Country macroeconomic work and natural resources

1 a EN&AIVooS THE WORLD BANK ENVIRONMENT DEPARTMENT Country Macroeconomic Work and Natural Resources Salah El Serafy March 1993 Environment Working Paper No. 58 This: -per has been prepared for internal use. The views and interpretations herein are those of the author(s) and should not be attributed to the World Bank, to its affiliated organizations or to any individual acting on their behalf. ACKNOWLEDGMENT The author was a Serior Adviser in the Environment Department of the World Bank before he became a consultant to the Bank while drafting this paper. For several years previously he had worked as Economic Adviser on the Economic Advisory Staff :n the office of the World Bank's Senior Vice President, Operations where he had given thought to the issues he raises here. The paper notes the dichotomy existing in country economic work between changes in the physical environment of many developing countries, and the standard macroeconomic indicators used by economists to describe country economic conditions, and to analyze important aspects of the economy before prescribing policy recommendations. The author views the adjustment of national income accounting to reflect environmental degradation as a key element in the pursuit of economic sustainability, especially where natural resources contribute significantly to economic performance. He argues that flawed accounting can lead to misleading policy advice and that the environment should not be viewed as a sector, like agriculture or transport, but as an envelope that contains all economic activities and provides the long term context in which developing country economies function. The author gratefully acknowledges the comments and suggestions made by two anonymous reviewers as well as by Paul Chabrier, Herman Daly, Sandy Davis, Vinod Dubey, Mohamed EI-Ashry, Robert Goodland, Enzo Grilli, Susan Hubert, Maritta Koch-Weser, Desmond McCarthy, Robert Picciotto, Jed Shilling, Andrew Steer, Vito Tanzi, and David Wheeler. None of the above, however, should be held responsible for any errors of fact or judgment that remain. Departmental Working Papers are not formal publications of the World Bank. They present preliminary and unpolished results of country analysis or research that are circulated to encourage discussion and comment; citation and the use of such a paper should take account of its provisional character. The findings, interpretations, and conclusions expressed in this paper are entirely those of the author and should not be attributed in any manner to the World Bank, to its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. Because of the informality and to present the results of research with the least possible delay, the typescript has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. ABSTRACT Sustainability Is viewed in this pap.r as essentially an economic concept, and placed firmly in a national income and product context. Income, by definition, must be sustainable; hence the need to "keep capital intact." Traditionally this is confined to human-made capital, and effected through capital consumption, or depreciation, which aims at ensuring the sustainability of present income by devoting part of the product to repairing and restoring the existing capital stock. Nature, including marketable natural resources, does contribute to the productive process, and is here viewed as capital that must be maintained to sustain income. The paper argues that the standard accounting approach to capital consumption is more applicl e- to renewable natural resources than to exhaustible resources which should be treated in the economic accounts as inventories, not as fixed capital. The nature and magnitude of the required adjustment to the national accounts are indicated, with reference to existing studies of individual countries and to efforts to change the United Nations System of National Accounts (SNA). The paper contends that this issue is of paramount importance for developing countries which tend to be more dependent on natural resource exploitation than industrialized countries. Certain macroeconomic implications of inadequate accounting (and hence macroeconomic analysis and policy advice) are elaborated, including the measurement of economic performance; income over-estimation (leading inevitably to over-consumption and insufficient saving and investment); and exchange rate policies that are not sufficiently sensitive to the contamination of income and the current account of the balance of payments with unrepeatable natural capital elements. An appendix examines a number of World Bank Operational Directives tat deal with macroeconomics for possible changes that would accommodate some of the issues raised. The paper strongly recommends that periodic country economic reports should cover the state of the environment, including natural resources, reproducing physical indicators of environmental change, and identifying policies that impinge on the sustainability of the natural resource base. Country Macroeconomic Work and Natural Resources TABLE OF CONTENTS Pae No. ACKNOWLEDGEMENT i ABSTRACT ii I. INTRODUCTION 1 II. APPROACH AND GENERAL CONSIDERATIONS 3 III. COUNTRY MACROECONOMIC WORK AND THE ENVIRONMENT 7 National Income Accounting 9 Natural Resources as Capital 9 Policy Implications 14 Structural Adjustment Operations 15 Country Strategies 16 Micro and Macro Issues 17 Relevance of Technological Progress 18 IV. THE NATURE AND MAGNITUDE OF NATIONAL ACCOUNTS ADJUSTMENT 20 Practical Measurements: Indonesia 20 The Role of Country Economists 24 Likely Magnitudes for Countries Other than Indonesia 24 Adjusting for Oil Extraction 25 V. SOME POLICY IMPLICATIONS . 28 Saving and Investment 28 Exchange Rate Policy 29 Certain Aspects of Trade Policy 32 VI. UNSETTLED QUESTIONS 34 Lack of Comprehensiveness 34 Difficulties of Agreeing on a Common Methodology 35 "Satellite" Economic Reporting? 35 VII. CONCLUDING REMARKS 37 EaSN. Appendix A Income from Depletable Resource Extraction 38 Appendix B Operational Directives 41 The Role of Operatinal Directives 41 Country Economic and Sector Work 41 Country Strategy Papers 42 Operational Directive 2.10 on Country Strategy 43 Policy Framework Papers 43 Adjustment Lending Directives 44 Standard Statistical Annexes 45 Environmental Action Plans (EAPs) 45 References Cited 47 TbLes Table 1 Indonesia: Amended WRI Adjustments of Nat:onal Accounts 23 Table 2 Primary Commodity Concentration of Exports of Selected 26 Countries Table 3 Oil Only: Downward Adjustment of GDP for 1988 27 Table 4 Indonesia: Implicatl' as of GDP Adjustment for Investment and 33 the Balance of Payments Country Macroeconomic Work and Natural Resources I. INTRODUCTION This paper seeks to draw the attention of Bank economists to the importance of the physical environment for country macroeconomic work. It will largely focus on natural resources, abstracting from other environmental concerns such as pollution, amenity preservation, and natural habitat protection. Many Bank economists are certainly aware of the relevance of the physical environment to their work. This is obvious from the products of many specialists dealing with agriculture, fisheries, animal husbandry, irrigation and drainage, population aid health, as well as other sectors. At the project level certain progress has been made in the Bank in recent years to ascertain environmental externalities of projects and incorporate these, to the extent possible, in project cost-benefit analyses. Some attempts have also been made in the Bank to apply the concept of "sustainability" to individual projects through seeking to tailor projects to the limitations of their physical surroundings, and by providing in project design for safeguards that would sustain the project's inputs and outputs. But the one major area of economic work at the Bnk which seems to have been slow in responding to concerns over sustainability is the area of macroeconomic analysis. The various macroeconomic aggregates collected, deployed, analyzed, and projected, and employed to diagnose economic weaknesses and prescribe policy cures, often remain divorced from the economy's physical environment which might be seriously deteriorating while short term macroeconomic measurements would indicate progress. Consequently policy prescriptions based on inadequately measured aggregates may be quite inappropriate. Again it would be wrong to presume that all country economists are oblivious to such issues, but there seems to be a gap that needs to be bridged between much of the country economic work as carried out in the Bank, and what several environmental missions have reported by way of seriously deteriorating country environments. It will be shown that we need better national income and product accounts to reflect major changes in the natural resource base as a gg gg for being able to gauge macroeconomic performance properly, and to offer sound policy advice. The paper therefore addresses the topic of adequate measurement of national income and product at great length before h settles down to indicating some Important macroeconomic policy implications of the proposed adjustmenis to the national accounts. National accounting is a field where the disciplines of economics, accounting and statistics overlap. It is a useful device to get approximate readings of changes in important economic aggregates, but It leaves out a great deal that happens outside the formal sector, and the estimates are sometimes based on guesses and incomplete knowledge. For good or ill, however, the measurement of ODP, with all its faults, has become an accepted barometer of general economic conditions, and has provided the basis on which much macroeconomic policy rests. The attention paid in this paper to the proper -2- measurement of the national product and expenditure and their various components may seem excessive to some readers, but it derives from the notion that unless we get better readings of these macroeconomic variables than we get at present, economic analysis and policy can be seriously defective. An initiative is underway to adjust the United Nations System of National Accounts (the SNA) in order to reflect in them environmental change. Until this process is complete, however, some interim measures - idicated later in the paper - need to be applied in order to improve macroeconomic measurements and analysis. The writing of this paper has coincided with the publication of a number of initiatives probing the impact of structural adjustment programs on the environment.j/ Such initiatives seek to cover some of the ground covered here, but they approach the subject from a different direction. In this study the attention is focused on the impact of a deteriorating natural resource base on country macroeconomic performance, and hence on economic policies, whereas studies such as that of WRI of the Philippines are primarily concerned with the *,nvironmental effects of macroeconomic policy instruments, such as taxes, interest rates, tariffs and exchange rates, and levels of public spending."Z/ Both approaches are useful, but the approach adopted here needs to be put forward, not just to correct and improve structural adjustment programs, but more generally, and perhaps more basically, in order to improve country macroeconomic analysis as a servant of development strategy, and as a basis for policy recommendations. yI See for example World Wide Fund for Nature - International, Structural Adiustment and The Enim en David Reed, editor, Westvlew Press, Boulder, San Francisco, Oxford, 1992; and Wilfredo Cruz and Robert Repetto, The Environmental Effects of Stabilization and Structural Adiustment Programs: The Philinoines Case, World Resources Institute, Washington D.C., September 1992. ft.ra.9. p. 1. -3- I1. APPROACH AND GENERAL CONSIDERATIONS This work applies the notion of "Sustainable Development" (or sustainability for short) to economic work at the Bank at a country level. The sustainability sought here is minimal sustainability consistent with economic orthodoxy. It derives from no other source than economic principles as laid down by the founding fathers of the profession. It relies on the twin concepts of capital and income which are central to economics. In order to reckon income properly (for an individual, a firm or a nation) capital must be kept intact. In other words part of current receipts must be used to repair, restore and maintain capital in order to preserve its ability to create future income. Marketable natural resources are certainly capital (see below) which, this paper argues, should be brought into the purview of national income reckoning. Like other forms of capital, they should be "kept intact" for the purpose of estimating income correctly. This, however, does not mean that they should be left unexploited. Indeed, following the minimal sustainabiity approach advocated here, they may be "mined" to extinction, provided that part of the proceeds from their exploitation is invested in alternative capital that would sustain income into the future. From the beginning of economic thought labor has been considered as the factor of production DA excellence, particularly as it was applied to land - another acknowledged original factor of production. Later, the Industrial Revolution was to highlight the role of human-made capital as yet another powerful factor in the productive process. In time the role of entrepreneurship and of technology came to be recognized, and were occasionally conflated with capital. Land, though treated from the beginning as a factor of production, had a separate and differentiated role. Its returns were but a "surplus,"its role as a factor was merely passive, and its reward, called "rent",was determined after all the other factors had claimed their share in the product. Hence the rent of land did not contribute to price determination. Other than land, the environment received no recognition in economic thougn as a factor contributing to production. Unlike the environment as perceived nowadays, however, the distinguishing characteristic of land in classical thought was its presumed indestructibility.1 Marshall, perhaps more than other neo-classical economists, found the demarcation between factors of production rather artificial, inventing the category quasi-rent for the reward of inputs temporarily in short supply. In more recent times work on the origins of growth indicated the difficulty of attributing progress clearly to any one factor, and it has become convenient to resort to simplified paradigms, captured in models such as the Cobb-Douglas production function, where all non-labor factors, including land, are subsumed under "capital." The fact that "Nature" contributes to the productive process has become abundantly clear with the unprecedented growth of economic activity on our finite planet during the past hundred years or so. Both as a receptor of wastes and as a source of materials and energy the earth is showing signs of stress, some of which appear to be irreversible, or otherwise difficult and very costly to reverse. The previously free services of Nature have come increasingly to be associated with cost, and a rising cost at that. Because much of Nature is not appropriated by individuals, or even nations, 2I It will be recalled that to the classical economists the rent of land derived (in the famous Ricardian phrase) from "the original and indestructible powers of the soil." -4- environmental stress has for long failed to be counted as a cost of doing business. Sooner or later, however, an environment-d price has to be paid in order to clean up the high seas, revive polluted rivers and lakes; restore air quality to acceptable standards; repair the ozone layer: and replenish soils, forests, and fisheries so that they can continue to be productive. Internalizing the external costs of production so that each economic activity can be properly costed has brought environmentalists and economists together. With proper costing, resource allocation will clearly improve, but this is primarily a microeconomic issue which lies outside the scope of this paper. The present study has been conceived specifically to indicate how natural resource considerations should be brought integrally into country macroeconomic work, and to demonstrate that in certain situations neglect of environmental deterioration may seriously undermine measurement of country economic performance, as well as the quality of Bank economic advice. A main message that should emerge out of this work is that the environment is not a sector, like agriculture or transport, but an envelope that contains all economic activities, and provides the long run context in which economies function and develop. Short-term indicators of economic change abound, and serve useful purposes, but for the purpose of managing development in developing countries they are seldom sufficient. For there remains a dimension, which is essentially long-term, that is necessary to keep firmly in mind in order for the analyst to perceive where an economy is heading; and whether the current prosperity indicated by short-term economic indicators is sustainable, or else transitory and hence will lead inevitably to future economic decline. The long view is indispensable for guiding development strategy for a country seeking to manage its natural resources rationally. By stressing the importance of the long