Long an enigma to most observers, the Euro-currency market

is now becoming the focus of wide attention as it has

become an important component of the world economic scene.
The author analyzes its growth and future role.

The Euro-currencymarket
inperspective
Eisuke Sakakibara A newcomer to the literature on the Euro- its implications. This extremely rapid
currency market may seem to need, at growth apparently encouraged the use of
least, a course in witchcraft, magic, and the word magic and, for want of a better
the mind of Sherlock Holmes, for it explanation, suggested a comparison with
abounds with allusions to "mystery," other cases of supposed economic magic,
"puzzles," "magic," and so on, by some like the deposit multiplier process so
of the most distinguished contemporary familiar in the context of a domestic
economists. Professor Machlup alludes, banking system. Although subsequent
on one occasion, to The Euro-Dollar Mar- debate sought to expose much of this
ket: A Mystery Story, and on another to trick, considerable concern developed
the similarities between Euro-dollars and about both the market's influence on the
a "magician's rabbits"; Charles Kindle- effectiveness of domestic economic poli-
berger devotes himself to Two Puzzles of cies, particularly the monetary ones, and
the Euro-Dollar Market, while Milton the market's contribution to world infla-
Friedman is inclined to attribute it all to tion because of its effective expansion of
the magic of a mere bookkeeper's pen. the world's money supply. More recently
There are, of course, many factors this concern spread to the market's role
which have contributed to this mystery in destabilizing short-term capital flows
and confusion. First, the lack of statistical and in the "collapse" of the international
data and qualitative information on the monetary system.
market has made it difficult to determine Third, and the most important source
the precise nature and extent of Euro- of mystery and confusion, has been the
currency operations. The absence of data, lack of an appropriate theoretical base
in particular, has encouraged observers and a broader perspective for discussions
to make more or less informed guesses on the Euro-currency market. This need
about the relative orders of magnitude is most obvious when discussions con-
involved; guesses which unfortunately centrate on policy questions like the con-
are often influenced by analytical con- trol of the market, particularly when
cepts frequently used in relation to do- there is an attempt to compare alternative
mestic money markets such as a multi- methods of control.
plier model, and which may have little
relevance in the international sphere. The multiplier analysis
These problems have been compounded Since the dominant institutions in the
by the rapid changes in the nature of Euro-dollar market are commercial banks
Euro-currency operations and institutions it seemed a logical first step to draw a
as the market has matured. parallel between the Euro-banking system
Second, the little statistical data that is and a typical domestic banking system,
available suggests an extremely rapid and to argue that the deposit expansion
growth in the net size of the market. As or money multiplier model, which is gen-
a result, a large part of the literature has erally applicable in the domestic case, is
been devoted to explaining the growth of also a relevant conceptual framework for
the Euro-currency market and to debating discussion of the Euro-dollar market.
11

