the euro-currency market - imf elibrary

Long an enigma to most observers, the Euro-currency marketis now becoming the focus of wide attention as it hasbecome an important component of the world economic scene.The author analyzes its growth and future role.

The Euro-currency marketin perspective

Eisuke Sakakibara A newcomer to the literature on the Euro-currency market may seem to need, atleast, a course in witchcraft, magic, andthe mind of Sherlock Holmes, for itabounds with allusions to "mystery,""puzzles," "magic," and so on, by someof the most distinguished contemporaryeconomists. Professor Machlup alludes,on one occasion, to The Euro-Dollar Mar-ket: A Mystery Story, and on another tothe similarities between Euro-dollars anda "magician's rabbits"; Charles Kindle-berger devotes himself to Two Puzzles ofthe Euro-Dollar Market, while MiltonFriedman is inclined to attribute it all tothe magic of a mere bookkeeper's pen.

There are, of course, many factorswhich have contributed to this mysteryand confusion. First, the lack of statisticaldata and qualitative information on themarket has made it difficult to determinethe precise nature and extent of Euro-currency operations. The absence of data,in particular, has encouraged observersto make more or less informed guessesabout the relative orders of magnitudeinvolved; guesses which unfortunatelyare often influenced by analytical con-cepts frequently used in relation to do-mestic money markets such as a multi-plier model, and which may have littlerelevance in the international sphere.These problems have been compoundedby the rapid changes in the nature ofEuro-currency operations and institutionsas the market has matured.

Second, the little statistical data that isavailable suggests an extremely rapidgrowth in the net size of the market. Asa result, a large part of the literature hasbeen devoted to explaining the growth ofthe Euro-currency market and to debating

its implications. This extremely rapidgrowth apparently encouraged the use ofthe word magic and, for want of a betterexplanation, suggested a comparison withother cases of supposed economic magic,like the deposit multiplier process sofamiliar in the context of a domesticbanking system. Although subsequentdebate sought to expose much of thistrick, considerable concern developedabout both the market's influence on theeffectiveness of domestic economic poli-cies, particularly the monetary ones, andthe market's contribution to world infla-tion because of its effective expansion ofthe world's money supply. More recentlythis concern spread to the market's rolein destabilizing short-term capital flowsand in the "collapse" of the internationalmonetary system.

Third, and the most important sourceof mystery and confusion, has been thelack of an appropriate theoretical baseand a broader perspective for discussionson the Euro-currency market. This needis most obvious when discussions con-centrate on policy questions like the con-trol of the market, particularly whenthere is an attempt to compare alternativemethods of control.

The multiplier analysisSince the dominant institutions in the

Euro-dollar market are commercial banksit seemed a logical first step to draw aparallel between the Euro-banking systemand a typical domestic banking system,and to argue that the deposit expansionor money multiplier model, which is gen-erally applicable in the domestic case, isalso a relevant conceptual framework fordiscussion of the Euro-dollar market.

11

©International Monetary Fund. Not for Redistribution

Typically, analysts adopted a fixed coeffi-cient version of the deposit expansionmodel, which assumes that the publicholds a fixed ratio of currency to bankdeposits and that banks hold a fixed ratioof reserves to deposits. Having calculatedthe relevant multipliers they attempted toappraise the credit creating power of theEuro-banking system on the basis of agiven primary deposit or increase inreserves. This type of multiplier modelessentially implies disequilibrium, andcontinuous expansion of credit until someconstraint intervenes.

Initially, few people disputed the appli-cability of the multiplier analysis, sincethe debate was essentially confined to themagnitude of the assumed leakage ratios.It was thus a simple matter for the "low-leakage-high-multiplier" school to attrib-ute the net size of the market, and itsrapid growth, to the inherent magic ofthe deposit-expansion process, while the"high-leakage-low-multiplier" school wasforced to resort to alternative explana-tions of the market size and growth.

More recently, however, several writershave withstood the temptation of associ-ating with either school, choosing insteadto abandon the multiplier analysis—atleast in its simple fixed-coefficient form—as a conceptual framework for analyzingthe Euro-dollar market. Essentially, twomain criticisms have been leveled againstthe simple multiplier analysis. First, somewriters have warned against interpretingthe total Euro-dollar deposit figure as ameasure of liquidity created by the Euro-dollar market (or of the net credit impactof the market). Therefore, they areagainst interpreting the multiplier as anindicator of the liquidity impact of agiven primary deposit or reserve basechange, as indeed each is in the contextof a domestic banking system. It is ar-gued that positive asset transformation(lending long-term on the basis of de-mand deposits), which is the essence ofliquidity creation in a domestic bankingsystem, may be less prevalent in theEuro-currency market. Therefore, insteadof primarily creating additional liquidityEuro-banks function more as a distribu-tion system for existing liquidity, fromareas of surplus to areas of deficit all overthe globe.

Second, it has been argued that theconditions assumed by the simple multi-plier framework—specifically an exoge-nously determined base and stable reserveand currency leakage ratios-are not evi-dent in the Euro-dollar market. Forexample, the assumption that the Euro-currency markets are incapable of achiev-

ing equilibrium within a reasonable timespan may not be justified.

In the domestic markets where thereare legal reserve requirements and ceilingson interest rates charged on time anddemand deposits, it may not be toounreasonable to assume continuous dis-equilibria. The Euro-currency market, how-ever, is characterized by a lack of bank-ing controls, the interest rates in theEuro-market move flexibly, and the adjust-ments of both depositors and borrowersin the markets are fairly fast.

Under these conditions, it seems farmore reasonable to adopt an equilibriummodel where the Marshallian scissors ofsupply and demand, rather than the insti-tutionally determined multiplier, deter-mine the output of the banking services.

The general equilibrium modelIn an empirical study conducted by the

author with John Hewson within theframework of a general equilibriummodel, it was suggested that at most theEuro-currency deposit multiplier wasaround unity in the period 1968-72.("Euro-dollar deposit multiplier: a port-folio approach," International MonetaryFund, Staff Papers, July 1975.) At leasttwo important implications are to bedrawn from this finding. First, the impactof the Euro-currency market on the worldmoney supply has not been very signifi-cant, and the Euro-currency market byitself has probably not been the source ofmuch inflationary pressure. Hence, expla-nations of the source of world inflation-ary pressure are to be found elsewhere,such as in the expansion of the monetary

Eisuke Sakakibara

a Japanese citizencurrently with theMinistry of Finance,Japan, was aneconomist in theExchange and Trade

Relations Department of the Fund whenthis article was written. He is a graduate ofthe University of Tokyo and receivedhis doctorate in Economics from theUniversity of Michigan. Mr. Sakakibaracollaborated with John Hewson on aresearch project on which this article isbased and on a book The Euro-currencyMarkets and Their Implications. He isalso the author of numerous articles oninternational economics and economictheory in professional journals.

bases of major industrial countries of theworld. The Euro-market has simply func-tioned as a distribution system for trans-mitting the monetary expansions of onecountry to other countries of the world.

Second, our findings showed that theidea of controlling the Euro-currencymarket as a means of regulating theoverall level of global liquidity seems tolack the appropriate conceptual base.However, this should not preclude thepossibility of some form of official inter-vention in these markets for other pur-poses. The Euro-currency market providesthe vital link between the national finan-cial markets of the world and, therefore,some form of close surveillance and finetuning may be warranted for the effectivemonitoring of the world economy. Inthis interdependent world, where oneeconomy cannot be isolated from devel-opments in others, problems of one areaof the world economy are soon trans-mitted to other areas. This increasinginterdependence and the greater interna-tionalization of the economies of theworld have been major undercurrents ofthe rapid growth of the Euro-currencymarket.

Greater internationalization andincreasing interdependence

The development of Euro-currencybanking within the general equilibriumsystem of international and domesticfinance can best be characterized as thelogical result of the internationalizationand liberalization of banking operationsthat have traditionally been closely con-trolled by national authorities. It is not bycoincidence that the return to externalconvertibility and the substantial relaxa-tion of exchange controls throughoutWestern Europe in 1958 were instru-mental in initiating Euro-currency bank-ing operations. The elimination of theseexchange and capital controls, along withthe competitive edge enjoyed by Euro-currency banks over their U. S. counter-parts in being able to operate without anyrestrictions in the form of interest rateceilings and legal reserve requirements,seem to have been important factors inthe subsequently rapid growth of theEuro-currency markets.

Thus, it may be reasonable to attributethe emergence and the expansion of theEuro-currency market to the liberalizationof exchange and capital controls and theresulting international competition formore efficient and cheaper banking oper-ations. Although the increases in the U. S.balance of payments deficit during thelate 1960s and early 1970s have often

12


been cited among the major stimuli to thegrowth of the Euro-currency market, thedirection of causation is not clear cut. Thedevelopment of relatively free interna-tional banking, prompted in part by theexistence of interest rate regulations inthe United States, would cause short-termcapital outflow from the United States,and, therefore, a deterioration of the U. S.balance of payments on both a liquidityand official settlements basis. Thus, thedeficits in the U. S. balance of paymentscould be called the result, and not thecause, of the rapid expansion of theEuro-currency market.

It seems proper, therefore, to view thedevelopment of the Euro-currency mar-kets in the broader context of the generalprocess of internationalization of eco-nomic activities involving trade, directinvestment, portfolio investment, andshort-term to medium-term banking oper-ations. The development of Euro-currencyoperations, along with the rapid expan-sion of international trade and invest-ment, has indeed changed the basic struc-ture of the world economy during thepast decade or so. The world has movedfrom a regime of relatively controlledinternational activities toward that ofcomparatively free international trans-actions. The internationalization and liber-alization of short-term to medium-terminternational capital should be viewed as,more or less, the beginning of the finalstage of this transition from a compara-tively controlled to a free regime in placeof the somewhat rigid Bretton Woodssystem of international finance.

The 1960s and early 1970s may, there-fore, be viewed as the transition periodfrom the U.S. dominated and tightly con-trolled international economic system toa freer system where the U.S. influenceis less dominant. The rapid expansion ofthe transactions of international banksin the Euro-currency market, as well asthe activities of other nonfinancial multi-national corporations, has served as thevehicle for this transition. Although theEuro-banks and other multinationals haveoften been accused of creating unneces-sary disruption in world markets, thisallegation would only be true if the worldeconomy were still operating under theold regime, or if the world could or shouldrevert to the old controlled system.

The effects of capital controlsThroughout the late 1960s and early

1970s many of the authorities that con-stitute the official sector repeatedly at-tempted to react to observed develop-ments in the private sector of the world

economy. Consequently, there were nu-merous instances where these authoritiesattempted to fix exchange rates throughofficial intervention either with or withoutthe imposition of new controls on short-term capital transactions. Only lately hasthe official sector of the world economybegun to realize that such attempts tocontrol private capital transactions in theinternational money and capital marketsare, in general, not feasible in the presentinternational environment, where the in-ternationalization of private transactionshas progressed to such a degree that someway is almost always found to circumventthese controls or to force further andincreasing corrective action to be taken.

It is quite ironical that the impositionof exchange and capital controls in somedeveloped countries in the late 1960s andthe early 1970s was one of the key fac-tors in the rapid growth of the Euro-currency market during this period. Since,in most cases, the controls that wereinstituted during this period were notintended to completely choke off all inter-national transactions, there was alwayssome way to circumvent them. The proc-ess of circumventing these controls gen-erally produced an expansion in the vol-ume of Euro-currency transactions. Forexample, the imposition of a host ofcapital controls in the United States in1968, supplemented by tight monetarypolicy during the period, increased theactivities of overseas branches of Ameri-can banks by tremendous amounts in1968 and 1969. The assets of overseasbranches of U.S. banks more than dou-bled during these two years, from $15.7billion in 1967 to $41.1 billion in 1969,while the number of overseas branchesjumped from 295 to 459 in the sameperiod. Similarly, the activities of foreignbranches of German banks, particularlyin Luxembourg, expanded quite rapidlyin the early 1970s following the imposi-tion of the minimum reserve requirementon German banks' external liabilities.According to published annual accountsat the end of 1971 and the beginning of1972, the consolidated balance sheet ofthe subsidiaries of large German banksin Luxembourg alone was some DM 6billion, compared with DM 2 billion ayear previously. The bulk of this increasewas thought to be the result of offsets tothe control.

Therefore, had it not been for thesecontrols, New York, as well as othersmaller money markets such as Frankfurtand Paris, probably would have kept pacewith the growth in London, Luxem-bourg, and other Euro-centers as the vol-

ume of international transactions in tradeand capital expanded. The imposition ofcontrols served to concentrate these freetransactions in short-term capital in Lon-don and, to a lesser degree, in Luxem-bourg, and other "off-shore" Euro-centers.However, the increasing volume of aggre-gate international transactions in short-term capital was the consequence of theinternationalization of economic activitiesof the countries of the world and not theresult of the imposition of capital con-trols. The imposition of capital controlsshould perhaps be viewed as a futileattempt by the official sector of the worldeconomy to retaliate against the increas-ingly strong waves of internationalizationin the private sector and such attemptsonly encourage private transactors tosearch for ways to circumvent them andthis serves to skew the geographical dis-tribution of these transactions to the areasof the world economy where controls areabsent.

Recent developments and the futureIn 1974 the Euro-currency market went

through a difficult period of adjustmentas the world economy strived to adaptitself to a new environment after thequadrupling of the oil price late in 1973.By the middle of the year, confidence inthe market was strained by the announce-ment of foreign exchange losses and anumber of much publicized bank failures,although these losses were not directlyconnected to Euro-market business. Con-cern also spread that Euro-banks couldnot continue to play a major role inrecycling oil surpluses because of capitalinadequacy of commercial banks andbecause of the difficulty of maturitytransformation that was required in oilfinancing. Danger of the lack of a clearlydefined lender-of-last-resort in the Euro-market was also emphasized in relation tothis problem of maturity transformationand the deteriorating credit worthiness ofsome borrowers in the markets.

Furthermore, it was feared in somequarters that the termination of U. S.capital controls in January 1974 wouldstrip the Euro-currency market of itsraison d'etre as a substitute market forNew York.

Indeed, the gross side of the Euro-cur-rency market contracted in the third quar-ter of 1974 for the first time in its history:external foreign currency liabilities of thebanks in the eight reporting countries(Belgium, France, the Federal Republic ofGermany, Italy, the Netherlands, Sweden,Switzerland, and the United Kingdom)

continued on page 41

13


The development ofthe Euro-currency market

How and why did the Euro-currency market emerge? Thisarticle reviews the historical and institutional characteristicsof the Euro-currency market.

Paul de Grauwe

The Euro-currency market is an interna-tional banking market specializing in theborrowing and lending of currencies out-side their countries of issue. Participantsin the market are commercial banks,monetary authorities, and nonbanks, thelatter comprising mainly business firms(particularly large multinational corpora-tions), government agencies, and semi-governmental entities, including centralbanks and international organizations.Comprehensive official statistics are lack-ing and estimates on the size of themarket vary widely, placing the grossvolume of Euro-currency assets of banksin major international banking centers inthe range of $200-400 billion. Availablestatistics suggest that interbank transac-tions constitute the largest and generallyfastest growing portion of the Euro-currency market, while nonbank sourcesand uses of funds channeled through themarket account for less than one third oftotal Euro-currency transactions. Sincethe largest part of the market is locatedin Europe and since the bulk of the trans-actions is in dollars, the market is com-monly called the "Euro-dollar market."With increasing use of currencies otherthan the dollar, for example, the deutschemark and the Swiss franc, a more appro-priate general term is "Euro-currencymarket"; but even the prefix "Euro" ismisleading as a significant part of the

14

transactions is carried out in centers out-side Europe, such as the Bahamas, Pan-ama, and Singapore. Therefore, termssuch as "xeno-currency" and "offshoremarket" might be preferable.

Origin and growthWhile international banking centers

had for a long time known some opera-tions in offshore currency assets and lia-bilities, two developments Jo ward the endof the 1950s appear to have been mostimportant in prompting banks to engageon a substantial scale in Euro-dollar oper-ations. First, in 1957 in response to thesterling crisis, the United Kingdomauthorities instituted tight controls onnonresident sterling borrowing and lend-ing by U. K. banks. In order to retaintheir position in the financing of worldtrade, the U. K. banks turned to dollarsas a substitute for sterling. Second, at theend of 1958 the currencies of the majorWestern European countries were madeconvertible for nonresidents. This allowedbanks in those countries to buy and selldollars freely and to use them in thefinancing of international trade.

In the early 1960s, two major inter-national dollar markets existed, one cen-tered on New York, the other on London.At that time the volume of internationaltransactions was larger in the New Yorkmarket, but it was already apparent that

the London banks had a competitiveadvantage. To some extent, this reflected"natural" locational advantages, for ex-ample, time differences and closer prox-imity to some important customers. Buta major factor was the absence of regu-lations of banking operations in cur-rencies other than the pound sterling inthe London market. Unlike banks oper-ating in the United States, banks oper-ating in the United Kingdom were not,and are still not, subject to legal reserverequirements or official interest rate ceil-ings in respect of their dollar transac-tions. This enabled them to pay higherdeposit rates and to operate with nar-rower margins than U.S. banks subject tosuch regulations.

