Stabilization and liberalization policies in Colombia : prospective simulations, 1985-90

STABILIZATION AND LIBERALIZATION POLICIES IN COLOMBIA: PROSPECTIVE SIMULATIONS, 1985-90 M. Cherif and Erh-Cheng Hwa Division Working Paper No. 1987-9 Country Analysis and Projections Division Economic Analysis and Projections Department The World Bank Division Working Papers report on work in progress and are circulated for Bank staff use to stimulate discussion and comment. The World Bank does not accept responsibility for the views expressed herein which are those of the author(s) and should not be attributed to the World Bank or to its affiliated organizations. The findings, interpretations, and conclusions are the results of research supported by the Bank; they do not necessarily represent official policy of the Bank. The designations employed, the presentation of material, and any maps used in this document are solely for the convenience of the reader and do not imply the expression of any opinion whatsoever on the part of the World Bank or its affiliates concerning the legal status of any country, territory, city, area, or of its authorities, or concerning the delimitation of its boundaries,9 or national affiliation.  ABSTRACT Over the decades of the sixties and seventies, Colombi*a. achieved impressive economic growth. However, since the beginniig of this decade, the country's growth has slackened and balance of paynents, have sharply deteriorated. The paper simuLates alterfative stabilization and liberalizing policies of Colombia during the per-ioxi 1985-1990 by using a dynamic general equilibrium model. The reults- show that given a reasonable external environment, it is feasible f.ar Colombia to use a proper mix of stabilization and liberalization policies to restore economic grcwth and maintain a stable balanze of payments. The policy mix includes three major components: izport- liberalizat,ion, government deficit reduction and nominal devaluatimn.  TABLE OF CONTENTS Page No. I. Introduction .............................. ..................1 II. Past Colombian Economic Policy Regimes....................... 2 1967-73 ........................................................... 3 1974-78 ..o.......................................................... 5 1978-84 ............................................................. 7 III. Stabilization and Liberalization: Some Theoretical Considerations ............................................... 9 IV. The Colombian Model ................................... 13 V. Some Experiments .......................................... 18 Base Case Simulation ........................................ 18 Alternative Simulations .............................. *.....27 1. Higher Devaluation . ................... ....... 28 Liberalization ....................................... ..... 31 VI. Conclusions ............................................... 35 Bibliography. ...................................................... 36 LIST OF TABLES Table 1: Key Performance Indicators .............................. 4 Table 2: Policy Indicators and the Price of Coffee ............... 6 Table 3: Sectoral Classification ................................ 14 Table 4: Key Policy Instruments and Exogenous Factors Colombia Projections Base Case ........................ 23 Table 5: Key Parameters of the Model ............................ 25 Table 6: Summay Table of Indicators ............................. 26  LIST OF TABLES (continued) Page No. Table 7: Scenario Descriptions ................................. 28 Table 8: Summary Table of Indicators -- Devaluation of 60 Percent ..........................................29 Table 9: Long-term Consequences of a Higher Devaluation (1985-90) ............................... 32 Table 10: Comparison of the Base Case with the Liberalization Case, 1985-86 ......................34  I. Introduction Over the decades of the sixties and seventies, Colombia achieved impressive gains in economic growth and employment. Since the beginning of this decade, however, the country's economic situation has taken a turn for the worse: growth has slackened, inflation has soared, and the country has slipped into major imbalances. The balance of payments position has deteriorated so ,harply that an injection of foreign capital has been required, and international reserves have been decreasing. By the end of 1984, Colombia almost reached a liquidity crisis that called for economic policies both to stabilize the economy in the short run and to restore economic growth over the medium term. Although the deterioration in the global' environment clearly contributed to Colombia's problems, domestic economic policies also played a major role. Colombia's external competitiveness eroded because of the appreciation of the real exchange rate and the high rate of domestic inflation caused by the budget deficits. Both situations reflected clear lapses in domestic policy formation. The increased use of quantitative restrictions as a stabilization tool was another. In contrast to the Colombian policy regime that has prevailed recently, the main focus of a stabilization program needs to be the reduction of the budget deficit (especially transfers of the national government), which has become a major source of monetary emission, and acceleration of the rate of nominal devaluations of the peso. Simultaneously, and coupled with the restoration of external competitiveness through devaluation and control of inflation, it is also  -2- suggested that import liberalization be initiated to reduce the distortions in relative prices. This paper estimates the' impact of such stabilization and liberalization policies on the prospects for the Colombian economy in the short and medium run. The analysis is based on a general dynamic equilibrium model of the Colombian economy, used to ensure consistency between the policy instruments and economic performance variables and among' the policy instruments themselves, and to assess the trade-offs between stabilization and trade liberalization policies. The analysis shows that the best policy mix for Colombia would be the simultaneous pursuit of stabilization and trade liberalization policies. The next section of this paper summarizes recent economic policy regimes in Colombia. Following theoretical discussion of stabilization and liberalization policies presented in Section III, the model used for the analysis is summarized in Section IV. The simulation experiments are presented in the fifth section. The final section presents conclusory remarks. II. Past Colombian Economic Policy Regimes In reviewing past policy, it is useful to look at four periods; before 1967; 1967 to 1973; 1974 to 1978; and 1979 to the present. These periods correspond roughly to different administrations but also different to economic policy regimes. The first period was characterized by inward-looking policy, with resultant low growth, high inflation and a large current account deficit. The second involved trade liberalization and export promotion, with high growth, low  -3- inflation and A,i small current account deficit, while the third period emphasized financi.al liberalization, with high growth, high