©International Monetary Fund. Not for Redistribution

 Typically, analysts adopted a fixed coeffi- ing equilibrium within a reasonable time bases of major industrial countries of the
cient version of the deposit expansion span may not be justified. world. The Euro-market has simply func-
model, which assumes that the public In the domestic markets where there tioned as a distribution system for trans-
holds a fixed ratio of currency to bank are legal reserve requirements and ceilings mitting the monetary expansions of one
deposits and that banks hold a fixed ratio on interest rates charged on time and country to other countries of the world.
of reserves to deposits. Having calculated demand deposits, it may not be too Second, our findings showed that the
the relevant multipliers they attempted to unreasonable to assume continuous dis- idea of controlling the Euro-currency
appraise the credit creating power of the equilibria. The Euro-currency market, how- market as a means of regulating the
Euro-banking system on the basis of a ever, is characterized by a lack of bank- overall level of global liquidity seems to
given primary deposit or increase in ing controls, the interest rates in the lack the appropriate conceptual base.
reserves. This type of multiplier model Euro-market move flexibly, and the adjust- However, this should not preclude the
essentially implies disequilibrium, and ments of both depositors and borrowers possibility of some form of official inter-
continuous expansion of credit until some in the markets are fairly fast. vention in these markets for other pur-
constraint intervenes. Under these conditions, it seems far poses. The Euro-currency market provides
Initially, few people disputed the appli- more reasonable to adopt an equilibrium the vital link between the national finan-
cability of the multiplier analysis, since model where the Marshallian scissors of cial markets of the world and, therefore,
the debate was essentially confined to the supply and demand, rather than the insti- some form of close surveillance and fine
magnitude of the assumed leakage ratios. tutionally determined multiplier, deter- tuning may be warranted for the effective
It was thus a simple matter for the "low- mine the output of the banking services. monitoring of the world economy. In
leakage-high-multiplier" school to attrib- this interdependent world, where one
ute the net size of the market, and its The general equilibrium model economy cannot be isolated from devel-
rapid growth, to the inherent magic of In an empirical study conducted by the opments in others, problems of one area
the deposit-expansion process, while the author with John Hewson within the of the world economy are soon trans-
"high-leakage-low-multiplier" school was framework of a general equilibrium mitted to other areas. This increasing
forced to resort to alternative explana- model, it was suggested that at most the interdependence and the greater interna-
tions of the market size and growth. Euro-currency deposit multiplier was tionalization of the economies of the
More recently, however, several writers around unity in the period 1968-72. world have been major undercurrents of
have withstood the temptation of associ- ("Euro-dollar deposit multiplier: a port- the rapid growth of the Euro-currency
ating with either school, choosing instead folio approach," International Monetary market.
to abandon the multiplier analysis—at Fund, Staff Papers, July 1975.) At least
least in its simple fixed-coefficient form— two important implications are to be Greater internationalization and
as a conceptual framework for analyzing drawn from this finding. First, the impact increasing interdependence
the Euro-dollar market. Essentially, two of the Euro-currency market on the world The development of Euro-currency
main criticisms have been leveled against money supply has not been very signifi- banking within the general equilibrium
the simple multiplier analysis. First, some cant, and the Euro-currency market by system of international and domestic
writers have warned against interpreting itself has probably not been the source of finance can best be characterized as the
the total Euro-dollar deposit figure as a much inflationary pressure. Hence, expla- logical result of the internationalization
measure of liquidity created by the Euro- nations of the source of world inflation- and liberalization of banking operations
dollar market (or of the net credit impact ary pressure are to be found elsewhere, that have traditionally been closely con-
of the market). Therefore, they are such as in the expansion of the monetary trolled by national authorities. It is not by
against interpreting the multiplier as an coincidence that the return to external
indicator of the liquidity impact of a convertibility and the substantial relaxa-
given primary deposit or reserve base Eisuke Sakakibara tion of exchange controls throughout
change, as indeed each is in the context Western Europe in 1958 were instru-
of a domestic banking system. It is ar- mental in initiating Euro-currency bank-
gued that positive asset transformation ing operations. The elimination of these
(lending long-term on the basis of de- a Japanese citizen
exchange and capital controls, along with
mand deposits), which is the essence of currently with the the competitive edge enjoyed by Euro-
liquidity creation in a domestic banking Ministry of Finance, currency banks over their U. S. counter-
system, may be less prevalent in the Japan, was an parts in being able to operate without any
Euro-currency market. Therefore, instead economist in the restrictions in the form of interest rate
of primarily creating additional liquidity Exchange and Trade ceilings and legal reserve requirements,
Euro-banks function more as a distribu- Relations Department of the Fund when seem to have been important factors in
tion system for existing liquidity, from this article was written. He is a graduate of the subsequently rapid growth of the
areas of surplus to areas of deficit all over the University of Tokyo and received Euro-currency markets.
his doctorate in Economics from the Thus, it may be reasonable to attribute
the globe.
University of Michigan. Mr. Sakakibara
Second, it has been argued that the collaborated with John Hewson on a the emergence and the expansion of the
conditions assumed by the simple multi- research project on which this article is Euro-currency market to the liberalization
plier framework—specifically an exoge- based and on a book The Euro-currency of exchange and capital controls and the
nously determined base and stable reserve Markets and Their Implications. He is resulting international competition for
and currency leakage ratios-are not evi- also the author of numerous articles on more efficient and cheaper banking oper-
dent in the Euro-dollar market. For international economics and economic ations. Although the increases in the U. S.
example, the assumption that the Euro- theory in professional journals. balance of payments deficit during the
currency markets are incapable of achiev- late 1960s and early 1970s have often
12