term, which is the appropriate time frame for development, the question of sustainability of development assumes prominence. Definitions of sustainability, such as that offered by Brundtland,A/ are admirable in their way, but for the purposes of this study the Brundtland definition is complex and overambitious, incorporating too many factors, including income distribution at a point of time as well as over time, and the notion of preserving the natural "heritage" for future generations. Such objectives are deliberately left outside this work in order to focus the coverage on certain basic economic considerations. By contrast with the Brundtland definition, the sustainable development to which this paper draws attention can be described as "weak sustainability," reflecting concerns rooted in economic thought, and avoiding at this stage issues of ecological conservation, and income distribution. Development, it should be stressed, is not a short-term affair, but a long-term process, involving building-up of capacities, human skills, institutions and infrastructure, while attempting to maintain the natural resource base from which developing economies tend to derive much of their prosperity. Should the natural resource base of an economy be deteriorating, either deliberately or fortuitously, future consumption is bound to suffer unless a conscious effort is made to offset this deterioration by countervailing capital formation in all its aspects, i.e. through investments in machinery and equipment, tecimological development, instittion building, health and education, and of course repairing and restoring the natural resource base. Were developing 4/ World Commission on Environment and Development (WCED), Our Common Future, Oxford University Press, 1987, popularly known as the Brundtland Report. Several definitions of sustainability are put forward in that report as well as in other works. -5- countries as richly endowed with natural resources at present, as the United States. had been two centuries ago, the scale of the problem would be much smaller, and the urgency of the issue less pressing. In many developing country situations populations have now exploded, simultaneously as natural resources supporting these populations have eroded te critical levels, and efforts to build up skills through training and investing in material capital to compensate for C.e deteriorating environment have been highly inadequate. It should be made clear that seeking to maintain the natural resource base as advocated in this paper does not mean that the natural resource base should be fossilized in its current state -- rather that it should be exploited rationally, according to sound economic principles, and not liquidated to finance consumption without due regard to the future. There seem to be three main avenues (though often criss-crossing) for bringing economic work to bear on the environment. One is the route already started in the World Bank to address the environmental impact of projects, minimize any harm they may produce through better design, and try to internalize environmental impact in project analysis. This can be viewed as a microeconomic approach. Another route, now being explored, is to identify sectoral or economy-wide practices that are harmful to the environment in order to devise offsetting policies and actions, and also encourage practices that are environmentally friendly. This can be a mixture of microeconomic and macroeconomic considerations and can be said also to have been initiated. A third approach which dominatc. this paper is entirely macroeconomic. This leans heavily in the direction of proper economic accounting, and following this through into the field of economy-wide macroeconomic policy. All three approaches are necessary, and fortunately would tend to be mutually supportive. But the contention is clearly false that all that is required from economists in this regard is better project analysis that would take into consideration both project externalities and proper valuation of inputs and outputs to reflect their true environmental scarcities and utilities. Better project analysis is certainly essential, but would not take care of the host of environmental concerns that needs to be addressed on a very wide economic front and cannot be captured in a project-by- project cost-benefit framework. After all, there are many situations where environmental stress has reached acute proportions and where new projects are either not being contemplated at all, or, if being seriously considered, would have little effect on the distressed environment, however perfectly designed they may be from an environmental point of view. Another idea worth considering is the belief that technological progress is bound to render environmental concerns superfluous. This idea can largely be discarded for being as unhelpful in a developing country context as it is unrealistic. Technological progress is likely to continue to be made, both in ridding the earth of some of the harmful emissions associated with production and consumption, and in economizing on the use of, as well as finding substitutes for, materials and energy sources. But technological progress is notoriously slow in developing countries, being handicapped by many factors including costs (see below). However, if and when technological advances are made, they will inevitably reflect themselves in changed practices and productive activities, and will be accounted for in the normal way after they have actually occurred. Technology, however, is unlikely to be able to repair all environmental damage or to restore species that have become extinct in the process. -6- The most important message of this paper is that economic work must try to distinguish between, on the one hand, asset liquidation such as that resulting from overfishing, felling trees without replacing them, and drawing down finite reserves of mineral wealth, and on the other hand true value added, created by the services of original factors of production through activities which can be replicated and sustained over time. The argument is worth repeating that although some of the natural resources in question may appear to be getting globally more abundant than hitherto believed, this provides little comfort to individual countries that are running out of the same resources within their own borders. And it is the country that provides the context fcr Bank operational and economic work, as well as for economic policy prescriptions, so that reference to global abundance in this regard distracts and confuses rather than advance understanding of the economic conditions of many a developing country served by the World Bank. -7- III. COUNTRY MACROECONOMIC WORK AND THE ENVIRONMENT The high dependence of many LDCs on natural resource exploitation raises questions about the adequacy of the current practice of viewing their macroeconomic problems through the short-term prism of fiscal and balance of payments developments, with little emphasis placed on issues of long term sustainability. This myopic view is compounded by the prevalent lack of discrimination between the genuine creation of value added and the generation of financial receipts through the sale of assets.J/ Bank economic reports on many resource-dependent countries, including Algeria, Tunisia, Egypt, Ecuador, Malawi, and Congo during the seventies and eighties may be faulted on this score. But it would be unfair to single out these countries since many other country reports suffer from the same limitation. For such countries, the loss of environmental capital, including soil erosion, decline of forest cover, or liquidation of mineral deposits, has been ignored in the economic analysis, and even treated as progress reflected in spurious measurements of economic growth and fiscal and balance of payments surpluses. For such countries the economic measurements of performance and the policy advice based on them have, at times, been dubious at best. Misreading the liquidation of environmental capital as economic progress may in fact have contributed to the obstruction of long term economic development in some of the countries mentioned, as will be illustrated later. Inevitably the productive base of such economies will give out, and valuable time will have been lost when a more accurate measurement of performance, and hence more appropriate policies, could have helped build up proper economic foundations for future development. The predicament of such countries is sometimes compounded by the assurance of false prosperity, certified for them by the national income statisticians, and endorsed uncritically by the economists, and imparted to prospective creditors who would advance loans over and above the true creditworthiness of the borrowers, thus contributing to situations of insolvency and loss of nation?! economic policy independence. This has been the story of several petroleum exporting countries that appeared very prosperous during the 1970s, and ended up in the mid-eighties with enormous debts and other economic difficulties, though clearly the oil price collapse that followed did aggravate their problems. Rather than wait until its marketable natural resources had become seriously eroded or otherwise the markets for those resources had collapsed, and the country was left with an intolerable I/ Commenting on an earlier draft Jed Shilling suggested that I distinguish natural "capital" that is used for production from a broader category of "assets" which would include also stores of value. Such a conceptual distinction would be difficult to maintain in practice, however. Besides, stores of value (part of which Marshall classified as "working capital") are usually capable of conversion into "productive" capital when the need arises. Furthermore Keynes acknowledged that liquid assets, such as bank balances, can serve transactionary, precautionary and speculative purposes jointly. We also have the authority of Hicks that the capital (of an economy) is "its stock of real goods with power of producing further goods or utilities in the future." Hicks suggested that such a definition "would probably be acceptable to most economists." [Sir John Hicks, "Capital Controversies: Ancient and Modern," American Economic Review (May 1974) 64: 301-316; emphasis added.] It was under the influence of Hicks that I began to see the environment as akin to a factor of production (namely capital). In the same work cited above Hicks states: "In order that a thing should have a price, it must be appropriable, but it is not necessary that a thing should be appropriable for it to be a factor of production." I therefore continue to use assets and capital interchangeably in this paper. -8- debt burden, and then begin to prescribe painful stabilization-cum structural adjustment policies, economists should have much earlier helped to devise a development-oriented longer-term adjustment strategy based on greater savings,more rational investments and diversification of economic activities. In conditions of greater abundance, the adjustment would have been less painful and the chances of developmental success brighter. Economic work during the past two decades on some of the countries already mentioned (Congo and Tunisia are conspicuous examples among many others) would clearly demonstrate the importance of this argument. It is true, however, that during periods of apparent prosperity built on the liquidation of natural resources, countries normally discount outside economic advice, but Bank economists should nevertheless offer such advice, once careful analysis has been made of the state of natural resources. As mentioned later, one of the gravest problems confronting such countries is the "Dutch Disease" which sets in as a result of natural asset liquidation, thereby undermining the tradable goods sectors. A pro-active exchange rate policy would be indicated to redress such a disequilibrium as argued in section V below. For developed countries environmental concerns largely relate to problems of pollution, including waste disposal. It may be that pollution receives disproportionate attention for this reason. Furthermore, pollution makes itself readily observable, whereas the cost of natural resource depletion remains hidden for a while, to be borne only later. Pollution raises formidable issues touching on health and sanitation, recycling, protection of scenic amenities and other related problems. Important among these is the issue of how to internalize pollution costs through adequate policies, and properly treating in economic measurements the impact of environmental disasters and the costs incurred for guarding against or mitigating the effects of pollution. Pollution problems confront practically all developing countries also, though in general relatively less severely since pollution tends to be associated with industrialization._/ To many people, however, the environment seems to raise pollution concerns in the first instance, and sight is frequently lost of the often greater issue for developing countries of natural resource depletion and degradation. Even sector specialists, or environmentalists producing Environmental Issues Papers and Action Plans, tend to ignore subsoil deposits in these documents, and fail to highlight their limited life expectancy under current exploitation profiles, either under the impression that such resources g/ This is not to minimize the existence of formidable pollution problems in developing countries associated with fuel combustion, urban congestion, untreated domestic, agricultural and industrial wastes, often released in waterways, and vehicular and other harmful emissions in concentrated urban settlements. Some studies have also indicated that the desire and ability to implement counter-pollution policies increase at levels of per capita income above a certain range. .9- are not strictly environmental, or because they appear to them to be so important that they must have already been covered in country economic work.2/ National Income Accounting Measurements of income and production to gauge economic performance must be adequate if they are to serve as a useful guide to macroeconomic policy, and they obviously are inadequate if significant depletion of marketable natural resources is taking place without being reflected in these measurements. Clearly not all countries need adjustment of their national income estimates to reflect environmental change. For many industrialized countries the adjustment is needed only for pollution, although for some, including the United States, top-soil erosion, depleted aquifers and declining petroleum reserves call also for some national income adjustment. For developing countries, however, the adjustment in many instances has to cover both pollution and natural resource degradation, and its magnitude will therefore normally be larger. Where countries are dependent to a high degree on activities such as timber production, fisheries exploitation or mineral and underground water extraction, and where the stocks of such resources are small relative to extraction rates, the adjustment needed to the accounts may be considerable. There is no P.iga fai& standard in such cases as to the degree of overestimation of national income as reckoned conventionally, since this depends essentially on the importance of the activity in the economy (roughly indicated by its share in GDP) and on the number of years the resource will last at current extraction or erosion rates. Generally speaking such countries tend to be poorer than the accounts make them out to be, and their economic growth may be quite different from conventionally calculated growth. Their true growth could even be negative where positive growth had been indicated by conventional measurement. As stated earlier this paper will altogether eschew issues of pollution as they affect national income and product estimation, and will attempt to focus on the adjustment needed for the erosion of an economy's capital base through natural resource depletion and degradation.A/ It will explore some of the policy implications of the adjusted accounts, and indicate a number of countries where the adjustments and their policy implications are likely to be significant, and therefore worth undertaking. Adjusting the accounts to cover more natural resources, pollution, or some aspects of pollution, could later be added when estimates of these have become available. The fact that such 2/ Environmental Issues Papers and Action Plans tend to ignore mineral deposits even when they appear to be rapidly diminishing and are important for the economy concerned. Pollution always takes pride of place in these tracts which normally attend also to soil erosion, fresh water availability and deforestation. See for instance the World Bank/European Investment Bank, Ilk Environmental Proram for the Mediterranean, 1990 which totally ignores the management of petroleum and phosphate deposits despite the dependence of several North African countries on these resources. II Pollution could of course be viewed as the depletion of the environment's capacity to absorb waste. This line of argument, which was suggested to me by Herman Daly, is interesting and might merit later investigation. - 10 - adjustments are partial, and will not encompass the totality of environmental change, does not represent a weakness of this approach. This issue is addressed later in the