inflation and a current account surplus. In the fourth period, economic policy has been an expansionary (public investment), financed by foreign credit; the outcome has been low growth, high inflation and balance of eayments problems. Only the latter three periods are discussed here. A. 1967-73 In contrast to previous years, the government pursued outward- looking strategies in the period 1967-73. Exports were encouraged by depreciations in the real effective exchange rate (REER). As shown in Table 1, the REER index fell gradually from around 83 in 1967 to 112 by 1973, a devaluation of about 34 percent. It was also in this period that a crawling peg and a CAT '1/ system were established. Imports were also liberalized; quantitative restrictions (QRs) expressed in terms of items requiring prior licensing decreased from around 96 percent in 1967 to 67 percent by the end of the period (Table 2). This import liberalization helped contain inflation and increased efficiency. Sectoral studies show that greater increases in efficiency took place in those sectors that were more exposed to foreign competition. During this period, economic growth averaged 6.3 percent a year, while the rate of inflation averaged 9.7 percent. This performance is the best achieved in Colombia's recent history. 1/ Tax credit certificates were issued to exporters for the payment of taxes, equivalent to a certain percentage of the f.o.b. value of exports.  -4 Table 1: KEY PERFORMANCE INDICATORS GDP Inflation Current Real Effective Growth Rate (%) Account/ Exchange Rate a/ Rate (%) GDP (%) (1980=100) 1961 5.3 7.9 2 5.5 5.3 3 2.9 21.9 4 6.6 14.9 5 2.8 11.9 -10.7 - 6 5.7 11.4 -15.2 82.2 7 4.2 10.1 -11.3 83.2 8 6.4 7.8 -2.7 90.5 9 6.3 7.0 -2.7 91.3 1970 7.0 7.0 -4.1 96.6 1 6.0 12.2 -5.8. 102.2 2 7.7 11.7 -2.2 108.2 3 6.7 19.2 -0.5 111.6 4 5.7 26.9 -2.8 111.1 5 2.3 24.5 -0.8 118.4 6 4.7 20.5 1.3 115.8 7 4.2 27.1 2.3 100.4 8 8.5 17.8 1.4 106.8 9 5.4 26.4 1.7 101.2 1980 4.1 26.3 0.4 100.0 1 2.8 25.9 -4.5 92.0 2 0.9 22.0 -6.5 87.8 3 0.9 23.4 -6.3 89.2 4 3.1 14.6 -5.0 92.1 Source: World Bank, International Financial Statistics. a! Decrease implies appreciation (increase implies depreciation).  -5- B. 1974-78 In August 1974, the government undertook a systematic financial reform that involved freeding the interest rates and reducing the reserve requirement ratio (RRR) and forced investmentse. The development role of the central bank was also reduced. The resultant sharp increase in the monetary base during 1972- 73 (Table 2) and the reduction in RRRs led to buoyant domestic demand, a high rate of inflation, and a deteriorating balance of payments. These developments forced the Lopez administration to adopt an economic stabilization program that nullified many of the liberalization measures taken earlier. During 1974-78, the government devalued the peso, reduced the CAT subsidies, raised the RRRs, reimposed a ceiling on UPAC deposits and, finally, raised import tariffs and tightened the granting of licenses. As the stabilization program began to take hold, real GDP growth fell from 5.7 percent in 1974 to 2.3 percent in 1975. Despite these efforts, the monetary base coirtinued to expand. In late 1975, the task of controlling inflation became even more difficult as coffee prices began to register a strong increase (Table 2). The related improvement in the terms of trade fueled both inflation and growth. At the same time, the real effective exchange rate appreciated. In January 1977, the government initiated another stabilization package to neutralize the increase in international reserves. The package consisted of restrictive monetary and fiscal policies, especially the curtailment of public investment. As the government believed the export boom would be transitory, it did not use import  -6- Table 2: POLICY INDICATORS AND THE PRICE OF COFFEE Export Coffee Reserve Growth Rates Tariff Prices Requirement Interest Monetary Exchange Claims on QRs Rate (US Dollars, Ratio (%) Rate (%) Base Rate Government (%) a/ (%) 1980=100) 1960 13.9 -- - - 40.0 15.11 - I 11.3 - 13.2 1.0 18.7 39.3 13.33 - 2 20.4 32.9 .3.9 91.3 47.0 12.44 - 3 11.3 - 1.6 29.3 12.7 62.4 11.55 - 4 16.3 60.9 0 26.6 63.1 11.55 - 5 18.0 - -2.8 i6.4 42.4 85.5 13.33 - 6 16.3 - 11.5 28.9 -4.8 44.7 19.55 - 7 20.0 - 25.0 7.5 11.1 96.2 16.0 - 8 26.5 - 27.5 12.3 -1.5 95.5 14.20 - 9 30.7 - 26.7 6.3 -2.3 83.9 15.10 - 1970 30.0 13.6 18.8 6.5 -6.4 77.0 16.0 32.0 1 27.3 13.6 7.1 8.1 34.7 71.6 13.87 27.0 2 26.1 13.6 25.5 9.7 1.3 70.1 14.69 31.0 3 28.6 13.6 32.1 8.1 -9.5 67.0 15.70 41.0 4 27.4 26.2 23.7 10.3 61.2 60.0 12.68 44.0 5 28.1 26.2 32.1 18.7 22.8 53.0 14.67 46.0 6 30.8 25.6 41.8 12.2 38.6 45.0 14.88 88.0 7 32e2 25.6 39.6 6.0 28.9 40.0 15.63 134.0 8 49.0 24.4 52.7 6.3 -25.1 35.0 15.99 104.0 9 53.4 25.6 28.3 8.8 150.9 63.7 18.03 103.0 1980 46.2 36.9 29.7 11.1 138.8 50.2 17.75 100.0 1 41.3 38.6 24.3 15.2 -33.0 65.0 18.13 72.0 2 38.9 35.9 18.5 17.6 535.1 50.0 17.20 78.0 3 33.5 34.2 21.0 23.0 100.4 58.7 16.8 74.0 4 41.0 36.0 - 27.8 119.6 - - 81.0 Source: World Bank, International Financial Statistics. a/ Items under prior licensing.  7 liberalization to absorb the liquidity. The government met with qualified success in preventing inflation from soaring further, but ended its term with a more restrictive trade regime, represented by a lower ratio of imports to GDP, a more regulated financial market and a7 c6urtailed public investment program. With international reserves having grown to over US$2 billion, the next administration did have more flexibility to adopt countercyclical policies. C. 1978-84 The incoming Turbay administration sought to reverse the reduction of public investment implemented during the stabilization program of the previous administration as a means of laying the foundation for sustained future growth. During 1979-80, both public investment and consumption grew sharply. As a consequence, both the fiscal deficit and official external borrowing rose sharply. GDP growth, which was driven mainly by domestic absorption, was less during 1978-80 than in the previous period but was still relatively high (6.0 percent). Then, in 1981, the external economic situation took a turn for the worse, a problem that persisted in 1982. One manifestation was a decline in. coffee prices. The effects on aggregate demand of that decline were not fully offset, even though the central government's overall cash deficit rose to 2 percent of GDP in 1981. The result was sharply reduced growth with persistently high inflation, and a shift in the current account balance into deficit (Table 1). The ensuing world recession weakened growth further. There was no resumption in growth until 1984, when a significant moderation in inflation also occurred.  -8- Viewed from the perspective of 1984/85, the major policy issues the Colombian economy faced can be summarized as follows. First, was the task of stabilizing the external account, for which sev-ral policy actions were required: (a) The bulging budget deficits, which were financed largely by the monetary expansion external capital dried up following the outburst of the debt crisis in 1982, needed to be trimmed. The fiscal deficit in turn fueled inflation and crowded out private investment. That situation could have been controlled by either reducing expenditures (e.g., transfers to national decentralized agencies and public enterprises) or by raising revenues (e.g., by broadening the tax base). (b) The over-valued exchange rate caused by the coffee boom during 1976-80 needed to be devalued to restore external competitivenes's. In other words, the crawling peg that was already in place needed to be speeded up. Second was the task of sustaining a reasonable rate. of economic growth over the medium term, which required a resumption of the liberalization program that was interrupted by the balance-of-payments dis.equilibrium in order to reap the benefit of international competition. The ad hoc measure of imposing import restrictions to achieve the short-term balance-of-payments objective should have been abandoned, the average tariff rate lowered and the dispersion of tariffs reduced. While the broad policy choices discussed above seem to be obvious, their likely effects on the economy over the short to medium term was not obvious. In the short run, stabilization and liberalization policies could have entailed adjustment costs. However,  -9- over the medium to long term, it is generally recognized that liberalization policies, if carefully carried out, would benefit the economy, as shown by Colombia's own experience during 1967-73 and the successful record of a score of outward-oriented East Asian developing economies. III. Stabilization and Liberalization: Some Theoretical Considerations Before moving on to the analysis, a theoretical discussion on the likely impacts of stabilization/liberalization policies on the macro economy seems in order to provide a reference for the later discussioni. The major instruments typically used in implementing stabilization policies are devaluation and reduction of expenditurcs..2/ In the literature, concerns have been voiced as to the potential short-run deflationary impact of these measures. From the perspective of the demand side of the economy, stabilization policies seem likely to generate a negative impact. Devaluation will raise the domestic price level (unless it is sterilized by tighter monetary policy) and hence reduce the real value of nominal money incomes, such as nominal wages and monetary assets, whose nominal values do not rise proportionately with the devaluation. Dornbusch (1973) thus argues that in a small economy, devaluation can be contractionary because it reduces absorption, as the decline in the real 2/ Raising the nominal rate of interest above the rate of inflation in a hyper-inflationary economy can, it is argued, also stabilize the economy by div;erting spending power away from goods as a result of increased fin.-ncialization (McKinnon 1973).  - 10 - wage and the real money stock accompanying devaluation reduces consumption. The reduction of the budget deficit frequently called for under a stabilization program, needless to say, exerts an immediate negative impact on effective demand. However, the effect of a devaluation on aggregate supply need not be negative. In general, the output of the traded goods sector will tend to increase, while its absorption falls, the end result being a trade surplus. At the same time, the output of the non-traded. goods sector tends to drop, thereby releasing factors of production to the traded goods sector. The overall effect on aggregate supply therefore depends on the relative strength of the two opposing effects, which cannot be determined a priori. It depends on such factors as the size of import demand and export supply elasticities, the degree of flexibility in nominal incomes (wages) with respect to changes in prices, the degree of factor mobility (Buffie 1984), the relative shares of traded and non-traded goods in total production, and, finally, the structure of final demand. Opening up the economy through trade liberalization, on the other hand, creates deflationary pressures in the short run. The reason is that the reduction of import barriers such as tariffs and QRs and of export impediments such as export taxes lowers the domestic prices of importables as well as non-tradables. If monetary and exchange rate policies are left unchanged, there will be a loss of international reserves, as the given supply of money is greater than the demand, which is reduced by the lower price level (Mussa 1983). This is the outcome predicted by the monetary approach to the balance of payments.  The real adjustment of trade liberalization policies occurs as import-competing industries face stronger competition from imports and perhaps suffer a loss of employment and output in the short run. The latter effect depends very much upon the degree of downward flexibility of wages and prices in the importable sector. The greater the flexibility, the lower are the adjustment costs in terms of a transitory loss of output and employment, and vice-versa. In turn, the exportable sector should expand because of a more favorable relative price regime. Its expansion may not, however, be strong enough to offset the loss of employment and output of the import-competing sector, especially if a significant import-liberaliz&tion program is implemented, either because it takes time for the export sector to respond to the new price regime or because the export sector is too small to begin with because of a long history of bias against exports. This discussion suggests that devaluation can complement trade liberalization. First, it mitigates the short-run negative impact on the import-competing sector of a trade liberalization program by raising the price level of importables. Second, it reduces the loss of international reserves, as the demand for money will be raised relative to supply. This consideration is particularly relevant to a situation where the government deficit increases in the short run as a result of trade liberalization and has to be financed temporarily by external borrowing in order to avoid crowding out the private demand for capital as a result of either higher inflation or higher interest rates. Accompanying trade liberalization with a devaluation would in this case provide more flexibility to the fiscal policy within an overall balance of payments constraint.  - 12 For trade liberalization to be effective over the medium term, there should be a lasting change in the relative prices of exportables, importables and non-tradables. In particular, the relative price of tradables should be more favorable than was the case under the regime that prevailed before liberalizatLon. That is, a real devaluation should occur. A nominal devaluation can generate real effects over the short run, largely because of various rigidities and adjustment lags, but over the medium to long term, it may by itself not be sufficient to bring about the required real depreciation, as adjustments gradually take place and the rigidities are overcome. In order to produce a real devaluation, a nominal devaluation need-s to be accompanied by appropriate macroeconomic policies. Lack of the support from macroeconomic policies has been singled out as the most important factor in the abortion of a large number of trade liberalization attempts in developing countries (Papageorgiou, Michaely, and Choksi 1986). It has been observed that many developing countries embark upon economic reform at a time of acute balance of payments crisis (Krueger 1983). Appropriate macroeconomic policies on these occasions frequently imply a drastic reduction in the fiscal deficit. In the short run, it would appear that trade liberalization measures and a fiscal deficit reduction could pose severe adjustment problems for protected import-competing industries. 