©International Monetary Fund. Not for Redistribution

been cited among the major stimuli to the
growth of the Euro-currency market, the
direction of causation is not clear cut. The
development of relatively free interna-
tional banking, prompted in part by the
existence of interest rate regulations in
the United States, would cause short-term
capital outflow from the United States,
and, therefore, a deterioration of the U. S.
balance of payments on both a liquidity
and official settlements basis. Thus, the
deficits in the U. S. balance of payments
could be called the result, and not the
cause, of the rapid expansion of the
Euro-currency market.
It seems proper, therefore, to view the
development of the Euro-currency mar-
kets in the broader context of the general
process of internationalization of eco-
nomic activities involving trade, direct
investment, portfolio investment, and
short-term to medium-term banking oper-
ations. The development of Euro-currency
operations, along with the rapid expan-
sion of international trade and invest-
ment, has indeed changed the basic struc-
ture of the world economy during the
past decade or so. The world has moved
from a regime of relatively controlled
international activities toward that of
comparatively free international trans-
actions. The internationalization and liber-
alization of short-term to medium-term
international capital should be viewed as,
more or less, the beginning of the final
stage of this transition from a compara-
tively controlled to a free regime in place
of the somewhat rigid Bretton Woods
system of international finance.
The 1960s and early 1970s may, there-
fore, be viewed as the transition period
from the U.S. dominated and tightly con-
trolled international economic system to
a freer system where the U.S. influence
is less dominant. The rapid expansion of
the transactions of international banks
in the Euro-currency market, as well as
the activities of other nonfinancial multi-
national corporations, has served as the
vehicle for this transition. Although the
Euro-banks and other multinationals have
often been accused of creating unneces-
sary disruption in world markets, this
allegation would only be true if the world
economy were still operating under the
old regime, or if the world could or should
revert to the old controlled system.
The effects of capital controls
Throughout the late 1960s and early
1970s many of the authorities that con-
stitute the official sector repeatedly at-
tempted to react to observed develop-
ments in the private sector of the world
©International Monetary Fund. Not for Redistribution
economy. Consequently, there were nu-
merous instances where these authorities
attempted to fix exchange rates through
official intervention either with or without
the imposition of new controls on short-
term capital transactions. Only lately has
the official sector of the world economy
begun to realize that such attempts to
control private capital transactions in the
international money and capital markets
are, in general, not feasible in the present
international environment, where the in-
ternationalization of private transactions
has progressed to such a degree that some
way is almost always found to circumvent
these controls or to force further and
increasing corrective action to be taken.
It is quite ironical that the imposition
of exchange and capital controls in some
developed countries in the late 1960s and
the early 1970s was one of the key fac-
tors in the rapid growth of the Euro-
currency market during this period. Since,
in most cases, the controls that were
instituted during this period were not
intended to completely choke off all inter-
national transactions, there was always
some way to circumvent them. The proc-
ess of circumventing these controls gen-
erally produced an expansion in the vol-
ume of Euro-currency transactions. For
example, the imposition of a host of
capital controls in the United States in
1968, supplemented by tight monetary
policy during the period, increased the
activities of overseas branches of Ameri-
can banks by tremendous amounts in
1968 and 1969. The assets of overseas
branches of U.S. banks more than dou-
bled during these two years, from $15.7
billion in 1967 to $41.1 billion in 1969,
while the number of overseas branches
jumped from 295 to 459 in the same
period. Similarly, the activities of foreign
branches of German banks, particularly
in Luxembourg, expanded quite rapidly
in the early 1970s following the imposi-
tion of the minimum reserve requirement
on German banks' external liabilities.
According to published annual accounts
at the end of 1971 and the beginning of
1972, the consolidated balance sheet of
the subsidiaries of large German banks
in Luxembourg alone was some DM 6
billion, compared with DM 2 billion a
year previously. The bulk of this increase
was thought to be the result of offsets to
the control.
Therefore, had it not been for these
controls, New York, as well as other
smaller money markets such as Frankfurt
and Paris, probably would have kept pace
with the growth in London, Luxem-
bourg, and other Euro-centers as the vol-
ume of international transactions in trade
and capital expanded. The imposition of
controls served to concentrate these free
transactions in short-term capital in Lon-
