices and to freedom of current international transactions. Not only havethe Articles of Agreement of the International Monetary Fund stressedthe importance of current account convertibility, but the GeneralAgreement on Tariffs and Trade (GATT) was established to uphold andfoster a code of conduct in the specific field of international trade. Incontrast, although continuing efforts have been made by theOrganization for Economic Cooperation and Development (OECD)toward the acceptance of a code of capital transaction liberalization, therules of the game espoused by the membership of the IMF did notinclude or extend to capital account convertibility, that is, to freedom ofcapital transactions. And yet, the evolution of the international economyhas been such that capital market interdependence seems to have runwell ahead of trade flow integration.

A number of factors account for the relatively rapid and deep integra-tion of international capital markets. They include such elements as theavailability of cross-border global investment opportunities, which, to beseized, required intermediation of resources across nations. These trendsalso allowed for cross-border portfolio and risk diversification and havecontributed to the enhancement of the efficiency of investment. Inessence, the factors just enumerated reflect the importance of economicfundamentals in determinating capital flows. But capital movements arealso affected by national policies and by the differences therein, as well asby the wedges created by the prevalence of economic distortions that varyacross countries.

Economic policies are pervasive in their effects, and therefore capitalflows reflect them directly—as is the case, for example, with tax policieor official guarantees—or indirectly—as illustrated by inappropriatemacroeconomic management. Distortions, in turn, which in the endamount to the existence of structures of differential costs across coun-tries, thus influence the direction and scale of capital flows. These flowwill tend to go toward the destination where the costs are the lowest, thatis, typically, toward havens where the distortions are the least important.The upshot of recent trends in capital accounts in the world economy hasbeen that, after the great leap given during Bretton Woods toward inte-gration of national economies through free trade in goods and services, aquantum jump has taken place on capital account, an event well ahead ofthe expectations embedded in the existing code of international financiaconduct.

There can be no doubt that the central challenge that confronted themembership of the IMF at the time of its inception was to ensure the inte-gration of war-ridden and restricted economies into an orderly interna-tional economic system. To this end, emphasis was placed on the attain-

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ment of freedom of current international transactions, which, as alreadynoted, became the standard for convertibility. This approach reflected theconcern with the notion of competitiveness of an economy (hence, theemphasis on the current account) and with the retention of a measure ofnational economic policy autonomy (hence, the acceptability of capitalcontrols).

To a large extent, the effectiveness of the approach that was thentaken to help the development of a relatively integrated world tradingsystem both explains and has provided the grounds for the emergence ofcapital flows on an increasingly important scale. These flows have mate-rialized in the presence, and despite the acceptability, of capital controls,a curious instance of events overtaking the norms intended to governthem.

Logic of Capital Account Liberalization

Interferences with international capital transactions have taken a vari-ety of modalities, including exchange restrictions and controls as well asspecific quantitative limitations on the scale of capital movements.Exchange rate practices typically have taken the form of dual or multipleexchange rates or of differential tax treatment of international financialtransactions. Quantitative restrictions, in turn, have constrained the for-eign asset and liability positions of banks and other domestic financialinstitutions or the domestic operations of foreign financial entities or theexternal portfolios, direct investments, or real estate assets of domesticresidents or the direct investments undertaken by foreigners.

Just as varied as the types of capital controls are the grounds on whichthey have been normally justified; these can be classified into four maincategories: containing balance of payments instability or undue exchangerate volatility; retaining domestic savings and preventing excessive foreignownership of domestic factors of production; taxing of domestic capitaland financial transactions; and reinforcing of domestic stabilization andreform efforts.

Much though these lines of reasoning may appear defensible in prac-tice, in theory their rationale is far more debatable. Balance of paymentscrises or unstable exchange rates will hardly be averted on a sustainedbasis by the adoption and maintenance of capital controls only.Fundamentally, external imbalances have roots in sources other thancapital movements and, therefore, the imposition of capital restrictionscannot be expected to replace appropriate action to remove the basicsource or sources of the imbalance. Thus, at best, capital controls can

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only act as palliatives while other essential policy measures yield theirresults.

