External debt, inflation, and the public sector : towards fiscal policy for sustainable growth

8944 T H E W O R L D B A N K E C O N O M I C RE VI EW, VOL. 3, NO. 3: 2 9 7 - 3 2 0 FIlLE CQPY SP.I8 External Debt, Inflation, and the Public Sector: Toward Fiscal Policy for Sustainable Growth Sweder van Wijnbergen Which tradeoffs are involved in formulating an external debt strategy? Should expenditure be cut to improve the current account, or will this reduce future output growth, thus undermining the benefits of any debt reduction? Are there alternatives that allow satisfactory output growth without jeopardizing creditworthiness? How can the necessary surplus of savings over investment be brought about at levels of investment high enough to sustain output growth? Should the government contribute to the internal adjustment by reducing its deficit? Macroeconomic targets for inflation and growth, and creditworthiness constraints on debt issue, impose restrictions on the extent to which deficits can be financed. Can the government cover the deficit within these targets and constraints? The absence of such consistency forebodes future policy change and so undermines the credibility of the adjustment program. The author uses empirical work on Turkey to illustrate the interactions between fiscal deficits and the macroeconomic variables upon which fiscal consistency hinges. The rise in interest rates and the collapse in commodity prices that followed the U.S. recession in 1982-83 triggered the debt crisis that has since dominated macroeconomics in the developing countries. The focus has been on Latin America, but the debt crisis has also plagued other developing countries. For them, too, devising strategies to deal with their external debt and formulating internal policies to allow sustainable growth within the limits of creditworthi- ness and macroeconomic stability are at the forefront. These same issues are the subject of this article. Throughout I draw on Turkey's experience since 1978, contrasting its strategy of high debt and high growth with Latin Ameri- ca's equally high debt, much higher external transfers, and much lower growth. A brief overview of external debt since 1980 sets the stage in the article's first section. The overview highlights the choices-and tradeoffs-in formulat- ing a strategy for external debt. At issue is whether restrictive expenditure Sweder van Wiinbergen is an economist in Country Department II, Latin America and the Caribbean Region, the World Bank. This article, originally prepared for the policy seminar on Adjustment Policies in Izmir, Turkey, on March 28-29, 1988, draws heavily on joint work with several colleagues in the World Bank. In particular the author would like to thank Ritu Anand, Ajay Chhibber, and Roberto Rocha for many stimulating discussions.