paper. In fact it can be categorically stated that it will never be possible to carry out comprehensive adjustments of national income to reflect every aspect of environmental change. Natural Resources as Capital Natural resources represent capital that can and should be used to produce goods and services for the benefit of their owners. From an economic viewpoint it is absurd to claim that all natural resources should be left untouched for use by future generations. If such a preservationist rule were to be applied, the next generation's use would likewise be constrained for the sake of saving these resources for still later generations. Like other forms of capital, however, natural resources need to be maintained in order that they can continue to help the productive process. Toward that end, if such resources are renewable, such as forests or fisheries, annual exploitation should be kept within the natural rate of regeneration of the resource. If it exceeds that natural rate, and the capital stock is therefore diminished, the diminution should be estimated and imputed as disinvestment, and reflected in the measurement of the national product. If exploitation falls below natural regeneration, then the owner would be adding to the final stock through a passive act of investfent. Either way the change in the stock should be assessed. There is an established precautionary convention in accounting not to count any appreciation of stocks in current income, but wait until it is actually realized lest the capital base should get eroded by over-consumption. On the other hand, declines in the value of stocks must, by accounting convention, be recorded, again on grounds of precaution. The usual way of effecting adjustments to reflect over-exploitation of renewable resources is to treat this as dpreciation, deducting the depreciation from the gross income or product, in order to arrive at an adjusted level of net income or product. This "usual"way is taken at its face value in this paper. Strictly speaking the adjustment for over-exploitation should be equal to the "user cost" which is only a part of the apparent depreciation. Valuation can be a formidable problem in such an exercise, but it is not totally insurmountable. It is more manageable for natural resources, especially those that are marketable, than for pollution, although for the loss of bio-diversity the difficulty of valuation. cannot be over- estimated. Where the market indicates prices for natural resources the economist should, at least initially, base the adjustments on those. But often one has to resort to shortcuts and imputation - such as, for instance, inferring the cost of soil erosion from the decline of marketable crop yields or from the higher cost of increased inputs (such as fertilizers) needed to compensate for the soil erosion. Full and comprehensive adjustment will,however, remain elusive, and all adjustments will inevitably be partial, and this has to be accepted. Where resources cannot be regenerated and commercial exploitation leads inevitably to a diminished stock, such as in the case of mineral extraction, national account adjustment requires special treatment. Strictly speaking the income derivable from this stock, if it were to be liquidated in one go, is the annuity that can be earned from re-investing the proceeds in income-yielding - 11 - financial or material assets.2/ However, it may not be possible, nor indeed judicious on account of market limitations, to liquidate resources abruptly. It may be more prudent to continue to exploit them gradually over time, unearthing some, and leaving the bulk underground. The owners of the resource will decide its annual exploitation rate in the light of their judgment of the resource's current market conditions and future prices, and in conjunction with their current financial needs, technical constraints on extraction, prevailing yields on alternative investments, etc. The rate of exploitation ultimately decided upon may or may not be judged by the economist to be optimal. But for the purpose of income reckoning this is irrelevant, since the accountant's function is to estimate the owner's income during the year that is already past, whether or not the owner had made ideal decisions and realised gains or suffered losses. I have proposed a method for estimating true income from the gradual exploitation of depletable resources, based on the proportion of the known reserves extracted in any one year and the rate of interest at which a certain portion of the receipts, identified as a "user cost,"must be re-invested in financial or material assets in order to maintain future income. "True income" would be the difference between the net receipts (i.e. net of extraction costs) and the user cost which represents asset diminution in the course of exploitation.10/ , Since non-renewable (or exhaustible) resources cannot be restored or maintained as renewable resources can, it does not make economic sense to view the decline in their stocks as preciatin to be deducted from gross income (or product) in order to arrive at an adjusted level of =g income.n/ Those who adopted such a faulty approach ended up with wiping out from the 2/ This view, which was from the beginning at the heart of my method to estimate the income content in the receipts obtained from natural capital liquidation, is consistent with the analysis put forward by Robert M. Solow in his 1974 paper, "On the Intergenerational Allocation of Natural Resources," Scandinavian Journal of Economics, 88 (1), pp. 141-9. IQ/ The method is explained in detail in my paper "Absorptive Capacity, the Demand for Revenue and the Supply of Petroleum," Journal of Energy and Development, 1981 (Autumn); and my Chapter 3, "The Proper Calculation of Income from Depletable Natural Resources" in Yusuf J. Ahmad, Salah El Serafy and Ernst Lutz, editors, Environmental Accounting for Sustainable Development, a World Bank-UNEP Symposium, The World Bank, Washington D.C., 1989. It is based on Hicks's definition of income, as laid down in his chapter on "Income" in Value and Capital (Second Edition), Oxford at the Clarendon Press, 1946. It also made use of Harold Hotelling's seminal article, "The Economics of Exhaustible Resources," Journal of Political Eonomy, April 1931, 39, 137-175. Hicks's approval of my use of his tentative suggestions regarding "wasting assets" to arrive at "true" income was expressed in a private communication to me in May 1987. .I/ See my "Depletable Resources: Fixed Capital or Inventories?" Paper read to the special meeting of the International Association of Research in Income and Wealth, Baden, Austria, May 1991, in press. It should be added that the user cost approach is also applicable to renewable resources where these are being "mined," i.e. where extraction exceeds natural regeneration, thus shortening the life expectancy of the resource. To use the entire decline of the stock during the year as depreciation (in the manner of the WRI study of Indonesia and elsewhere) exaggerates the necessary adjustment to income. The degree of exaggeration declines, however, as the rate of over-exploitation increases and the user cost rises. Where the net offtake is small and the life expectancy of the resource is therefore not much - 12 - net product the entire contribution of the activity to income, since that contribution represented also the magnitude of asset erosion. Instead, after calculating the proper magnitude of the "user cost", this should be excluded altogether from gos income since it represents "inventory drawdown," and no further adjustment of net income would be required. The proportion of "true" income to the net receipts obtained from selling an exhaustible resource is indicated by the quantity: 1 1 (1+r)"' where r is a discount rate and n the life expectancy of the resource measured in years at current exploitation rates. The proof of this formula and its underlying assumptions are shown in Appendix A at the end of Lis paper. After some htial skepticism there is now greater appreciation of this method which has actually been applied in several places.12/ The "user cost" in any case is the proper magnitude of resource "depreciation" if the adjustments were to be confined to the calculation of net income. For the majority of industrialized countries, the adjustment resulting from taking account of natural resource exploitation, whether exhaustible or renewable, along the lines indicated above will not make a sizeable difference to income estimates as conventionally reckoned, owing to the limited contribution of domestically extracted natural resources to their economic prosperity. Except for countries such as those exploiting North Sea petroleum deposits, or for regions or states within Canada, the USA, or Australia, where natural resources (largely forests or petroleum) currently contribute significantly to economic activity, will the needed adjustment to the regional or domestic product be appreciable, and therefore worth undertaking. The last made statement, however, should not be taken to mean that natural resources are unimportant for developed countries, since however small the contribution of domestic natural resources to economic activity appears in ODP, the denial of natural resource availability would reduce GDP by a multiple of their primary contribution. This diminished, the needed adjustment can be negligible. However, since the WRI estimation of income from forests is confined to timber production and leaves out the n:gative effects of deforestation on carbon dioxide absorption, soil stabilization and water-shed integrity, some overestimation of the impact of timber extraction on income may in fact bring the estimates closer to reality. I owe this last point to Susan Hubert. J2/ See J.M. Hartwick and A.P. Hagen, Economic Depreciation of Mineral Stocks and, the Contribution of El Serafy (World Bank Environment Department, Divisional Working Paper, No. 1991-27, November 1991.) See also M.A. Adelnan g A., User aQst in Oil Productin. MIT Center for Energy Policy Research, October 1990, where the authors make use of my formula. I have given several instances of the application of the El Serafy method in practice in "Depletable Resources: Fixed Capital or Inventories?" 9g. gk. - 13 - is because natural resources often provide the base on which much value added in secondary and tertiary sectors is generated.12/ However, this is quite a different issue. But for some develcoing countries the required adjustment to the accounts can be substantial, deriving from a combinatioi of several natural resources, all being simultaneously exploited and eroding at various rates aided by population pressures and the impact of poverty. In an environment characterized by widespread indigence, the pursuit of survival can lead to serious. liquidation of whatever natural capital there is since the future gets discounted by the poor at extremely high rates of time preference. This is not to say that natural capital does not also get destroyed where time preference is relatively low. It is part of the purpose of this study to indicate a few of those countries where the adjustment needed to the conventionally estimated national product would be appreciable, and to urge country economists to be aware of the problem of an eroding resource base, and alert to the extent to which natural resources may be diminishing. The list of countries where the problem is likely to be important can be expected to expand with time as awareness of the problem increases and the necessary work to assess it is done. The adjustment to the accounts could actually be undertaken by the Bank country economists themselves, or with their guidance and cooperation by the national statistical offices. It should be stressed once more that we must not expect either comprehensiveness or precision from the proposed process of income adjustment. It is difficult, if not impossible, to ascertain all the stocks of natural resources at a point of time, and in every case to place a monetary value on that stock. Also, even if the market sets a value on the resource, we may not be able to ascertain the complex gradations of its quality, or fathom the costs of extraction exactly, either in average or marginal terms, or predict their future course with any precision - though we might be fairly certain that future costs will be higher than current ones, which in turn are probably higher still than the costs of earlier periods. Though some of the cost of mineral exploitation may decline over time due to technical progress, the fact remains that early exploitation tends to focus on rich deposits of easy access, so that later exploitation, other things being equal, inevitably faces higher extraction costs. Approximation of the relevant magnitudes, however crude, would be an improvement on current practice, and would bring greater accuracy and realism to current economic measurements which are often divorced from what is actually occurring in the physical environment, and would improve the insight of the economic analyst and the relevance of the analysis. In particular country situations, therefore, the focus should be on effecting the adjustment in respect of those resources that figure prominently in the economy concerned, extending the coverage over time in the direction of comprehensiveness to encompass more and more resources as knowledge of the resource base 12/ It is interesting that Gavin Wright, in "The Origins of American Industrial Success, 1879-1940" (The American Economic Review, Vol. 80 No. 4, September 1990) attributes much of America's industrial success in that period to natural resources, asserting that their contribution has been "underappreciated" and adding (p. 665) that *... it is perhaps understandable that Americans have not been inclined to attribute their country's industrial success to what appears to be accidental or fortuitous geographic circumstances." The economic development of many other countries, besides the United States, including Australia, Canada, the USSR and Brazil appears also to have benefited greatly from their natural resource endowment, and may be showing signs of deceleration owing to the erosion of this endowment. - 14 - increases and the methods of estimation improve. Where the market indicates values for such resources, there Is really no excuse for the country economist to abstain from undertaking the adjustment, but his or her primary concern should be for the year-to-year change in the stock rather than for the value of this stock at a point in time. To the economist, the flow accounts, in other words, are far more important than the balance sheets. This last point is important since some analysts, following OECD tentative guidelines,14/ have focused on the estimation of the opening and closing stocks of proven reserves of exhaustible resources, using market prices current at the time for each, and have proposed that the difference' (made up of the diminution due to exploitation, and changes due to re-estimation of reserves) be brought into the income estimates. Since the resource stocks are normally much larger than annual extraction, re-estimation of *heir size, as well as incorporation of changes in their value in the flow accounts following price flut. ations, can dwarf the adjustment specifically due to extraction, and we may end up therefore with gyrating and economically meaningless adjusted income, and in some cases with estimates of so-called net income higher than those for gross income..1/ My own method brings the reassessment of stocks into the flow accounts through changes in the reserves-to-extraction ratio and consistently indicates a net income level lower than gross income, that is if the user cost is treated as depreciation. Since extraction takes place inevitably out of a finite stock, the net must always be less than the gross. Policy Imlications If, as this paper maintains, economists in some situations are unable to gauge economic performance through accurately estimating national income and its changes over time, how can they tell if an economy is growing, declining or stagnating? How can they indicate a meaningful country level of per capita income for international comparisons? How can they judge a proper level of money supply, a tolerable level of external debt, or manageable fiscal and balance of payments deficits - all of which need to be related to national income? How can they estimate a balance of payments current account deficit when the current account contains unrepeatable exports of environmental capital? How can they judge the adequacy of the saving/investment effort? The relation of welfare to income raises yet a host of further issues, but, as stated earlier, this paper will leave welfare JA/ See OECD, Department of Economics and Statistics (Treatment of Mining Activities in the System of National Accounts - Note by the Secretariat: Meeting of National Accounts Experts, 29th to 31st May 1985.) Mime.. 11/ Such were the estimates proposed by Robert Repetto and Associates, Wasting Assets: Natural Resources in the National Income Accounts, World Resources Institute, June 1989, Washington D.C. for Indonesia. This WRI study produced adjusted net income estimates for Indonesia higher than conventionally calculated gross income for two years. See also my paper, "Depletable Resources: Fixed Capital or Inventories?" op.ci. -15- considerations aside, focusing only on the