Similarly, capital restrictions are unlikely to succeed in retainingdomestic savings in the absence of appropriate incentives to keep thosesavings from spontaneously flowing abroad; here again, it must bestressed that, in general, capital flight is caused by factors other than theexistence of freedom of capital movements, and it is toward those fac-tors—rather than to the confinement of that freedom—that policy oughtto be addressed. Taxation of capital transactions is unlikely to be helpedmuch by capital controls. Clearly, whenever such taxation exceeds signif-icantly its levels abroad, it will be imperative that a barrier be created toprevent the shrinkage of the tax base. The introduction of capital controlscan be instrumental to this end, but it must also be acknowledged thattheir continued effectiveness cannot be assured, as long as the incentivesto circumvent them (i.e., the taxation differential that made them neces-sary to begin with) continue to prevail.

With regard to the ability of capital controls to assist in the stabiliza-tion and reform efforts undertaken domestically, an argument in thisdirection can be plausibly made on a temporary basis; but it must also bekept in mind in gauging the usefulness of such controls for these purposesthat their very presence may well impair the credibility of those effortsthemselves, if only because they may provide incentives to slow themdown.

Arguments in support of capital controls have also often been made onthe basis of the costs of capital account openness. Prominent amongthose arguments is the belief that capital flows, if left unfettered, willincrease economic instability in that they contribute to magnifying, ratherthan to offsetting, external shocks. But this instability argument does notdepend only on whether capital movements act to reinforce or to com-pensate the shock; it also hinges on whether the shock is internal or exter-nal and permanent or transitory. Once these other aspects of the shockare taken into account, we are confronted again with the considerationthat capital controls cannot replace action aimed directly at the removalof the underlying causes of the instability.

Another type of perceived cost of an open capital account is the limita-tion it can impose on the effectiveness of domestic policies. True thoughthis concern is, it applies to economic openness in general, that is, itencompasses the openness of the trade and the current accounts as well.Therefore, this would be an argument against opening the economy(which would carry hardly any support as a general economic policyproposition) and not against capital account liberalization as such. Yetanother cost of open capital account is the fear of losing domestic savings

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or of a shrinking tax base. As stated above, these are contestablearguments.5

Traditional benefits of capital account liberalization, in turn, includethe welfare increase that is made possible by the availability of foreign sav-ings to supplement the domestic resource base, which makes it feasible tohave a larger capital stock and place the economy in a potentially highergrowth path than otherwise. From another perspective, free trade in cap-ital (e.g., through international borrowing and lending flows) can helpreduce the costs of the intertemporal misalignments that periodically arisebetween the patterns of production and consumption. Another benefit tobe derived from freedom in capital transactions is that by allowing fortrade in risk assets, the sharing and diversification of risks that otherwisewould not be available become feasible.

In essence, the analysis of the costs and benefits of capital accountliberalization does not differ from the traditional tenets derived from theconventional examination of the advantages and disadvantages of freetrade, in general. Both of them have to do with the pros and cons ofclosed versus open systems. Closed systems, other things being equal, willneither suffer from (import) external shocks nor disseminate (export) theconsequences of internal shocks. Open systems, in contrast, will be influ-enced by (import) external shocks and will disseminate (export) theeffects of their domestic shocks.

Capital controls, which help close otherwise open economies, act toinsulate them within the system, for better or for worse. As with all typesof controls, the effectiveness of those used to contain capital flows willerode over time. Yet, for a time at least, they can inhibit certain types ofexternal financial transactions, limit access to international markets,restrict domestic financial market competition, and, most likely,discourage the repatriation of flight capital. In this manner, capitalcontrols can introduce distortions and give rise to inefficiencies in thedomestic financial system that will impair the competitiveness of theeconomy at large. Thus, although they are often advocated as a protec-tive shield, capital controls can instead make the economy morevulnerable to financial and other economic shocks.

But capital controls can add further distortions if they encourage theduration of prevailing sources of imbalance and of inappropriate policiesin an economy. In these circumstances, only controls of increasingrestrictiveness can contain the erosion of their effectiveness to allow forthe maintenance of the causes of imbalance and for the delay in

5An extensive discussion of the costs and benefits of liberalization of the capital accountcan be found in Hanson (1992).