Such differential treatment of nationaland offshore banking operations wastypical not only for the United Kingdombut also for most other countries whereimportant offshore banking centers devel-oped. This explains much of the spectacu-lar growth of the Euro-currency market.However, it is not the sole explanation.The New York financial market mighthave maintained its relative position ininternational financial transactions had itnot been for specific actions taken by theU. S. authorities to restrict the outflow offunds from the United States. First, in1963 an "interest equalization" tax wasintroduced which effectively closed theNew York capital market to many foreignborrowers. Second, in order to cope withincreasing balance of payments deficits,the U. S. administration instituted in 1965a voluntary program of direct controlsover nonresident lending by banks andother financial institutions—the Volun-tary Foreign Credit Restraint (VFCR)


Guidelines. This program was graduallystrengthened and in 1968 made effectivelymandatory. Third, controls over U. S. di-rect investment abroad were introducedwhich limited inter alia the use of U. S.bank credit to finance new or additionaldirect investments abroad.

This set of controls had two impor-tant effects on the growth and structureof the Euro-currency market. First, U. S.companies wishing to finance new oradditional foreign investment outlays hadto rely more on funds raised outside theUnited States. Second, U. S. banks con-strained in lending to foreign residents,including foreign branches of U.S. com-panies, had to raise funds outside theUnited States if they wanted to avoidlosing out in the growing internationalloan business. They succeeded in doingthis by establishing branches in Londonand elsewhere, thus shifting a large partof their international business from NewYork to offshore banking centers.

The growth of the Euro-dollar marketsince the late 1960s followed essentiallysimilar lines. In 1969 the U. S. authoritiesembarked on a course of restrictive mon-etary policy. As U. S. banks were unableunder Regulation Q to increase the inter-est rate on time deposits, including certifi-cates of deposit, they experienced a sub-stantial drain of funds which wereattracted to more profitable investmentoutlets. They turned to their Londonbranches and borrowed heavily fromthem. In the process, interest rates in theEuro-dollar market rose sharply, increas-ing the drain of deposits from the U. S.market to the Euro-dollar market. In1970 the Federal Reserve eased its mone-tary stance and partially relaxed Regula-tion Q ceilings on time deposits. U. S.commercial banks could again competefor time deposits in the U. S. market, andrepay most of their outstanding debtsvis-a-vis their London branches. As aresult, Euro-banks were left with liquidfunds, but since at the same time majorEuropean countries followed policies ofmonetary tightness, there was ample de-mand for funds by European borrowers.

The growth of the Euro-currency mar-ket continued to be very rapid until mid-1974, with an estimated growth rate ofmore than 40 per cent in 1973 and early1974 in that part of the market on whichofficial statistics are reported to the Bankfor International Settlements (BIS). Thus,its growth continued undiminished, evenafter termination in January 1974 of U. S.measures restricting capital outflows.However, by mid-1974 concern about theviability of some banks and uncertainty

Chart 1The growth of the Euro-currency market, 1965-74 *

Billions of U.S. dollars

Source: BIS Annual Reports and Fund staff estimates.This covers only that part of the market which is accounted for by banks or countries reporting to the BIS.

about the future of the market caused itsgrowth to be checked sharply, and therecently resumed growth of the markethas been at a significantly reduced rate.

The changing structure of themarket

Throughout the history of the market,the U. S. dollar has accounted for by farthe largest share of transactions. How-ever, the share of nondollar-denominatedassets and liabilities continued to increase.At the end of 1973 the nondollar share

of the market had increased to 28 percent, from about 17 per cent in 1969.This trend was mainly the result of anincreased demand for deutsche mark andSwiss franc financial assets as these cur-rencies were at that time generally ex-pected to appreciate. Since investments inthe Federal Republic of Germany andSwitzerland by nonresidents were increas-ingly restricted by capital controls, de-mand for deutsche mark and Swiss francassets shifted to offshore banking centersand, as a result, Euro-banks became in-

15


creasingly active in the deutsche markand Swiss franc part of the market.

Not only the currency composition butalso the regional composition of the mar-ket has changed over time. This changecannot be detailed because of the lack ofcomprehensive statistics. However, esti-mates made by the BIS give a generalidea of the direction of shifts in the pat-tern of uses and sources of funds chan-neled through the market. These esti-mates point to an increasing relativeimportance of countries outside NorthAmerica and Western Europe as lendersand borrowers in the Euro-currency mar-ket since 1964.

Banks active in the Euro-currency mar-ket operate from widely dispersed bank-ing centers. London is still the maincenter of the offshore banking business.However, since 1970 its share in the totalhas declined, mainly to the advantage ofthe Bahamas, Singapore, Panama, andBeirut. There has also been a significantchange in the distribution of Euro-currency business among banks accordingto their national origin. From 1963 to 1969the share of U. S. banks in the LondonEuro-currency market increased substan-tially (fr~im about 25 per cent to 54 percent of the total). The remainder wastaken up mainly by U. K. banks. However,since 1973 U. S. banks have accountedfor somewhat less than 40 per cent ofthe London market, and banks with headoffices outside the United States and theUnited Kingdom have gained a largershare. At the end of 1974 these banksaccounted for more than 30 per cent ofthe total Euro-currency business centeredin London. Since the mid-1960s, therehas also been a growing number ofmostly multinational consortium banks,which in 1974 accounted for about 7 percent of the total Euro-currency businessbased on London.

General features of theEuro-currency market

The Euro-banks have developed somecharacteristic lending and borrowingpractices. In general these techniquesemerged as a response to the particularstructure of the market and to changesin this structure.

First, the Euro-currency market is a"wholesale" market in the sense thatmost final borrowers are large companiesor official entities and the average unitsize of transactions is large. As a result,the banks' overhead costs are relativelylow.

Second, the Euro-currency market is toa large extent an interbank market. Thus,

more than 75 per cent of the foreigncurrency liabilities and assets of the re-porting European banks are against otherbanks. In the last few years most of theincrease in the gross size of the marketwas due to an increase in interbank de-posits.

Third, the Euro-currency market is ahighly competitive market. New entryinto the market is unrestricted. This hasat times led to a general decline in themargin between deposit and loan ratesand lower rates of return on Euro-currency assets than those on domesticcurrency assets in national markets. Dur-ing periods of increasing competitionamong banks operating in the Euro-currency market some Euro-banks havealso taken higher credit risks, both in thechoice of borrowers and in the acceptanceof longer maturities of loans generallyextended on an unsecured basis. There issome evidence that the market hasrecently become more cautious both withregard to exposure to individual bor-rowers and to longer maturities.

While in many ways the Euro-currencymarket is similar to national money mar-kets, it is basically different from themsince it is a market wthout central mone-tary authority and free from controls.

Loans and depositsAs a means of spreading the risk inher-

ent in generally large scale loans, Euro-banks have increasingly relied on thetechnique of syndicating medium-termloans extended outside the interbank mar-ket. There are different methods for syn-dicating a loan. The common character-istic is that it involves a large numberof participating banks (as many as 95 in

Paul de Grauwe

was an economist inthe Exchange andTrade RelationsDepartment under theYoung ProfessionalsProgram of the Fund

before accepting a position as Lecturerin economics at the Catholic University ofLouvain in his native Belgium in 1974.He holds the Licentiaat-Doctorandus degreefrom that University and a Ph.D. ineconomics from the Johns HopkinsUniversity. He has published a number ofarticles in professional journals.

one case) with one bank—the lead bank—managing the loan. This system hasallowed many small- or medium-sizedbanks to operate in the Euro-currencymarket. The same factors that have led tothe growth of syndicated loans have inrecent years also prompted many banksto join in consortia. In order to limit thedefault risk resulting from indirect loanrelationships often involving many banks,Euro-banks typically place limits on theamount of outstanding advances that theywill extend to any single borrower and toborrowers in any single country.

Another typical feature of Euro-currency lending outside the interbankmarket is the use of "floating rate" medium-term credit arrangements. These representa type of roll-over credit with interestrates determined periodically, usuallyevery six months, on the basis of interestrates prevailing in the interbank market.In this way lending banks aim at reduc-ing the interest rate risk that is inherentin unmatched maturities of assets andliabilities. Most loan contracts specifylending rates as a margin over thedeposit rates of "reference banks," usu-ally taken to represent the London Inter-bank Offer Rate (LIBOR). However,"LIBOR" is not necessarily the rate atwhich interbank funds are obtainable forrefinancing by all banks participating ina syndicated loan.

Many loan agreements contain a multi-currency clause. Before the recent up-heavals in the exchange markets, mostloans were denominated in U.S. dollars.However, as the uncertainty concerningexchange rates grew, so did the risk forlenders and borrowers faced with thechoice of currency. The multicurrencyclause provides an important element offlexibility in this respect by offering achoice of currencies in which the whole orparts of a loan may be drawn upon.

Euro-banks do not provide checkingfacilities. However, the relatively shortmaturities of most Euro-currency depositsmake these deposits very close substitutesfor liquid assets. In 1966 an importantnew facility was introduced. Followingthe lead of their offices, U.S. branches inLondon started issuing negotiable dollarcertificates of deposit (CDs). These arenegotiable receipts for a U.S. dollar de-posit with a London bank. The advantageof this instrument is that it combines theyield opportunities of time deposits witha high degree of liquidity. The liquidityof CDs, of course, depends on a well-functioning secondary market. The latterexists and it is generally agreed to bevery efficient.

16


Concern over the availability and longevity of natural resourceshas escalated to the point where it finds expression in aquestion that is so absolute as to have parallels not in thesocial sciences but in philosophy. Having posed the question,the author examines the conceptual boundaries and practicaldimensions of the problem of scarcity of raw materials.

Bension Varon

The complicated concept of resourcescarcity cannot be properly examinedexcept in relative terms—that is, relativeto time, need, and price. But the questionof scarcity of natural resources is a vitalone, relevant to the present and thefuture, and therefore it must be examinedclosely so that rational decisions may bemade by policymakers round the world.

Enough ofeverythingfor everyone,forever?

17


The realization of the finiteness of ourglobe in terms of mineral, land, andenergy resources is upon us with all theattendant alarm and worry. The perva-siveness of its impact is not surprising.As issues evolve, our awareness of thembecomes greater. We are made aware thatthe frontiers—with the exception of theoceans—are largely closed, that inven-tories of resources are now more accuratethan ever, that there is global interde-pendence in terms of requirements andgoals, and that planning for the futuremust take these factors into account.

The greatest concern over resourcescarcity has been triggered by populationgrowth. World population increased fromabout 750 million in 1770 to nearly3.7 billion in 1970. The number of peopleadded to the world population since theIndustrial Revolution is probably tentimes greater than the number added inthe preceding 200 years. Unprecedentedpopulation levels will need to be sup-ported in the future and they will putconstant pressure on resources. At thesame time, while exploring the universe,we have become painfully aware of thesmallness of our world in relative terms,yet this world is all the "managementexperiment" granted us. Science and tech-nology have been our most valuablemanagement means, responding to andsupplying ever-increasing requirementsfor ever-increasing numbers of people.Attempts at worldwide population con-trol have not been very successful, sothat progress—and our belief in it as thenatural order of things—has been largelysustained by technology.

High InventoriesThe resource picture for the world as a

whole is not discouraging; inventories ofmost major resources are at least as high,by any count, as they were 20-30 yearsago relative to projected requirements,and technology is expanding. Yet there isvery real pessimism. This is more becauseof changed attitudes than of changedphysical parameters. The widespreadsense of insecurity is brought on in partby the realization that there are costs to bepaid in terms of pollution and the qualityof life, even for beneficial technologicaladvances. And we are even seriouslyquestioning whether human ingenuitycan, in fact, keep in step with humanreproduction and requirements. Further-more, faith in the role of the price mecha-nism either for tempering demand or forbringing forth additional supplies haseroded; as a result, there is lesseningreliance on the "invisible hand" to achieve

economic efficiency in the market place.The idea of equitable consumption of

resources is central to the concern overtheir potential scarcity. Historically speak-ing, consumption has been uneven andlargely inequitable, both within individualnations and among nations. Acute scarci-ties were faced through exclusion, withwhole segments of society existing at baresubsistence levels and small, exclusivesegments feasting at tables of plenty. Buttoday, in an era of internationalism, whenthere is growing understanding of thetrue interdependence of nations, the ideaof selective consumption is insupport-able. Thus, the question of resourcescarcity and what it means must ulti-mately be put in terms of how it relatesto developed and developing countriesrather than in general global terms.

The term "natural resources" refers toelements, products, or forces found byman in his natural environment which hemay utilize for his own benefit. In thisbroad sense, the resources provided bynature include "natural products" suchas minerals, forests, fish, and water and"amenities or situations," such as water-falls, waterways, natural harbors, andfertile soils, of current or potential eco-nomic or social value. The principal cri-terion is their present or future usability.Amenities are primarily nature's hand-outs, although subject to modification ashuman needs dictate, while the rest ofher treasures must be won through theapplication of capital, labor, technology,and constant search. "Nonrenewablenatural resources" are those inorganicmaterials extracted from the earth thatcannot be replenished within any periodof time short enough to be of significanceto human planning.

Although unquestionably supply prob-lems of food and energy at present loomlarge too, the question of mineral raw

a citizen of Turkey,was a SeniorEconomist in thePolicy PlanningDivision of the PolicyPlanning and Program

Review Department of the Bank whenthis article was written. He is nowAssistant Director, Policies and ProjectionsBranch of the Centre for NaturalResources, Energy and Transport, at theUnited Nations.

materials needs to be examined carefully.The three groups of resources differ bas-ically, for example, fuels are dissipatedduring consumption while land's produc-tivity is variable, and mineral raw mate-rials are reusable to a large extent. Yet,the three categories are interrelated andreinforce one another: higher energycosts affect the cost of producing andprocessing many mineral raw materialsand the availability and cost of fertilizerswhich further affect agricultural output.Higher import bills or higher investmentrequirements to fill the need for any onecategory of resources inevitably influencethe capacity to obtain the others. Butexaggeration of imminent shortages orthe precise fixing of "grace periods" con-cerning minerals do not serve well to dealrationally with the minerals problem.What is needed is a proper perspective.

The growth of demandConsumption of mineral fuels and raw

materials on a large scale started withthe Industrial Revolution, and the pace ofconsumption since then has been astound-ing. World consumption of all mineralcommodities combined increased tenfoldbetween 1750 and 1900, whereas, overthe same period, population expanded bya factor of 2.2 and per capita consump-tion of all goods and services by 4.5.During the past 70 years, however, min-eral consumption (including fuels) grewby a factor of about 12, population by2.4, and per capita consumption by 5.3.Demand for mineral raw materials in-creased somewhat more (13-14 times)than demand for fuels (11-12 times) inthe present century.

The trends for individual ores andmetals vary widely and point up thedynamics of resource conservation andcreation—something that does not emergefrom the composite picture. For example,world consumption of pig iron between1900 and 1970 increased 10-11 times,while steel production expanded by a fac-tor of roughly 20, reflecting an increaseduse of scrap. Similarly, consumption ofnew copper rose 14 times, but use ofcopper metal increased 20 times, as theproportion of secondary (recycled) copperexpanded from 10 per cent at the turnof the century to 35 per cent in 1970.The growth factor for zinc was 11.4, butthat for lead only 4.5, again partly dueto expanded scrap utilization, which rosefrom 8 per cent in 1910 to over 40 percent (in the United States) at present.

The upward trends for the traditionalminerals were checked by the introduc-tion of new raw materials, chiefly alumi-

18

Bension Varon


num and nickel, which are countedamong the most important in modernindustrial production. Aluminum con-sumption rose from negligible quantitiesin 1900 to 10 million tons in 1970, andnickel consumption jumped from a simi-lar base in 1900 to nearly 600,000 tonsin 1970. Apart from new metals, thedynamic change in growth patterns wasalso wrought by a thirtyfold increase inthe use of alloying metals such as chro-mite, manganese, molybdenum, tungsten,and cobalt, as the direct result of ad-vances in metallurgy.

Consumption growth slowingApart from recycling, there are already

signs—historically verified and theoreti-cally anticipated—that consumption ofmost minerals is now growing at a decel-erating rate, and considerably slower thanthe gross national product (GNP) in theUnited States and other industrializedcountries, as saturation levels are beingapproached. The interaction of incomegrowth, structural change, and accumula-tion of "stock" (capital goods in service)in these countries is bringing about adecline in the "intensity of use" (require-ments per unit of GNP) of most minerals.There are, of course, exceptions, such asaluminum, fluorspar, and certain alloys,which are either continuously displacingother metals or go into highly dynamicindustrial end-uses, such as aviation,refrigeration, and pollution control; butthese exceptions do not invalidate thegeneral statement. Yet, there is basis forconcern, for the consumption base of theworld is so very large now that evenmoderate rates of growth can create anintolerable strain on the world's totalresource base over the long run.