don and, to a lesser degree, in Luxem-
bourg, and other "off-shore" Euro-centers.
However, the increasing volume of aggre-
gate international transactions in short-
term capital was the consequence of the
internationalization of economic activities
of the countries of the world and not the
result of the imposition of capital con-
trols. The imposition of capital controls
should perhaps be viewed as a futile
attempt by the official sector of the world
economy to retaliate against the increas-
ingly strong waves of internationalization
in the private sector and such attempts
only encourage private transactors to
search for ways to circumvent them and
this serves to skew the geographical dis-
tribution of these transactions to the areas
of the world economy where controls are
absent.
Recent developments and the future
In 1974 the Euro-currency market went
through a difficult period of adjustment
as the world economy strived to adapt
itself to a new environment after the
quadrupling of the oil price late in 1973.
By the middle of the year, confidence in
the market was strained by the announce-
ment of foreign exchange losses and a
number of much publicized bank failures,
although these losses were not directly
connected to Euro-market business. Con-
cern also spread that Euro-banks could
not continue to play a major role in
recycling oil surpluses because of capital
inadequacy of commercial banks and
because of the difficulty of maturity
transformation that was required in oil
financing. Danger of the lack of a clearly
defined lender-of-last-resort in the Euro-
market was also emphasized in relation to
this problem of maturity transformation
and the deteriorating creditworthiness of
some borrowers in the markets.
Furthermore, it was feared in some
quarters that the termination of U. S.
capital controls in January 1974 would
strip the Euro-currency market of its
raison d'etre as a substitute market for
New York.
Indeed, the gross side of the Euro-cur-
rency market contracted in the third quar-
ter of 1974 for the first time in its history:
external foreign currency liabilities of the
banks in the eight reporting countries
(Belgium, France, the Federal Republic of
Germany, Italy, the Netherlands, Sweden,
Switzerland, and the United Kingdom)
continued on page 41
13
The development of
the Euro-currency market
How and why did the Euro-currency market emerge? This
article reviews the historical and institutional characteristics
of the Euro-currency market.
Paul de Grauwe
The Euro-currency market is an interna-
tional banking market specializing in the
borrowing and lending of currencies out-
side their countries of issue. Participants
in the market are commercial banks,
monetary authorities, and nonbanks, the
latter comprising mainly business firms
(particularly large multinational corpora-
tions), government agencies, and semi-
governmental entities, including central
banks and international organizations.
Comprehensive official statistics are lack-
ing and estimates on the size of the
market vary widely, placing the gross
volume of Euro-currency assets of banks
in major international banking centers in
the range of $200-400 billion. Available
statistics suggest that interbank transac-
tions constitute the largest and generally
fastest growing portion of the Euro-
currency market, while nonbank sources
and uses of funds channeled through the
market account for less than one third of
total Euro-currency transactions. Since
the largest part of the market is located
in Europe and since the bulk of the trans-
actions is in dollars, the market is com-
monly called the "Euro-dollar market."
With increasing use of currencies other
than the dollar, for example, the deutsche
mark and the Swiss franc, a more appro-
priate general term is "Euro-currency
market"; but even the prefix "Euro" is
misleading as a significant part of the
14
©International Monetary Fund. Not for Redistribution
transactions is carried out in centers out-
side Europe, such as the Bahamas, Pan-
ama, and Singapore. Therefore, terms
such as "xeno-currency" and "offshore
market" might be preferable.
Origin and growth
While international banking centers
had for a long time known some opera-
tions in offshore currency assets and lia-
bilities, two developments Jo ward the end
of the 1950s appear to have been most
important in prompting banks to engage
on a substantial scale in Euro-dollar oper-
ations. First, in 1957 in response to the
sterling crisis, the United Kingdom
authorities instituted tight controls on
nonresident sterling borrowing and lend-
ing by U. K. banks. In order to retain
their position in the financing of world
trade, the U. K. banks turned to dollars
as a substitute for sterling. Second, at the
end of 1958 the currencies of the major
Western European countries were made
convertible for nonresidents. This allowed
banks in those countries to buy and sell
dollars freely and to use them in the
financing of international trade.
In the early 1960s, two major inter-
national dollar markets existed, one cen-
tered on New York, the other on London.
At that time the volume of international
transactions was larger in the New York
market, but it was already apparent that
the London banks had a competitive
advantage. To some extent, this reflected
"natural" locational advantages, for ex-