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appropriate policy action. Apart from the costs that also arise from likelyattempts to capture the rents to which capital controls give rise, there isalso the risk of moral hazard that the efforts to evade capital controls cancreate for other areas of economic activity; thus, the use of capitalcontrols to tax capital transactions not only can encourage flight ofresources abroad but also can provide incentives to undertake otherdomestic unofficial activities, a moral hazard risk that should not beunderestimated.

Capital Flows and Monetary and Exchange Policies

The possibility, already alluded to, of avoiding taxes when capitalcontrols are lifted points out clearly the immediate impact of capitalaccount openness on the effectiveness of government policies. Again,this is no more and no less than a specific manifestation of the generalprinciple that it is easier to influence a closed system by policy or byother internal means than it is to affect an open environment.Therefore, clearly the ability to tax arbitrarily is very much limited bythe abandonment or dismantling of capital controls. This may be seen(and it has often been described) as a reduction in the effectiveness offiscal policy brought about by the liberalization of capital flows. Butthere is no such reduction in fiscal policy efficiency, a more importantconsideration, because efficiency is bound to increase with the elimina-tion of the distortions caused by capital controls. Moreover, the argu-ment does not need to hold with regard to fiscal policy effectivenessfrom two different standpoints: one, that the very tendency (often suc-cessful) to circumvent the controls will make the ability to tax in thepresence of capital restrictions more apparent than real; the other is thatthe immediate effectiveness of controls (actually, it should be the effec-tiveness of the introduction and progressive tightening of such con-trols) should be distinguished from their longer-term effectiveness,which undoubtedly will shrink with the erosion of the ability of controlsto insulate the economy.

The relationships that are most often discussed are those between cap-ital movements and monetary, as well as exchange, policies. A well-knownargument that links the three together is often brought up in discussionsof the advantages and disadvantages of different exchange rate regimes.In this context, the point has been frequently made that with a freelyfloating exchange rate, the independence and effectiveness of domesticmonetary policy can be maintained even in the presence of an open cap-ital account. Correspondingly, the flip side of this argument is also often

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brought up: that is, with a fixed exchange rate, the independence andeffectiveness of domestic monetary policy can be preserved only by theestablishment of capital controls. Actually, this line of reasoning has beeninvoked many times as an explanation for the acceptance of capital con-trols in the Bretton Woods code of conduct.

Both arguments, however, are spurious, except in the short run.Under flexible exchange rates, the independence and effectiveness ofdomestic monetary policy with an open capital account can be main-tained only if the monetary policy stance is broadly compatible with thatprevailing abroad. Monetary policy, like other domestic policies in gener-al, competes in the world economy, so that there will be a tendency forresources to flow toward the areas where the best-quality monetary man-agement is in effect. Actually, the argument is that this tendency is con-tained by the freely floating exchange rate, which will move (depreciate)to the extent necessary to eliminate the incentive for resources to flowabroad. In essence, then, the argument is equivalent to the case—alsooften made—that with a flexible exchange rate, a national economy canchoose its own inflation rate. But this can be true only temporarily, asbasically resources will tend to flow toward stable environments ratherthan stay in settings where the efforts to maintain stability are character-ized by attempts to try to offset one instability (that in the price level)with another (that in the exchange rate).

Similarly, with fixed exchange rates, it is also misleading to argue thatthrough capital controls the independence and effectiveness of monetarypolicy can be preserved. Here again, the main point is that monetarypolicies compete internationally; the tendency will develop for resourcesto move toward the domain of the best-quality policies. The approachhere is one of containing that tendency by means of quantity restrictions(capital controls), rather than by price adjustments (flexible exchangerates). In effect, an analogous argument can be made that the attainmentof monetary autonomy by capital controls is equivalent to saying that bythe introduction of capital controls, a country can choose its own infla-tion rate. Other than in the short run, the argument is indeed debatable;controls can only attempt to contain the tendency for resources to flowout, but they will not eliminate it. In the process, their effectiveness willbe eroded and with it, the independence of monetary policy and the pos-sibility of choosing a national inflation rate that differs significantly fromthe one prevailing abroad. This sequence of events can be slowed down,though not definitely stalled, by progressively tighter controls, of course.In general, however, the force of behavior will be for resources to movetoward stable environments and to escape from those where the conse-quences of price instability are temporarily contained by capital controls.