This concern is based on assumptionsof predetermined needs according to pres-ent patterns and fixed resources accordingto present knowledge. But need is rela-tive. It can be modified by changes intastes, relative prices, and in the materialcomposition of goods. For example, nickelis used to manufacture stainless steel;stainless steel to manufacture bumpers;bumpers go on cars; cars are needed fortransportation. While under the presentsystem and technology of production eachinput at each stage would be conceivedof as representing a "need," in realitythey represent nothing more than deriveddemand which can be met with alterna-tive inputs (cobalt instead of nickel, rub-ber instead of stainless steel). Moresignificantly, the end product, the privatecar, represents a choice about transporta-tion, rather than a need.

Therefore, a deceleration in the growthof demand can be brought about in avariety of ways, by a variety of factors,and changes in what we commonly meanby "way of life" need not have negativeconnotations.

The supply baseReserves for a large number of min-

erals have increased tremendously overrecent decades, despite massive consump-tion: reserves of copper have risen by 3.5times since 1935; of bauxite 7 times since1950; of iron ore 11 times, potash 23times, and chromite 6—7 times since thelate 1940s; and while reserves of leadand tin are relatively small, their pro-jected reserve lives—20 years—are stillthe same as they were 40-50 years ago.Furthermore, "potential resources" exceedreserves (ores that can be economicallymined at present) quite significantly inmany cases, and their inventories haveincreased also.

Obviously, some minerals such as sil-ver, tin, and zinc are scarcer than others.But their trends are not independent ofother concurrent developments. Becauseof advances in understanding and alteringthe molecular structure and compositionof minerals, the range of combinationsfor using metals is ever expanding. Con-sequently, in terms of utilization, thetotal resource base does not have fixedboundaries. Its physical limits, too, arebeing expanded at present with the explo-ration and anticipated exploitation of theocean beds' vast mineral resources. Inthis sense, the oceans are a true frontierwhose potential yields may be so vast asto make it impossible at this stage ofdevelopment to assess definitively theirultimate impact upon the total supply pic-ture.

Costs and pricesEven where ore grade deteriorated in

metal content, no hard historical evidenceof sharply rising costs is to be found. Forexample, while the metal content of cop-per ore is estimated to have declined from8 per cent in the sixteenth century to lessthan 1 per cent (in the United States) atpresent, copper costs declined from about$10 a pound four centuries ago to ap-proximately 30 cents a pound around1940 and have risen only moderatelysince then. Therefore, one can state thatthe surge in metal prices in 1973/74 (nowreversed), had little to do with the sheerphysical depletion of natural resources. Infact, buoyant demand, disruptions ofsupplies, problems at the processing end,currency adjustments, and speculation

contributed to the price hike. While thecost-push factor for exploration and min-ing has been operative till now, in thefuture reserve depletion, by itself, will beonly one of the factors determining thelong-term level of prices. Other factorswill include the stance taken by produc-ing countries, technological change, anti-pollution, and land conservation meas-ures, energy costs, and finally policydecisions affecting the pace, distribution,and productivity of global investment inexploration and mining as well as inprocessing.

The scarcity scareYet, the worry persists: How long into

the future can resource expansion andtechnological advances proceed with pricesremaining within tolerable levels in rela-tion to consumption and developmentgoals? Attempts have been made to definethe situation, the most famous beingthe study on the "Limits to Growth,"(March 1972) sponsored by the Club ofRome and conducted by a team of sys-tems analysts from the MassachusettsInstitute of Technology headed by Pro-fessor Dennis L. Meadows. This studylacked truth in packaging: the team pos-tulated as fixed those variables and rela-tionships which in fact cannot be takenas fixed. While this was increasinglyunderstood after initial excitement overthe MIT study had subsided, the adventof the energy crisis revived doubts andfostered a feeling of insecurity about allnatural resources. There is, however, apost-energy-crisis view expressed by Mr.M. Claude Guillemin, Director of thenational geological service of France, inan interview in 1974. When asked if theworld is on the "eve of catastrophe" withregard to natural resource availabilities,Mr. Guillemin replied: "In the case ofenergy resources, perhaps. In other min-eral resources, surely not." Referring tothe now famous "water lily in a pond"illustration of the dynamics of exponen-tial growth in the MIT study, he statedthat the illustration is "mathematicallycorrect, but biologically false," since ifthere are too many lilies in a pond, therewill be also other organisms which willattack them and block their exponentialgrowth. He went on to liken economicreaction to biological reaction, highlight-ing the opportunities for conservation andespecially the difference between oil andother minerals in terms of reusability—"acopper bar, for example, can exist eter-nally." ("La Fin du Gachis" (The End ofWaste), L'Express (Paris), April 22-28,1974.)

19


"unlike the food situation, pressure onraw materials resources will not comefrom population growth in developingcountries"

Scenarios that venture into the indefi-nite future have little application to viableplanning periods and to mechanisms ofmanagement as we now know them. Forour own planning time frame, 30 years atbest, the more pressing question centerson the distribution of both consumptionand production of raw materials betweenrich nations and poor nations, and theproblem of scarcity that arises in thisrelationship.

The distribution problemDeveloping countries consume less than

10 per cent of the world's annual outputof mineral raw materials. Yet, they pro-duce 33 per cent of the total output andpossess 40 per cent of all known reserves.Through exports, which account for fourfifths of their output, they supply 50 percent of the domestic requirements ofindustrialized nations (both market ori-ented and centrally planned economies)and 70 per cent of their import require-ments. While these figures point up theproducer-consumer dichotomy, they arein keeping with the obvious link betweendevelopment and raw material based pro-duction. Underconsumption of raw mate-rials of such proportions on the part ofthe developing countries reflects theirsevere underdevelopment.

A simple calculation based on availableforecasts covering the next 25-30 yearsreveals that of the increment in antici-pated world raw materials consumption,over half would result from increasedper capita consumption in industrializednations (both market oriented and cen-trally planned economies); one fifth fromadditional population growth in thesecountries; at most a quarter (but probablymuch less) from increased per capita con-sumption in developing countries; andonly 5-10 per cent from populationgrowth in these countries. Unlike thefood situation, pressure on raw materialsresources will not come from populationgrowth in developing countries—thatpopular alarm factor in all equationsdescribing the future. Therefore, despitesome narrowing of the gap, a child born

in an industrialized country stands toconsume on the average at least 10 timesmore mineral raw materials in the year2000 than a child born in a developingcountry. In light of this, and because theycontrol 40 per cent of world mineralreserves, it is not surprising that devel-oping nations resist diagnoses and impli-cations of the problem of scarcity fromthe point of view of present large con-sumers.

There has been talk recently of thepossibility that the dichotomy betweenthe have and have-not nations mightresult in new pricing policies for rawmaterials. Developing countries hardlyhave to demonstrate their urgent need foradditional revenues. But it is not far-fetched to suggest that the notion thattheir raw materials deserve higher pricesis also based on the concept of scarcityper se. To be aware of potential resourcescarcities is one thing; it would be amistake, however, to infer that so loosea contingency ought to be somehowreflected in current prices, which wouldmean differentiating between the impor-tance and longevities of individual re-sources on the basis of subjective andimprecise knowledge.

LDCs complaintDeveloping countries, in essence, are

complaining less about prices and moreabout their level of underdevelopment. Atthe heart of their argument is the propo-sition that they were denied opportunitiesas well as the means, such as technology,capital, and market access to develop onall levels.

To illustrate one aspect of the basicproblem, the value of developing coun-tries' current mineral output is about 30per cent of the market value of the fin-ished products. And this refers only tothe processed, metal ingot stage, not tothe manufactured end products. Highprofits (and external economies) comefrom processing, since value can beincreased by as much as four timesthrough semiprocessing and by as muchas 20 times through full processing up to

the metal bar stage. If the entire currentmineral output of developing countrieswere to be processed up to this stage, thevalue of their aggregate output could beas much as $10-12 billion higher. This isnot to suggest that no progress has beenmade toward the local processing of min-erals, nor that processing should be pur-sued without regard to comparativeadvantage or investment priorities. Thisillustration does portray the difficultiesthat arise when only one or two sectorsof an economy grow, having little feed-back effect on the economy as a wholewhich lacks enough internal strength orexternal support to respond quickly to theinitial stimulus. And it symbolizes thedifference in the stages of developmentbetween the developing and developedcountries, which, in turn, affects theirtrade relationship.

The economic benefits of trade havelong been understood and amply demon-strated. In the postwar era trade has beenrecognized as a valuable avenue for pro-moting peaceful political relations by suchnations as the United States and theSoviet Union, the Federal Republic ofGermany and the German DemocraticRepublic, Japan, and the People's Republicof China. Nations must now take fulleradvantage of trade as the handiest toolfor bridging the gap between the havesand have-nots, on the one hand, and forassuring efficient global exploitation andutilization of resources, on the other.However, despite decades of publicizedcommitment to free and expanded trade,trade remains highly sensitive to black-mail, manipulation, and pressure fromspecial interest groups.

The answerWhere does all this leave us? Without

a categorical answer to the original ques-tion. On a manageable scale of assessmentthere seem to be no major or insurmount-able long-term problems of scarcity ofindustrial raw materials if we countadvances in resource creation and utili-zation, and the application of every man-agement tool, such as planning, tech-nology, trade, and conservation. Makinglarge allowances for human ingenuity indealing with problems that are recognizedto be important is perhaps an act offaith, but not of blind faith. We knowwe have a global problem on our hands.The faith that we can handle resourcemanagement well will gain substance onlyif the world demonstrates that it can dealwith the pressing problem of narrowingthe gap between the rich and the poorcountries.

20


The World Bank Group may now be expected to increase itslending to the mining sector. The pressure to find and developnew mineral resources is increasing the risk of miningventures at every stage. The author, a Bank attorney, discussesprevious lending for mining in the context of guarantees bothto mining companies and to the developing countries wherethe mines are located.

David M. Sassoon The World Bank Group has advanced$721 million for mining ventures in thedeveloping countries since it began extend-ing financial assistance for such purposesin 1957. Of this amount $609 million waslent by the Bank and the InternationalDevelopment Association (IDA) and thebalance has taken the form of invest-ment and lending by the InternationalFinance Corporation (IFC). An increasingamount of Bank Group loans to the min-ing sector can be expected in the decadeahead, as capital requirements grow andas known resources are depleted anddemand rises.

The Bank's limited involvement in themining sector up to now (slightly lessthan 2a/2 per cent of total Bank Grouplending) is due to a number of factors.

Mining operates at levels of physical,commercial, and political risks that arenormally significantly higher than thoseof other industries. Mining projects

require extremely heavy investments, notonly in physical and social infrastruc-ture facilities, but also in preinvestmentexpenditures on exploration and metal-lurgical testing, which, because thereis no certainty of discovery, will often bewritten off as a loss. In addition, muchof the requisite technical expertise hasbeen, and still is, concentrated in thehands of a relatively small number ofmultinational corporations with free accessto the capital markets of the world ontheir own account. The investment cli-mate was, until recently, more stable, andnationalization and expropriation of for-eign-controlled mines less customary thannow. Mining was thus more readily fi-nanceable without Bank participation.And finally, the Bank itself used to bereluctant to finance governmentally ownedand managed industrial enterprises, fur-ther curtailing its limited involvement inthe sector.

Financing themining sector:the Bank's role


A commitment to the membercountry

As a rule, mining projects have beenfinanced on a project-by-project basis,rather than in the framework of a bal-anced sector approach. Most projectswere referred to the Bank from the out-side, generally after the bulk of the con-tractual arrangements between the for-eign private participants and the hostcountry had been at least substantiallycompleted. If arrangements for financinga project appeared unfair to the membercountry, the Bank simply refused to par-ticipate. The Bank's policy in this areahas been very clear.

Where the safety of the Bank's owninvestment was concerned, the Bank wasduty bound to influence the terms andconditions of the transaction between theprivate foreign investors and the hostgovernment. Beyond that, however, it didnot act as the advocate of the govern-ment in its negotiations with foreigninvestors, but it did make sure that thegovernment had competent legal and bus-iness advice. When necessary, the Bankhas made the retention of outside legaland other counsel a requirement for itsparticipation in mining projects and,where appropriate, has been willing toinclude the cost of such services as part ofits loan. Whether the Bank's attitude inthis area will change and become moreactive, and if so, what particular formthis involvement may take, remains tobe seen.

The Bank's procedure with mining proj-ects, irrespective of the portion it wasasked to finance, was first to be satisfiedthat the whole project was fair to theBank member country where it was lo-cated, that the allocation of benefits andrisks was properly balanced, that the proj-ect made economic sense, and that theinvestment was secure. The Bank wouldbe unwilling, for instance, to participatein financing a railway, port facility ortownship which depended on a mine forits justification, without being satisfiedwith the project as a whole, and viceversa.

This was Bank practice in the Falcon-bridge ferro nickel mine in the DominicanRepublic, where the Bank financed thepower facilities as well as in the Mifermairon ore project in Mauritania, where theBank financed the railway and port facil-ities. In these cases the loans were madeto the mining company directly, which ofcourse was the project entity. But thesame total project appraisal was made forthe Burfell power project in Iceland, serv-ing the Alusuisse aluminum smelter, and

the Volta power project in Ghana, serv-ing the Valco aluminum smelter. Here theloans were made to the member country'sgovernment or to one of its agenciesresponsible for the operation of the infra-structure facilities in question. These twoforms of financing—direct financing ofthe project entity and indirect financing ofthe supporting outside infrastructure fa-cilities—involve different legal and finan-cial problems and techniques, but thechoice of the form is essentially irrelevantto the Bank's evaluation of the project asa whole. In all cases, the companies oper-ating the mining facilities were the realparties to which the Bank looked forassumption of the risk and for securityof its loan repayment. The Bank has,therefore, financed infrastructure facilitiesas well as production facilities proper,and depending on the particular circum-stances, has lent money to a private cor-poration which was the project entity, aswell as to a member country's govern-ment or to one of its agencies.

Choice of borrowerOf the 26 projects financed by the

Bank Group to date, 4 financed infra-structure, 11 production facilities, and theremainder both. Lending by the IFC was, ofcourse, exclusively for private enterprise,while Bank loans went about equally tothe private and government sector, al-though in the majority of projects controlof the mines was in private hands. TheBank of course has certain preferences inthis area. It prefers to lend directly to theentity or enterprise that will be responsi-ble for the construction and operation ofthe project, so that any problems areattended to immediately. If the project isto be carried out by a private corporation,or if any of its infrastructure facilitiesare to be controlled or operated by theprivate corporation, the guarantee of the

David M. Sassoon

is an Israeli attorneywith the LegalDepartment of theBank who has heldprofessorial postsin universities in Israel

and the United States, and is the authorof several books and articles on subjectsrelated to international business, commerce,and shipping.

member country ( a requirement of theBank's Articles of Agreement) will nor-mally be confined to the payment of thedebt service of the loan. The membercountry will not be required to ensure thefull performance of all of the borrower'sundertakings, nor to agree to provide allof the funds and other facilities requiredto complete the project, which is the casewhere the government is the borrower orwhere the loan is made to a state corpora-tion or enterprise. All that the guarantorgovernment will usually be requested tocovenant in this case is: "not to take,cause, or permit to be taken any actionwhich would prevent or interfere with theconstruction and operation of the projector with the performance of the bor-rower's obligations."

The choice of borrower under eachloan will be resolved by reference to theparticular portion of the project whichthe Bank is asked to and is willing tofinance. Under the Articles of Agreement,the Bank would normally finance theforeign exchange cost of projects; financ-ing local costs in these types of projectsis exceptional. The Bank's participationin projects which require large foreignexchange expenditures-and mining proj-ects in the less developed countries al-most invariably fall into this category—are therefore on the whole confined to thefinancing of imported equipment and ma-terials. This may have a bearing on theportion of the project that the Bank iswilling to finance, and it is also a factorto keep in mind in the choice of bor-rower.

The terms of the loansIn the past, where the borrower was

privately owned, a commitment of sub-stantial shareholder equity or subordinateddebt was required, and shareholder guar-antees for cost overruns and repaymentwere normally sought. These usually in-cluded financial commitments to provideall funds necessary to complete and op-erate the project, and to repay the loan,quite apart from other more customarytypes of security such as mortgages ofplant. In the case of the Shashe projectin Botswana, the private party, a sub-sidiary of Roan Selection Trust, was evenmade to assume one half of the cost ofthe engineering studies of the infrastruc-ture, financed by the IDA under a $2.5million credit to the government, in caseit did not proceed with the project.

In addition, because the Bank's prac-tice is to charge as low a lending rate asis consistent with its own financial condi-tion (currently SVz per cent), and because

22


there is no reason to give the benefit ofthis low rate to a private investor, theBank has insisted that the member coun-try's government, which must guaranteethe Bank loan, charge the private party aguarantee fee equal to the difference be-tween the Bank's and the market interestrates. On the other hand, where theloan was made to the government orto one of its agencies in support of amining venture, the lending rate was ofcourse the Bank's usual uniform lowlending rate. But this does not mean thatthe government was seen as the real pro-vider of the funds to cover the debt ser-vice of the loan. In all these cases, as theinfrastructure facilities were designed toservice the mining operation or enter-prise, the Bank insisted on adequate ar-rangements to ensure that the govern-ment receive sufficient guarantee from theprivate participants in the mining ventureto repay the debt to the Bank.