3/ Devaluation can 3/ Despite this concern, Blejer and Mathieson (1981) noted that a very important component of the stabilization programs implemented in Latin American countries has in fact been the opening up of the economy through the elimination of trade barriers in order to contain inflation.  - 13 - offset some of the pains suffered by import-competing industries and at the same time provide room for stronger export expansion. A policy of devaluation, however, needs to be carefully weighed against the consequences of higher inflation. The trade-off is worth taking if it increases the potential for sustained trade lib6eralization. IV. The Colombian Model The above discussion yields the strong message that a proper coordination and dosage of adjustment policies are necessary to produce the desired results. For this reason, we developed a model for policy simulation to assess the impacts on the macro performance of the Colombian economy over the short and medium term. The mu'.ti-sector (Table 3) dynamic general equilibrium model we constructed (Cherif and Hwa 1985) is composed of supply and demand relationships for three interrelated markets: commodities, labor and money (credit). The novelty of the model is that it integrates a computable general model with a monetary model. This integration permits examination of the stabilization and liberalization policies in a single consistent framework. The model has a policy focus, incorporating stabilization and liberalization policy instruments: nominal exchange rate, public sector expenditures, domestic credit, reserve requirements, tariffs and restrictions on imports, and external borrowing. The major macro performance indicators are the rate of economic growth, the rate of inflation, and various ratios -- government budget balance to GDP, current account balance to GDP, exports to GDP, imports to GDP, and debt service.  - 14 - Table 3: SECTORAL CLASSIFICATION AGRICULTURE 1. Coffee 2. Most exported a/ 3. Most imported b/ 4. Non-traded crops MINING AND ENERGY 5. Mining 6. Petroleum products 7. Electricity, gas and water INDUSTRY 8. Consumer goods: Food, beverages and tobacco Printing Durable consumer goods 9. Textiles, clothing and footwear 10. Intermediate and raw materials: Wood products Paper products Leather products Chemicals Non-metallic minerals Basic metals Metal products 11. Transport equipment 12. Other capital goods 13. Construction SERVICES 14. Services a/ Pergamino coffee, rice, sugarcane, tobacco in leaves, beans, bananas, sesame, cotton fiber, flowers and cattle. b/ Cereals except rice, green peas, other legumes and fruits, soybeans, cocoa and milk production.  - 15 - Since a major purpose of the stabilization/liberalization policies is to effect structural transformation on both the supply and demand sides, and since its impact is primarily transmitted through altering the relative prices between sectors, e.g., switching expenditures between domestic goods and imports and switching production between traded and non-traded goods, the model has a sufficiently disaggregated production side to allow for relative prices to play a suitable role (Table 3). The decisions of firms, households and traders are modeled in the typical way of a Walrasian general equilibrium model while those of the government and banking system are assumed to be exogenous. In the short run, firms Lace a fixed capital stock obtained from the depreciated capital stock and investment of the previous year. They employ labor up to the point where the nominal wage rate is equal to marginal productivity. Output (value-added) is produced by a Cobb-Douglas technology embodying labor and capital, with a given total factor productivity (TFP) growth. The representative consumer spends a certain proportion of disposable income, which consists of wage-income, non-wage income and transfers after the deduction of taxes and net social security payments. Total consumption is allocated between different commodities according to their relative prices. The government collects various taxes based upon imports and exports. Its recurrent expenditures consist of subsidies to exports,  - 16 - other subsidies and wages, 4/ and transfers to decentralized agencies. Both recurrent and capital expenditures are exogenous. Importers' behavior depends on domestic final and intermediate demand and the -relative price of imports vis-a-vis domestic goods. Import prices are inifluenced by world prices, tariffs, tariff equivalent QRs and the opportunity cost of advance import deposits (AID), which is the product of the rate of the AID and the interest rate on certificates of deposit. Export demand is determined by world demand and the relative price between the world price and the supply price of exports. The latter includes the CAT subsidies and implicit interest rate subsidy. The demand and supply behavior generated by all agents with respect to real goods is balanced by a change in relative prices. In the labor market, the sectoral labor supply is determined by relative wages,, with supply and demand balanced through the adjustment of relative wages. The aggregate wage rate varies with changes in the rate of inflation, measured by the deflator for private consumption. The absolute price level in the model is determined by the balance between supply and demand for money. 5/ The total money stock 4/ A distinction is made between public administration and government. The accounts of the former are consistent with the macroeconomic balances. 5/ In a pure general equilibrium framework with perfect price and wage flexibility, only relative prices matter introducing a mechanism by which the average price level is determined should not alter the real variables of the model. However, our model incorporates some important rigidities in the Colombian economy, such as exogenous nominal transfers, world prices, minimum wages and the fixed (nom'nal) exchange rate, which make the price level a relevant determinant of real magnitudes.  - 17 - is defined as the sum of currency and demand deposits (Ml), time deposits (TD) and other insignificant items. The nominal demand for these assets is a function of the price level, real GDP and the real interest rate. The supply of money is defined as the sum of domestic credits (claims on the private sector and on the government) and claims on the rest of the world. It depends on the. average price level for two reasons. First, the demand for money (demand and time deposits) will determine the extent to which commercial banks can provide non- inflationary finance (credits) to the domestic market. The higher the rate of inflation or the price level, the lower will be the demand for bank deposits and hence the supply of non-inflationary finance. Second, under a fixed exchange rate system, claims. on the rest of the world, which is an important source of money supply for a small open economy, are determined by the balance of payments, which in turn depends on the price level. To see this relationship, raising the price level with a given nominal exchange rate would reduce the competitiveness of exports and increase imports, a shift that would worsen the trade balance and correspondingly reduce the supply of money. The interest rate, which in the model affects the long-run allocation of investment and capital, is determined by the demand for and supply of real credits to firms, as well as by U.S. interest rates and expected devaluation. The demand for real credits is determined by firms' planned real investment. The supply of firm credits is determined by the monetary base and policy parameters such as reserve requirement ratios. The supply of credit to the government responds to the government deficit.  - 18 - The long-term growth of the economy depends upon capital accumulation, population growth and productivity improvement. The model postulates that aggregate investment depends on domestic and foreign savings. The government investment program is exogenous. Sectoral private investment depends on the' relative profitability of sectors. The latter is determined by relative wage-rental costs. Dynamic simulations of the calibrated model for a historical period 1980-84 show that the model tracks the main endogenous variables fairly well (Figures 1 and 2). V. Some Experiments Base Case Simulation The assumptions in the base case are as follows. In the fiscal arena, the government would reduce the deficits mainly by raising revenues and maintaining modest growth in real spending, particularly investments. These policy initiatives entail a significant increase in revenues and slower expenditure growth. Tax revenues would be augmented by institutional measures such as conversion to a value-added tax. On the expenditure side, investment and government consumption are assumed to stagnate at constant prices starting in 1986 as part of the stabilization plan. With the government deficit reduced, the required deficit financing is expected to drop correspondingly, as a result of which there is a sharp decline in the growth of the central bank's claims on the government from 137 percent in 1984 to only 20 percent in 1985. This lower growth rate is maintained throughout the decade. It is  ' 19 - Chart 1 GDP (CONSTANT) GROWTH RATES GOVT. BUDGET BALANCE / GDP 0 e3a t4 ,-O1 021t 00254 V t -0 024- 0 020- \ .B - U -0 0?7- G 0 etS-- 0: D T- -e 030- 0 ee0 ,, A,,, ,,6 - 0000 -0 039--I 1981 1982 1983 1984 p -e 039 ,, i . . . . . . . . . . . . . . . . . ' 1980 1981 I98? 1983 1984 YEAR YEAR ACTUAL(SOLID LINE) AND PROJECTED C - ) ACTUALCSOLID LINE) AND PROJECTED C--------) CURRENT ACCOUNT BALANCE / GDP CONSUMER PRICE INDEX GROWTI- RATES Q 011 '0 27S1 0 00] Cc Z -b 3 1:3 5 R -0 0'R R E N -0 2-1 -0~~~~ e7 ---X3 22S-+ IR A -6 032 C p TR -884-' AE L -1805-1 - YEAR 1 9 1982 1983 1984 A&TuL(sowIDLINE AS ROJCTED( )YEAR ACTUL0011D LNE) ND POJECED C-------ACTUAL(SOLID LINE) AND PROJECTED ( -----)-  - 20 - Chart 2 IMPORTS GNFS (CONSTANT) GROWTH RATES MONTIIS OF IMPORTS 821 Is e-i ii 12S5-~ 0 2 p 15 eq 4 1 7 8- 00 R R T -'T -8 -s-* 198l is82 1983 1984 2 t ' -*, r '-'-' | YEAR 1980 1981 1982 1983 1984 ACIUAL(SOLID LINE) AND PROJECTED (-- ) YEAR ACTUALCSOLID LINE) AND PROJECTED C--- - CREDIT EXPANSION RATE EXPORTS GNFS (CONSTANT) GROWTH RATES e weo4 0 475 - c la'-s , R 8~ li 3858- / O3- : I e- e 42350i - - 1 " p -, p o0 888-. A - R r -r N 8 488-' T S s - ------. 0 N 8 375-J 1911982 1983 1984 -8 1I iEAR 1981 1982 I983 1984 ACTUAL(SOLID Lt(E) AND PROJECTED C- ) -- YEAR ACTUAL(SOLID LINE) AND PROJECTED C--------  ERRATA On page 21 "US$580 billion and US$786 billion" should read as "US$580 million and US$786 million". t, vIt  - 21 - assumed that credit remains tight until 1986 and then is eased starting in 1987 by decreasing the required reserve to around 38 percent. This shift in monetary policy accommodates an expected drop in foreign capital inflows. In the meantime, the nominal exchange rate is devalued by about 40 percent in 1985 after a 28 percent devaluation in 1984. After these adjustments, the real exchange rate is at the level of 1975. Thereafter, the real exchange rate is assumed to maintain the purchasing power parity. The external environment the Colombia economy faces, which has affected its performance in the past, will continue to do so in the future. The critical variables are external inflows of capital, world interest rates, export prices (especially of coffee) and export of certain commodities. Capital flows are expected to drop in 1987 and 1988 to a level of around US$580 billion and US$786 billion, respectively. This drop is similar to the one that occurred, in 1983, which was partly responsible for the stagflation. To offset this problem, additional capital inflows will be needed. We assume thiese will amount to US$500 m.A.llion and US$300 million in 1987 and 1988, respectively. Colombia's exports of coffee are largely determined by the- export quota established by the ICA. Petroleum and coal, which accounted for only 11 percent of total exports in 1985, are expected to increase to 25 percent of exports by 1990, overtaking coffee to become the leading export items. The projections for exports of mineral products are based on on-going projects that are expe-.ted to become on-  - 22 - stream beginning in 1987. These exports, which account for a substantial amount of Colombia's total export value, are not influenced by the devaluations. This assumption seems to be valid because the gestation periods for petroleum and coal development are longer than the time periods being contemplated by the model. The assumed values of commodity prices and world inter.est rates, approximated by the U.S. .TreasuLry bill -.a.te for the projection period 1985-90, are contained in the lower part of Table 5 under the heading "Exogenous Factors." In additioa to the policy assumptions and changes in exogenous variables, the parameters for the key relations in the model also influence the simulation results in important ways. The price elasticities of export demand and the elasticities of substitution between domestic and imported goods, and the price elasticities of supply, are among the important parameters that determine the impact of changes in incentives, such as devaluation, on the performance of the economy. These values are reported in Table 4. The simulation results for the base case are summarized in Table 6, which provides the basis for the discussion here. GDP is projected to grow at about 2.7 percent and 4.4 percent per annum in 1985 and 1986, respectively. This growth would be led by a strong expansion in exports resulting mainly from a real depreciation in the exchange rate. Beyond 1986, the growth in GDP -would continue at roughly the same rate throughout the remainder of the 1980g. The growth in consumption would likely be 1 percentage point lower than the growth in -DP; in per capita terms, the growth rate would be about l.5 percent per year.  - 23 - I I . I N * . ..- . I -} I I 1 - 9 -4 I - I .' - I. - . - - . . .Z -~. .~ - , - - * - - N ; ! 1- A I I, --', | h-1 N - - -b N - -. I I . W . . . . . . . . |. t - - = , a% .4 -4. - -- I I I I I >4 K t I - -- N ,t-~ ' *a .' 4. * ,4 ? -4 - . .n i t - -. --'-: -~ . i t 4 - c J - I^Z - ~. - .: >s 11 . 4 |-z - ~ .1.... -4 j -4. ;~~ A  Table 5 '.L V PO)3 It V II 1%I'it 1133 oilII!~'I I ) t xi I'; I #0333 3! AC I Oil 6 COI OMIJ) IA P3(33 3, ( II t33346 g )A,3 ti AS1 L I. U)IJAN~ 31/113il/ Li 39310 390 1 39112 PvI1. ;ii)t14 19(35 1I1 3'J3)toi 1 1900 3909 191 -- - - - - - - - - --- - - - - - - - - - - - - - - - - - - - - - - - - -- - - - - - - - - - - - - - - - - - - - - - - - -------- -----. 3fiSCAL POLICY expe330IT(JReS (1(W1 .J1ATI W IP3P3O3... tit() 3. 10 4 .633 3.53) 2 .00 5 1 3 - I,76 0.00 0.00 0.00 0.0ti .,REAL 134VEIM134T .... -el3. b5 314.131 13 U05 4.-40 -3.b4 1.14 -0.00 0.00 0.00 0.00 0.00 1'AX IIATES (%) . .WALiE I1CO11..................1 . l I. 11 I 13 13 . 30 3. 0 I. 30 I. 30 1. 10 1.10 1. 10 ,,131OU--ALiE 1I4COIAE ... 3. 19 2,20 1.93 1.91 1.91 1.91 1.91 1.9) 1.91 1.91 1,91 J.C0111'033ATE INCOMAE .... 4,5 32.64 15.41 15.41 12.62 10.63 33.55 13.65 11.55 11.55 31 .5S ~.AVJ3LHA3T TAIFII RAJE-. 11.52 10.31 38.22 131.98 21.23 28.3(1 20.~42 28.00i 27.94 28.38I 20.40 . .SALES TAX. .. .. .. .. .. .......0.00c 0.00 0.(t0 01.00 6.00 10,00 10.00 10,00 10.00 10.00 10.00 MONITAIIVlY P0 I CY CLAIMS 0ON GOVE, GilOWlhl F4AII:(%)..............34.b3 6.13 2 3 6.03, 32 31. I 136.19 20.02 19.97 19.97 19.91 19.91 19.97 ItoilQL3ILI) IIESElIVi: HATIO () 46,20 41.31 30J.00i 33.49 46.00 46.00 45.00 4b. 00 46.00 45.00 45.00 IRADE. ANDr LX01A3I3E RIAWI POLICY HOMINAi EXCI3AI3ICE 3AATE(iRlOWIli ~).............. 13t.12 15.25 lJ.64 23.112 21,81 411.00 9.62 17.20 18.01 35.29 33,02 AL3IAUCE IMPVEiI DEPOSIT I \ RATES (%)............... ....51 s 3.0II1 2.41 0.01 6,00 6.00 6.00i 6.00 6.00 . 6.00 6.00 iMPIORT EXIEMPFION RAT,IE i' 41.20 41.20 3~9 .1VIA 39.01) 39.00 39. 00 39.00 39.00 39.00 39.00 39.00 AVIl:RAGL AIANIFF HA-TE (A),. 17.52 18.37 10.22 1 0.906 21.23 28.30 28.42 283.08l 217.94 28l.30 28.40 VAIIIArI014 It# TAIIIfF RAJES W ......................... 37.90 31.014 31.11tit it). 0 36.06 30,(65 30.65 J30.65 30.65 30.65 30.66 sEC:T3IAAI. IAIIIf-f MAlES -.COI-FLE.................... .0. (it 0. 03) 0.011 11 (J0 0.0 (it .00 0.00it 0.110 0.00 0.1)0 0.00 . 11063 L gI~l3li ILt) ...........6.b2 1.25 1 tt6 '3 6 1.99 19.99 39.99 39.99 19.99 39.99 39.99i .MOSI IMI'31131L0 ..............6. 62 1.25 -It, i.61 11.99 39.99 3 9.9E9 39.99 . 19.99 19.99 1.9 0ui .3I 11IADIJIz..............0,1(1 (i.0t (3.431 3.3, DO. 0.00 0.130 0.110 0.00 0.00 0. 311 0.00 .M3N130........................2 13 12. 1 t 2 36I 2.3le 2.36 103.114 10.04 30.04 10.04 31 .0IJ4 30.04 *3'1II 11o E iJm...................t6 .31 6. 33 6. 33 6J. 13 6.13 141 14.13 14. 33 14.133 14. 1: 14.13 ..LIECtilCt,IV.................1 0. 131 3 31 00 0.00 O10l a 0.00 lk i 0.130 33. 00 0.00 O 3,00 3. 00 U,IOHsuMLIi (;00135...............37,:30 21 11~ I it.3 3.13-3 27.b2 36 . 52 35.52 35. 52 35.52 35.52 3b . 52 ,L Xi II ES...................25.6fi 24.41 24 332 313 110 40.63 431I. 63 40.,63 433 :14.63 40.63 411. 3 436:1 I 34 13J3M303 IA1E.................39.53I it).11 1913 1 9. 17 21 96 29.96 29 96i 29. 96 29,96 29.96 29.96 I H3AtISPO111....................46i.333 4 1..33 41 .:1 4/ :13 52 .22 61),2~ 60.22 4113. 22 60.22 60. 22 60).22 *.01311.1 CAPl IAt.............. 3 I.6 36l3 3I 6 I310 lk 11 310 2 0.5IS6 20I.56 20.1)6i 233. 56 211. 56 211 - 233?t 56 313316 I IIIIC 11 O1 .............. ..0, 333 1. 00 (3,11 O 3 3 00L 0 .00 (3 till 0I fi30 O 13 .00 0 00 (131 O Lt)) 10 .sLUvICks ..................... . 0.4 0.!16 33 541 0.5t6 01.56 0.5i11 ,b 0.56 0.56 1.66) 33. 51 LQ133IVAI 3.33 1. C(I33 .3 Li..33 333 (1.31it1 I1.3till 33 33 0 till 3 31(O 0 .333 13 331 0).00 (3.31(3 O33.t31 .AO336 ) L1X01I LO)...........tit) O100 I3.3Oil 33 t3t) 0.3)0 33.033 0.330t O3.330 0.0tit (J3 1333 33.333 MOS I1 mi03'03 I Lo .......... .. 0. tit)3 12 .3(3 O3 tit) .13.3( 40.1)3 30. 00 30. .33 30) .(30 30 .0( 3(1. t33 i33). (1t). NON -I 3AUH) 3...............0.1)) 3.13it) 11.3tit) 3)1333 0.0oi It.01t)1 .1 0. 31 0.0 O.033 13,333 33 (33 Li3 I14 III ..................... (30 DO 133) 3 .33 3333 33 330 313. 013 33).3130 33) .O 3)0 33 .3(1 311 1)3 333 (33 :1" O l'L 113133 HIM............... .. 33 3)33 32.3333 31 3333 .'3 3(I 433.3t)3( 403 033 433.3331l 4t).(3 433.313( '1( 133 411 fit) L I Li: 3333 C IV. . ... ...1 13(1 3) 33 13.333 33 ti(1 33. 3333 3) 1to 31.313 O3. 130 33 33. 3)O 33 3  Table 5 (cont'd) COl1JLUOOO 00 2.0 0 i0 3000 io 30 j( .0 L .10 30 00 3311 1111 0.fi)0 12,111 0,( III) 000 3.0 01( 30.00 30.~00 30,01) 30.00t * .IH[EflUL ItA1tm...... ~ 0,0 1j0 00 2 (,00i 30,00) 30.00 30.1) 3.0 30.00 30..tI 311.00t IIAS1I ....-* 0.00f 12,0 11,1.1 2o.110 30.00 30.,00 30.00i( 3110,00 3.0 3.1 00 E 0.00 12, 00 0.011n 10 00 00 30.00 3uLOO 30.00 30.00 30.(Of 114ANSIIII CIf .......... ..0.00t000 0,111 11.0 30.0 t) 0.00 0.11 0.00 0.00 0.00 0.1 .SIVL..........1000.00 .00 1.1.00 00 118.00 901.00 90.00t 911.00 980 980 .0 F-X0GEH0US FACIOUS1300 460 0O2 0601449 t4.3 CAPITAL INFLOW (MAILLIONl UJS$ 1112.92 (101.97 (8011.-03 603.30 10112.801300 14.0 10.2 10.0 14.9 14.0 TIIEAS(iIAV RATE %)................1I.1)2 14.00 10. 72 B. 62 9.00 Li.60 8.00 8.00 00 .0 l0 REAL expon TS (G14iiWT(l %) O t . 91 0 1 ' I.0 c0fpfe-.........................2.24 -16.6(1 -2.01 3.09 13.17 1.41 0.0 109 .0 119 .0 .M Itl1IU................... 2.01 - 0.6 bo -.40 10. ~00 6.06 2 5.0 1)fl 2.00 7.14 6.61 6.25 -PE(ROLEUM................... .0.11 -8.,72 6.36 J8.,33 t.(J.12 23.013 11.66 60i.17 46.14 0.00 0.0)1i WORLOPRIES.....................NA -23.69' I .i 2.22 il.12 -4.64 4.8ti6 13.36 8.10 8.10 8a.09 -COFFEE ......~r................26.99 -2.39 1) lb -(.115 -0.38 0.00 22.93 -5,36- 1.87 1.81 1.81 , MOST iMIORIIID-...............26.89 -2.39 6 .I! -(.815 -0.38D 0.00 22.9B3 -5.36 71.87 7.07 7.87 .,NOSI iAlt)lED..................0.00. 0.00 0. (iti (J.00 0.00 .0.00 0.00 0.00 0,00 0.00 0.00 .1N14(i............................14.711 2.10i 2. 6 - b. 0O -4.21 3.30 1.45 1.45 1.45 7.46 7.46 ..'fIMIIII. ......................53.64 12.00 . 2 !i 19 (2.904 -2.11 0.00 0.)0a 0,00 0.00 0.00 0.00 Ei EC1IAIITV....................NA 0. 00 0. tit) 01( 0.00I 0).110 0.11it 0.0on 0.00 0.1t10 0.00 ..CONSUMER GhOODS................3.11 2.10 2 .1 -600 (J -4.21 3.0 14 145 .5 7.5.5 ..'IE)TII-ES...................... 0.93 2.70 -2. 6.1 '!. 00 -4.21 3.30 7.66 1.65 1. 55 1.66 7.bS ItJ)IEkRIAEOI AI AE................. 20.53 2.10 -2 63 .5.50t -4.21 4.94 1. 50 8t.07 8.00 18.00 81.00 I 14AtspL1IIT..............5.08O 2. 703 2. 1J -5.00 -4.21 6.00 1.51) 0.00 8.00 8.00 8.00 ..0THER CAPITAL.................16.66 2.70 -2. 1) 5.0 cik 4.11 4.113 1.66 8.00 8l.00 B.0 (J, 8.00 m4O1ISi(l IICIl..................NA 0.00 0. (10i 0.0 0.00 0.00 0.00 0.00 0.00 0.00 0.00 -.SE4VIL1S...................... j5.61 2.70 2. 