proper measurement of national performance indicators. ifi/ To sum up, where an economy derives significant parts of its prosperity from natural resource exploitation, and where the resource depletion fails to be reflected properly in the national accounts, inowading the balance of payments, then (a) income will be overestimated; (b) savings and investment exaggerated; (c) the fiscal deficits (if natural resource exploitation is carried out in the public sector (as it often does in developing countries) underestimated; (d) and if natural resources are exported, the current account may in reality be in deficit, but papered over by unsustainable exports of assets. Where such phenomena are not recognized, the domestic currency would be seriously overvalued to the detriment of future development. This is because development relies to a large extent on diversifying the economy's productive base and creating employment opportunities outside the primary sector of natural resource extraction. By relying on conventional income measurements such economies may be judged wrongly to be healthy and growing satisfactorily while their natural resources last, but in reality their prosperity would prove to be ephemeral, inevitably giving out when the natural resources being exploited have been depleted or have approached extinction. A major drawback of faulty economic accounting, as explained above, is its obfuscation at the macroeconomic level of certain symptoms of the Dutch disease phenomenon that sets in as a result of excessive dependence on natural resource exploitation. Among other things the Dutch disease upsets relative prices in favor of nontradeables, thus undermining the development of sustainable productive activities that could create employment opportunities and contribute to export promotion and efficient import substitution. With few exceptions, there is still a too limited awareness of the Dutch disease phenomenon among economists working on countries whose prosperity derives from diminishing and degrading natural resources. And little integration has so far occurred of the detailed environmental work carried out on such countries-and which clearly indicates some degree or other of resource depletion and degradation- and economic reporting and other analytical econonic efforts which have tended to give a great weight to short term economic aggregates, without sufficient attention paid to long term development. Even when long term projections of macroeconomic aggregates are attempted, these often extrapolate from shot term magnitudes and do not always reflect trends in resource depletion and degradation. The policy implications of the Dutch disease phenomenon are further elaborated below (Section V.). Structural Adjustment Operations The Bank has recently tightened the process of assessment of its lending operations for their environmental impact, but exempted structural adjustment operations from such scrutiny. Some staff concerned with the environment have therefore proposed that structural adjustment operations, including SECALs, be subjected to the same process of environmental assessment, in order to investigate the environmental impact of such typical loan conditions as the reduction or removal of subsidies on pesticides, fertilizers and petroleum products. Raising the price of gasoline and kerosene, for instance, might encourage the consumption of coal and fuelwood, and could thus worsen emissions and lead to further deforestation. Others have been disturbed by the impact on jf/ See, however, the qualification made at the end of the first part of Section VI "Unsettled Questions," footnote 29. - 16 - poverty and nutrition, and hence indirectly on the environment, of the belt-tightening measures associated with stabilization programs which nearly always accompany structural adjustment, at least in its early phases. But besides such passive scrutiny of SAL impact, which needs nevertheless to be undertaken at least in order to assess any harmful effects these operations may have on the environment, structural adjustment programs could conceivably be used actively and effectively to bring about major changes in policies already in place which are judged to be inimical to the environment, as well as encourage other policies that would be instrumental in protecting the environment. No matter how desirable such an objective might appear so that SALs might actually play an active environmental role, it is an objective that cannot at present be realized owing to the lack of sufficient knowledge about the precise linkage between environmental degradation in specific country situations and the policies in place behind such degradation. Special investigations would need to be carried out systematically in the context of country economic and sector work to identify those current practices that enhance environmental deterioration in specific country contexts, and then devise corrective policy actions. This does not deny the possibility that once a certain type of environmental degradation has been traced back to identified factors, the same factors may be at work in different countries, and thus call for identical or similar remedial policy action. A case in point is deforestation which in various country situations can stem from the same set of factors. These include insecurity of land tenure, subsidization of credit for settlement activities and for cattle ranching, under-taxation of land - besides such policies as export enhancement measures that disregard the underpricing of exports' content of natural resources.17/ In order to use structural adjustment operations effectively to change policies that are inimical to the environment, much prior economic work, especially at the sector level, has therefore to be undertaken, specifically to identify the policies that need to be changed, and explore their economic impact before and after they change. Few environmental Issues Papers or Environmental Action Plans have so far succeeded in identifying such policies, which need to be uncovered over time through patient and systematic country economic and sector work. Until this is done, handling environmental issues under adjustment operations will remain Mr fZ partial, and largely of limited effect. Just as it may be expected that poverty cannot be eliminated through individual adjustment operations -- though of course, some poverty alleviation may be feasible through adjustment programs in a partial and limited sense - the same can be said also of seeking to protect and maintain the environment through structural adjustment lending. A great deal of detail should be unearthed first by country economic and sector work as part of the process of economic reporting, and then 17/ See for example my Chapter VI, "Environmental Issues and the Natural Resource Base," in Costa Rica: Country Economic Memorandum, World Bank, Report No. 7481-CR, dated December 6, 1988. The issues behind deforestation identified were similar to those found for Brazil in the works of Dennis Mahar ("Government Policies and Deforestation in Brazil's Amazon Region," World Bank, 1989) and Hans Binswanger, ("Fiscal and Legal Incentives with Environmental Effects on the Brazilian Amazon," Agriculture and Rural Development Department, the World Bank, 1987.) - 17 - thoroughly analyzed for potential policy change. Once the policy changes have been identified, however, structural adjustment operations can be an ideal medium for effecting the desired results. Although structural adjustment programs have sometimes been blamed for damaging the environment, such a blame is generally unwarranted. Apart from issues, such as those of relative alternative fuel prices, or the uncritical encouragement of exports whose natural resource contents are underpriced, the argument seems to be based on the economic hardships apparently imposed by stabilization-cum-structural adjustment programs on an already poverty stricken population, forcing the poor inevitably into environmental disinvestment in an attempt to survive. The same argument is also often used to blame adjustment programs for reducing the living standards of poorer nations when they are called upon to service external debts whose proceeds had not been utilized wisely in the first place to support productive investments. Such arguments wrongly focus on the pain, normally associated with the intended cure, without objectively taking into account the origins of the waste, and the inefficiencies and over-consumption which had led to over-borrowing. The origins of the economic difficulties that emerged, and which the device of structural adjustment is meant to address in an orderly fashion as a temporary and unavoidable measure, should be included in any objective analysis of the impact of structural adjustment operations on the environment. This does not mean, however, that country economists and other specialists should not pay special attention to any harmful effects which reduced public expenditure or lower private consumption under adjustment programs might inflict on the environment. In this regard, the environment is very similar to vulnerable groups which should be specifically protected from the impact of adjustment programs through special measures to enable them to survive the adjustment process. Country Strategies Over the years the Bank has found it productive to expend considerable resources to clarify, rationalize and articulate its country assistance in the form of forward looking country strategy papers. To plan and execute Bank operations in individual countries, country Departments and Divisions have been set up, with country and other specialists working at various levels on economic and social problems. Within the Bank, the Region is required periodically to put forward and justify its lending operations, country economic work, and other activities *nvolving the use of Bank resources in the form of a strategy paper for the approval of Senior Management. Such strategy papers have different guises, some of them being brief and informal, e.g. to signal abrupt changes in country situations, but most of them have a three to four year perspective, take months to prepare, and get reviewed by various units and at various levels in the Bank before they are adopted. Strategy Papers are often complemented by other efforts, such as Policy Framework Papers, drafted for IDA borrowers by the country concerned in cooperation. with the Bank and the IMF. These cover development problems and policies in a three-year forward perspective which gets updated every year (see below). Generally speaking, it can be asserted that coverage of environmental issues, including natural resources, in strategy papers has until now been pm f&=, or otherwise too scanty to be useful, either for illuminating an appropriate strategy for long term development or for policy analysis conducive to recommended policy changes. In Policy Framework Papers, although the relevant Operational Directive states otherwise, environmental considerations tend to be almost non-existent (See Appendix B below). The reason for this is either that sufficient prior work had not been undertaken to guide movement on policy, or that highly detailed studies of the environment had ' -18- remained unread by the country economist, or otherwise insufficiently analyzed to be incorporated in economic work. As argued earlier, the description and analysis of natural resource change should be part and parcel of country economic reports, and seriously and systematically addressed in Country Strategy Papers and Policy Framework Papers. In particular, environmental change in the form of disasters, loss of forest cover, watershed degradation, soil erosion, mineral deposit depletion and reassessment of subsoil reserves, should be indicated In country economic reports and strategy papers in value terms if possible, but at least in physical terms in the first instance. In fact, because of the volatility and uncertainty of many natural resource prices, the physical measurements would quite often be more informative and dependable than value estimates, since the latter, where they relate to environmental stocks, can obscure what is actually happening to the physical assets. Economic reports should show the rate of exploitation and other declines in relation to the natural stocks available in order to indicate the relative seriousness of the deterioration. Once the extent of environmental deterioration is ascertained, the economists should bring in their expertise in order to assess its economic significance and then adapt their analysis accordingly. Micro and Macro Issues The attention given in this paper to the proper measurement of macroeconomic indicators (ODP and NDP levels and growth, savings, investment, the current account balance, etc.) should not be taken as indicating an absence of need for a parallel movement among sector specialists and country economists aimed at improving the economic analysis of projects to accommodate environmental concerns. Serious attention should be given by them to project externalities, and to the correction for these by setting proper values on them and bringing them into the cost calculations. Secondly, many environmental benefits of investments are left out at present because of insufficient knowledge or inadequate efforts to capture them in the analysis. Once these benefits are estimated and internalized in the calculations, many environmental investments would appear more justifiable than before. Thirdly, the process of shadow pricing inputs and outputs should be extended to environmental goods and services where the market falls to reflect their true scarcities in adequate prices. And lastly, care should be exercised lest border prices of traded commodities, often used as shadow prices in project analysis, should themselves be underpriced and fail to reflect full environmental costs. These are important issues, and country economists, who are often called upon to help with the estimation of shadow prices, should be more aware of them than they appear to be. Relevie of Technological ProrMss The belief appears unwarranted that current environmental stress is certain to be alleviated and even eliminated through the accumulation of kaowledge and technological progress. Optimists cite the failure to materialize of forecasis of doom, such as those made by Malthus in the last century, and more recently by the Club of Rome. Optimism seems to be based on the notion that whatever environmental assets get lost, the advent of new technologies, the accumulation of human knowledge, combined with investments in human and physical capital will somehow compensate for them. While nobody can deny that knowledge accumulates and technology will continue to advance and find substitutes for materials that become scarce (tough it is impossible logically to predict technology's . 