Forms of securitySecurity arrangements in these cases

have taken different forms. The Bank hasoccasionally insisted on obtaining liens orpledges which could be enforced directlyagainst third parties who were, for exam-ple, to be the purchasers of the miningproduct. Shareholder guarantees runningdirectly to the Bank are also in this cate-gory because the Bank can enforce themby being a party to the contract. Whenthe Bank is not a party to the arrange-ment, the security will run directly fromthe consumer or from the shareholders tothe borrower, not involving a right thatthe Bank can enforce directly, but ineffect producing a somewhat similar fi-nancial guarantee for the borrower.

From the legal point of view, a distinc-tion can clearly be made between ar-rangements which give the Bank directrights and remedies against a third party(other than the borrower), and thosewhich do not establish a direct contrac-tual relationship between the Bank and athird party. Financially, that distinction isperhaps less significant, because the latterarrangements, by aiming to strengthen orsafeguard the financial position of theborrower, also contribute, though moreindirectly, to the protection of the Bank'sinvestment.

The security"Take or pay" long-term purchase con-

tracts are a frequently encountered formof security arrangement in this type ofloan. They consist, broadly speaking, ofthe obligation of a third party to purchasea product or service or to pay for it, evenif it is not purchased—and this third party

undertaking is often assigned to the Bank.In some cases, the obligation to pay ex-ists, even if the product involved has notbeen produced. The third parties involvedmay be the shareholders of the borrower,as in the Falconbridge project. In otherinstances, they are outsiders interested ina steady supply of the product, for ex-ample, an Argentinian state agency as abuyer of gas transported through a Bankfinanced Bolivian pipeline. In some casespayments for the service or product aremade to a trustee who must earmark andapportion the receipts between the variouscreditors, and often the government also,in accordance with priorities agreed uponbefore transferring any money to theprivate producer. There is no establishedpattern.

No matter what form the particularsecurity takes, the infrastructure, if pub-licly owned, has to be secured by themining operation and its sponsors. Theobligation of the government as a bor-rower or guarantor in these cases willprotect the Bank's loan, but this protec-tion is in addition to, and not in lieu of,the security which the private investorsmust furnish. The specific security ar-rangements are in effect designed to pro-tect the government as guarantor (or asborrower) as much as they are designedto protect the Bank as lender. There isless likelihood of the Bank having toinvoke the government's direct obligationin these circumstances, and it is for thisreason that such projects can receiveBank rather than IDA financing, thoughthe country itself may normally haveaccess to IDA funds only. Even in theunlikely circumstance of the Bank enforc-ing the government's direct obligation,the government will usually be subro-gated to the rights and benefits of thesecurity arrangements.

Force majeureAlthough World Bank Group lending

since 1957 accounts for less than iVzper cent of the total investment in miningin the developing countries, this has beenestimated to represent a 6-8 per cent in-volvement in total mineral expenditures,and a contribution of between 20-25 percent of costs. The discrepancy arisesbecause the object of requesting theBank's financial participation in the pasthas frequently been not lack of money,but the inability to raise it without theWorld Bank's presence in the deal, soughtfor what might be termed its stabilizinginfluence.

However, private parties furnishing se-curity want to be free from their commit-ment if government interference causes

enforcement of the security, and insiston limiting their obligations to covertechnical or commercial but not politicalrisks. The subject is known in Bank par-lance as the "force majeure" exception.Many security arrangements contain forcemajeure exceptions, releasing the privateparties from their obligations to supplyfunds (irrespective of the technique used)for cost overruns or repayment of theloan capital in the event of political inter-ference.

Loans to governments vs. loansto private companies

Many covenants found in loans to pri-vate parties will not apply in cases wherethe borrower is a government or a gov-ernmental agency providing infrastructureor production facilities for mining withthe assistance of Bank financing. Wherethe borrower is a private corporation, itsdebt/equity ratio will normally be subjectto limitations imposed by the Bank, So,too, a restriction on dividends to share-holders or on interest on shareholders'advances, and a commitment to keepworking capital at adequate levels willbe necessary. And there will normally besome real or personal security required.With governments, or governmentalagencies, liens on specific revenues orassets as security for loans valid againstthird parties will not generally be sought,unless they are obtained by another credi-tor or lender participating in the financ-ing, or where specific unencumberedassets may be seized by another creditoroutside the member country. As alreadynoted, a typical form of security that theBank seeks in lending to a private inves-tor in the mining sector is precisely ofthis kind—namely a shareholder's com-mitment or an assignment to the Bankof a contract to take or pay for the miningproduct or both.

It is the Bank's usual policy not torequire specific security for its loans togovernments or governmental agencies,and to permit the government in thesecases to borrow on the basis of itsgeneral credit. Regarding mining projectsin what would otherwise be IDA coun-tries, the Bank relies on the security thegovernment has—directly or indirectly—obtained from the beneficiaries of theparticular project. The Bank does not,however, wish other lenders to take spe-cific security or to acquire preferences orpriorities of payment which could put theBank in a subordinate position, or makepayment to the Bank by a member coun-try (either as borrower or as guarantor)more difficult than payment to another

continued on page 41

23


"Indexing"Brazil's

Jack D. Guenther

During the past seven years, inflation inBrazil has averaged over 20 per cent ayear, but this has not impeded economicgrowth in real terms of about 10 percent a year. This success in "living withinflation" frequently has been attributed—in part, at least—-to the system ofindexing or "monetary correction" adoptedin 1964 which provided for wages, finan-cial obligations, taxes, the exchange rate,and other economic variables to increasepan passu with the general level of prices,thereby minimizing the distortions usuallyassociated with inflation.

However, indexing in Brazil is not asall-embracing as is sometimes suggestedand almost nothing is indexed through asimple 100 per cent link to prices. In thecase of wages, for example, prices areonly one element in the wage formula,which itself has undergone several revi-sions during the past decade to keepit in line with the Government's generalwage policy. In the case of financial obli-gations, only about one f i f th of the lia-


versus discretionary action-fight against inflation

How far can indexing help in reducing the distortions ofinflation? The author examines this question, in detail, with aview to correcting some popular beliefs about the natureand extent of indexing in Brazil.

bilities of the Brazilian Treasury andfinancial system outstanding at the endof 1973 was indexed—mainly governmentbonds and mortgage paper—and the pro-cedure for linking these obligations toprices also has been changed several timeswhen the system was not providingresults consistent with the interest rate andother policies being pursued by the Gov-ernment. Finally, in the areas of theexchange rate and charges for publicsector services, there is no formal systemof indexing; these important prices areadjusted upward frequently, but at thediscretion of the authorities after takingaccount not only of movements in pricesbut also of other factors. A survey of thesystem shows, therefore, that promptdiscretionary action by the Brazilianauthorities has probably been moreimportant than indexing in adapting theeconomy to inflation. In fact, with theresurgence of inflation to over 30 percent in 1974, the problems produced inBrazil by indexing became more acuteand led to its abandonment even in someof the limited areas where it was pre-viously applied.

Review of past trendsThe main features of Brazil's economic

and financial crisis prior to 1964, whichled to the introduction of indexing, arewell known. Price increases, which had av-eraged about 20 per cent a year during the1950s, began to accelerate rapidly in 1959.Strong trade unions negotiated succes-sively larger wage adjustments, credit wasgranted liberally to accommodate highercosts, and the resulting wage-price spiralpushed inflation to over 80 per cent in1963. As the Government tried to sup-

press inflation, the distortions in relativeprices also became more severe. Exportsstagnated because of delays in adjustingthe exchange rate; apartments were leftempty as rent adjustments lagged; andelectricity, telephone, and other publicservices deteriorated as the charges forthese services were kept artificially low.Interest rates, although nominally high,were negative in real terms, and saverssought protection in real estate or thetransfer of funds abroad. Finally, Brazil'spublic finances were seriously weakened,because all charges for public sector serv-ices and certain minor taxes were spe-cific rather than ad valorem; moreover,taxpayers delayed payments to takeadvantage of the loss in purchasing powerof the cruzeiro.

Faced with this combination of highinflation and serious distortions in rela-tive prices, the new Brazilian Governmentwhich took power in April 1964 adopteda medium-term plan to: (1) eliminateinflation gradually over a period of four orfive years; and (2) minimize inflationarydistortions during the transition period.While the reduction of inflation wasslower than expected, the program tominimize the distortions arising frominflation has been more successful: mostreal interest rates have been positive; theexchange rate has been adjusted regularlyto compensate for increases in domesticcosts relative to those abroad; and rents,tax revenue, charges for public services,and other key economic variables all haveroughly kept pace with inflation. Savingand investment in the economy have beenhigh, output has risen at an unprece-dented rate, and the balance of paymentshas been strong.

Readjustable treasury bondsReadjustable treasury bonds, which

were indexed for inflation in addition topaying a small nominal interest rate, wereissued in 1964: these bonds have set thepattern for most other forms of"monetary correction" of financial assets,although such indexing has not spreadvery widely in the private sector. The1964 law did not prescribe what indexwould serve for adjusting the bonds, butin practice the bonds were linked to thewholesale price index with a lag of sev-eral months. Initially the treasury bondswere not well received, and most Bra-zilian savers preferred to continue con-verting their idle funds into foreignexchange. To meet this problem, the Gov-ernment offered a new series of bondsin May 1965 which gave purchasers theoption of monetary correction basedeither on the wholesale price index oron the exchange rate with respect to theU. S. dollar, whichever was more favor-able. This option could be chosen ex post,but after the crawling peg exchange sys-tem was adopted in 1968, the rate ofdepreciation of the cruzeiro in relation tothe U. S. dollar was always less than therate of increase in wholesale prices, andmonetary correction based on wholesaleprices was consistently the more favor-able option.

One of the most troublesome problemsencountered in Brazil's indexing has beenthe lag between price increases and thesubsequent adjustment of the indexedpaper. For various operational reasons,the average lag in adjusting treasurybonds to inflation was about five monthsuntil 1972. In 1973, with inflation declin-

25


ing, this lag was considered to be inter-fering with the efforts to control inflation.The Government, therefore, temporarilyeliminated the lag by using "projected"inflation for the current months wherestatistics were lacking, thus introducinga departure from the practice of linkingto actual prices.

In the late 1960s and early 1970s,sales of these indexed treasury bonds tothe Brazilian private sector were relativelysmall, and their role in Brazil's capitalmarket remained quite limited. At theend of 1973, only about 15 per cent ofthe outstanding bonds was held by thegeneral public. Most of the bonds were

treasury bonds, the Government hasenjoyed wide freedom to change the indexin order to meet the needs of its housingpolicy or its overall economic policy.

As a result of the system of indexing,the Brazilian mortgage market, which wasalmost nonexistent in 1963, has grownsubstantially in the past decade. The sys-tem has had a series of problems, how-ever, including at various times a highlevel of defaults, and this has led to agradual movement away from full index-ing. The most frequent (although incom-plete) explanation for these defaults wasthat the family incomes of some mort-gagees did not grow pari passu with the

"indexing of private sector financialobligations other than those related tohousing finance remains ratherlimited"

in the hands of the commercial banks(which are permitted to use them to ful-fill part of their minimum legal reserverequirements) or the National HousingBank (which receives indexed depositsand therefore needs indexed liquid assetsuntil the funds are lent for housing).With the acceleration of inflation in 1974,however, indexed bonds for the first timebecame more attractive to the privatesaver than nonindexed paper. This causedconsiderable problems in domestic capitalmarkets, as private savers drew funds outof nonindexed accounts to purchase thebonds. In response, the Government tem-porarily discontinued the sale of indexedbonds and switched exclusively to treasurybills. These treasury bills, which circulatein Brazil much more widely than thebonds, have an average maturity of sixmonths and have never been indexed onthe grounds that linking such a short-term asset to a price index would not beadministratively feasible.

Housing financeApart from treasury bonds, the only

other major financial transactions thathave used indexing extensively are thosepertaining to housing finance. Since 1964both assets and liabilities in the housingsector have been linked to either a priceor wage index and adjusted monthly,quarterly, or annually in accordance withmovements in the index. There have beenfrequent changes in the system of index-ing, however, and, as in the case of

mortgage obligations. The problem becameso severe that in 1972 the systemwas revised to ensure that mortgage pay-ments declined in real terms over time.All obligations continued to be indexed,but the initial service schedule on mort-gages, which previously involved equaltotal payments (amortization plus inter-est) over the life of the contract, wasswitched to one of equal amortizationpayments. Under this system, becausereal interest payments became smallerover the life of the loan, total monthlypayments declined in real terms despitethe indexing.

When inflation rose to over 30 percent in 1974, the Government againrevised the system of mortgage financingto reduce the "burden" produced by

Jack D. Guenther

a U. S. citizen, is agraduate of 'Yale andHarvard, and alsostudied at KingsCollege, Cambridge.Since joining the

Fund staff in 1960, he has worked mainlyon Brazil, Argentina, and the Caribbeancountries, and is presently an AssistantDirector in the Western HemisphereDepartment.

indexing. Under a new system of taxrebates, the effective adjustment of mort-gages in 1975 will be equal to inflationminus 10 percentage points. The rebateis at least Cr$240 per year, and the relieffrom indexing, therefore, is greater than10 percentage points on those mortgagesin which annual service payments are lessthan Cr$2,400 (about US$300). Indeed, onmany small mortgages, even the nominalservice payments will decline in 1975under the new system. Because the sav-ings instruments that finance housingcontinue to be fully indexed, the Treasuryin effect will have to subsidize the Hous-ing Bank by paying the rebates from thebudget.

Other financial assetsContrary to popular belief, indexing of

private sector financial obligations otherthan those related to housing financeremains rather limited in Brazil. At theend of 1973 only about 19 per cent ofthe total financial obligations issued bythe Brazilian Treasury and the Brazilianfinancial system was indexed (Table 1).The Brazilian treasury bonds accountedfor half of the indexed paper, and theremainder was mortgage bonds and sav-ings deposits, which are used almost exclu-sively to finance housing. On severaloccasions during the past decade, theGovernment, in its efforts to develop amedium- and long-term capital market inBrazil, has tried to encourage the spreadof indexing into other parts of the privatesector, but the movement appears tohave been resisted by borrowers. Financialinstitutions, of course, are unable to acceptindexed deposits unless they can find bor-rowers willing to contract loans withindexing. Private firms, however, gener-ally have been reluctant to assume such"open-ended" obligations, apparently pre-ferring the certainty of rates fixed innominal terms, even if these rates arehigh, rather than rates fixed in real termswhere the nominal interest might turnout to greatly exceed their projections.

The erroneous impression that index-ing is very extensive in Brazil's privatesector is partly due to the ex ante mone-tary correction advertised by Braziliancommercial banks on their time deposits.This ex ante correction for inflationmerely means that a certain projectedrate of inflation presumably has beenallowed for when setting the total inter-est rate. The practice of ex ante monetarycorrection originated partly to circumventBrazil's usury law, which limited interestto 12 per cent; the borrower would agreeto pay, for example, 12 per cent interest

26


Table 1Principal financial obligations

issued by the Treasuryand the financial system

outstanding at end of 1073

Billionsof

cruzeiros

TotalNonindexed

Sight depositsBills of exchangeTime depositsCurrency in

circulationTreasury bills

IndexedTreasury bondsSavings deposits

Mortgage bonds

218176773728

1717

422114

7

Percent

oftotal

100

81

351713

88

19

1063

Source: Central Bank of Brazil.

and a further 15 per cent allowance forinflation. At times the portion correspond-ing to inflation also received a differenttax treatment from the remainder of theinterest—on the grounds that "interest"which merely permitted the saver to keeppace with inflation should not be con-sidered taxable income. The fact is, how-ever, that the total return paid on instru-ments with ex ante monetary correctionis agreed in advance, and the instrumentis not indexed in the sense that thereturn varies with the actual behavior ofprices.

Index of business loansThe National Development Bank is at

present the only major source of indexedloans to business. This bank uses mainlyits own capital and part of the resourcesof the social security system to makefully indexed loans. Late in 1974, however, borrowers from the bank becamealarmed as their obligations began to beadjusted upward in line with the accel-eration of inflation. Consequently, thedemand for loans began to lag. The bankauthorities were concerned that this mightdeter investment and announced, there-fore, that adjustment of annual servicepayments on its loans will in future belimited to a maximum of 20 per centregardless of the rate of inflation. Theloan principal will continue to be fullyindexed, however, which will require theborrower to make additional service pay-ments beyond the original maturity of theloan.

The coexistence of indexed and non-indexed financial assets has led to con-siderable problems, particularly when the

rate of inflation varies significantly. Therecent upsurge in Brazil's inflation causedindexed treasury bonds to become moreattractive than fixed-interest securities forthe first time in over five years. Duringthe course of 1974, the total return onindexed treasury bonds rose from 17 percent (13 per cent monetary correction and4 per cent interest) to almost 40 percent, while interest on nonindexed timedeposits increased only from 21 per centto 27 per cent. This shift in favor ofindexed paper led to an outflow of fundsfrom many financial institutions, whichthe Brazilian authorities first tried to off-set by fiscal measures reducing the taxa-tion of interest on nonindexed assets.Finally, however, they made the decisionto suspend temporarily the sale of treasurybonds to the public between August 1974and February 1975, when sales wereresumed on a limited basis. Also, to par-tially offset the changed flow of funds,the Central Bank early in 1975 divertedresources from the housing system, whichwas capturing indexed funds greatly inexcess of its needs, to the investmentbanks, whose nonindexed offerings wereunable to attract private savings. TheCentral Bank reportedly will pay the dif-ference to the Housing Bank between theindexed return required on their invest-ments and the nonindexed rate that willbe paid by the investment banks.