ample, time differences and closer prox-
imity to some important customers. But
a major factor was the absence of regu-
lations of banking operations in cur-
rencies other than the pound sterling in
the London market. Unlike banks oper-
ating in the United States, banks oper-
ating in the United Kingdom were not,
and are still not, subject to legal reserve
requirements or official interest rate ceil-
ings in respect of their dollar transac-
tions. This enabled them to pay higher
deposit rates and to operate with nar-
rower margins than U.S. banks subject to
such regulations.
Such differential treatment of national
and offshore banking operations was
typical not only for the United Kingdom
but also for most other countries where
important offshore banking centers devel-
oped. This explains much of the spectacu-
lar growth of the Euro-currency market.
However, it is not the sole explanation.
The New York financial market might
have maintained its relative position in
international financial transactions had it
not been for specific actions taken by the
U. S. authorities to restrict the outflow of
funds from the United States. First, in
1963 an "interest equalization" tax was
introduced which effectively closed the
New York capital market to many foreign
borrowers. Second, in order to cope with
increasing balance of payments deficits,
the U. S. administration instituted in 1965
a voluntary program of direct controls
over nonresident lending by banks and
other financial institutions—the Volun-
tary Foreign Credit Restraint (VFCR)
Guidelines. This program was gradually
strengthened and in 1968 made effectively Chart 1
mandatory. Third, controls over U. S. di- The growth of the Euro-currency market, 1965-74 *
rect investment abroad were introduced Billions of U.S. dollars
which limited inter alia the use of U. S.
bank credit to finance new or additional
direct investments abroad.
This set of controls had two impor-
tant effects on the growth and structure
of the Euro-currency market. First, U. S.
companies wishing to finance new or
additional foreign investment outlays had
to rely more on funds raised outside the
United States. Second, U. S. banks con-
strained in lending to foreign residents,
including foreign branches of U.S. com-
panies, had to raise funds outside the
United States if they wanted to avoid
losing out in the growing international
loan business. They succeeded in doing
this by establishing branches in London
and elsewhere, thus shifting a large part
of their international business from New
York to offshore banking centers.
The growth of the Euro-dollar market
since the late 1960s followed essentially
similar lines. In 1969 the U. S. authorities
embarked on a course of restrictive mon-
etary policy. As U. S. banks were unable
under Regulation Q to increase the inter-
est rate on time deposits, including certifi-
cates of deposit, they experienced a sub-
stantial drain of funds which were
attracted to more profitable investment
outlets. They turned to their London
branches and borrowed heavily from
them. In the process, interest rates in the
Euro-dollar market rose sharply, increas-
ing the drain of deposits from the U. S.
market to the Euro-dollar market. In
1970 the Federal Reserve eased its mone-
tary stance and partially relaxed Regula-
tion Q ceilings on time deposits. U. S.
commercial banks could again compete
for time deposits in the U. S. market, and
repay most of their outstanding debts
vis-a-vis their London branches. As a
result, Euro-banks were left with liquid
Source: BIS Annual Reports and Fund staff estimates.
funds, but since at the same time major This covers only that part of the market which is accounted for by banks or countries reporting to the BIS.
European countries followed policies of
monetary tightness, there was ample de-
mand for funds by European borrowers. about the future of the market caused its of the market had increased to 28 per
The growth of the Euro-currency mar- growth to be checked sharply, and the cent, from about 17 per cent in 1969.
ket continued to be very rapid until mid- recently resumed growth of the market This trend was mainly the result of an
1974, with an estimated growth rate of has been at a significantly reduced rate. increased demand for deutsche mark and
more than 40 per cent in 1973 and early Swiss franc financial assets as these cur-
1974 in that part of the market on which The changing structure of the rencies were at that time generally ex-
official statistics are reported to the Bank market pected to appreciate. Since investments in
for International Settlements (BIS). Thus, Throughout the history of the market, the Federal Republic of Germany and
its growth continued undiminished, even the U. S. dollar has accounted for by far Switzerland by nonresidents were increas-
after termination in January 1974 of U. S. the largest share of transactions. How- ingly restricted by capital controls, de-
measures restricting capital outflows. ever, the share of nondollar-denominated mand for deutsche mark and Swiss franc
However, by mid-1974 concern about the assets and liabilities continued to increase. assets shifted to offshore banking centers
viability of some banks and uncertainty At the end of 1973 the nondollar share and, as a result, Euro-banks became in-
15