19- future course) the relevance of technological progress to environmental problems in developing countries, to say the least, is unclear. Take, for instance, the problem of population. Many parts of the world are suffering from environmental stress caused by populations that have become too large for their supporting environments. In theory a given space can accommodate much larger populations if these are sufficiently trained and backed by enough capital investments. In theory also the application of birth control technology and massive capital injections could break the vicious circle of poverty and dependence from which existing populations are suffering. In practice, however, such solutions remain hopelessly beyond the reach of most impoverished countries. Even the physical problem of stabilizing population size, despite the availability of birth control technology for generations, appears untenable owing to economic, social and political impediments that are not easy to surmount. Technology optimists tend to underestimate the many practical handicaps that lie in the path of applying even already known technologies to actual problems in developing countries, let alone the social and financial impediments against introducing new technologies. The possibility of advancement through technological progress is doubtless real, judging from past experience. But caution and realism should guard against complacency and single-minded reliance on the notion that technological progress will be a panacea for environmental ills. And it is unrealistic to expect that technological breakthroughs will materialize on time and be applied automatically to remove or alleviate past or ftture environmental damage. After all, technological progress is discontinuous, cannot be predicted, and willhave its costs. And one should not too readily assume that those who will be in most need of technological innovations will be able to afford the cost of acquiring them. What is the relevance of technological progress to natural resource accounting? We must remember that accounting is an M oa function that seeks to describe past behavior of individuals, firms and nations, embodying such a description in a standard format of flow accounts and balance sheets. It has no business predicting the future, although good accounting is indispensable for guiding future decisions. Accounting often has a one-year perspective during which technology can safely be assumed to remain unchanged. When technological progress occurs, the decision-takers may or may not incorporate the new technologies in the activity concerned, thereby improving or worsening their ability to compete and to realize profits. This in turn will be reflected in the accounts once the year is over. When a new machine appears on the market, old equipment may have to be amortized prematurely, and the accountant will reflect enepreneurial decisions in this respect ;I the accounts. National income is the aggregate of all incomes generated in the various units that make up the economy, and will thus be affected by the behavior of its component units. One problem that confronts accountants and economists alike, is the difficulty of treating capital which, by its very nature, endures beyond a single accounting period. The assumption of unchanged technology during the accounting period, tempered by anticipation of certain obsolescence, has been the basis of accounting conventions for capital amortization which rely on arbitrary bench marks regarding the life expectancies of various assets. Such conventions have yielded rough, but perfectly workable, approximations of asset erosion that are essential for calculating net income. The economist faces similar problems in regard to capital depreciation, and hence the estimation of net income. The problem of inflation compounds the difficulty. Just like the index number problem which has not been dealt with satisfactorily in analytical terms, albeit without reducing the usefulness and popularity of index number calculations, rough estimates of depreciation, based on the -20 - assumption of temporarily unchanged technology, nowever unsatisfactory, are still worthwhile and are certainly needed for approximating net income.1/ JA/ Many of the issues concerning the definition and measurement of capital and its valuation are considered in Sir John Hicks's "Capital Controversies, Ancient and Modem," g. ift. -21- IV. THE NATURE AND MAGNITUDE OF NATIONAL ACCOUNTS ADJUSTMENT It is only if the income adjustment is quantitatively sizeable that such an adjustment will be worth undertaking, and once undertaken, it should be followed through into the policy area. A great deal of the adjustment to national income to reflect environmental change will be in the nature of capital consumption, or depreciation, which will affect only the net product or net income, leaving GDP and GNP unchanged. If the old practice continues, which makes use of conventionally reckoned GDP and GNP as bases for growth measurement and for international comparisons of per capita income levels, the environmental correction will be in many respects futile, since it will only affect net income. That is why there is a strong case for inviting the attention of economists to focus on NDP and NNP if the adjustment to the national accounts advocated here is to make a difference for gauging country performance, and for providing a premise for international income comparisons as well as to serve as a basis for policy recommendations.2/ The habit of using net income rather than gross income for country economic analysis will therefore have to be nurtured among country economists, and indeed all economists. For those countries that derive a significant portion of their prosperity from mineral extraction or from "mining"their renewable natural resources, depreciation is not the right approach to adjusting income. The user cost of resource extraction should be excluded altogether from GDP and GNP, and the parallel net variants of income (NDP and NNP) will, therefore, need no correction. However, since a large number of practitioners in this field still prefer to think of such adjustments in terms of depreciation, the appropriate magnitude of the relevant depreciation would be the user cost I have earlier indicated.2Q/ This should be borne in mind as it is important for ascertaining the proper size of the adjustment as indicated immediately below. Practical Measurements: Indonesia At this stage it would be appropriate to ask what kind of magnitudes have been found, or are likely to be found, for the needed adjustments to the accounts to reflect natural resource depletion? 12/ A parallel movement from convention might also be from the national or domestic product valued at factor cost to the national or domestic product valued at market prices on the argument that the market fails to internalize external environmental costs so that a set of taxes and subsidies is needed to correct the so-called factor costs. Clearly, bowever, care should be exercised because not all taxes and subsidies seek to correct market failures. I have argued along these lines in chapter 5, "Sustainability, Income Measurement and Growth," in Robert Goodland, Herman Daly and Salah El Serafy, editors, Population, Technology and Lifestyle. The Transition to Sustainability, Island Press, Washington, D.C., 1992. LO/ See for instance Hartwick and Hageman, g2. cit., who insist on calling their adjustment "Economic Depreciation of Mineral Stocks" while concluding that the El Serafy formula does "track true economic depreciation (computed by direct methods) quite clearly." I have insisted that the liquidation of mineral stocks is conceptually not depreciation like that of fixed capital, but is, instead, tantamount to the using-up of inventories. See my paper "Depletable Resources: Fixed Capital or Inventories?" 9. gft. - 22 - One of the most quoted studies in this field is that of the World Resources Institute (WRI) of Indonesia (Wasting Assets: Natural Resources in the National Income Accounts, 1989, already cited) which calculated a series of adjusted NDP to reflect depletion and degradation in Indonesia's natural resource sectors of petroleum, forestry, and soil (on Java) for the period 1971-1984. On the basis of the WRI study, the net adjustment to Indonesia's GDP for environmental "depreciation" amounted to -9% of GDP per year on average (unweighted average based on calculations shown in table 1.2, p.6, of the WRI study, 92. it.) during the fourteen year period covered. The WRI study specifically concluded that, while the growth rate calculated from the unadjusted GDP series during the same period averaged 7.1 % per annum, on the basis of the adjusted NDP it was only 4.0%.21/ The growth rate can, of course, be immaterial in this context since a level of income consistently reduced because of environmental degradation and depletion may have higher, lower, or the same rate of growth as that of the unadjusted GDP. What is important is the magnitude of the adjustment in any one year, the average of such a magnitude over the period studied, and its trend over time. There is little doubt that the WRI study of Indonesia's national accounts has been extremely valuable, besides being a pioneering attempt to translate concepts into practical measurements. Moreover, the bases of the calculations are clearly set out so that later researchers could adjust part or the whole of the estimates in the light of better data or more robust methods of estimation. Above all it seems that that study did hit on the right approach which is advocated in this paper, namely to identify a few resources that are important for the economy concerned and adjust the national accounts in respect of these resources as a first step, with the full knowledge that the sum- total of the adjustment will be partial, but could be enlarged over time when other resources are covered. As shown in Table 1 below, the negative annual adjustment of about 9% a year on average during the fourteen year period 1971-1984, as estimated by the WRI study, was made:up of 2.2% for petroleum, 6% for forestry and 0.9% for soil (all negative). As the estimates for petroleum are faulted,2/ these can be excluded from the WRI estimates, confining the adjustment initially to forestry and soil erosion. The adjustment in respect of both latter factors adds up to the annual equivalent of about 7% of GDP on average in the period under review. (See Table 1.) To this, we should now add a different adjustment for petroleum depletion, based on the estimation of the user 2/ The end-product of the WRI calculation was the average growth rate of the net product, but clearly - as argued before - this is much less interesting than the average downward adjustment over the period studied. 22/ Every time Indonesia's petroleum reserves were re-estimated in an upward direction, WRI would add the whole adjustment, valued in current prices, to net income, causing such "net" income to exceed gross income in an erratic and economically meaningless fashion. - 23 - cost.Q/ My own calculations, using the formula on page 11, and a 5% discount rate (see footnote 24 below), indicate a GDP adjustment for petroleum of -7.8% on average in the period 1971-1984. This would make the total downward adjustment for the three factors identified (petroleum, forestry and Java soil) equivalent to some 15% of GDP - a very significant change indeed. Table 1 shows amended adjustments to the national accounts of Indonesia based on the WRI study. The impact of this huge adjustment to the economic accounts of Indonesia on the various macroeconomic aggregates is considered in the next section. L3/ It is assumed here that the WRI estimates for resource depletion in respect of forestry products and Java soil are roughly correct. Applying the user cost approach to this depletion instead would reduce the WRI estimates somewhat, but this will not be pursued in this paper. See also footnote 11 above. -24- Table 1 INDONESIA: AMENDED WRI ADJUSTMENTS OF NATIONAL ACCOUNTS (Percent of GDP) Yat WRI Total Of which WRLAdiustment Petroleum COrce Adiustment Petroleum Excluding User Cost Adjustment Petroleum 1971 +21.7 +28.0 - 6.3 - 4.5 -10.8 1972 - 1.6 + 5.6 - 7.2 - 6.4 -13.6 1973 - 4.1 + 6.0 -10.2 - 9.1 -19.3 1974 +35.7 +44.2 - 8.5 - 6.4 -14.9 1975 -14.7 -10.3 - 4.4 - 5.6 -10.0 1976 - 8.4 - 2.3 - 6.1 - 9.7 -15.8 1977 -19.3 -13.8 - 5.5 -11.3 -16.8 1978 -16.8 -11.7 -5.1 -10.5 -15.6 1979 -21.8 -11.8 -10.0 - 9.8 -19.8 1980 -23.8 -14.6 - 9.2 - 9.3 -18.5 1981 -18.4 -12.9 - 5.5 -8.6 -14.1 1982 -14.3 -9.4 -4.9 -6.1 -11.1 1983 -22.3 -14.2 - 8.1 - 6.0 -14.1 1984 -17.3 -13.1 - 4.2 - 6.3 -10.5 Average - 9.0 - 2.2 - 6.8 - 7.8 -14.6 Source: WRI, WastinM AsMe, gp.,t, Table 1.2, p. 6; and own calculations of petroleum user cost based on a 5% discount rate. -25 - The Role of the Country Economists Economists, including Bank country economists as well as developing country economists, may not have given enough thought to considerations such as those raised above. Some Bank economists have reacted to informal approaches by taking the position that unless the Bank officially - i.e. through guidelines and directives issued by the offices of the Bank's Chief Economist and the Regional Chief Economists - tells them to do so, they will continue with conventional income measurements and base their analysis on them. Bank economists of course do not, themselves, carry out national income measurements, and few of them have had the experience of estimating national income on the ground. Some seem to have an exaggerated confidence in the conventional income estimates offered to them by country statistical offices, or feel a justifiable reluctance to venture onto new unfamiliar grounds indicated by the proposed adjustments. When the accounts mix asset sales with value added, as argued before, the issue of sustainability, which is a sine Wa 8= for proper income estimation, gets lost, and economic reports would sometimes seek a comparability that does not exist between economies as diverse and incongruent as Malaysia and Korea, allegedly because of the similarity of their (unadjusted) per capita income levels. Issues as important as those emphasized in this paper, should obviously not be neglected on whatever pretext, even if they appear to raise thorny or controversial problems of measurement. The first step of adjusting the national accounts for marketable resource depletion and other environmental degradation - along the road to a better understanding of natural resource-dependent economies - has not even been attempted inside or outside the Bank on a significant scale. The work done so far on Indonesia, and also on Papua New Guinea and Mexico with the Bank's collaboration, has revealed many dark areas and has unearthed many uncertainties involved in carrying out the adjustment. All this naturally feeds the reluctance of Bank economists to embark on what is viewed as an arduous journey with an uncertain destination. But we should realize, however, that there are also many dark areas and uncertainties in standard national income accounting, where imputation, contingency estimation and short-cuts are resorted to on a significant scale and on a regular basis. These, however, seem to be taken rather lightly by economists, both inside and outside the Bank. Likely Magnitudes for Countries Other than Indonesia Since the country is the focus of the bulk of. economic work at the Bank, the country should provide the context in which the adjustments should be made, and in which the policy implications of the adjustments should be pursued. It has been mentioned before that we could not hope for comprehensive adjustments of the national accounts that would capture the totality of environmental degradation, but instead should, along the lines of the WRI study of Indonesia, concentrate on a few resources that are judged to be important for the economy concerned, and be content with partial adjustments in the expectation that as time goes by the extent of the coverage will expand. The main task of effecting the adjustment, and of carrying out the subsequent policy analysis, will have to be part of the country economic work. The country economist should be making use of environmental work already accomplished, and setting in motion a process for collecting and analyzing environmental data so that he or she should have a firm grasp of changes occurring in the environment and the impact of these changes on the economy. Indonesia is not an isolated case where the adjustment to national income for environmental depletion and degradation would make a significant difference to the accounts. Generally speaking the economies of developing countries depend to a significant degree on primary production: mineral extraction; forestry exploitation; soil and water dependent agriculture; livestock; fish and fish products etc., so there is a presumption that where the natural base of such production is eroding the impact on the economy will be appreciable. The old SNA did not pay any attention to the deterioration of the naturt' - 26 - resource base as a cost to be charged against what is conventionally reckoned as value added by primary activities, but the economist should pay special attention to this cost. Table 2 is illustrative, showing the overwhelming dependence of a number of developing countries on three primary commodities each, and the high concentration in their exports of such commodities, even for large economies such as that of Nigeria, Egypt or Mexico. The original source from which Table 2 is extracted shows no less than 54 developing countries where the ratio of exports of three primary commodities to total exports exceeded 40% in 1990. Adiusting or Oil Extraction The magnitude of the adjustment needed to be made on account of resource depletion will vary inversely with the life expectancy of the resource (i.e. will be minimal for countries with abundant reserves, such as Saudi Arabia) and will also vary inversely with the discount rate used to calculate the user cost, and to guide extraction policies and the re-investment of the user cost in alternative assets.2A/ Table 3 focuses on crude oil in the national accounts of 14 developing countries. The share of this activity in GDP circa 1988, as conventionally reckoned, varied roughly between 0.8% for Thailand and 38.5% for Oman, and the range of life expectancy of the proven reserves (i.e. the ratio of reserves to annual extraction) varied from 6.1 years for Thailand to 98.9 years for Saudi Arabia. Using a 5% discount rate the downward adjustment indicated for the oil sector ranged from 0.8% for Saudi Arabia to 70.8% for Thailand. The effect of the adjustment on GDP (the product of multiplying the share of the oil sector in GDP by the sector's downward adjustment), as can be seen from the last column in Table 3, ranged from 0.1% for Venezuela and Mexico to 13.6% for Oman. On the strength of the data in Table 3, countries where the oil adjustment alone will make a difference of 4% or more of GDP are Cameroon (4.4%), Tunisia (4.7%), Egypt (5%), Congo (8.3%), Trinidad and Tobago (9%), Ecuador (9.5%) and (as already noted) Oman (13.6%). As illustrated in the detailed case of Indonesia, the adjustment indicated above for the oil sector is only part of a larger adjustment that has to be undertaken for certain developing countries, so the total adjustment will probably make an appreciable difference to the accounts in many of the countries listed in Table 3. The effect of such adjustments on policy considerations will also be considerable. Some of the countries listed in Table 3 may be useful targets for investigation in a future pilot study to examine the appropriateness of past policies recommended in country economic work in the light of the adjusted accounts. a/ For an exposition of my method and illustrations of the magnitude involved, see chapter 3 in Ahmad g. al., editors, Environmental Accountin for Sustainable Develoment, .. t. As explained there, the