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The basic argument to be made is that domestic monetary policies areendogenous to domestic, as well as foreign, economic market forces.Attempts to escape from the influences of these forces, effective thoughthey may be initially, can only fail. All the well-known reasons against theuse of quantitative restrictions generally accepted in the context of themarket for goods and services and of the consequent international tradeflows apply just as much in the context of the capital market and of thesimilarly consequent international capital movements.

With the globalization of international capital markets that has result-ed from the dismantling of national capital controls, a phenomenon thathas been observed in many economies is that capital flowing from abroadcan threaten domestic inflation objectives (another way of expressing theloss of monetary independence), or that it can impair the economy'scompetitiveness (thus showing the closeness of the link between capitalflows and exchange rate developments). The dilemma that such capitalinflows pose to the receiving economy is that action taken to meet infla-tion objectives (in particular, letting the exchange rate appreciate ratherthan allowing for the domestic monetary expansion that would resultfrom the inflows of capital in the absence of exchange rate adjustments)will endanger competitiveness; on the contrary, protecting competitive-ness (by not allowing the exchange rate to appreciate and, thus, accept-ing the monetary expansion induced by capital inflows) may jeopardizeinflation control (and eventually competitiveness also as the exchange ratebecomes overvalued). In most circumstances, both a measure of inflationcontrol and a measure of competitiveness are typically lost.

Traditional means to resolve the conflict have consisted in attempts tosterilize the capital inflows—at the expense of expansions in domesticpublic debt, which tend to keep interest rates high, thus raising fiscalcosts and perpetuating inflows in search of attractive yields; adoption ofdual exchange rates—which distort the economy and are often cir-cumvented; efforts to tighten fiscal policy—which is a valid policy optionif the scale of the fiscal adjustment and that of capital inflows are com-mensurate, though not otherwise; and generally the adoption of soundpolicies—which clearly is an appropriate course of action. Over the longerhaul, besides the maintenance of sound domestic policies, the optimalreaction to capital inflows must encompass the enhancement of the flex-ibility of factor and product markets so that the tendency towardexchange rate appreciation can be compensated for by domestic cost andprice decreases, thus keeping competitiveness safe and inflation at bay.

In sum, freedom of capital flows does not eliminate macroeconomicpolicy independence. Openness of the economy does that. And the pur-suit of a flexible exchange rate policy does not restore policy indepen-

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dence. Although it is true that exchange rate flexibility helps to insulatethe economy, it will not be sufficient to bring about complete insulation,particularly in the presence of unsustainable domestic policies that willprovide incentives for resources to flow to more stable settings.

Thus, the perceptions of domestic policy constraints due to capitalaccount opening can only be real in the short term, as a transitory stage.And such perceptions do not pertain exclusively to capital controls. Theyare applicable to all types of controls, be they on flow (trade) or stock(capital) variables or of domestic or foreign origin. Although capital con-trols may be justified as instruments to deal with specific circumstances ordefended on country-case grounds, sight should not be lost of the fun-damental fact that controls are inefficient as instruments to guide eco-nomic behavior or as a basis for policy effectiveness.

Systemic Considerations

Many of the observations made in the paper so far can be placed in asystemic setting in order to provide the rationale for the obvious need ofbringing the international code of conduct in line with the reality of theworld economic environment. The discussion in this systemic context willbe conducted from the standpoint of the IMF, in its capacity as guardianof the code of conduct.

Much progress has been made in the last half century toward the accep-tance of the advantages of trade and current account openness, anendeavor that represented perhaps the central challenge that the worldeconomy confronted in the wake of World War II. Supervision of theacceptance and discharge of the responsibilities of such openness in termsof the observance of constraints on national policies (e.g., by the pro-scription of use of exchange restrictions or of discriminatory practices) wasa main function of the IMF. To a large extent, such progress laid naturalgrounds for the emergence of capital flows on an increasing scale thatcame only to reinforce the commitment to an open and globally integrat-ed system. The last two decades witnessed the developments in capitalaccounts rise in prominence and eventually surpass in importance those oncurrent accounts.6 And yet, despite these broad-ranging developmentsand the onset and resolution of an international debt crisis, the interna-tional code of conduct has remained unchanged in the domain of thenorms governing capital flows. These flows have continued to be treated

6A detailed examination of these capital account developments can be found inInternational Monetary Fund (1991).