©International Monetary Fund. Not for Redistribution

 creasingly active in the deutsche mark
and Swiss franc part of the market.
Not only the currency composition but
also the regional composition of the mar-
ket has changed over time. This change
cannot be detailed because of the lack of
comprehensive statistics. However, esti-
mates made by the BIS give a general
idea of the direction of shifts in the pat-
tern of uses and sources of funds chan-
neled through the market. These esti-
mates point to an increasing relative
importance of countries outside North
America and Western Europe as lenders
and borrowers in the Euro-currency mar-
ket since 1964.
Banks active in the Euro-currency mar-
ket operate from widely dispersed bank-
ing centers. London is still the main
center of the offshore banking business.
However, since 1970 its share in the total
has declined, mainly to the advantage of
the Bahamas, Singapore, Panama, and
Beirut. There has also been a significant
change in the distribution of Euro-
currency business among banks according
to their national origin. From 1963 to 1969
the share of U. S. banks in the London
Euro-currency market increased substan-
tially (fr~im about 25 per cent to 54 per
cent of the total). The remainder was
taken up mainly by U. K. banks. However,
since 1973 U. S. banks have accounted
for somewhat less than 40 per cent of
the London market, and banks with head
offices outside the United States and the
United Kingdom have gained a larger
share. At the end of 1974 these banks
accounted for more than 30 per cent of
the total Euro-currency business centered
in London. Since the mid-1960s, there
has also been a growing number of
mostly multinational consortium banks,
which in 1974 accounted for about 7 per
cent of the total Euro-currency business
based on London.
General features of the
Euro-currency market
The Euro-banks have developed some
characteristic lending and borrowing
practices. In general these techniques
emerged as a response to the particular
structure of the market and to changes
in this structure.
First, the Euro-currency market is a
"wholesale" market in the sense that
most final borrowers are large companies
or official entities and the average unit
size of transactions is large. As a result,
the banks' overhead costs are relatively
low.
Second, the Euro-currency market is to
a large extent an interbank market. Thus,
16
©International Monetary Fund. Not for Redistribution
more than 75 per cent of the foreign
currency liabilities and assets of the re-
porting European banks are against other
banks. In the last few years most of the
increase in the gross size of the market
was due to an increase in interbank de-
posits.
Third, the Euro-currency market is a
highly competitive market. New entry
into the market is unrestricted. This has
at times led to a general decline in the
margin between deposit and loan rates
and lower rates of return on Euro-
currency assets than those on domestic
currency assets in national markets. Dur-
ing periods of increasing competition
among banks operating in the Euro-
currency market some Euro-banks have
also taken higher credit risks, both in the
choice of borrowers and in the acceptance
of longer maturities of loans generally
extended on an unsecured basis. There is
some evidence that the market has
recently become more cautious both with
regard to exposure to individual bor-
rowers and to longer maturities.
While in many ways the Euro-currency
market is similar to national money mar-
kets, it is basically different from them
since it is a market wthout central mone-
tary authority and free from controls.
Loans and deposits
As a means of spreading the risk inher-
ent in generally large scale loans, Euro-
banks have increasingly relied on the
technique of syndicating medium-term
loans extended outside the interbank mar-
ket. There are different methods for syn-
dicating a loan. The common character-
istic is that it involves a large number
of participating banks (as many as 95 in
Paul de Grauwe
was an economist in
the Exchange and
Trade Relations
Department under the
Young Professionals
Program of the Fund
before accepting a position as Lecturer
in economics at the Catholic University of
Louvain in his native Belgium in 1974.
He holds the Licentiaat-Doctorandus degree
from that University and a Ph.D. in
economics from the Johns Hopkins
University. He has published a number of
articles in professional journals.
one case) with one bank—the lead bank
—managing the loan. This system has
allowed many small- or medium-sized
banks to operate in the Euro-currency
market. The same factors that have led to
the growth of syndicated loans have in
recent years also prompted many banks
to join in consortia. In order to limit the
default risk resulting from indirect loan
relationships often involving many banks,
Euro-banks typically place limits on the
amount of outstanding advances that they
will extend to any single borrower and to
borrowers in any single country.
Another typical feature of Euro-
currency lending outside the interbank
market is the use of "floating rate" medium-
term credit arrangements. These represent
a type of roll-over credit with interest
rates determined periodically, usually
every six months, on the basis of interest
rates prevailing in the interbank market.
In this way lending banks aim at reduc-
ing the interest rate risk that is inherent
in unmatched maturities of assets and
liabilities. Most loan contracts specify
lending rates as a margin over the
deposit rates of "reference banks," usu-
ally taken to represent the London Inter-
bank Offer Rate (LIBOR). However,
"LIBOR" is not necessarily the rate at
which interbank funds are obtainable for
refinancing by all banks participating in
a syndicated loan.
Many loan agreements contain a multi-
currency clause. Before the recent up-
heavals in the exchange markets, most
loans were denominated in U.S. dollars.
However, as the uncertainty concerning
exchange rates grew, so did the risk for
lenders and borrowers faced with the
choice of currency. The multicurrency
clause provides an important element of
flexibility in this respect by offering a
choice of currencies in which the whole or
parts of a loan may be drawn upon.
Euro-banks do not provide checking
facilities. However, the relatively short
maturities of most Euro-currency deposits
make these deposits very close substitutes
for liquid assets. In 1966 an important
new facility was introduced. Following
the lead of their offices, U.S. branches in
London started issuing negotiable dollar
certificates of deposit (CDs). These are
negotiable receipts for a U.S. dollar de-
posit with a London bank. The advantage
of this instrument is that it combines the
yield opportunities of time deposits with
a high degree of liquidity. The liquidity
of CDs, of course, depends on a well-
functioning secondary market. The latter
exists and it is generally agreed to be
very efficient.
Concern over the availability and longevity of natural resources
has escalated to the point where it finds expression in a
question that is so absolute as to have parallels not in the
social sciences but in philosophy. Having posed the question,
the author examines the conceptual boundaries and practical
dimensions of the problem of scarcity of raw materials.
Bension Varon
The complicated concept of resource
scarcity cannot be properly examined
except in relative terms—that is, relative
to time, need, and price. But the question
of scarcity of natural resources is a vital
one, relevant to the present and the
future, and therefore it must be examined
closely so that rational decisions may be
made by policymakers round the world.