adjustment is quite sensitive to the discount rate. The income content of receipts from liquidating an asset of a life expectancy of ten years is 42% if the discount rate is 5%, and 65% if the discount rate is 10%. I have argued that it is unlikely that new investments will offer as much as a 10% annual yield, and that 5% seemed more probable. I also argued that the discount rate to be used in the calculations could be changed periodically to reflect actual market behavior. - 27 - Table 2 PRIMARY COMMODITY CONCENTRATION OF EXPORTS OF SELECTED COUNTRIES (Top Three Commodity Exports as a Percentage of Estimated Merchandise Exports, 1990) COUNTRY PERCENTAGE COMMODITIES Uganda 97.0 Coffee; hides and skins; cotton Nigeria 96.4 Crude petroleum; cocoa; refined petroleum Algeria 96.0 Crude petroleum; refined petroleum; gas Angola 95.2 Crude petroleum; refined petroleum; coffee Rwanda 95.2 Coffee; tea; hides and skins Mauritania 92.0 Shell fish; iron ore cone; fresh fish Chad 90.5 Cotton; crude vegetable materials; metal ores Gabon 85.8 Crude petroleum; other wood; metal ores Malawi 84.9 Tobacco; tea; sugar and honey Congo 84.0 Crude petroleum; other wood; metal ores Madagascar 69.0 Coffee; spices; shell fish Panama 56.7 Fruits and nuts; shell fish; fresh fish Venezuela 51.4 Crude petroleum; non-ferrous metal scrap; coal, etc. Egypt 39.6 Crude petroleum; cotton; refined petroleum Mexico 39.4 Crude petroleum; fresh vegetables; refined petroleum Sourgc; World Bank, Global Economic Prospects and the Developing Countries, April 1992, Appendix E, Table E12 - 28 - Table 3 OIL ONLY: DOWNWARD ADJUSTMENT OF GDP FOR 1988: (In Descending Order of Impact on the Oil Sector) Reserves to Share of Downward(*) Effect of Extraction Oil in Adjustment Adjustment Ratio GDP of oil sector on GDP years percent percent percent Thailand 6.1 0.8 70.8 0.6 Tunisia 6.9 6.8 67.9 4.7 Cameroon(**) 8.4 7.0 63.3 4.4 Trinidad & Tobago 9.7 15.2 59.4 9.0 Ecuador 11.9 18.0 53.2 9.5 Egypt(**) 12.7 9.8 51.1 50 Congo(**) 14.4 19.6 42.1 8.3 Malaysia(**) 17.0 8.2 41.5 3.4 1ndonesia(**) 19.4 10.4 37.0 3.8 Oman(***) 20.4 38.5 35.2 13.6 Nigeria 32.3 9.9 19.7 2.0 Mexico 58.7 1.7 3.4 0.1 Venezuela 96.0 12.1 0.9 0.1 Saudi Arabia 98.9 21.6 0.8 0.2 Notes: * Adjustment using 5% discount rate ** Calculations for 1987 or 1978/88 * Calculations for 1986 - 29 - V. SOME POLICY IMPLICATIONS National Accounting provides an isgg look at a country's performance which should inform and illuminate economic analysis and guide future policy recommendations. The importance of proper accounting for gauging performance can be readily perceived. For it is clearly important that the economist should know if an economy is stagnating, progressing or declining, and the annual rates of change involved. Genuine economic performance will be clarified if care is taken to insulate it from deliberate or fortuitous acts of natural asset liquidation. Three particular policy areas that will be affected by the adjustment need also to be highlighted. These are (a) whether the saving/investment effort of the country concerned is adequate; and (b) whether the current account balance of the balance of payments is truly in surplus or deficit; and (c) the magnitude of that surplus or deficit and its impact on exchange rate policy. Certain aspects of international trade policy are also briefly addressed. Savine and Investment Countries have to devote a portion of their current income to capital maintenance in order to sustain their existing level of income into the future, and have to' raise their stock of capital through saving if they intend to augment their future income. The net addition to capital, i.e. gross investment less depreciation, is their main avenue for generating a higher level of future income. New technologies get embodied in new capital, thus raising capital's future productivity. Both this and improved management, if and when they occur, will be reflected in higher future income. A practical way of measuring the aggregate response of an economy to new investments is the incremental capital output ratio (ICOR). Inefficient and less productive investments would normally reflect themselves in high ICORs, whereas efficient and productive investments would lower the value of the measured ICORs. Though this measure has a number of drawbacks, it is nevertheless useful, and is used frequently in the Bank's country economic analysis. Where natural resources are being rapidly depleted and the depletion is wrongly reflected in growing income, the ICORs measured would be deceptively low, and whatever inference gleaned from them about the productivity of capital, highly misleading. Deceptively low ICORs would result from income being inflated by natural asset sales, with little or no investment having been recorded to generate the extra income apparently obtained. On the other hand if the economy-wide level of investment is itself inflated because the disinvestment of natural capital had not been accounted for, then the measured ICORs would be higher than the true ICORs. On balance, however, if natural capital disinvestment were to be incorporated in the ICOR measurements, the adjusted ICORs will always rise, indicating lower capital efficiency than had been previously thought.211 2/ If natural disinvestment is denoted by d. the fraction that will denote the adjusted ICOR will be I - d instead of the original J , (where I denotes investment and Y income). The adjusted AY - d AY ICOR will always be larger than the unadjusted ICOR (if it remains positive) because I > AY. * 30 - The same argument can be advanced in respect of the usually more sophisticated measurements of partial and total factor productivity which are often used for indicating lines of production that would exploit changes in comparative advantage. If the factors used as inputs exclude natural resources, and if the liquidation of natural capital is confused with value added, such productivity indicators would be spurious, and comparative advantage could conceivably be wrongly identified in activities that would, besides, accelerate natural capital disinvestment.b/ More generally the level of investment actually undertaken in economies whose natural capital is deteriorating may prove inadequate as a means of raising, or indeed sustaining, future income. As Table 4 shows, gross domestic investment in Indonesia, as conventionally reckoned, averaged 24.2% of GDP in the period 1971-84 - a respectable rate which might be regarded as adequate, considering Indonesia's level of per capita income. But a closer look reveals the Inadequacy of Indonesia's saving and investment effort. Column 4 of Table 4 shows that if natural capital deterioration is counted as disinvestment, the true level of Investment works out on average to 8.9% of GDP during this period - a level of gross investment which is highly inadequate by any standard.2J/ Such a recalculated level of investment is in fact approximate since it is a hybrid of gross and net investment: it began as gross investment from which was netted out an estimate of environmental "depreciation." While this new magnitude would be useful for approximating true investment, a more accurate measure of net investment should exclude from gross Investment also all depreciation of human-made capital, and once again emphasis in economic analysis should preferably be placed on the net rather than the gross estimates. While it is true that the new investments (captured in the wrongly calculated 24.2% investment ratio, already cited) have been generating income, the unaccounted-for decline of natural capital is almost certain to reduce the ability of the economy to produce future income. Incorporating natural capital disinvestment in the accounts will adjust income downward, leave consumption unchanged, but reveal a lower level of investment (and saving) than conventionally calculated. The country economist should therefore be drawing attention to the need for such an economy to make an extra effort to save and invest while natural capital is being liquidated, when such an effort would be easier to undertake, rather than wait until the capital deterioration has progressed too far to render resource-mobilization efforts difficult and onerous. For this purpose alone, the economist should be alert to the magnitude of the natural resource depletion taking place. Exchange Rate Policy 21 For a useful exposition of total factor productivity, see Anne 0. Krueger and Baran Tuncer, Estimating Total Factor Productivity Growth in a Devel0Dine Country, World Bank Staff Working Paper No. 422, October 1980. 21/ Strictly speaking the recalculated investment ratio will be 11.1% not 8.9% of the adjusted GDP. From the equality Y - C+I (i.e. income being the total of consumption and investment) it can be seen that C remains the same while both Y and I are reduced by natural capital disinvestment. Originally Y (100) - C (75.8) + 1 (24.2); but adjusted, this becomes: Y (85.3) = C (75.8) + I (9.5). The new 1 (9.5) works out to 11.1% of the adjusted Y (85.3). -31- Another very important policy area that needs special scrutiny is that of the exchange rate. Correcting the exchange rate is a policy drive that recurs practically under all structural adjustment programs supported by the Bretton Woods institutions. The exchange rate is a price of paramount importance, and it provides a common interest between the Bank and the IMF, particularly in the context of adjustment programs. The level of a recommended exchange rate, by agreement of the two institutions, is determined by the IMP, whereas the Bank may discuss exchange rate Rg)jy with the borrower in general terms only. Under structural adjustment operations Bank conditionality in this respect has tended to be to the effect that the borrower observe an exchange rate policy that would ensure international competitiveness, leaving pronouncements on the actual level of the exchange rate to the Fund. For many years the IMF has been applying a formula based on the Purchasing Power Parity theory as one of its principal means to determine a recommended exchange rate level. At the risk of over simplification, this begins with identifying a base year in the past when it is thought that the exchange rate was at a "sustainable" level i.e. when It appeared to be neither over- nor under-valued. [Indications for such a base rate would be a financeable balance of payments on both the current and capital accounts.] An index of domestic Inflation, based on the selected year, is then reckoned and brought forward to the present, and this is compared with a composite weighted index of Inflation in the country's main trading partners. If domestic inflation has exceeded trading partners' Inflation by say 20%, while the nominal exchange rate had remained unchanged, then the domestic currency will have become effectively over-valued in real terms by roughly the same percentage, and devaluation to eradicate the difference will be recommended. Such a simple formula can be a useful rough and ready guide to recommended exchange. rate adjustments, but if applied along the lines set out above it will be next to useless when the balance of payments is propped up by inflows of foreign exchange derived from unrepeatable sales of natural assets. In other words, if part of the exports which figure in the trade balance, and hence in the current account, is of a capital nature, then its proper place should be in the capital account, and the current account will therefore need adjusting to reveal its true position. The current account may in fact be in serious deficit, though the Inflow of unsustainable foreign exchange, earned by unrepeatable natural asset sales, will cause it to appear In surplus, and devaluation would not even be thought of at all as a possible policy Instrument. This situation occurred frequently in the 1970s, especially with respect to oil exporters. A careful analysis of Bank and Fund economic work in that period will probably show the inadequacy of that work in regard to exchange rate policy. But there are other equally serious complications surrounding this approach to recommended exchange rate changes. For one thing, the selection of the base year may itself be marred by the existence of unrepeatable natural capital exports in that year, so the presumed "sustainability"of the exchange rate at that earlier date may itself be questioned. For another, the current availability of foreign exchange (derived in part from asset liquidation, but conflated with current receipts) gives the country access to unsustainable levels of Imports which would tend to dampen domestic inflation and cause the domestic currency (in the light of the purchasing-power-parity approach) to appear to be under-valued, not over-valued as the true situation would reveal. Thus for many petroleum exporters, where the balance of payments was for a time flush with export earnings, devaluation was not advised on the presumption that the domestic currency was not overvalued. - 32 - The above argument is another way of saying that liquidating natural assets generates what has come to be known as a Dutch disease phenomenon, deriving its name from the economic side- effects of the bonanza the Netherlands enjoyed on locating gas deposits. While the new finds provided highly appreciated resources that were allocated to consumption and social security programs to the satisfaction of many, they had the effect of causing certain sectors of the economy to shrink, to the detriment of manufacturing industry and employment. The Dutch disease causes the domestic currency to become effectively overvalued, and thus obstructs exports and encourage imports. Within the domestic economy it upsets the terms of trade between tradeables and non- tradeables in favor of the latter, which then attract resources away from activities that would have employed labor, diversified the economy, and provided a sustainable basis for exports and efficient import substitution. Economists working on natural-resource dependent countries that are prone to the Dutch disease should pay special attention to the problem, and should be thinking early on in terms of domestic currency devaluation in order to move the economy concerned away from its unsustainable dependence on natural resource exploitation, constrain consumption, diversify its industrial base, and set the economy along a more enduring path of economic development. Coming back to the example of Indonesia, we may consider once more the data presented in Table 4. Excluding the impact on the balance of payments of soil erosion and forestry exploitation, we may focus on the oil subsector only since it is largely for export. [About 70-80% of crude oil extracted in Indonesia was exported in the period studied.] If we net out from the current account balance the user cost of the oil sector, as shown in Column 2 Table 1, we arrive at an adjusted current balance that consistently shows a deficit in the period 1971-84. In the earlier part of the period (1972-77) the exchange rate had remained constant at 415 Rupiahs to the U.S. dollar. In that period the current account showed a surplus in one year (1974) and moderate deficits in the rest, with an average deficit over that period of 1.7percent of GDP. Clearly this conventionally calculated moderate deficit was considered commensurate with Indonesia's position as a developing country, dependent to some degree on foreign savings to finance its development, and therefore did not indicate devaluation for the Rupiah. The approximate adjustment of the current account, along the lines described above, as shown in the last column of Table 4, shows an average current account deficit not of 1.7% of GDP, but of 10.0%. Such a substantial deficit - had it been estimated - would certainly have directed attention to devaluation as a possible policy instrument to help Indonesia develop. The calculated deficit would in fact be larger than 10% if the user cost contained in forestry product exports were also to be accounted for. The above strictures on the conventional treatment of natural resource sales in the balance of payments may appear radical, but they would meet with the approval of no less an authority on international trade and payments than Professor Haberler. Writing on the surpluses generated by oil exports in the first half of the 1970s, Haberler wrote: 21 "Nor need I go into the important question whether in a deeper sense the word 'surplus' is not inappropriate, for the reason that these surpluses merely reflect the depletion of an exhaustible resource - of oil in the ground - and do not represent an addition to real wealth." 