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as they had been in the Bretton Woods period, when their scale was farmore limited and when the concern of the international economy focusedmainly on the resumption of trade and other current account flows.

But at present, the presence and predominance of capital movementshave become permanent features of the world economic setting; in effect,it can well be said that they constitute part of the world economic struc-ture. And those movements took off in the period of flexible exchange ratearrangements that succeeded the Bretton Woods order. It could have beenargued that such flexibility rendered redundant the need for capital (or anyother external) controls, just as it was often argued that freely floatingexchange rates reduced the need for international reserves. Neither argu-ment conformed to the reality that accompanied exchange rate flexibility:both international reserves continued to be needed and capital controlremained in place in many countries, even though in a growing number

those controls became either de jure or de facto less predominant. In theprocess, a state of world economic affairs that linked exchange rates andexchange rate management closely with trade and current account flows,as well as competitiveness, moved to a setting where exchange rates andexchange rate management—because of the influence of capital flows, andthe capital account—became even more closely related to monetary poli-cies and to monetary conditions as well as to inflation control.

An important consequence of growing capital movements has beenthat they helped to make it clear that the independence of monetary pol-icy, in particular, and of domestic economic management, in general, isfundamentally more apparent than real. A corollary of this consequenceis the need for consistency of policies across countries as a condition fororderly international economic developments. These considerations ineffect stress the increasing futility of attempts at pursuing national objec-tives at the expense of international aims.

Nowhere is this consideration better illustrated than in the context ofdevelopments in the European Monetary System (EMS), which repre-sents actually a quantum jump over the Bretton Woods order in that it isbased on fixed exchange rates with freedom of capital movements.7 Theintimate linkages among domestic financial policies of EMS members

7Many observers attributed the success of the EMS to the existence of capital controls inmany of the participating economies, the argument being that the independence given upby exchange rate fixity was regained by capital restrictions. These arguments carry far lessweight at present, when capital flows have been liberalized within the EMS. For further dis-cussion, see Guitian (1988 and 1992d). In this context, the turmoil that characterizedEuropean and world money markets and the EMS toward the end of 1992 and in early1993 represented perhaps the most serious challenge of its existence, but I do not believethose turbulent events counter the fundamental logic of the paper.

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have become a well-known reality often written about; this is particularlytrue with regard to the benefits and costs of anchoring one's policies onthose of the less inflationary members of the system. This should not besurprising in a regime that ensures the openness of its components interms of both prices (fixed exchange rates) and quantities (free capitalflows). In these circumstances, any domestic policy imbalance in theanchor economy (say, an improper policy mix) has repercussions on theother economies of the system. And the latter cannot sever this linkageunless the market on its own gives the policies in other countries in thesystem a measure of credibility that exceeds that typically accorded to theanchor country. Actually, to operate optimally, systems like the EMSshould be able to shift the role of anchor between the countries(of sufficiently large size, of course) so that the group at large can bene-fit at all times from the advantage of being linked to the country with theset of policies of best quality. That is, the EMS should import the bestpolicies and the resulting best economic performance from where theyprevail and export them to where they are most needed.

In this general context, the recurrent turbulence experienced inEuropean and world currency markets since late 1992 warrants consider-ation. In that period, short-term capital and monetary flows have period-ically moved against the currencies perceived as vulnerable in the systemand the flows have been of a magnitude sufficient to prompt the with-drawal of Italy and the United Kingdom from the exchange ratemechanism (ERM) of the EMS. They also brought about downwardexchange rate realignments in other countries (Portugal, Spain) and mostimportant, in the context of this paper, the reintroduction on a tempo-rary basis of capital control measures in Ireland, Portugal, and Spain.More recently, they have led to an adaptation of the rules of operation ofthe ERM to expand the margin allowed to national economic policy dis-cretion. And arguments have resurfaced advocating capital controls as atool of economic management.8