WagesAfter 1964 the new Brazilian Govern-

ment eliminated strikes and collectivewage bargaining and ordered that future

wages for national and local governmentemployees), or remained completely free ofcontrol (as in the areas of services andagriculture).

The official wage formula used inBrazil since 1965 is quite different froma cost of living escalator clause operatingduring the life of a wage agreement. Eachcontract is signed for a 12-month period,and contract renewals for the variousindustries are spread throughout the year;once the wage is determined there is nolink to prices and no adjustment innominal wages is made until the contractexpires. The rise in the cost of living istaken into consideration only when a newannual contract is signed. Furthermore,in the mid-1960s even the new contractdid not include full compensation for pastinflation. The formula was specificallydesigned, in fact, to break the previouspattern of fully compensating for pastinflation which, together with escalatorclauses during the contract period, hadbeen largely responsible for the wage-costspiral under the previous system of col-lective bargaining. The formula was basedon the recognition that the maintenanceof average real wages did not require fullcompensation for past inflation wheninflation was declining.

Specifically, wage increases grantedunder the 1965 formula reflected threecomponents, which were designed to (1)raise the real wage up to the average ofthe previous 24 months; (2) provide forthe maintenance of this average wage bygranting an additional amount equal toone half of the "projected" inflation dur-

"restraint on wages undoubtedly was amajor reason for Brazil's success inreducing inflation rapidly"

wage adjustments in the industrial sectorbe made in accordance with an officialformula. Total employment in the union-ized sector, for which the wage formulawas designed, was less than 2 millionworkers out of a work force of 30 million.This sector included, however, the stronglyorganized groups, and the purpose ofusing the standard formula for thesegroups was to ensure relatively uniformwage adjustments rather than adjustmentsdependent on the relative strength of eachunion. Other wages in the economy con-tinued to be set by the Governmentindependently of the formula (as in thecase of the minimum wage and the

ing the year covered by the wage agree-ment; and (3) allow a small additionalamount for higher productivity. Theallowances for future inflation and prod-uctivity were announced each year bythe Ministry of Planning. Not surpris-ingly, the estimate of future inflationalways was less than the actual inflationturned out to be. For example, in theyear beginning August 1966, the pro-jected inflation used in the wage formulawas only 10 per cent, whereas the actualincrease in the cost of living was 30 percent. As a result, average real wagesdeclined during 1966 and 1967, despite theprofessed goal of the formula to main-

27


tain them (Table 2). This restraint onwages undoubtedly was a major reasonfor Brazil's success in reducing inflationrapidly in these years—from 90 per centin 1964 to about 25 per cent in 1967—while at the same time increasing invest-ment and strengthening the balance ofpayments.

Table 2Wages and prices

Costof

livingused inwage

formula '

Percentageincreaseduring

previous12 months

December1966 41.91967 25.51968 22.81969 24.51970 22.11971 19.81972 17.91973 13.91974 29.5

Average increasegranted In

yearly wagesettlementsmade during

month 2

Privatesector

Publicsector

In per cent

30.0 3

20.124.528.222.022.019.416.635.0

30.0320.125.126.422.422.620.016.635.5

Sources: Getulio Vargas Foundation; aridMinistry of Labor.

* Refers to previous month; figures forDecember represent the increase In pricesduring the 12 months ended in November.

1 under the official wage formula.9 Estimate based on partial data.

Wage formula revisedBrazil's wage formula was revised in

1968, and since that date real wagesgranted under the formula have risengradually. The major change was theintroduction of a new component in theformula to compensate for the excess ofactual inflation over projected inflationduring the previous contract period: incalculating the real wage base for thecoming year, the revised formula used notthe actual real wage received in the pastyear but the intended (higher) real wagethat would have been received if inflationhad been as projected. Also, the allow-ance for the growth in productivity wasraised gradually from zero to 3 per cent.Because of these 1968 adjustments to theformula, real wages granted under theformula rose by an average of about 2per cent a year from 1968 through 1973.

Because wage contracts are signed for12 months, a temporary decline in realwages still can occur with an upsurgeof inflation during the life of the con-tract. To deal with this problem, inDecember 1974 the authorities departedfrom the formula and granted a special

advance wage boost of 10 per cent to allworkers whose contracts had been signedin the period January—June 1974 andwhose wage adjustments, therefore, hadnot yet fully reflected the mid-yearupsurge of inflation. At the same time,they further liberalized the formula toprovide in future a straightforward in-crease in real wages of 4 per cent ayear. These latest discretionary wageboosts were taken at a time when con-sumer demand was showing signs ofweakness and output in some sectors ofmanufacturing was declining for the firsttime in almost ten years.

After 1968 Brazil's revised wage for-mula probably tended to perpetuate pastprice rises without any significant effectin either accelerating or decelerating therate of inflation. There were occasionsduring that period, however, when exoge-nous forces tended to change the rate ofinflation. For example, in 1972, relativelygood harvests led to a decline in the rateof price increases; and more recently, thesharp increase in world prices of petro-leum and other commodities, togetherwith excess domestic demand, producedan acceleration in Brazil's inflation. Oncethese price trends were set in motion,either increasing or decreasing the pre-vious rate of inflation, the wage formulatended to reinforce the trend. However,this reinforcement of price trends prob-ably was less pronounced than under thesystem of collective bargaining andescalator clauses that existed before the1964 reform. This is because—except forthe advance in December 1974—the Bra-zilian formula adjusts wages to compen-sate for actual price trends only when the12-month contract expires, which meansthat wage payments do not fully reflectnew price trends until a full year haselapsed.

Other areas of indexingApart from wages, treasury bonds, and

mortgages, the other principal areaswhere some form of indexing is used inBrazil are house rents and certain fiscaltransactions.

During the late 1960s and early 1970s,three schemes existed for adjusting houserents, depending on when the contractswere signed: (1) contracts signed between1964 and 1967 were adjusted each year bytwo thirds of the percentage increase inthe minimum wage; (2) contracts signedprior to 1964 were adjusted by the fullincrease in the minimum wage plus anadditional 10 percentage points; and (3)contracts signed after 1967 were free ofcontrols. By 1974, however, most rents

payable on pre-1964 contracts had beenbrought up to the market level, andalmost all rent contracts are now freelynegotiated. In practice, however, many ofthese freely negotiated contracts haveclauses which link payments to the read-justable treasury bonds.

In the area of public finances, severaltypes of indexing have been introduced.One of the first acts of the new Govern-ment, in July 1964, was to index unpaidtaxes and related liabilities. Taxpayershad used many devices to delay payingtaxes, including testing the assessmentsin the courts in order to benefit from in-flation while the case was under consid-eration. The 1964 legislation provided thatall tax liabilities not paid in the calendarquarter when they became due would besubject to monetary correction. The post-1964 tax laws also provided for the an-nual revaluation of fixed assets andworking capital; the revaluation of thefixed assets was made mandatory, whilethe revaluation of working capital wasoptional. At present, after several changes,the index for readjustable treasury bondsis used for all these purposes.

Indexation has been used also—butrather sporadically—for income tax brack-ets in Brazil, in order to ensure that thebrackets are adjusted upward roughly inline with inflation. This policy antedatesthe 1964 reform, for already in 1961 theincome tax brackets were defined as mul-tiples of the minimum wage and were,therefore, adjusted automatically eachtime the minimum wage was changed.This link to wages proved unsatisfactoryafter 1964, when minimum Wages fortwo or three years were adjusted upwardby a lower percentage than the increasein prices, which would have resulted inincreased income tax burdens at all levelsof real income. This increase in tax rateswas not desired by the Government, andin November 1964 the law was modifiedto provide that the income tax bracketsbe adjusted in accordance with move-ments in prices rather than the minimumwage. In 1973 and 1974, the procedureagain was modified, and the Governmentdeparted further from indexing. In 1973,as part of the policy to improve incomedistribution, the upper brackets wereincreased by 15 per cent and the lowerbrackets by 26 per cent; and again in1974 the upper brackets were raised by12 per cent and the lower ones by asmuch as 41 per cent. Thus, the authori-ties have exercised a considerable amountof discretion in adjusting the tax bracketsin the past decade. Although the brackets

28


have been changed regularly, the size ofthe increase has been dictated by generalpolicy considerations rather than by rigidadherence to an index.

The system of minidevaluationsThere are two other areas—the ex-

change rate and charges for public ser-vices—where regular adjustments alsohave been made to offset the effect ofrising prices, but without any rigid sys-tem of indexing.

currencies. The Central Bank has statedthat the value of the cruzeiro now isbeing set mainly in relation to a trade-weighted package of currencies ratherthan in relation to the U. 5. dollar alone,but the composition of the basket and theweighting of the currencies in the baskethave not been announced.

Although the exchange rate is notformally indexed, the authorities havebeen able through the system of mini-devaluations at frequent, irregular inter-

"one of the most importantachievements in Brazil since 1964 hasbeen the strengthening of publicsector finances"

In August 1968 the cruzeiro was depre-ciated by 12 per cent in terms of the U. S.dollar, and the authorities announced thatin the future it would be depreciatedfrequently by small amounts. The criteriaused for adjusting the rate would beprice changes in Brazil compared withthose abroad, the level of internationalreserves, and the behavior of exports.

Although the cruzeiro has been de-valued roughly in line with price differ-entials in recent years, this has not beendone through a formal system of index-ing, as is sometimes suggested. The eco-nomic authorities have been free todevalue by somewhat more or less thanindicated by price differentials if thatcourse seems advisable in the light ofoverall policy considerations. In Decem-ber 1971, for example, the cruzeiro wasdepreciated fully in line with the U. S.dollar; but in February 1973, at the timeof the second U. S. dollar devaluation,with Brazil rapidly gaining reserves andstruggling to control inflation, the cruzeirowas appreciated by 3 per cent with respectto the U. S. dollar. The Brazilian deci-sions on these occasions were made afterconsidering all the advantages and dis-advantages of following the U. S. devalua-tion (particularly the effects on the bal-ance of payments and domestic prices)rather than by a predetermined link ofthe exchange rate to price indices.

Any attempt to rigidly index theexchange rate would encounter formida-ble difficulties. For example, there wouldbe the problem of selecting which priceseries to use in Brazil and in other coun-tries, particularly in a world of floating

vals to convince exporters, borrowers, andforeign lenders of their firm intention tomaintain a realistic exchange rate. Pro-ducers are prepared to undertake long-term investments in the export sector,with the confidence that the exchange ratewill be adjusted roughly in line with rela-tive costs and that export prospectswill continue to be attractive when theinvestment is completed. This new policytoward exports, which traditionally waslacking in the Brazilian economy, un-doubtedly contributed to the tripling inthe U. S. dollar value of Brazil's exportsbetween 1968 and 1973 and particularlyto the rapid development of manufacturedexports.

Charges for public sector goodsand services

One of the most important achieve-ments in Brazil since 1964 has been thestrengthening of public sector finances,which had seriously deteriorated duringthe years of high inflation. This improve-ment was aided by indexing tax arrearsto discourage taxpayers from delayingpayments. Probably the most importantinnovation in this area, however, hasbeen the policy of frequently adjustingthe charges for public sector goods andservices—such as electricity, transporta-tion, water, wheat, and petroleum—inline with rising costs.

After 1964, charges for all public sectorservices were adjusted upward by amountsgreatly exceeding current inflation. It was,in fact, the necessity for a large amountof such corrective inflation that causedthe Government to opt for a gradual

rather than an abrupt halting of inflationafter 1964. By the early 1970s the chargesfor public services in Brazil were higheven by international standards, and thelarge public sector investment programsbeing carried out in electricity, transpor-tation, steel, and other areas are now be-ing financed to a substantial extent byuser charges.

It is important to point out that whilethese charges for public goods and ser-vices have risen roughly in line withinflation in recent years, this is not aresult of any system of indexing, butrather of discretionary action. As in thecase of the exchange rate and most inter-est rates, the adjustment for inflation inthis area is accomplished by administra-tive decision rather than by an automaticlink to prices.

ConclusionBrazil's experience gives strong support

to the view that the removal of distor-tions caused by inflation is essential if ahigh rate of economic growth is to beachieved. In particular, where economicdevelopment has high priority, those eco-nomic variables that are important forencouraging saving, investment, and ex-ports cannot be permitted to lag behindgeneral price increases. The Brazilian casedoes not, however, provide much evidencethat widespread indexing is the mostappropriate way to achieve this goal.Rather, it seems to show that discretion-ary action by economic managers was themain element in Brazil's success, and thatthe indexing was highly selective, flexible,and subordinated to general policy con-siderations.

29

Jack D. Guenther

During the past seven years, inflation in

Arabic edition

Finance & Development is nowavailable in an Arabic edition.Readers who wish to receivethe Arabic language editionshould send their currentaddress label and include theiraddress in Arabic. New readers mayalso send their requests to:

The EditorFinance & Development

(Arabic edition)International Monetary Fund BuildingWashington. D.C. 20431


John W. Lowe Speculative booms in property valueshave occurred in recent years in bothdeveloped and developing countries. It isoften argued that the resulting transfer ofresources is a considerable deterrent toeconomic growth.

But what are the real economic conse-quences of land speculation? The answersare complex. While any specific conclu-sions depend on the underlying featuresof a specific economy, this article triesto show that in general the main implica-tions of a rise in the price of land areindirect and are quite distinct from theeffects commonly assumed.

The discussion is limited to significantshort-term upswings in the price of land(generally, in a small area, such as anurban center). Over the long run, aspopulation and income grow, the value ofland increases secularly in line with thevalue of many other assets in an econ-omy. This trend is disregarded here. A com-prehensive analysis of the relationship ofland values to all other variables in aneconomy is a part of general value theory,which is beyond the scope of this article.

Land speculation is seen here primarilyin the context of developing countries.However, the issue may be given dimen-sion by the example of the increase inland values that has occurred in London.Prior to the recent fall of the marketthere, it was commonly said that propertyvalues had generally doubled and in manycases tripled over the last five years.Prime freehold property in the City ofLondon is currently valued at about $50 asquare foot. If it is assumed that averageland in London is worth about $10 asquare foot, but that this is twice what itwas worth five years ago, then the aggre-gate increase in the market value of allof London—some 600 square miles—hasbeen on the order of $84 billion over thepast five years. This compares with agross national product for the UnitedKingdom of $145 billion in 1972.

In downtown Teheran, Iran, whereinvestment in land is very popular, primeproperty currently sells for about $70 asquare foot, exceeding the value of thebest property in London, even thoughper capita income in the United Kingdomis between five and six times that of Iran.

MisconceptionsThe waste of private savings "going

into land" is a common cry of anguisheddevelopment officials. To use a Keynesianmetaphor, the implication is that peopleare digging holes and burying their hard-earned money there. This is not, ofcourse, the way land transactions work.X pays Y for a piece of land at price P;then Y takes X's money and deposits itin his bank. The savings thus flow throughthe land transaction and continue circu-lating in the economy, just as with anytransaction, whether a loaf of bread or apiece of land in central Teheran is in-volved. One must look beyond the monertary transactions to identify the realeconomic consequences.

Here it is not difficult to embark onanother misleading train of thought.Acquisition of land holdings is commonlyviewed as an alternative to the accumula-tion of industrial capital. It would seemthat any increase in the value of landwould imply a decrease in the rate ofacquisition of industrial capital. Conse-quently, it might seem that potentialgoods production would suffer during aland boom.

To analyze this proposition, it is neces-sary to separate what is capable at anygiven moment of producing output in aneconomy from a bidding up of the marketvalue of an item in that economy. Inother words, the stock value of productivecapital (which includes land) should beconsidered as distinct from the value ofthe flow of goods produced by this capi-tal.

In the simplest terms, growth in outputin an economy depends on increases in

Land speculationDoes it have

real economic consequences?30


the capital stock that produces the output(disregarding for the moment such factorsas capacity utilization and changes in thecapital-output ratio). To identify theeffects of land speculation on output andgrowth, one must identify the impact ofshort-term increases in the price of landon aggregate savings and on the invest-ment of savings in additional productivecapital.

Output and priceThe total capital stock of an economy

can produce a given output, whatever itsmonetary value. Clearly, changing theaggregate price at which any one of thecapital components is valued does notdirectly affect the aggregate of real goodsthat the stock is capable of producing. Adoubling or tripling of the price of land,in other words, does not in itself makeland more (or less) capable of growing,say, more wheat. (The inducement togrow wheat more intensively becauseland is more expensive is considered sepa-rately below.)

The relative price of any form of capi-tal, such as land, ordinarily bears a rea-sonably consistent relationship to therelative value of what that form of capitalis capable of producing, such as (continu-ing the above example) wheat. But thisrelationship is not necessarily fixed. The

ratio between the price of the stock ofland and the price of its output (its"price-earnings ratio") can vary widely.