2W Gottfried Haberler, "Oil, Inflation, Recession, and the International Monetary System," Journal of EneMrgy and Development. Spring 1976, p. 184, note 12. - 33 - In sum, the incorporation of natural resource concerns in economic measurements along the lines elaborated above is essential for properly understanding the process of development in natural resource dependent countries, and for guiding their progress with appropriate macroeconomic policies. Ignoring the depletion and degradation of natural capital from country economic analysis is tantamount to ignoring massive acts of borrowing by the present from the fiture, at no interest, and without the slightest intention of repayment. Sooner or later, however, the cost of such borrowing will have to be met and the economy will suffer the after-effects of a profligacy that could have been avoided by better economic measurement and analysis. Certain Aspects ofTrade Policy International prices of traded goods are used in project analysis to replace domestic prices which may be adulterated by taxes and subsidies, monopoly elements, the impact of exchange controls, and quantitative impediments to trade. "Border prices" (i.e. international prices of goods at the national border) have been applied extensively as shadow prices by Bank economists in the economic analysis of projects: not necessarily because these prices are judged to be ideal or optimal from the standpoint of economic efficiency, but simply on the grounds that they represent a second-best trade alternative through which a country can enhance its welfare. The border price valuation of costs and benefits in project appraisal makes a lot of sense, but, (as argued earlier in the section on Micro and Macro issues) can be inimical to the domestic environment if trade is liberalized while such border prices are artificially low, falling below the full environmental cost of maintaining the natural resource concerned. The drive to reduce trade barriers under structural adjustment programs, therefore, may in some respects unwittingly be a vehicle for environmental damage. Artificially depressed prices for natural resources entering international trade can be produced by various factors. These include outside political power pressure on weaker countries to expand supply; contracts made with foreign concessionaires conducive to accelerated exploitation without regard to the sustainability of the natural resource base; and backward rising supply curves reflecting the low income of the suppliers, combined with a paucity of supply substitutes, so that exporters will react to falling terms of trade by raising sales rather than curtailing them, thus further depressing prices. If free trade in underpriced natural resources is introduced and left unchecked, it will bring harm to the long term interests of natural resource exporting countries. Competition under such conditions could be ruinous to small countries which, individually, will tend to be incapable of protecting themselves from this so-called free trade. Border prices, therefore, may need to be adjusted by shadow-pricing them again in order to take account of natural resource sustainability (i.e. include in them the cost of maintaining a renewable resource, such as in the case of timber, and the user cost of a depletable resource, such as in the case of petroleum). But while this procedure will improve the economic analysis of new projects, it will not bring much benefit to a natural resource-dependent economy that needs to be helped by appropriate macropolicy to protect it from the possibly harmful effects of free trade at less than economic prices. Shadow-pricing apart, it is unlikely, however, that individual countries can put in place the right set of policies that will ensure their protection from such "freedom of trade." This would require concerted action by exporters in the same situation, perhaps aided by international development organizations. But until such situations are recognized, free trade in under-priced commodities should not be seen as self-evidently beneficial for primary product exporters. This .34- concern should be considered seriously when structural adjustment operations are being designed, containing the now almost standard approach of trade liberalization. - 35 - Table 4 INDONESIA: IMPLICATIONS OF GDP ADJUSTMENT FOR INVESTMENT AND THE BALANCE OF PAYMENTS 1 2 3 4 8 6 ar Total..AdW ent Adfustment for Oil Grs Domesi Adiustd Gmss CuAised Curn Inveset DOMestic Investment Account Balatte Account Balance M of OD) (I of O . ( D (% of ODP (% of ODP)- (%..f_G-DM 1971 -10.8 .4.3 18.4 6.6 -4.2 -8.5 1972 -13.6 6.2 21.8 8.2 -3.3 -9.5 1973 -19.3 -9.1 20.8 1.5 -3.1 *12.2 1974 -14.9 .6.4 19.5 4.6 2.0 -4.4 1975 -10.0 5.5 23.7 13.7 -3.5 *9.0 1976 *15.8 -9.7 24.1 8.3 -2.3 -12.0 1977 -16.8 *11.2 23.4 6.6 -0.2 *11.4 1978 .15.6 -10.1 23.9 8.3 -2.6 -12.7 1979 -19.8 -8.6 26.6 6.8 1.7 -6.9 1980 1 -18.5 -7.8 24.3 5.8 3.6 4.2 1981 *14.1 -7.3 29.6 15.5 *0.9 -8.2 1982 -11.0 *5.9 27.5 18.5 .5.8 -11.7 1983 -14.2 -5.9 28.7 14.5 -7.5 -13.4 1984 -10.5 6.1 26.2 5.7 -2.2 -8.3 Average 14.7 -7.4 24.2 8.9 -2.2 *9.5 aggggi Data on GDP, Domestic Investment, anx Current Account Balance are from World Bank, World Tables, 1991. 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Unpaid housewife work is one example of activities left out. Besides, many subsistence activities, and an unknown (but believed to be growing) quantity of "underground" transactions (including tax-avoiding or illegal trade) escape enumeration altogether, and are left out of the gross domestic product. Such "leakages" from the measured income stream clearly undermine the value of the conventional measurements u%ich focus only on recorded transactions. However, very few voices have been raised against the continued use, for the purpose of economic analysis, of conventional measurements of macroeconomic aggregates that are recognized to be only partial.22/ Difficulties of AgMiVZ on a -Comon Methodology Perhaps even more importantly than difficulties already cited, the quest for adjusting the national accounts to reflect environmental change, which began hesitantly from seeking to devise an overall physical indicator of change, and developed into proposals to revise the United Nations System of National Accounts (SNA) seems to have come up against an impasse. Towards the end of the 1980s, after years of debate and explcration, a certain consensus had finally been reached regarding the SNA that (a) the accounts should be adjusted to incorporate natural capital depletion and degradation; and (b) since some aspects of the new accounting had remained controversial, the adjustment of the SNA would not be made in the "core"accounts, but only peripherally in so-called "Satellite Accounts." The machineries for setting up the format of the satellite accounts and producing guidelines for their realization have been slow and cumbersome, and have involved the participation of many individuals and institutions of diverse outlooks and mandates. The methodologies used in elaborating the new guidelines have therefore been hesitant and eclectic, and have tended to suffer from lack of rigor, and from an unclear economic vision. Much attention has been paid to building up an integrated system of balance sheets and flow accounts, while sight has been lost of the relative unimportance for economists of the balance sheet. Besides, balance sheet variations would automatically be brought into income estimates to the detriment of the latter. In many cases both the volume and the value attached to environniental assets in the balance sheet woluld bCe controversial, certainly partial, and besides, subject to sharp fluctuadons, from year to year. The integration of such yearly changes into the flow accounts would bring unwarranted elemments We as volatility into income estimation, ultimately producing economically meaningless measurements of income that would obscure true economic performance. This can only serve to undermine the credibility of the exercise. "Satellite" Economic -R-epollingz 22/ Monetary policy analysts in particular do not seem to be too concerned about this issue, justifiably claiming that a partial, but consistent, series of national income can still be valuable for analytical purposes and as a guide to policy. I owe this point to Paul Chabrier of the IMF. - 38 - Until the arguments presented here have been accepted within the Bank and elsewhere, and incorporated in economic and sector work, perhaps a "fall-back" approach might be useful as an interim measure. Just as it has been decided at this stage to confine environmental adjustments of national income to satellite accounts under the new SNA, the country economist might initially confine environmental adjustments of performance measurement to a "satellite"part of the Economic Report and strategy documents he or she is preparing, where a number of back-of-the-envelope calculations may be made to gauge the dimensions of natural resource depletion and degradation, and where he or she can carry out soire re-assessment of income and its growth and explore the implications of these for policy prescriptions. In this task, the economist would be helped greatly if the state of the environment, including natural resources, were given adequate space in country economic reports, and if physical indicators of environmental change were periodically produced. The analysis would certainly benefit if these were used imaginatively in the course of economic reporting and existing policies affecting natural resources identified. Physical indicators might include, as appropriate, the rate of deforestation, the reserves and life expectancy of mineral deposits, the state and change in the fish wealth, water (quantity as well as quality), soil, pollution, etc. The implications of approximate re-estimations of the accounts for savings and investment, the balance of payments, domestic terms of trade, and the like should then be investigated as proposed above, so that more realistic economic policies can emerge. -39- VII. CONCLUDING REMARKS This paper has attempted to address the concept of sustainable development from the point of view of correct income measurement that relies unavoidably on the notion of keeping capital intact. It has drawn attention to the poverty of macroeconomic analysis where the physical base of natural resources is eroding, while misleading indicators of satisfactory growth are recorded. The dichotomy currently existing in Bank work, as well as in the work of others, between the physical environment and measured economic aggregates is false and unhealthy, and the two worlds of economics and of natural resources should be combined in an attempt to improve the economic analysis and policy proposals for natural resource-dependent economies. The problem will not go away simply by improving project analysis to accommodate environmental concerns. Project analysis should improve, but it is not sufficient to address the macroeconomic issues identified in this paper, including spurious measurement of country performance; overestimation of the creditworthiness of natural resource-based economies; and ascertaining whether the current account of the balance of payments is in deficit or surplus, and whether the savings/investment effort of such economies is adequate. Proper national income accounting to reflect natural resource changes is imperative as a first step towards sustainability, and an action program needs to be devised in order to re-estimate income for a selected group of natural resource-dependent economies, to sensitize country economists to the problem, and to train those who need training in appreciating the implications for economic policy of adjusting incomes and other macro-aggregates to reflect environmental deterioration. The adjustment to income that needs to be made is likely to be appreciable, and therefore worth undertaking, in the case of a large group of developing countries, and the calculations advanced here to the effect that the adjustment may be about 15 percent of GDP for Indonesia, illustrate that such an exercise will probably yield significant results. If the arguments advanced in this paper are accepted - and for this a series of discussions needs to be initiated - these arguments should be incorporated in the relevant Operational Directives, and a program of application in actual country situations be devised and implemented, and become a major area of environmental concern to be monitored periodically in the process of recording environmental progress within the Bank. Meanwhile, active preparation should begin without delay of physical indicators of environmental deterioration, to complement. the numerous short term economic measurements that make up the bulk of the statistical annexes to the various Operational Directives dealing with country economic reports, policy framework papers, country strategy papers, structural adjustment loans and the like. Appendix B briefly surveys the relevant Operational Directives, drawing attention to the fact that many of them do encourage coverage in Bank reports and analyses of natural resource changes. In some respects certain amendments to the ODs are proposed in an attempt to address the issues raised in this paper. -40- APPENDIX A INCOME FROM DEPLETABLE RESOURCE EXTRACTION This appendix largely reproduces a part of my 1981 paper (gg. cit.). It is assumed that receipts from the sales of a depletable natural resource are net of extraction cost. The extraction cost contains elements that do not directly generate value added, such as materials used as inputs in the process of extraction, but would normally also contain payments to factors of production, which should be included in GDP in the usual way. A time series of expected net receipts R from the sale of a resource which, as a result of exploitation, will come to an end in a future year n contains a true income element X, where X < R, such that if R - X (the capital content) is invested year after year at interest rate r, the accumulated investment will ensure that the owner will be able to draw the same level of income X indefinitely even after the resource has been totally exhausted. It is possible to identify X/R, that is the proportion of net receipts that can truly be called income, and its complement 1 - X/R, the capital element (or "user cost") as a proportion of net receipts. This can be done by equating the capitalized value at interest rate r of the finite series of receipts R with the capitalized value at the same interest rate of the infinite series X. The capitalized value of the finite series R, accruing in equal amounts over a period of n years, would add up to: 1 E R * - R ( 1 +1 ) no 0 1- And the infinite series X would add up to: X* X 0 1+r Setting n d SR = X*', 0 0 and multiplying by the denominator in both quantities, we get: Dividing by R: -41- X=R[I- 1 (1 + r) n X/R = 1 -+ 1 X/R=1- (1 + r)12not and I1 - X/R + 1 * (1 + r o In this formulation, it is assumed that the receipts R accrue at the beginning of each accounting period. If, alternatively, they accrue at the end, the fraction X/R will be 1- 1 (1 + n It is also assumed that the relative prices of the resource and the goods and services on which the stream of income will be spent do not change. If there is reason to believe, for instance, that such goods and services will appreciate over time relative to the resource, the capital element to be set aside has to be larger (and the income content smaller) to make it possible to maintain a constant income stream in real terms. The converse is true if there is reason to believe that the resource would appreciate relative to the goods and services that would make up future expenditure. But these are refinements that could be incorporated in the method suggested and would not affect much the results obtained. The method proposed, with the implicit assumption of constant relative prices, seems adequate if the direction in which future relative prices will change is uncertain. This method does not rely on the assumption that the resource will be exploited in equal installments over its life. The future profile of exploitation can be entirely flexible, changing from year to year. For any one year, however, the accountant must ask what the proportion current extraction makes of the remaining stock. The discount rate is an arbitrary rate selected to approximate the prospective yield on investing the equivalent of the user cost, and to guide the owner's decisions about the rate of exploitation. The discount rate may be changed periodically in the light of market behavior. It should be noted that this method can handle new discoveries which augment the known reserves. Rather than add the value of new discoveries to income along the lines of the World Resources Institute's study of Indonesia, the new discoveries will just raise the life expectancy of the resource if extraction rates remain unchanged, or alternatively cause the owners to raise the rates of extraction. Either way the result would be a higher level of "true income" than hitherto. Clearly, it would be erroneous to inflate national income by the mere discovery of new deposits which are yet to be exploited. -42- The "user cost" represents a disinvestment, and should not be included in the gross product at all, so that no further adjustment to the net product would be needed on account of resource depletion. However, if the gross product continues to be inflated by leaving in it the whole of R, then the proper magnitude of the "depreciation," to reach an adjusted net product, will be the quantity identified here as a "user cost." In this case the "user cost" indicated by this method will always lead to a level of net product lower than that of gross product - which is how it should be. -43 - APPENDIX R OPERATIONAL DIRECTIVES The arguments presented above, if accepted, draw attention to certain weaknesses in the Bank's country economic work as carried out at present, whether at the reporting stage (i.e. drafting economic reports) or at the stage of economic analysis and policy formulation. Of course, some country economists are aware of these issues, and manage to bring to their country work a most needed longer term