Dramatic though these events seemed at the time, they could not beconsidered unexpected or unfounded. For nearly five years, the EMS hadbeen operated more and more as a regime of fixed, nonadjustable,exchange rates. But this was not accompanied by the progressiveconvergence in the economic policies of participating countries that

8As of August 2, 1993, EMS member countries decided to increase the permissible mar-gins of fluctuation of their currencies around their central parities from 2 1/4 percent to 15percent. This decision has enlarged the scope of national policy discretion within the EMS.Soon thereafter, views began to be heard again advocating the need for the reintroductionof capital controls; see, for example, Eichengreen and Wyplosz (1993).

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would have been required by a fixed exchange rate system. A fundamen-tal inconsistency thus developed that, not having been correctedopportunely, could not but lead to the events that actually took place.

Perhaps the most important issue that international currency marketturmoil poses for the arguments made in this paper is whether or not theemergence of monetary turbulence is the most powerful argument infavor of the desirability of capital controls. I think the answer is negative.It is true that capital controls can contain for a time market turbulence;but they cannot replace actions to remove the underlying causes of theturmoil itself. For these reasons, rather than wonder about theusefulness of capital controls to insulate national economies, policymak-ers would do better to focus their attention on the constraints that mar-ket forces impose on national economic policies; and capital mobility isbut one illustration of those market forces.

The question for nation states in the current world environment is notwhether they are willing to live with the constraints of interdependencebut only how they will live with them. A possibility is to generalize theregime of flexible exchange rate arrangements that replaced the BrettonWoods par value system. This approach would contain the degree ofinterdependence among national economies by limiting the extent ofspillovers across their frontiers. But as already argued, the ability of flexi-ble exchange rates to provide insulation is more limited than often imag-ined, as experience over the last two decades has shown.

The other approach is to accept the existence of interdependence andwith it the constraints it sets on national freedom of action. This is theapproach behind the EMS. But as made evident by the currency marketevents just discussed, it is easier to recognize the presence of constraintsthan to accept the limitations they impose. The functioning of the ERMallows for virtually complete dissemination of spillovers across the EMS.In this setting, currency turmoil can be handled by actions such as thosediscussed earlier, for example, sterilization and fiscal policy tightening,provided the turbulence is limited in scale and duration. But if the tur-moil is of a permanent nature, these steps will not suffice. And yet, theseare not grounds to advocate (or resort to) capital controls. Essential forhandling sustained currency market turmoil will be the elimination ofdomestic policy inconsistencies and the presence of flexibility in productand factor markets, so that domestic cost-price variations can replaceexchange rate fluctuations as the valve of adjustment to shocks and eco-nomic imbalances.

In sum, the only grounds on which to argue for capital controls aretheir short-term effectiveness, that is, as an expedient means to containturmoil while fundamental policy actions are taken. But they can replace

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neither those actions nor the flexibility required in all economies to con-front shocks, whether provided by the exchange rate regime or byupward and downward movements in domestic costs and prices.

Looking at the international economy as a whole, there are grounds toargue for the introduction of capital account convertibility in the code ofconduct as an aim of equivalent importance to current account convert-ibility. To this end, capital controls and other restrictions on internation-al capital transactions should receive treatment similar to that given tocurrent account restrictions. The separate treatment given so far to thesetwo types of restrictions carries no weight in logic. But at present, neitherdoes it carry weight in practice, as in effect, capital flows across nationson an increasing scale and with growing freedom. As a result, where theyremain, capital controls have become far less effective than they would bein a setting characterized by a network of widespread interferences withmovements of assets across national borders. As was the case with currentaccount liberalization during the Bretton Woods regime, the establish-ment of freedom for capital transactions represents a key challenge for themembership of the IMF. But the challenge has already been substantial-ly met by world economic developments, for practical purposes.

Concluding Remarks

There is a consensus that capital account openness, other things beingequal, is preferable to the prevalence of capital controls. The case forthose controls is typically based on second-best reasoning, and it hasoften been accompanied by discussions of the conditions that an econ-omy should satisfy before considering external financial liberalization.These conditions typically include the establishment of a stable macro-economic setting at a realistic rate of exchange. An important element ofthe setting will also of course be a sustainable fiscal position. It will bedesirable in addition to have a liberal domestic financial system and onealready endowed with a sound safety net to withstand the inroads likelyto be caused by foreign competition.