This latter term is familiar stockexchange jargon, and an analogy withstock transactions is relevant in thisinstance. The value of securities on astock exchange is periodically bid to greatheights. But the increase in the marketvalue of outstanding securities (disregard-ing for the moment the impact on encour-aging new issues) has no direct relation-ship to the productive capacity of thefirms the securities represent. The effectis simply to increase the price the investoris willing to pay in relation to the under-lying earning power of the asset. Thismay be because the investor anticipatesincreases in the future value of real out-put and bids up the current price accord-ingly. Or, if the investor is relying mainly

on anticipated increases in price, he maycare little or even not at all what the

earnings of the asset are. In the lattercase it hardly matters whether the under-lying capital generates any earnings atall. This may be termed "pure" specula-tion.

Traditional economic theoryIt is useful to discuss some other fac-

tors in analyzing landspeculation in the

framework of traditional economic theory.It will be evident, however, that thegreater the speculative motive for landacquisition, the less reliable are the con-clusions to which traditional theory leads.

Traditional economic theory would sug-gest that an increase in land values wouldlead to an increase in the supply of land.Of course the total stock of land is fixed,but bidding up existing land values maylead to the extension of usable land area,for example, by draining swamps or ferti-lizing and irrigating arid land. In anurban context, marginal land areas maybe reclaimed and developed.

But in practice, a rise in land valueswill not greatly induce a supply of addi-tional land, particularly in the short run.In both developing and developed coun-tries today, the most dramatic instances

of land speculation havebeen in central


urban areas, where the supply of land isrelatively fixed. Within any reasonablyshort time reference, the supply of land istherefore inelastic.

Traditional theory would suggest twofurther considerations. First, as landprices increase in relation to earnings,there is a decrease in earnings in relationto price or yield. Investors, comparingthe yields on alternative investments,would then probably turn to other pur-chases with higher yields. As a result, theprice of land—for want of demand—would drop to a more normal relationshipwith other assets. However, if investorsare relying primarily on a continued rapidincrease in land prices, the long-termconsideration of slightly lower yield maybe minor. Investors may purchase despitea low yield, driving prices even higher(and yields lower).

Second, it might be assumed that aninvestor paying a high price for a low-yielding asset would be induced to in-crease its output—for example, by usingfertilizers to increase the output of wheat.In an urban context, the land purchasermight build a taller or newer building togenerate higher rental incomes. The activ-ities thus stimulated may give rise to sub-stantial increases in demand for relatedinvestment, such as fertilizer productionor building construction (continuing theabove examples). Again, however, purelyspeculative motivations may vitiate theseassumptions in the short run. If the landpurchaser is looking primarily to short-term speculative gains (and ignoring taxdisincentives and the like), he may beindifferent to leaving his land in anunimproved state. Thus areas in somemajor cities (for example, central Tehe-ran) remain conspicuously undeveloped.

Inflation and speculationA characteristic of land acquisition is

the impact of inflation on it. Land hasalmost always fared well as a form ofprotection against inflation. It is probablysafe to say that the value of land oftenincreases more than proportionately ininflationary environments. This may beexplained partly by economics and partlyby psychology. Land, like gold, is a verybasic savings medium as perceived bymost savers. Few assets represent realcapital more visibly or tangibly. In theuncertainty of rapid inflation, people tendto fall back upon fundamentals andacquire land to protect their savings. Asmore and more people turn to land acqui-sition for this reason, increases in landvalues relative to other assets can becomeself-accelerating. Speculative motivations

may then compound the protection-of-assets motivation for land acquisition.

The extent to which inflation mayaccount for a sustained increase in landvalues depends upon how widely expecta-tions of continued price increases areshared. A generally anticipated drop inthe rate of inflation may account for theend of a boom in land prices.

Distribution of wealthIt has already been shown that bidding

up land values in the short run bears atbest a tenuous relationship to the factorsaffecting the formation of real productivecapital in an economy. Over time, ahigher price of land is likely to inducecapital formation in the form of greateruse of tractors and fertilizers on the farm,a greater density of buildings in the city,and so on. But a short-run increase of amore speculative nature is less likely toproduce these results. Rather, the mainshort-run effects will be indirect, resultingfrom changes in the distribution ofwealth enjoyed by landowners relative tononlandowners. These may in turn affectthe determinants of savings and produc-tive investment in an economy.

It is often assumed that the net effectof an increase in land values is to makethe rich richer, since they are more likelyto own land. In many countries, however,land is a very widely held asset. Landownership may have been passed downin small parcels for generations so thatbroad segments of the population mayenjoy the benefits of an increase in landvalues. In land booms in some developingcountries, prime lots of land have beensyndicated or broken up into small seg-ments and sold to small individual savers.

John W. Lowe

a U. S. citizen, is anInvestment Officer inthe Department ofInvestment Promotionand Special Projects ofthe InternationalFinance Corporation.

Mr. Lowe joined the staff of the WorldBank Croup in 1970. He holds anundergraduate degree in physics from YaleUniversity and a masters degree fromHarvard Business School. In 1973 Mr. Lowewas on leave of absence researching capitalmarkets development issues at the LondonSchool of Economics.

In such circumstances, a land boom mayactually improve the distribution ofwealth. More often, however, areas wherethe most dramatic increases in landvalues have taken place, such as centralurban areas, are held by relativelywealthy individuals. Clearly, the ultimateresult of the effect of increases in thevalue of land on the distribution ofwealth is dependent on who owns theland.

Two refinements may be added to theabove points. First, while any individualholding a small piece of land may besaid to enjoy increases in its value, anindividual cannot generally benefit untilthe plot is sold. But if such an individualsells his property, he will have to paymore for a new one. If the individual hasto pay more for new property or, notion-ally, to himself to retain property he has(foregone capital gain), it makes little netdifference to his well-being if the prop-erty he has is suddenly worth more. Hiswealth has increased, but so has his costof living. On the other hand, those withland in addition to what they need to liveon can benefit directly from increases inland values by selling off extra land hold-ings. In this category the wealthy areespecially likely to predominate.

A second consideration is that it isgenerally easier for the wealthy to borrowto purchase land and to borrow againstincreases in the value of their land. Insummary, the wealthy can often accumu-late land more easily, and can more easilyenjoy increases in its value. These factorstend to worsen the distribution-of-incomeeffects of a general increase in land prices.

Savings and motivationAmong both rural and urban house-

holds, the acquisition of land is a majormotive for saving. Bidding up land valuesrelative to incomes earned by wage earn-ers may have an important effect on sav-ings motivation in an economy. If pricesescalate slightly, there may be an induce-ment to save more money for home own-ership. On the other hand, if they escalaterapidly, wage earners may think it futileto save to acquire property and savingsmay drop accordingly.

Entrepreneurial motivation may also beaffected. In rural areas, increases inland values relative to income puts theacquisition of farm property by tenantfarmers more and more out of reach. Theman who tills the soil is then more likelyto remain a tenant rather than an owner,and he may therefore become indif-ferent to adopting new agricultural tech-niques or to increasing the productivity of

32


his farming methods.Analogous consequences may result in

urban areas when city workers see theprice of land escalate beyond their abilityto save and borrow to acquire it forhomes. As the proportion of owner-occupiers of homes decreases, the upkeepand maintenance of urban property willdeteriorate. In both urban and rural areas,when fewer and fewer people are able toown their own property, feelings ofalienation and bitterness are likely toincrease.

At this point, the social character ofsome of the effects of a rapid bidding upof land values should be evident. In anysociety, output is not only a product ofthe size of the capital stock but also ofhow effectively that stock is used. Theability to acquire land may significantlyaffect the aggregate motivation of work-ers and thus the magnitude of their out-put.

Similarly, the status of land distribu-tion may have a significant dampening(or encouraging) effect on potential out-put. For example, land ownership by asmall elite usually has particular socialconsequences which pervade the produc-tive characteristics of an economy. Theseeffects are complex but well-known andit is not necessary to discuss them here.

Demand effectsIncreases in the value of land may

induce changes in consumption and sav-ings patterns in an economy, even ifindividuals do not realize cash gains fromsale of their property. Landholders enjoy-ing increases in the value of their assetsmay feel wealthier and more secure, andas a result may increase the amount ofconsumption out of their current income.Increases in perceived wealth, by increas-ing consumption, may increase aggregatedemand. If there is insufficient demandin the economy, output and income willincrease; if there is too great a demand,the result will be inflationary.

The kind of demand likely to be stimu-lated by such effects would depend onthe taste of those holding land and enjoy-ing the increase in its value. If landhold-ing is broad-based, so also would be thedemand for goods and the type of goodsdemanded. On the other hand, if land isheld among a relatively few wealthy indi-viduals, increases in demand are morelikely to be in the form of luxury goods,a relatively high proportion of which areimported.

While increases in the demand forimported goods may adversely affect acountry's balance of payments, increases

in the value of land may also attract capi-tal inflows from abroad. At least in theshort run, this would have a compen-sating effect on the balance of payments.The net effect of capital inflows fromabroad for land purchase will depend (aswith many of the other considerationsthat have been examined) upon how thefunds are ultimately used. Capital fromabroad may make available to the domes-tic economy resources that can be usedfor the importation of highly productiveequipment, or it may be diverted to con-sumption. The results are determinedprimarily by the persons receiving theresources (that is, who sell the property)and how they in turn utilize the proceedsof the transactions.

TaxationTaxation of the transfer of land, al-

though it tends to reduce the liquidity ofwealth in the form of land holdings, doesnot necessarily stop speculative purchasesof land. Fewer transactions may takeplace and thus reduce the availability ofland to new savers; but each transactionmay take place at a substantially higherprice. The end result of high transfertaxes on land may be to increase thevolatility of the property market bydecreasing its "depth."

An alternative approach is to includetaxation of land based on periodicallyrevalued prices as part of a generalwealth tax. Wealth taxes present specialdifficulties in terms of accurately apprais-ing the value of land, particularly if fewactual transactions are taking place. Theseproblems can be overcome by valuationprocedures, however, and land taxesunder a property tax system based oncapital values, or assessed periodically onincreases in land value, are used in manycountries.

The justice of such taxes is defendedparticularly in countries where land isacquired as a refuge from inflation orwhere land values are increasing dispro-portionately in an inflationary environ-ment. By taxing such appreciating landvalues, it is argued that a governmentmore fairly apportions its costs amongthose realizing the greatest benefits. Pre-sumably if increases in land value arelargely the result of speculation, the sameargument applies.

One consideration that should be keptin mind in taxing gains essentially result-ing from such increases is that, if thereare subsequent losses from a drop in themarket, those who have paid high taxassessments may be penalized unduly.This could be corrected by adequate pro-

visions in the tax code for loss carry-backs.

Government policyThe effects on distribution of income

and on aggregate savings, investment,and output in an economy as a result of arapid bidding up of land values, it hasbeen seen, are diffuse, tend to be felt onlywith the passage of time, and may in anyevent be overshadowed by other factorsor events. Certain sectors of the popula-tion enjoy increases in relative wealth.There may be a flurry of transactions, butthese are not likely to be the source ofmuch immediate discontent or tension. Bycontrast a collapse in land values afterthe build-up of a rapid boom has imme-diate repercussions. In the end, the prob-lem of the cyclical nature of an unusuallyrapid bidding up of land values is whatusually prompts most governments totake action against land speculation.

When land becomes overvalued in thesense of not being in long-term equilib-rium relative to the value of other assetsin the economy, then for one precipitatingreason or another, the land market islikely to collapse. At this time familiarconsequences will follow very quickly. Ingeneral in the balance sheets of indivi-duals and companies as well as banks, amajor asset item becomes worth substan-tially less in realizable values. The networth of those individuals and institu-tions decreases as a result, and outstand-ing liabilities increase in relation to networth. There is a "reverse demand"effect. As it becomes difficult to disposeof land in order to secure cash, a liquiditysqueeze develops, intensifying the dropin demand. Credit is reduced, and ageneral contractionary impulse is feltthroughout the economy.

Prompt and appropriate action by pub-lic authorities may reduce these effectsbut there will inevitably be some contrac-tion in aggregate income and growth.These are legitimate concerns of a gov-ernment and justify measures by the pub-lic authorities to discourage purchases ofland for purely speculative reasons.

It is important to recognize, however,that considerable and sustained increasesin land prices may only reflect real in-creases in the relative value of land in aneconomy. Interference with this processmay only impede normal equilibriumadjustment. Particularly in a rapidlygrowing economy, a rapid bidding up ofland may simply reflect the suddenlyincreased capital value of potential earn-ings that properly developed land couldproduce.

33


TheGeneralizedSystem ofPreferencesexamined

The first ten-year preferential tariff schemewas introduced in 1971. The author

analyzes the schemes now in operation andsuggests that the time is ripe for improving the system.

Zubair Iqbal

The first United Nations Conference onTrade and Development (UNCTAD) thatconvened in Geneva in 1964 proposed theintroduction of a system of preferentialtariff rates by developed countries favor-ing the manufactured and semimanufac-tured imports from less developed coun-tries. This was one of a package of globaltrade measures instituted to promote thedevelopment process in less developedcountries. The proposal, which came to beknown as the Generalized System of Pref-erences (GSP), called upon developedcountries to eliminate or reduce tariffs onall manufactured imports from less devel-oped countries. All the developed coun-tries that had agreed to provide preferen-tial treatment to less developed countriesunder this proposal have by now intro-duced their individual GSP schemes, thusassuring either free entry or at reducedtariff rates to manufactures, semimanufac-tures, and a few primary and agriculturalproducts which are exported from lessdeveloped countries. The full tariff ratecontinues to apply to imports from othercountries. This preferential treatment is,however, subject to certain stringent quan-titative limitations and is applicable onlyfor a period of ten years from their insti-tution by the preference granting coun-tries. These countries are the original sixmembers of the European Economic Com-munity (GSP introduced from July 1971);Japan (August 1971); Norway (October

34

1971); Denmark, Finland, Ireland, NewZealand, Sweden, and the United King-dom (January 1972); Switzerland (March1972); Austria (April 1972); Canada (Jan-uary 1, 1974); and the United States(proposed for implementation in 1975).Denmark, Ireland, and the United King-dom upon joining the EEC, replaced theirschemes with the EEC scheme on January1, 1974. Some East European countrieshave also implemented GSP schemes.

GSP is an important element of theglobal development strategy and now thatit is finally in operation a comprehensiveevaluation of the coverage and globaltrade effects of GSP is of interest. More-over, in the light of the Multilateral TradeNegotiations (MTN) currently under waythat may, through global reduction intariffs, reduce the preferential effects ofthe GSP schemes, an analysis of theseschemes becomes all the more importantin order to determine the extent of revi-sions that would be required in theschemes to compensate for the adverseeffects of the reduction of tariffs.

GSP works in either of two ways, orin a combination of both. (1) It canincrease the return on exports that arealready being sold in the preference-giving countries. Such an increase inreturns may be measured by the reduc-tion in the burden of the nominal tariffin developed countries borne by theexporter from a less developed country.

(2) It can reduce the price of a newproduct in the preference-giving country,thus giving rise to a new line of exportsfrom the preference-receiving country.The advantage of preferences accruing toless developed countries for the exportof manufactured products can be assessedin terms of the resulting expansion inexport possibilities for these countries,that is, the trade effects of preferences.

This study seeks to provide an assess-ment of the global trade effects of all theschemes, taken individually as well ascollectively, by estimating the trade crea-tion (that is, the increase in world trade)and the trade diversion (that is, thedecline in the exports of nonpreferredcountries) effects. These estimates aredrawn upon to determine the basic weak-nesses of the schemes currently in opera-tion and to suggest possible ways ofenhancing their effectiveness.

The GSP schemesThe effectiveness of any GSP scheme

is determined by a number of basic fac-tors, such as the definition of manufac-tured goods, the extent of tariff cuts, thetariff quotas, the safeguard measures likeescape clauses, rules of origin, definitionof countries as preference-receivers, andthe duration of preferences. One commonintent of the schemes currently in opera-tion is to combine these factors in such away as to bring about an increase in


exports of less developed countries bene-fiting from the tariff preferences withoutmaterially harming the domestic competi-tors in developed countries which grantthese preferences. The structure of suchschemes should, therefore, be analyzed interms of these factors.• Product coverage

All the schemes cover manufacturesand semimanufactures, a limited numberof primary commodities, and a few agri-cultural and fishery products as definedby the Brussels Tariff Nomenclature(BTN). They include resource-based man-ufactures, fabrics, chemicals, metalic andnonmetalic manufactures, equipment, andfinished consumer goods. However, tex-tiles, leather and its products, and petro-leum products are excluded from theschemes in order to protect domesticproducers of these products in preference-granting countries. New Zealand extendspreferential treatment only to a few pri-mary commodities, while the EEC excludesfrom its scheme all primary commoditiesas well as base metals up to the ingotstage. The manufactures and semimanu-factures that were not accorded prefer-ential treatment in 1970 constituted 62 percent of all such dutiable products im-ported by preference-giving countriesfrom preference-receiving countries. Theexclusion of such a large range ofmanufactures from the GSP has limitedthe usefulness of the schemes for pro-moting manufactured exports of lessdeveloped countries.