perspective. Besides, many agricultural economists and other sector specialists, can hardly be faulted on this score, as they show awareness of the importance of the physical environment in which the activities they design and supervise are set. This has been clear especially in the case of specialists dealing with soil erosion, water resource development, desertification, animal husbandry, drainage, water clogging and salination, and many others. What is lacking, however, is the integration of such elements into an economy-wide analysis, and the reflection of these diverse considerations in a comprehensive macroeconomic approach leading to proper policy formulation. The country economist is the agent within the Bank who is best placed to carry out such integration. The Role of Operational Directives Operational nirectives provide guidance to Bank staff on how best to organize their various activities, and present these in an acceptable and fairly uniform format. The efforts and documents produced in the process of drafting these directives absorb great resources, and the Directives are often written by knowledgeable and experienced persons. Besides, they go through many iterations, and benefit from many rounds of internal discussion in an attempt to incorporate in them the experience and insights of various Bank units. While it may be true that Operational Directives may remain unread by some practitioners, they nevertheless constitute a stock of reference material to be consulted by new staff, and by all staff when doubt is raised about document contents, formats, methods or procedures. A few relevant Operational Directives are considered below in order to assess their possible role in improving country economic work along the lines suggested in this paper. Country Economic and Sector Work Operational Directive 2.00 on "Country Economic and Sector Work", issued in March 1989, rightly stresses that country economic and sector work is "a key element of the Bank's assistance to its borrowers,"and that it should "provide a thorough understanding of their development problems, of the need for and availability of external financing, and of the analytical framework for evaluating development strategies and donor assistance activities." This OD further states that an important objective of country economic work is "to inform the Bank and member countries of the situation, prospects, and creditworthiness of borrowing countries." The "long term quality and sustainability of development" is specifically cited in OD 2.00 (para. 2) as depending on factors such as "the causes, manifestations, and treatment of poverty, the efficacy of economic institutions, and the environmental effects of alternative policy options." -44- The continuity and variability of country economic work and its inter-connections with Bank country strategy is further stressed (para. 5) where the OD draws attention to the fact that "CESW is a systematic, continuous program of investigation and analysis, whose specific objectives are determined within the Bank's country strategy." Paragraph 10 of OD 2.00 further states that "although devoted primarily to macroeconomic policy issues and analysis, the CEM also integrates the analyses and policy recommendations flowing from Bank sector work." From the foregoing, it can be seen that there is enough material in the OD on country economic reports that can be used imaginatively by a country economist who is aware of the issues discussed in this paper. But the general drift, as well as the structure of the OD, however, shows lack of specific concern for changes in the natural resource base. This omission Is highlighted by the coverage specified in the annexes depicting the various variables, parameters, ratios and growth rates that must be worked out in country strategy papers. These clearly ignore physical environment indicators of change, which could conceivably be included in the Country Data Sheet (Annex 1.) Once the thrust of this paper is accepted, a section on "Macroeconomic Policies and the Environment," incorporating the arguments presented in this paper will need to be added quite early in OD 2.00, preferably under "Purpose, Scope and Approach." The addition of a set of physical indicators of environmental change is further considered below. It would be useful if every Country Economic Report were to contain a chapter devoted to environmental change, summarizing evidence gathered from environmental reports, issues papers and other relevant documents, and identifying economic policies that impinge on the environment. Country Strategv Paners Country strategy papers are documents internal to Bank management, and are disclosed outside Bank management only in part as has recently been agreed with the Board for IDA- borrowers2/. The importance of these documents for marshalling Bank resources in support of its borrowers cannot be exaggerated, and much effort and resources are therefore expended in their formulation, again with wide participation from the various units that make up the World Bank. As mentioned earlier, OD 2.00 specifically stresses the importance of country economic and sector work for the formulation of Bank country strategies. Such strategies pick up the major issues identified in CESW, and mold them into a coherent approach to development in the country concerned, identifying a role for the Bank in such an approach. Unless the environment is properly covered in CESW, such strategies would be spurious in situations of defective degradation of the resource base. 2QI The practice has been established that a summary Bank country strategy is included in the President's report for the first structural adjustment operation in the country concerned in every fiscal year; otherwise, if no structural adjustment operation is planned, then this summary would be included during presentation to the Board of the first investment loan in the fiscal year. This practice is now being re-considered to include 4so IBRD borrowers, but instead of being so comprehensive, the intention is to present the summary strategy not every year, but following the normal cycle of strategy papers, i.e. every three years or so. .45 - Operational Directive 2.10 on Country Stratem Operational Directive 2.10:Country Strategy Papers, issued in September 1990,ismore recent than OD 2.00, and urges staff to focus on key issues of country strategy worthy of senior management's attention. It stresses the need for realism, attention to creditworthiness, and Bank exposure. The revised annexes emphasize creditworthiness and exposure indicators, and contain a new supplementary tab!e on debt workouts for countries with projected arrears, a new table on money and credit with optional projections, and a new optional Private Sector Account. [See Operational Directive 2.10: Country Strategy Papers, Manual Transmittal Memorandum para 2.(h).] The optional annexes would become mandatory once training of staff had been completed. The "Socioeconomic Data Division (IECSE) of the International Economic Department will ensure that templates for these annexes are available to country economists." (Same Transmittal Memorandum, para.4). It has been standard practice for CSPs, and their earlier predecessors, the Country Policy Papers, to project the major country economic variables ten years forward in an attempt to capture development trends. In its new version the OD emphasizes the importance of the long view "for the analysis of external debt issues." [Para.6.] But it fails to mention the sustainability of the natural resource base which is essential in its own right for projecting future development, as well as for creditworthiness assessment, and for judging the external debt burden. There is much emphasis in these projections on the usual short term Indicators, albeit extended over the longer term, without specific reference to the state of natural resources. True, population growth is in the background particularly as it affects per capita consumption, but there is no transparency or attempted comprehensiveness regarding natural resource coverage. Nowhere in OD 2.10 is the concept discussed of sustainable development in the context of the natural resource endowment of the country concerned. While "Natural Resources" are mentioned in Annex A of OD 2.10as part of the "Social Indicators of Development," the ones specified are extremely limited and confined to area, population density, agricultural land and its density, forests and deforestation rates. Access to safe water is curiously included under "Natural Resources." Clearly missing in this coverage are subsoil deposits and their life expectancy at current exploration rate, soil erosion, water supply, pollution indices, fisheries stock trends, and similar physical indicators of the resource base. As complete a set of environmental indicators as possible should be mandatory in the annexes to strategy papers, and this should be the responsibility of the Environment Department to produce, after preliminary work had been carried out by the Regional Environment Divisions. Poliev ramework ae Operational Directive 2.20: "Policy Framework Papers" was reissued in October 1989 in a revised form. Among several changes, this version specifically draws attention to (a) incorporating "social and environmental, as well as macroeconomic, sectoral, and institutional issues", and (b) "Setting out priorities for policy action to highlight key policy areas." PPPs are prepared for all countries eligible for IMF's Structural Adjustment Facility (SAP) or the Enhanced Structural Adjustment Facility (ESAF). These documents are properly described as "vehicles"for governments to record agreements with the Bank and the Fund "on the broad outline of medium-term programs to overcome balance of payments problems and foster growth." The role of these documents in "achieving consensus" between the Bank and Fund on appropriate medium- .46- term adjustment programs is highlighted (para. 1), but missing is the use of these documents as stepping stones in the drive by the Bank to help realize longer-term development in these countries - - a responsibility to which Bank economists, much more so than Fund economists, should be paying special attention. OD 2.20, however, cannot be faulted for neglecting the longer-term perspective of development. Paragraph 3 specifically states: "Although a PFP focuses on a three-year period, it should indicate in broad terms how the proposed program relates to the country's longer-term development priorities, and what it does to overcome the more fundamental constraints to development.' It goes on to say that: "PFPs should maintain an adequate balance In the coverage of macroeconomic, sectoral, social, environmental, and institutional aspects." However, owing to the fact that such documents tend to be initiated in the M , and are processed swiftly through the Bank's management and the Board, so that specific Fund operations can get approved on time under the SAP or ESAF, Bank staff tend to leave much of the drafting of these documents to the IMF, so that the longer term perspective of development, insisted upon in OD 2.20, tends to get neglected. What is required in this respect is that the country economist should be anticipating the PFP, and preparing in good time a set of issues making up a program that balances short and medium concerns with longer term development considerations Including protecting the natural resource base. For this purpose, much preliminary work on the environment needs to be undertaken as part of CESW, and related analytically to the issues of long term economic and social development. Adjustment Londing Directives Two ODs are currently under preparation [8.60 on substance and 9.10 on procedures] to guide structural adjustment lending operations. These are not new initiatives, but have antecedents that go back in time to the Inception of structural adjustment lending twelve years ago and have been periodically updated. Preparation of OD 9.10ismuch more advanced than that of OD 8.60,and both drafts are of course still subject to change. As these stand, there Is hardly any reference in them to the physical environment within which structural adjustment takes place. Nor do the mandatory annexes that have to be produced for adjustment operations cover the state of the natural resource base even where this is likely to affect future performance. As stated earlier, until country economic and sector work covers this aspect of the economy, properly producing physical indicators of natural resource change, and identifying policies that should be manipulated to maintain the natural resource base, individual structural adjustments operations are unlikely to be an effective vehicle for environmental protection. In other words, it is the quality and coverage of economic work that have first to improve, before this can be fed into country strategies and get incorporated in country -47- operations, including those for structural adjustment. Once country economic work has taken care of the issues identified here, the desired changes will fall naturally into place. Structural adjustment programs have to be placed within a projected medium term macroeconomic framework, and unless future changes in the natural resource base are captured in such a framework, the latter would fail to be useful. Sandard Statistical Annexes During the recent drive to produce a new set of ODs to replace the old collection of Operational Manual Statements on Bank operations, an effort was made to standardize the set of statistical annexes that are appended to country strategy papers, adjustment operations and similar documents in an attempt to minimize the burden falling on the country economist who is usually responsible for overseeing the production of such annexes. If it is accepted that a new set of physical indicators of environmental change should be produced and annexed to economic documents, including PFPs, this should also be standardized and annexed without change to the various documents in question. Environmental Action Plans (EAPs) The last OD to be considered here is Operational Directive 4.02: Environmental Action Plans, which was issued as recently as on July 21, 1992. This aims to provide guidance to staff "for assisting borrowers in preparing country environmental action plans." During the IDA-9 Replenishment it had been agreed that all IDA borrowers should complete BAPs by the end of IDA- 9, i.e. by June 1993. Subsequently it was decided that EAPs would be initiated for IBRD borrowers also. The OD's Manual Transmittal Memorandum (MTM) adds that if the June 1993 deadline "proves impossible" the Bank "must be satisfied that (a) preparation of a suitable country environmental strategy is well advanced, and (b) preliminary findings from the preparatory work have been incorporated into the Bank's country assistance strategies." (MTM, para. 3.) The incorporation of environmental issues in country assistance strategies is emphasized throughout the OD, together with the understanding that the BAPs need not be embodied in a specific document. What these plans should do is "setting forth a long-term national environmental policy and investment strategy based on comprehensive environmental analysis." (OD 4.02- Annex A, para. 1.) The OD further stresses that BAPs should indicate "priorities and related policy recommendations" in various areas, including setting "an information system for monitoring the state of the environment.... and ....the management of natural resources..." (Tgg.,para. 2.) According to OD 4.02, the BAP should recommend an overall plan for environmental policy and investment strategies affecting the priority issues defined in the rest of the RAP and the country's overall development plans [Annex A, p. 4 (h)]. Among such priorities, the OD specifically mentions (emphasis added): "Analysis of major development activity. and trends in economic .rowth..resource use. and conservad . This analysis covers major sectors - agriculture, forestry, industry, transportation, energy, housing, Infrastructure, education, health and social services, mining, parks, and tourism - with special reference to the environment in all cases.* -48 - The OD further states that: "The analysis also identifies specific constraints on future economic growth," including shortages of arable land and water ... and ... "degradation and depletion of coastal zones, forests, soils, energy, and other natural resources..."(Annex A, d.) In sum, this OD is both comprehensive and clearly geared to integrating environmental trends in country strategies. If the EAPs actually produced manage to be faithful to the spirit of this OD, all that remains to be done is to ensure that BAPs are produced to the high standards indicated, and to see to it that once done, they are periodically revised and integrated in country economic work along the lines proposed in this paper. It would be interesting to examine some of the EAPs completed so far to see if any of them can match up to the very high standards indicated in OD 4.02. But in order for the provisions of OD 4.02 to affect country strategy as intended, OD 2.10 itself (dealing with Country Strategy Papers) should be amended to incorporate these worthy environmental concerns. .49- REFERENCES CITED Adelman, M.A. et.al., User Cost In Oil Production. MIT Center for Energy Policy Research, October 1990. 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