But like in many other areas of economics, waiting for conditionssuch as those just listed to materialize before proceeding to liberalizecapital movements may prove the best recipe for the permanence of cap-ital controls. Just as plausible would be the opposite argument, one thatwould contend that the capital account should be opened with no priorconditions, for the following reasons. An open capital account will con-strain domestic policies to the extent necessary to bring about balanceand stability to the economy. On this reasoning, a stable macroeconomy,

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rather than a precondition for liberalization of capital transactions, canalso be seen as a result of capital account convertibility. Similar argu-ments can be made with regard to the exchange rate—open capital flowswill bring about a realistic exchange rate rather than require it ex ante.And the same reasoning applies to the need for domestic financial liber-alization, which can also be seen as an outcome of, rather than a pre-requisite for, external financial opening.

Clearly, in the extreme, neither of these positions is likely to beapplicable to any concrete economy. Neither need the opening of thecapital account wait until all desirable conditions are in place, becausesuch a point in time is unlikely to be reached. Nor should it proceed inthe absence of a minimum of favorable domestic economic conditions.Balance between these two extremes will be necessary. Such balancemeans that capital account liberalization should be undertaken in less-than-optimal domestic economic conditions, but not under circum-stances so far away from optimality that the credibility of the decision toopen the economy to international financial transactions is so impairedthat it cannot be sustained.

Another pragmatic consideration that is often raised in discussions ofcapital account liberalization concerns the sequence of balance ofpayments opening; that is, discussions have often focused on whetherthe current account opening should precede or follow the liberalizationof the capital account.9 Many arguments favor the opening of the cur-rent account first for a variety of reasons including, in particular, thevarying speed of adjustment in the market for goods and services andin that for capital; the former is perceived as slower and therefore inneed of lead time in the opening to the external environment. But theredoes not seem to be an a priori reason why the two accounts could notbe opened up simultaneously, if only because the very presence of cap-ital controls can be an obstacle to current account liberalization.Although there is no categorical answer to the issue of sequencing—which, in any event, is influenced by the initial conditions of individualeconomies—it is plausible to argue that simultaneous rather thansequential liberalization, if accompanied by credible, sound domesticeconomic policies in a stable external environment, would reinforce oneanother.

A related issue to the sequence of liberalization is that of its speed, onwhich arguments can be grouped as favoring either a gradual or a rapid

9An excellent discussion of the various issues involved in the decision to liberalize aneconomy and of the sequence in which it should be undertaken will be found in McKinnon(1993).

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approach. Here again, no single, categorical answer can be given. But theadvantages and disadvantages of each approach warrant gauging. Gradualopening softens the inroads of external competition and provides leewayfor domestic preparation to confront that competition. But precisely bygiving leeway to adjust, there is no guarantee that the leeway will be, ineffect, used to confront external competition as opposed to the tendencyto continue exploiting the opportunities of a closed or partially closedeconomy. If gradual opening encourages delays in adjustment, its costswill not fall below those from a fast liberalization, and yet it will not ben-efit from the latter's advantages. These advantages are the transparent sig-nals that rapid opening of the economy conveys to economic agents andthe consequent total absence of leeway for delays in behavioral adjust-ments to external competition.

It is generally agreed that efficiency criteria argue for completely freeexchange systems, with appropriate prudential safeguards, of course. Butthere are also pragmatic considerations that advocate the establishment offull currency convertibility. These considerations include the desirabilityof strengthening the role of market forces as opposed to administrativecontrols; the need to encourage international resource flows; and theneed to supplement domestic financial market liberalization andderegulation.