The few agricultural and fishery prod-ucts that are included in the schemes areprocessed vegetables, fruits, beverages,and fish and related products. Imports ofthese products accounted for only 4 percent of the dutiable imports of preference-granting countries in 1970. Most of theagricultural products that could be profit-ably exported from a large number of lessdeveloped countries are excluded from theschemes.• Depth of tariff cut

The Nordic countries and the UnitedStates grant duty free treatment toagricultural and fisheries products, whileother countries grant various degrees oftariff cuts. In view of the generally hightariff protection accorded to agriculturalproducts in preference-granting countries,the preferential tariff margins would belarger for those countries that grant duty-free entry for such products. However, inthe EEC—the largest import market foragricultural products—the margins amountto only about 4 per cent because mostof them are excluded from its scheme.

Duty-free treatment is accorded to man-

35


ufactures and semimanufactures by theEEC, the Nordic countries, and the UnitedStates. Japan also grants duty-free treat-ment to such products except some textileproducts, clothing, and footwear on whicha 50 per cent reduction of the most-favored-nation (MFN) rate of tariff isapplied. Austria and Switzerland apply a

uniform 30 per cent reduction, whileAustralia and New Zealand apply varyingrates of reduction, depending on theproduct. Canada applies a 33 per centreduction in the Commonwealth prefer-ence rates or MFN rates (whicheveris lower) on imports from preference-receiving countries.

In general, the preferential margins arerelatively high on finished products cov-ered by the schemes and relatively low onsemimanufactures and raw materials (seeTable 1).• Safeguard measures

All schemes of preferences provide forsafeguard mechanisms so that preference-

Table 1Generalized System of Preferences Schemes of Developed Market Economy Countries: Nature of Tariff Cute

EEC'

Tariff GSP(per cent) status

Leather goods, semimanufacturedand manufactured

Rubber and productsWood and cork in roughWood panelsWood and cork, semimanufacturedWood and cork, manufactured

articlesPaper, pulp and paper wastePaper and paperboardPulp, paper, manufactured articlesWool and its fabricsCotton yarnCotton fabricsJute yarnJute fabricsClothing and clothing accessoriesGlass and glass productsPrecious stones, metals, and

products thereofIron and steel, unworkedIron and steel semimanufactured

productsFerro-alloysCopper, semimanufacturesNickel, semimanufacturesLead, semimanufacturesTin, semimanufacturesAluminum, semimanufacturesZinc, semimanufacturesHousehold equipmentProducts derived from coal,

petroleum, etc.Plastic productsOrganic chemicalsChemical elements, inorganicTanning materialsColoring materialsPaints, varnishes, etc.Essential oils, perfumes, and

materialsOther chemicals, semimanu-

facturedElectrical machines, apparatusNonelectrical machineryFootwearTravel goods, handbags, etc.FurnitureToys

6.87.33.9

12.7

5.3

7.92.8

10.612.411.57.4

13.08.0

19.011.613.4

12.54.5

6.85.67.45.19.24.8

10.99.27.8

4.511.18.05.66.76.96.8

5.8

5.28.46.2

11.111.38.2

11.3

F«FFINCINC

EXCFFINCEXCINCINCEXCEXCPTF

FPT

FEXCPTFFFFINCF

PTFFFPTFF

F

FINCFINCFINCINC

Japan' Norway Finland

Tariff GSP Tariff GSP Tariff(percent) status (percent) status (percent)

15.09.13.8

18.09.0

11.45.09.27.97.07.8

11.210.020.017.310.0

11.05.5

10.27.5

16.514.515.66.3

14.910.414.0

11.512.210.98.56.5

10.19.1

8.9

8.310.510.817.413.312.510.8

Pt, INCPTFPTPT

PTFFPTFFINC50J550J5

PT.5075F

INCF

FFFFFFFFF

PTFFFFFF

F

FFPT

50RFPTPT

13.013.20.0

11.06.6

6.10.02.58.46.15.0

16.90.00.0

22.810.0

5.712.8

7.30.04.85.05.05.0

11.45.56.9

5.315.714.310.612.52.8

10.3

6.4

12.17.68.7

17.121.48.08.8

PTPTFFF

FFFFPTPTPT, INCPTPTPT, INCF

FF

PTFFFFFFFF

FfPTFFFF

F

FPTFEXCFFF

12.412.70.02.53.7

5.40.06.0

10.810.310.924.412.621.236.726.4

5.25.4

6.411.04.12.01.81.83.11.09.0

5.016.117.17.80.04.88.5

0.0

5.49.77.9

14.214.49.6

10.8

GSPstatus

PTFF

FPTEXCEXCFEXCPTF

FF

FFFFFFFFF

FPTFPTFFF

F

PTPTFPTEXCFPT

New Zealand Sweden

Tariff GSP Tariff GSP(percent) .status1 (percent) status

13.529.30.0

42.537.3

47.50.0

26.438.630.915.919.55.0

23.044.621.5

26.70.0

22.80.0

25.015.326.523.120.917.842.5

10.027.917.95.8

22.53.5

39.4

27.2

15.127.139.838.250.041.939.4

PT, INCINCEXCEXCEXC

PTEXCPT, INCPT, INCEXCFFFFEXCPT, INC

PIEXC

EXCEXCPTFEXCINCEXCINCPT, INC

PT, INCINCFPTEXCFPT

PT

PT, INCPT, INCINCEXCEXCEXCPt, INC

6.88.70.03.32.1

3.90.02.53.88.08.9

13.88.09.5

14.69.0

2.23.4

5.92.33.11.50.01.53.20.05.3

0.910.09.04.33.00.05.8

0.0

6.86.25.1

12.19.78.85.4

PTPTF

PTPTPTPTPTPTPT

FF

PTFF

FFFFFFF

F

FPTFPTFFF

Canada Switzerland

Tariff GSP Tariff GSP(per cent) status4 (per cent) status

16.416.613.013.810.2

16.20.0

13.516.014.914.217.718.80.0

22.914.1

11.412.5

10.47.29.3

16.011.312.513.210.817.1

13.615.611.912.515.011.315.2

7.5

11.115.214.821.518.918.517.5

PT, INCPT, INCINCINCINC

INCINGINCINCEXCEXCEXCINCEXCEXCINC

INCINC

INCINCINCINCINCINCINCINCINC

INCINCINCINCINCINCINC

INC

INCPT, INCINCEXCINCINCINC

4.2 F2.8 F2.3 F

18.7 F4.9 F

7.0 PT2.4 F

12.9 F11.14.65.6

11.28.89.1

10.36.1

1.00.1

6.511.03.11.74.21.3

11.41.2

NC

T

5.4 INC

2.6 EXC4.6 F2.1 EXC1.7 PT0.5 F1.5 F5.5 F

4.7 f

1.4 PT3.2 PT2.1 PT8.7 F8.4 F8.6 F6.5 F

Sources: UNCTAD, Third Session, Vol. II; Annual neport, 1966/67-1970/71, Tariff Board, Australia; Interhatlanal Customs Journal. No. 29: New Zealand; various UNCTAD and GATTdocuments regarding the nature of GSP schemes currently in operation.

1 All imports under the EEC Scheme are subject to ceilings.1 Most of the products are subject to restrictive ceiling limitations for safeguard reasons.1 In general, British preferential rates are applied to imports from beneficiary countries.4 GSP rates under the Canadian scheme are 33 per cent less than the British Commonwealth preferential rates or the MFN rates, whichever is lower.* All rates under the scheme aie 30 per cent below the MFN rates.• F: All items within the product group are admitted free of duty.

50 per cent: All items admitted at rate 50 per cent below the general tariff rates.PT: Part of the items in the group admitted free of duty while others subject to general tariff rates.INC: All items in the group granted preferential treatment but not at zero rate and/or subject to quantitative restrictions.PT, INC: Preferential, nonzero tariff rate apply to only a part of the product group; rest not subject to preferences.EXC: Ail items in the group excluded from the scheme.

36

FF

F

FF

FF

FFFF

FFFF

FF

I

P

FF

F

F

F

F

F

F

F

FFFFFFT


giving countries can retain some degreeof control over the trade which might begenerated by the new tariff advantages ofthe preference-receiving countries. Suchsafeguard provisions can be classified intotwo broad categories: a priori limitationsand the application of escape clauses. Thea priori limitation formula is intended to

regulate preferential imports on the basisof past trade performance of beneficiaries(basic amount) plus a certain increment(supplementary amount). The currentapplication of this formula is so restrictivethat the actual expansion of preferentialtrade in the future might be negative, thatis, it might go below the present level.

The escape clause, on the other hand,provides grounds for withdrawing thepreferential treatment, in whole or in part,when the import of a product from thepreference-receiving countries increases tothe point where it can either cause orthreaten serious injury to domestic pro-ducers of similar or directly competitiveproducts in the preference-granting coun-tries. Since no criteria for determiningserious injury are clearly defined, theapplication of the escape clause is fraughtwith uncertainty.

The EEC and Japan apply the a priorilimitation formula on manufactured andsemimanufactured products and apply theescape clause for agricultural and fisheryproducts. Other countries use the escapeclause for all types of products.

In the United States, the escape clausetakes the form of a "competitive need"formula, which limits imports from majorbeneficiary countries. The formula laysdown that if a beneficiary country sup-plies more than 50 per cent of the totalimports of a particular eligible item, orsupplies to the United States a quantityof that article valued at more than US$25million a year, then that country loses itsbeneficiary status. In the preferenceschemes of Austria, the EEC, Japan,Sweden, and the United States, action canbe taken unilaterally and against specificcountries under the escape clause.• Rules of origin

To qualify for preferential treatment,goods must at present satisfy the directconsignment rule and comply with the "ori-gin criteria" specified by the preference-giving countries. In general, goods areconsidered to have originated in apreference-receiving country if they havebeen produced in that country eitherwholly or by substantial transformationfrom materials or components that areeither imported or are of undeterminedorigin. Austria, the EEC, Japan, theNordic countries, and Switzerland followthe "process criterion," which implies thattransformation of the raw materials orcomponents must be enough to lead tothe classification of the exported goodsunder a BTN heading other than thatof the materials or components used intheir production. In order to apply theprocess criterion, qualifying and non-

qualifying processes are listed and theseare often applied very stringently, there-by preventing the beneficiaries fromobtaining full advantage of the GSPschemes. Australia, Canada, New Zea-land, and the United States base theircriteria of origin on value-added. Underthis a transformation is considered sub-stantial and eligible for preferential treat-ment by Australia, Canada, and New Zea-land if the value-added exceeds 50 percent in the beneficiary country. In theUnited States, the preferential treatmentis granted only if the value-added per-centage is at least 35 per cent for individ-ual countries, or if it is 50 per cent fortwo or more countries that opt to betreated as one beneficiary.

The other main condition for satisfyingthe origin requirements relates to directconsignment. Preferred goods must beconsigned directly to the preference-giving country from the exporting(preference-receiving) country withoutpassing through the territory of any othercountry. All preference-giving countriesapply this condition, while Japan requires,in addition, that at the time the goodsleave the country it must be the intentionof the exporter to ship them to Japan.• Beneficiary countries

The preferences are, in general, extendedto all less developed countries that belongto the so-called Group of 77 (which nowhas over 100 members) and the dependentterritories of developed countries. How-ever, each preference-granting countryreserves the right to exclude any countryfrom its list of beneficiaries. For example,the U. S. scheme excludes communistcountries unless they are members of theInternational Monetary Fund and are acontracting party to the General Agree-ment on Tariffs and Trade (GATT). TheUnited States also excludes members ofthe Organization of Petroleum ExportingCountries (OPEC), countries which are aparty to any action that results in thewithholding of supplies of vital com-modity sources for international trade orin the raising of prices of such commodi-ties to an unreasonable level, and countriesgranting reverse preferences to developedcountries other than the United Statesunless such arrangements are to be elimi-nated before January 1, 1976. Addition-ally, a country that has appropriated U. S.property without adequate compensationloses its beneficiary status. Specifically,24 countries and territories are excludedby the U. S. scheme at present, includingall members of OPEC; Somalia, Uganda,and the People's Democratic Republic ofYemen because of financial disputes with

37

Austria Aust ra l ia United States

9.214. 05.1

17.07.1

INCINC

INCINCINC

10.228.30.0

40.037.5

EXCPTPTEXCPT

16.49.37.0

12.66.6

Fffrf

Tariff GSP Tariff GSP Tariff GSP(percent) status (percent) status* (per cent) status

10.55.214, S19.113.111.222,816.028. 030.214.9

INCmeINCINCmeEXCEXCINCINCEXCINC

35.00.024.018.211.60.049.00.045,023.415.2

EXCEXCEXCPTPTPTEXCINCINCPTINC

10.40.06.26.722.311.618.410.48.522.613.4

fFrfEXCEXCEXCEXCEXCEXCf

8.E5.3

INCINC

18.30.0

INCINC

12.54.5

FF

8.916.011. 08.7

13,09,3

15.113.324.4

INCINCINCINCINCINCINCINCINC

16.60.0

15.025. 015.0lfi.3fi.O

20.033. 2

INCINCmemeINCINCmememe

7.8 PI5.6 F8.0 F8.9 f7.8 F7.B F7.7 F7.9 F

10.0 F

11.218,011. B10.510.020. B13.5

6,8

INCPTPTINCINCINCINC

INC

8.822.527.52.98.3

31.939.5

9.0

PTPTPTmemeINCINC

INC

9.111.112.36.66.5

10.710.6

8.5

EXCFFFfFF

F

IS. 513.310.017.919.514.817.3

PTINCINCINCINCmeINC

5.449.845.840.045.042.546.5

INCINCPTPTINCINCme

7.58.47.0

10.fi12.810.911.4

FFFEXCFFF


Table 2Trade Effects of Tariff Cuts and Quantitative Limitations Under the GSP Schemes Based on 1971 Data

(In thousand U. S. dollars)

Tariff Cuts Only

Donor Countries

Australia

Austria

Canada

European EconomicCommunity

Japan

New Zealand

Nordic countries

Switzerland

United States

Total

Decline Inexports ofdevelopedcountriesto donorcountries

4,033

2,150

12,785

111,805

17,528

3,075

24,094

4,469

200,296

380,235

Increase inexports of

less developedcountriesto donorcountries

9,821

4,084

29,262

331,688

69,387

8,685

45,557

9,194

878,928

1,386,603

Tradecreation

5,788

1,934

16,477

219,880

51,859

5,610

21,463

4,725

678,632

1,006,368

Tradecreationas per-centageof donorcountry'sImports

0.78

0.27

0.85

3.04

5.29

2.83

0.97

0.36

7.94

4.22

Decline inexports ofdevelopedcountriesto donorcountries

2,070

1,068

3,421

38,446

9,690

2,949

14,607

4,084

71,329

147,664

Tariff Cuts and Quantitative

Increase inexports of

lessdevelopedcountriesto donor

countries

4,910

1,645

6,396

59,177

11,341

8,388

25,879

8,430

254,366

380,532

Tradecreation

2,840

577

2,975

20,731

1,651

5,439

11,272

4,346

183,037

232,868

Limitations

Tradecreationas per-centageof donorcountry'simports

0.38

0.08

0.15

0.29

0.17

2.75

0.51

0.33

2.14

0.98

Tradecreation

in the firstyear of

operation ofthe schemes »

3,144(1974)

725(1972)3,628(1974)

1,548(1972)

-1,787(1972)4,714(1972)

11,600(1972)4,963(1972)

297,794(1975)

—Sources: UNCTAD documents on Individual country schemes; UN Statistical Office, World Trade Annual and Supplement, 1971.1 Projected values. Calculated on the basis of linear-trend approximation at current prices.

the United States; Romania, Hong Kong,Israel, Spain, Portugal, Cyprus, Greece,and Turkey are excluded because of theirtrade agreements with EEC grantingreverse preferences to EEC members.Other preference-granting schemes are,however, not as restrictive as the U. S.scheme. The exclusion of countries frompreferential treatment for reasons otherthan their level of economic developmenttends to limit the usefulness of the GSPas an approach to export promotion forless developed countries. In addition, itcreates uncertainty about preferentialtreatment of a country. Uninterruptedpreferential treatment over an extendedperiod is necessary in order to ensureeffective implementation of investmentplans prompted by them.

Trade effects of GSP schemesThe UNCTAD secretariat has obtained

some information on the actual operationof the schemes from both preference-receiving and preference-granting coun-tries, with special emphasis on the effectsof preferences on trade flows as well asthe use of safeguard mechanisms in donorcountries. The information collected onthe trade flows of eligible commodities forAustria, New Zealand, the Nordic coun-tries, and Switzerland for 1972 and 1973shows that the introduction of preferenceschemes has resulted in a somewhat faster

rate of growth of these preference-grant-ing countries' imports of eligible com-modities in comparison with ineligiblecommodities. This has increased the shareof eligible commodities in total importsfrom the preference-receiving countries. InFinland, for example, the share of importsfrom beneficiaries eligible for preferentialtreatment grew by 1.2 per cent. For Nor-way, this share increased by 5.1 per centand Sweden had an even higher rate. InSwitzerland, the share remained more orless unchanged for the first year of itsscheme. Austria showed a significant in-crease in the share of preferred importsin total imports, but that was due pri-marily to a sharp rise in the value of fuel

Zubair Iqbal

a citizen of Pakistan,is an economist inthe Exchange andTrade RelationsDepartment. Beforejoining the fund as

a "Young Professional in 1972, he taughtat the Islamabad University in Pakistan. Heholds a Ph.D. from Michigan StateUniversity and is the author of a numberof articles on preferences and otherissues relating to trade and development.

imports for which the preference statushas since ended. No information wasavailable to the UNCTAD secretariat onthe operation of the schemes of the majordonors like the EEC, Canada, Japan, andthe United States.