13 -5S.0IL -4.11 3.18 7.45 7145 1.45 1.45 1.45  - 26 - Table 6: SUMMARY TABLE OF INDICATORS (Base case scenario) 1985 1986 1987 1988 1989 1990 Real Growth Rates CDP 2.7 4.4 1.0 3.2 4.0 5.4 Imports -5.3 8.7 2.1 6.4 7.4 8.3 Exports 9.8 5.2 13.7 12.3 6.2 7.4 Investment -1.7 9.7 -3.2 3.5 7.88 8.8 Consumption 1.1 3.8 -0.1 1.9 3.3 4.7 Inflation 24.3 17.9 26.5 27.6 24.5 19.9 Real Wage Rate 91.4 88.7 90.3 89.0 88.7 87.5 (1980=100) Real Exchange Rate 97.2 97.2 97.2 97.2 97.2 97.2 (1980=100) Budget Deficit/GDP (%) -0.57 0.16 0.68 1.28 1.76 2.23 Current Account Balance into GDP (%) -3.1 -3.5 -2.1 -1.3 -1.4 -1.3 Exports/GDP (%) 14.5 14.6 16.5 17.9 18.3 18.6 Imports/CDP (%) 13.5 14.0 14.2 14.6 15.1 15.5 Debt Service Ratio (%) 37.1 37.0 36.4 40.6 32.3 29.3 The performance of non-coffee exports would likely improve significantly over the period 1985-90. As a result of significant real depreciations, total exports would grow by an average of 10 percent per year during 1985-86. The strong jump in total exports during 1987-88 reflects mainly exports of coal and petroleum. As a result of the fiscal measures discussed above, the government's budget deficit would drop during 1985-86 but would remain  - 27 - above 2 percent of GDP. It would be roughly in balance in 1987, when the additional tax increases are expected to be initiated. The exchange rate adjustments produce a more open economy; therefore, the ratio of exports and imports to GDP, after bottoming out in 1985 at a level of 14 percent of GDP, will expand significantly during the latter half of the 1980s, reaching about 19 percent and 17 percent of GDP, respectively. 6/ The debt service ratio would also improve from the 1985 levels. The base case presented above suggests that Colombia's economy could enter on a recovery phase, with economic growth gradually rising throughout the 1980s. Further, the current account deficit could be significantly reduced from the high levels reached recently, falling to 1.3 percent of GDP during 1988-90, based on export growth of 3.5 percent per year and import growth .of 5 percent per year. Reserves would,' therefore stabilize at 4.7 months of imports by the end of the .decade. Alternative Simulations The base case assumes a devaluation of around 40 percent in 1985, which still leaves the real effective exchange rate below the pre- coffee boom level. The following alternative simulations assess the impact of a higher rate of devaluation (60 percent in 1985) first without and then with the liberalization of imports through tariff reductions and the removal'L of QRs. Table 7 summarizes the main assumptions embodied in the alternative simulations. 6/ A 1 percent increase in the openness of the economy, measured by th.e ratio of imports to GDP, is assumed to increase overall productivity by 0.2 percent. Import liberalization stimulates output growth by 0.5 percent in 1987 and 0.2.percent in 1988.  - 28 - Table 7: SCENARIO DESCRIPTIONS Description 1. Base Case O Devaluation of 40 percent in 1985. o Maintenance of the real exchange rate at the level in 1985. 2. High Devaluation Case o Devaluation of 60 percent in 1985. O Maintenance of the real exchange rate at the level in 1985. O A ceiling of 40 percent imposed on the nominal interest rate. 3. Tariff Reduction O Tariff rates reduced by 37 percent in 1985 and another 9 percent in 1986. o Other policies as in (2). 4. Tariff Reduction and Removal of QRs o Removal of QRs in 1985. o Other policies as in (3). 1. Higher Devaluation The short-term impact of an additional 20 percent devaluation generates slightly lower growth of output -- 2.2 percent vs. 2.7 percent in the base case -- and a higher rate of inflation -- 33.2 percent vs. 24.4 percent in the base case in 1983 (Table 8). The higher inflation is produced by an increase in the prices of traded goods, validated by a  - 29 - Table 8: SUMMARY TABLE OF INDICATORS -- DEVALUATION OF 60.0 PERCENT 1985 1986 1987 1988 1989 1990 C 2.2 4.6 0.4 3.0 4.0 5.4 imports -8.2 9.2 0.0 6.2 8.1 8.7 Exports 12.5 6.0 13.1 12.4 6.5 7.7 Investment -4.3 10.0 -6.3 2.6 8.6 9.1 Consumption 0.1 4.0 -0.6 1.6 3.1 4.7 Inflation 33.2 21.3 21.3 32.9 35.0 26.4 Real Wage Rate (1980=100) 90.6 87.8 89.7 88.1 87.4 85.9 Real Exchange Rate (1980=100) 103.7 103.7 103.7 103.7 103.7 103.7 Current Account Balance/ CDP (%) -2.6 -3.1 -1.4 -0.4 -1.5 -0.5 Debt Service Ratio 36.7 *36.5 36.0 39.3 30.9 28.0 higher rate of growth in the supply of money associated with the improvement in the balance of payments. The fall in output can be explained as follows. First, aggregate domestic absorption is reduced in real terms by the erosion of the nominal incomes of consumers as inflation rises and by the reduction in real investment associated with the decline in foreign, savings. For the export-oriented sectors, the increase in foreign demand stimulated by the devaluation outweighs the contractionary effect on domestic demand so that the overall effect on demand of the higher devaluation is stimulating. For the domestic import-competing sectors, the higher race of devaluation induces substitution of domestic goods for imports, as the latter become more expensive, and also provides a  - 30 - stimulus to demand. The strength of this stimulus depends on the elasticity of substitution between domestic goods and imports. The greater the elasticity, the stronger will be the stimulative impact. However, the stimulative price effect is offset by the depressing effect on quantity owing to a decline in total absorption. In Colombia, the overall elasticity of substitution is small because of the fact that intermediate and capital goods are a significant portion of total imports, and there is little substitution possibility for them in the short run. This negative effect on quantity outweighs the price effect and produces a decline in demand for the import-competing sectors. The demand for non-traded goods falls after the higher devaluation, mainly because of the decline in overall absorption. However, the decline is mitigated by the fact that non-traded goods are cheaper relative to traded goods in the consumers' budgets. If the favorable price effect outweighs the unfavorable absorption effect, the demand for non-traded goods need not fall. On the supply side, the output of exportables rises because the increase in producer prices more than offsets the increase in the unit cost of production (irncluding wage and intermediate input costs). In other words, a fall in the real product wage produces an increase in profits per unit for exporters. This profit reflects the fact that the increase in overall demand outweighs the upward shift in the supply curve caused by higher wage and input costs. An important underlying factor is that wage increases in Colombia, while following the overall rise in the cost of living, lag behind it and have an overall elasticity smaller than unity, which allows room for a real devaluation. The achieved real deval;'ation in 1985 would be 6.7 percent.  