In conclusion, economic logic advocates the dismantling of capitalcontrols; developments in the world economy make them undesirableand ineffective; and a strong case can be made in support of rapid anddecisive liberalization of capital transactions. All these considerationsunderwrite strongly a code of conduct that eschews resort to capitalcontrols as an acceptable course of action for economic policy. And inthe context of the EMS, the tensions that have afflicted it since late1992 must also be seen from the following perspective: capital accountliberalization has created a global capital market capable of handlinginternational capital movements on a worldwide scale that vastlyexceeds the capacity of reaction of individual central banks. This is per-haps the strongest argument for national policy consistency and forcontinuous vigilance to avert the emergence of exploitable national pol-icy divergences. Paradoxically, the need for consistency in this contextgoes beyond the international perspective to contain the margin forarbitrage among divergent countries' policies. In fact, it extends to thenational domain in order to make the conduct of monetary policy,which is typically confined to the national domain, compatible with pol-icy decisions taken to liberalize domestic financial and capital markets,which have contributed to establish a world market in financial assetsand liabilities.

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References

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de Vries, Margaret Garritsen, The International Monetary Fund, 1966-1971: The SystemUnder Stress (Washington: International Monetary Fund, 1976), 2 vols.

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Eichengreen, Barry J., and Charles Wyplosz, "Taming Speculation," in European EconomicPerspectives (London: Centre for Economic Policy Research, October 1993).

Fischer, Bernhard, and Helmut Reisen, Towards Capital Account Convertibility, OECDDevelopment Centre, Policy Brief No. 4 (Paris: Organization for EconomicCooperation and Development, 1992), pp. 1-33.

Frankel, Jeffrey A., "Quantifying International Capital Mobility in the 1980s," in NationalSaving and Economic Performance, ed. by Douglas Bernheim and John B. Shoven(Chicago: University of Chicago Press, 1991).

Friedman, Milton, "Deja Vu in Currency Markets," Wall Street Journal (New York),September 22, 1992, p. 18.

Greene, Joshua E., and Peter Isard, Currency Convertibility and the Transformation ofCentrally Planned Economies, IMF Occasional Paper No. 81 (Washington:International Monetary Fund, 1991).

Guitian, Manuel, "An Old-Fashioned Vision of Monetary Policy for an Emerging Europe,"in The Monetary Future of Europe (London: Centre for Economic Policy Research,1993).

(1992a), "Capital Account Liberalization: Bringing Policy in Line with Reality," apaper presented to an international conference on Money and Finance in the OpenEconomy, Institute of Economic Research, Korea University and Bank of Korea(Seoul, 1992).

(1992b), The Unique Nature of the Responsibilities of the International MonetaryFund, IMF Pamphlet Series, No. 46 (Washington: International Monetary Fund,1992).

(1992c), "Monetary and Exchange Rate Policies for Stabilization and Reform," apaper presented to a seminar on The Transition and Adjustment at the Joint ViennaInstitute, Vienna, Austria, on October 6, 1992.

(1992d), Rules and Discretion in International Economic Policy, IMF OccasionalPaper No. 97 (Washington: International Monetary Fund, 1992).

(1992e), "Remarks on the Debt Crisis," in Changing Fortunes: The World's Moneyand the Threat to American Leadership, by Paul A. Volcker and Toyoo Gyothen (NewYork, N.Y.: Times Books, 1992).

"The European Monetary System: A Balance between Rules and Discretion" inPolicy Coordination in the European Monetary System, IMF Occasional Paper No. 61(Washington: International Monetary Fund, 1988).

Hanson, James A., "Opening the Capital Account: A Survey of Issues and Results," PolicyResearch Working Papers, WPS 901 (Washington: The World Bank, 1992).

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Horsefield, J. Keith, ed., The International Monetary Fund, 1945-65: Twenty Tears ofInternational Monetary Cooperation (Washington: International Monetary Fund,1969), 3 vols.

International Monetary Fund, Determinants and Systemic Consequences of InternationalCapital Flows, A Study by the Research Department of the International Monetary FunIMF Occasional Paper No. 77 (Washington, 1991).

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McKinnon, Ronald I., The Order of Economic Liberalization: Financial Control in theTransition to a Market Economy (Baltimore: Johns Hopkins University Press, 2d ed.,1993).

Polak, Jacques J., "Convertibility: An Indispensable Element in the Transition Process inEastern Europe," in Currency Convertibility in Eastern Europe, ed. by John Williamson(Washington: Institute for International Economics, 1991).

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