As far as the beneficiary countries areconcerned, their exact supply response topreferences is not known. David Wallundertook a study for the World Bank in1973 to determine the reaction of pro-ducers in the leading beneficiary countriesto lowered tariffs under the GSP schemes.His findings were based on interviewswith producers in India and importers inthe developed countries, and showed thatboth importers and exporters were largelyunaware of the existence of the GSPschemes. He also found that whenimporters were aware of preferences, theimpact of preferences was lessened in theshort run by the inability of the exportersto meet the increased demand for pre-ferred goods. In this particular case, noteven one increased or new trade flowcould be identified by importers or pro-ducers as having resulted from the GSP.

An assessmentWhile the schemes have not been in

operation long enough to provide a clearpicture of their economic effects, it ispossible to estimate their likely tradeeffects. Estimates have been made of the

38


decline in exports of developed coun-tries and the increase in exports frompreference-receiving countries to thepreference-granting countries as a resultof preferences. Thus, the global tradecreation effect, that is the differencebetween the increase in preference-receiving countries' exports and thedecline in developed countries' exports,can be ascertained. This estimated tradecreation effect may serve as one measureof the beneficial effects of GSP schemes.Estimated export supply elasticities andimport demand elasticities were used toobtain estimates of trade creation for allthe GSP schemes on the basis of 1971trade data (see Table 2). If one disregardsquantitative limitations such as exclusionsand tariff quotas, then the overall reduc-tion in exports of developed countries isestimated to be $380 million while exportsof less developed countries increase byabout $1,386 million, resulting in a globaltrade creation equal to $1,006 million, orover 4 per cent of the developed countries'imports of products covered by their GSP

schemes in 1971. However, if quantitativelimitations are taken into account, theestimated trade creation declines to$233 million, or less than 1 per cent ofthe developed countries' imports of pre-ferred commodities in the same year. Thisamounts to less than 5 per cent of externalassistance provided by developed coun-tries to less developed countries in thesame year and shows the extremelylimited benefits that are likely to flowfrom the GSP schemes to the less devel-oped world. These results tend to showthat the GSP schemes currently in opera-tion generate very limited incentives forencouraging manufactured exports fromless developed countries. Products coveredby the schemes comprise only 2 per centof the total imports of preference-grantingcountries. Quantitative restrictions such astariff quotas and exclusions negate thepositive effects which might otherwiseoccur.

For the preference schemes to be ofmeaningful use to the less developedworld, some basic changes will have to

be effected in their structure. Among themajor shortcomings are the quantitativelimitations, such as exclusions of productsin which less developed countries arelikely to be more competitive, and thetariff quotas that are built into theschemes to regulate the flow of preferen-tial imports into donor countries. Theserestrictions are motivated by domesticconsiderations in donor countries. Therelaxation of these restrictions would bethe most effective instrument in increas-ing the beneficial effects of the schemesfor the recipient countries. Efforts in thisdirection should not only aim at enlargingexisting quotas but should also extend thelist of eligible items to include productsin which less developed countries special-ize. Since the Multilateral Trade Negotia-tions currently under way are very likelyto introduce global tariff cuts, the bene-ficial effects of preferential tariffs onimports from less developed countrieswill be sharply curtailed unless offset byliberalization of quantitative restrictionsmade by preference-granting countries.

Recently, UNCTAD released a report on the GSP which gives an overall view of theschemes in operation, their trade implications, and future trends. Here is an analysisof that report:

United Nations Conference on Trade and Development—Operation andEffects of the Generalized System of Preferences, United Nations, NewYork, N.Y., 1974

The Generalized System of Preferences(GSP) was established by UNCTAD inresponse to the proposal of the develop-ing countries that concessions from thedeveloped world be centered on traderather than aid. The report under con-sideration was prepared for the first re-view of the GSP held in April 1973 byUNCTAD's Special Committee on Pref-ences. It describes the main features ofthe preference schemes introduced by thatdate and discusses the implications forthe exports of preference-receiving coun-tries to the markets of the preferencegivers. Individual studies in the reporttreat the likely effect on the benefits ac-cruing under the GSP of the enlargementof the European Economic Community(EEC), of the conclusion of free tradeagreements between the enlarged EEC andthe remaining European Free Trade Asso-ciation (EFTA) countries, and of the Mul-tilateral Trade Negotiations (MTN).Other studies describe in some detail the

preference schemes of the EEC, Japan,and the United Kingdom, and investigatespecific aspects of the GSP such as therules of origin requirements, the benefitsof GSP to the least developed amongdeveloping countries, and the effect ofthe GSP on countries receiving EEC andCommonwealth preferences.

In 1970, beneficiary countries' exportsto the preference-granting market econ-omy countries amounted to $24 billion.Of these, exports amounting to only $9billion were subject to customs duty inthe first place, and goods worth only $2.1billion (or 23 per cent) received prefer-ential treatment under the GSP. TheseGSP schemes excluded from preferentialtreatment up to 96 per cent of the dutiableagricultural imports from developingcountries and up to 62 per cent of dutiableindustrial imports, which include textiles,leather goods, and petroleum products.The report argues that even these figurestend to overstate the share of developing

countries' exports benefiting from prefer-ences. Under the EEC's preference schemeeach exporting country can receive apreferential margin over the most-favored-nation (MFN) tariff only for exportswithin some quota. Other countries allowGSP treatment to be revoked under escapeclauses. Rules of origin which excludefrom preferential treatment clothingmanufactured from imported textiles orradios assembled using imported transis-tors are considered too restrictive by thereport. Requirement that goods must beconsigned directly from the exporting tothe importing country make it more diffi-cult for landlocked countries to takeadvantage of the schemes.

The report expresses concern at theerosion of preferential margins duringgeneral tariff reductions that may resultfrom the MTN. However, it goes on tosuggest various ways in which compensa-tory concessions could be made to devel-oping countries. It calls for cuts in theMFN tariffs and the removal of quantita-tive restrictions on such goods as tex-tiles, leather, and agricultural productswhich are of particular interest to devel-oping countries but are now largely ex-cluded from the GSP. The developingcountries should press for an examinationof "voluntary" restraints on their exportsof manufactures and for stricter criteria

39


governing the resort to safeguards byimporting countries. It also suggests thatany tariff cuts agreed should be imple-mented in advance for imports fromdeveloping countries.

A second area of concern centersaround the EEC. The enlargement of theCommunity means first of all the replace-ment of the relatively more liberal GSPschemes of Denmark, Ireland, and theUnited Kingdom by the Community'sscheme. Furthermore, the establishmentof free trade agreements between theEEC and the remaining EFTA countriesand the movement toward preferentialagreements with Mediterranean countriesmeans that trade between these countries

will be placed on a more favorable basisthan the EEC's trade with developingcountries.

Since the studies comprising the reportwere all completed between November1972 and March 1973, the report lacksany description of the important prefer-ence schemes of the United States andCanada. Events in the EEC have alsopassed the report by, since it was com-pleted before the effects of enlargementcould be clearly seen and before the sign-ing of the Lom£ Convention. In addition,at the date of completion of the studies,few figures were available on the actualbenefits to developing countries of theGSP. Thus, the report is obliged to deal

only with the potential benefits which itidentifies with the share of developingcountries' exports which receive preferen-tial treatment under the various schemes.

The benefits of preferential tariffs havenot proved as tangible as was once hopedand the GSP must be adapted if it is toremain relevant. "Should the GSP remainbasically unimproved," the report states,"it will, for practical purposes, have lostmuch of its value by 1977." In this firstreview attention appears to be movingfrom the lacunae of current tariff prefer-ence schemes to those other trade barrierswhose removal is of vital interest todeveloping countries.

Mark Allen

Toward a new framework forinternational resourcetransferscontinued from page 9

national taxation. For the IBRD, it wouldbe logical that, instead of seeking theconcerned government's permission be-fore floating its bonds, it should have anautomatic right to borrow in any capitalmarket where the country has beenenjoying an overall balance of paymentssurplus.

While the World Bank has shown con-siderable vitality in deepening its activi-ties (by turning its attention to productiveprograms for the lowest 40 per cent ofthe population), it has not shown thesame vitality in extending the range of itsservices, such as buffer stock financing,export credit financing, and use of itsguarantee powers. These services arelikely to become even more crucial in the1970s as trade expansion comes to berecognized as an increasingly importantsupplement to resource transfers.

"Third Window" for medium-termaid

Though the IBRD and the IDA haveserved admirably as mechanisms forchanneling assistance to the developingcountries, it is becoming increasinglynecessary to evolve a new mechanism forobtaining and directing assistance atterms intermediate between the IBRD andthe IDA. The introduction of a "ThirdWindow," (which the bank is presentlycontemplating) is, therefore, a pragmaticand inevitable response to the changing

40

circumstances.At some stage, consideration should

also be given to a general review of theArticles of the World Bank which wereconceived and drafted in the environmentof the 1940s. This is becoming necessaryas the basic economic situation of thedeveloping countries is undergoing afairly rapid change, calling for a greatermeasure of flexibility in the Bank opera-tions. For instance, the original Articlesexpected, quite rightly at that time, thatthe bulk of the Bank assistance would bein projects and in foreign exchange, sothat restrictions were built into the rulesof the game against program lending andlocal cost financing. The Bank has impro-vised pragmatically in its actual opera-tions to get around these restrictions asthe need arose: still the long shadow ofthe Articles is always there and theneeded flexibility is sometimes missing.Program lending and local cost financingstill have to be justified, on a case-by-casebasis, as deviations from a normal trendwhich is bound to influence the form andcharacter of lending. One can find otherinstances of such restrictions in the Arti-cles: for example, procurement of goodsand services restricted only to Bank mem-bers; extremely limited preference marginto developing countries for procurementwithin their own country; a strict finan-cial rate-of-return criterion.

The Bank practice has moved consider-ably, though not sufficiently, away fromsome of the restrictive aspects of theArticles. But the Articles themselves mayhave to be reviewed, not only to bringthem into conformity with the actual

practice but also to build into themenough flexibility to accommodate theneeds of the 1970s and the fast changingrole of the World Bank in the future. Itshould be recognized at the same timethat a general review of the Articles islikely to be a very difficult and treach-erous process and can only be undertakenif the necessary political consensus forsuch a step is available. In the mean-time, there is no alternative to pragmaticimprovisations.

An exercise in futility?What are the chances of designing and

implementing a new framework for inter-national resource transfers? Why shouldwe assume the necessary political will andthe enlightened international attitude thatis needed even to begin traveling downthis road? Is the whole conception a mereexercise in futility? It is difficult toanswer these questions, and yet they arethe most crucial ones. For the time being,we can only hope that there will at leastbe the beginnings of a serious negotiationbetween the rich and the poor nations atthe Special UN Session in the fall of1975, and one of the elements in thisnegotiation will be a new framework forinternational resource transfers. Whilethe negotiations can be expected to behard and long and difficult, it would beuseful to develop some negotiating prin-ciples (which is all that this articleattempts to do) and agree on some nego-tiating forum in which an orderly dia-logue can be pursued. No one can predictthe results of such a dialogue. But it isimperative at least to make a fresh start.


The Euro-currency marketin perspectivecontinued from page 13

declined by US$12 billion (over 5 percent) from their June level. Concernabout the stability of the market, how-ever, soon subsided—reflecting, in part,confidence derived from the central banks'statement of support issued after theBank for International Settlements (BIS)meeting in September 1974—and themarket growth, although moderate, wasresumed in the fourth quarter of 1974and the first half of 1975.

Major worldwide roleThe developments during 1974 are, in

a sense, suggestive of the true nature ofthe Euro-currency markets in the contextof the broad structure of the world econ-omy. The market, which may havestarted as a substitute for U. S. marketsand which could have been viewed as ananomaly or aberration ten years ago, hasnow established itself as the major cor-nerstone of world capital and the mone-tary scene. Without the enormous expan-sion of the Euro-currency market in thefirst half of 1974, the recycling of oilfunds would have been very difficult, atleast in the short run, and the worldeconomy would have suffered from addi-tional pains and strains. The sag in themarket in the third quarter was nothingbut the reflection of the fact that thismarket is a short-run and competitiveone, which cannot bear the burden ofmedium-term and long-term functions ofrecycling, and that even a competitive

market needs some overall frameworksupported by the official authorities of theworld. In any event, the re-emergence ofNew York as a world capital and moneycenter cannot take away the major rolewhich the Euro-currency market hasplayed during the last decade. The Euro-currency market will continue to functionas a major financial center of the worldand will be integrated more and morewith U. S. markets now that major restric-tions on U. S. markets have been lifted.

The importance of the Euro-currencymarket in the world economy hasincreased to such a point that its futurecannot be discussed separately from thefuture of world economy as a whole. Aslong as the international transactions ofthe world, or the integration of the worldeconomy, proceed as smoothly as theyhave in the past, the Euro-currency mar-ket will continue to play a major role inthe world economic scene. Conversely,the sound development of the worldeconomy cannot be maintained withoutthe smooth functioning of the Euro-currency market.

Official interventions in the marketThe degree of development of the Euro-

currency market, which is also an indica-tion of the degree of monetary inter-dependence of the economies of the world,is such that effective coordination of themonetary and other policies of, at least,the major countries of the world seemsessential to the proper management andmonitoring of the world economy. Inthis sense, agreements on some form ofcoordinated surveillance and official inter-

vention in the Euro-currency market maylay the foundation for further cooperationin coordinating economic policies of thecountries of the world.

Since Euro-banks are internationalfinancial intermediaries which do notcreate money or net liquidity but merelydistribute money created elsewhere in thesystem, they primarily serve to increasethe velocity of domestically createdmoney. In these circumstances, officialintervention in the Euro-currency marketcould be directed at controlling this ve-locity. The volume of international moneycan only be controlled by the effectivecoordination of the monetary policies ofthe authorities of the reserve centers.Under the present "limping" or de factodollar standard only the Federal ReserveBank of the United States has the powerto control the supply of U. S. dollars and,therefore, the supply of internationalmoney. In these circumstances, becausethe Federal Reserve is likely to givepriority to domestic considerations, thustending to set the supply of dollars inaccordance with domestic needs, thesupply of U.S. dollars may not be con-sistent with the requirements of othercountries. As a result, there may besignificant scope for other countries tomeet their own policy objectives by inter-vening in the Euro-currency market inan attempt to vary the velocity of U. S.created dollars. The explicit or implicitagreement by the Federal Reserve on suchintervention could lead a way to morefull-fledged coordination of monetary andother policies of the countries of theworld.

Financing the mining sector:the Bank's rolecontinued from page 23creditor. The Bank, therefore, includes inits agreements with members (whether asborrower or as guarantor) a "negativepledge" provision which assures it ofequal and pari passu treatment if specificsecurity or preference is later given toanother lender. To be sure, the Bank hassometimes agreed to waive the right toparticipate in a security by virtue of thenegative pledge undertaking if the cir-cumstances justified it; but it would beless than prudent and it could weakenits position in the capital markets of theworld if it did not pursue the practice ofincluding a negative pledge covenant in itsagreements with governments.

What of the future?A growing Bank role in lending to the

mining sector can be expected. There islikely to be more emphasis on local par-ticipation and on the fairness and open-ness of agreements governing the rela-tions between the foreign and localparticipants. This would probably involvedifferent legal and financial problemsfrom those the Bank has been accustomedto, but these should not pose any realdifficulties. It will, however, also entailthe assumption of greater risks on behalfof already overstrained economies. Itwould be irresponsible to focus attentiononly on the profits of successful ventureswithout taking into account the potentialfor losses and failure. The bargainingpower, and the geological and relevanttechnological knowledge of the producingcountries must be strengthened, and ade-quate mineral policies and explorationtechniques established so that the eco-nomic and social benefits of successfuloperations might be realized more quickly.

If the problems which now beset theindustry are to be solved—and many ofthem are essentially political in nature—as everyone is well aware, a closer part-nership between the mineral producingand the mineral consuming countriesmust be forged. The need for this is veryurgent now because the balance of min-eral reserves is gradually expected toshift toward the developing countries inthe future. As a healthier country/corpo-rate relationship is a precondition to anyprogress in the exploration and exploita-tion of new resources, governments aswell as corporations will have to moderatesome of the positions which have in thepast led to conflict between them. Corpo-rations will have to be more receptive tolocal demands (financial, economic, social,and political), and governments will haveto minimize the political risks to attractthe capital required for the developmentof new sources of surjolv.

41


the euro-currency market - imf elibrary

Documents