31 - The opposite situation occurs for the output of importable and non-traded goods (agricultural importables, non-traded agriculture, electricity, conisumer goods, raw materials, transport equipment, construction and services). The short-term decline in output and inflationary pressures are some of the negative effects of devaluation. However, favorable effects are recorded for the balance of payments, creditworthiness and foreign reserve position, all of whose improvement is the main policy objective in the stabilization plan envisaged for Colombia. Table 9 shows the medium-term consequences of a higher devaluation. On average, gross domestic output grows at a slightly l6wer rate than in the base case -- 3.1 percent vs. 3.3 percent respectively -- while inflation is around 4.0 percent higher. Lower import growth and higher export growth lead to a significant improvement tn the balance of payments. During the period 1985-90, the current account deficit under the higher devaluation is reduced by around US$2.2 billion relative to the base case level, As a result, reserves recover to about 6.5 months of imports, while the debt service ratio falls to around 28 percent by the end of the decade, leading to an improvement in creditworthiness. This higher initial devaluation rate also implies a higher annual devaluation rate of around 4.7 percent because of the required depreciations of the peso needed to maintain the real effective exchange rate at the 1985 level. Liberalization The case of a 60 percent devaluation demonstrates how exchange rate parity can be modified to achieve an improvement in the balance of  - 32 - Table 9: MEDIUM-TERM CONSEQUENCES OF A HIGHER DEVALUATION (1985-90) Higher Base Devaluation Case (60%) GDP Geometric Growth Rate 3.3 3.1 Inflation 23.9 27.9 Imports of GNFS 4.9 4.3 Exports of GNFS 9.4 9.8 I Current Account Balance -5.3 -3.1 (billion US$) Reserves in Months of Imports (1990) 4.7 6.5 DSR (1990) 29.3 28.0 Government Budget Balance/CDP (%) (1990) 2.2 2.7 Nominal Devaluation Rate (annual average) 17.2 21.9 payments position and creditworthiness of the country. In this section, the short-run impact of a combination oT devaluation and liberalization of imports is assessed. Two import liberalization schemes are considered. First, the average tariff rate is reduced by 38 percent in 1986 -- one year after the 60 percent devaluation takes place. Second, in addition to the tariff reductions, all QRs .on imports are removed in 1985. 7/ 7/ In the model, the QRs are expressed in terms of the tariff equivalent equivalent rate and calculated from the 1980-84 period such that imports as -calculated from the estimated equations are equal to the observed ones.  - 33 Compared with the base case, the devaluation-cum-liberalization through a tariff reduction produces higher output growth (5.1 percent versus 4.4 percent) and lower inflation (16.6 percent versus 17.9 percent) in 1986 (Table 10). It also generates higher export growth (600 percent versus 5.2 percent) and import growth (11.1 percent versus 8.7 percent), but with no apparent deterioration in the current account position. The only negative development is a deterioration in the budget deficit. While inflation would be significantly higher initially in 1985 because of the 20 percent additional devaluation, that effect would soon be moderated by the import liberalization policy adopted in 1986> which would result in a contraction in the monetary base. This lower rate of inflation would be accompanied by higher economic growth. The. main sources of the higher growth are exports and private consumption. Exports would rise because of the initial devaluation, but also because of gains in competitiveness resulting from the subsequent dampening of inflationary pressures by the import liberalization, Consumption would benefit from the increased revenue (higher growth) and lower inflation in 1986. The additional liberalization of imports through the removal of the QRs during 1985-86 further stimulates economic growth and dampens inflation. Both exports and imports grow still further. Because of the balanced increase in both exports and imports, the current account balance does not deteriorate appreciably. The interesting result is that the government budget balance improves because of the expansion in revenues associated with the more rigorous output growth. This result confirms the argument that the first step in import liberalization  34 - Table 10: COMPARISON OF THE BASE CASE WITH THE LIBERALIZATION CASE, 1985-86 .Devaluation of 60% Tariff Base Case Reduction QRs .1985 1986 1985 1986 1985 1986 GDP 2.6 4.4 2.2 5.1 2.6 5.3 Inflation 24.3 17.9 33.2 16.6 31.3 12.2 Exports 9.8 5.2 12.5 6.0 14.0 6.1 Imports -5.2 8.7 -8.2 11.1 -7.1 12.9 Consumption 1.1 3.8 0.1 5.2 -0.2 5.5 Investment -1.7 9.7 -4.3 8.3 -0.9 9.6 Current Account Balance/GDP -3.1 -3.5 -2.6 -3.6 -2.8 -3.8 Reserves in .Months of Imports 4.8 5.0 5.4 .4.4 5.3 4.6 Government Budget Balance/GDP v%) -0.57 0.1 -0.2 -0.1 0.6 0.5 should be the removal of QRs which would not only improve resource allocation but also strengthen the fiscal position. The simulations yield this conclusion: a proper mix of stabilizationL and libevalization policies is a feasible approach to attaining both the growth and balance of payments objectives simultaneously.  - 35 - VI. CONCLUSIONS This review of Colombia's recent economic development shows that more liberal economic policies have been conducive to growth, price stability, and balance of payments equilibtrlum. However, the liberalization episodes of the 1970s were interrupted by domestic policy excesses as well as by the coffee boom of 1976-78. The global recession of the early 1980s coincided with the tapering off of the coffee boom and with the sharp expansion in public investment, which itself was a delayed response to the coffee boom. The drying up of external capital associated with the debt crisis meant that the government deficit had to be financed by the creation of money. This measure resulted in high inflation, a loss of competitiveness, and finally a balance of payment crisis. Tariffs and QRs were employed to stabilize the, external account. That is a de-liberalization policy was used that was totally at variance with the government's intentions in the 1970s. This paper shows that given a reasonable external environment, it is feasible for Colombia to use a proper mix of stabilization and liberalization policies to restore economic growth and maintain a stable balance of payments. The analytical results are based upon counter- factual simulations of a dynamic general equilibrium model of Colombia. The policy mix includes three major components: import liberalization, government deficit reduction and nominal devaluation.  - 36 - BIBLIOGRAPHY [1] Blejer, M.I., D.J. Mathieson. 1981. "Preannouncement of Exchange Rate Changes as a Stabilization Instrument." Staff Papers 28(4) (December). [2] Buffie, E.F. 1984. "Imported Inputs, Wage Rigidity and Devaluation in the Small Open Economy." University of Pennsylvania. June. [3] Cherif, M., and E. C. Hwa. 1985. "A Proposed Medium-Term Model of Structural Adjustment for Colombia." Memo. June. [41 Crockett A.D. 1 981. Stabilization Policies: Some Considerations.. Staff Papers,.28(1). March. [5] Dornbusch, R. 1973. "Devaluation, Money and Non-traded Goods." American Economic Review 63. December. [6] McKinnon, R.I. 1973. Money and Capital in Economic Development. Washington, D.C.: Brookings Institution. [7] Mussa, MiLchael. 1983. "The Adjustment Process and the Timing of Trade Liberalization." Graduate School of Business, University of Chicago. October. [8] Papageorgiou; Michaely, Choksi (1986). "Phasing of a Trade Liberalization Policy: Preliminary Evidence." CPD Discussion Paver No. 1986-42.