Enough of
everything
for everyone,
forever?

17

©International Monetary Fund. Not for Redistribution

 The realization of the finiteness of our economic efficiency in the market place. materials needs to be examined carefully.
globe in terms of mineral, land, and The idea of equitable consumption of The three groups of resources differ bas-
energy resources is upon us with all the resources is central to the concern over ically, for example, fuels are dissipated
attendant alarm and worry. The perva- their potential scarcity. Historically speak- during consumption while land's produc-
siveness of its impact is not surprising. ing, consumption has been uneven and tivity is variable, and mineral raw mate-
As issues evolve, our awareness of them largely inequitable, both within individual rials are reusable to a large extent. Yet,
becomes greater. We are made aware that nations and among nations. Acute scarci- the three categories are interrelated and
the frontiers—with the exception of the ties were faced through exclusion, with reinforce one another: higher energy
oceans—are largely closed, that inven- whole segments of society existing at bare costs affect the cost of producing and
tories of resources are now more accurate subsistence levels and small, exclusive processing many mineral raw materials
than ever, that there is global interde- segments feasting at tables of plenty. But and the availability and cost of fertilizers
pendence in terms of requirements and today, in an era of internationalism, when which further affect agricultural output.
goals, and that planning for the future there is growing understanding of the Higher import bills or higher investment
must take these factors into account. true interdependence of nations, the idea requirements to fill the need for any one
The greatest concern over resource of selective consumption is insupport- category of resources inevitably influence
scarcity has been triggered by population able. Thus, the question of resource the capacity to obtain the others. But
growth. World population increased from scarcity and what it means must ulti- exaggeration of imminent shortages or
about 750 million in 1770 to nearly mately be put in terms of how it relates the precise fixing of "grace periods" con-
3.7 billion in 1970. The number of people to developed and developing countries cerning minerals do not serve well to deal
added to the world population since the rather than in general global terms. rationally with the minerals problem.
Industrial Revolution is probably ten The term "natural resources" refers to What is needed is a proper perspective.
times greater than the number added in elements, products, or forces found by
the preceding 200 years. Unprecedented man in his natural environment which he The growth of demand
population levels will need to be sup- may utilize for his own benefit. In this Consumption of mineral fuels and raw
ported in the future and they will put broad sense, the resources provided by materials on a large scale started with
constant pressure on resources. At the nature include "natural products" such the Industrial Revolution, and the pace of
same time, while exploring the universe, as minerals, forests, fish, and water and consumption since then has been astound-
we have become painfully aware of the "amenities or situations," such as water- ing. World consumption of all mineral
smallness of our world in relative terms, falls, waterways, natural harbors, and commodities combined increased tenfold
yet this world is all the "management fertile soils, of current or potential eco- between 1750 and 1900, whereas, over
experiment" granted us. Science and tech- nomic or social value. The principal cri- the same period, population expanded by
nology have been our most valuable terion is their present or future usability. a factor of 2.2 and per capita consump-
management means, responding to and Amenities are primarily nature's hand- tion of all goods and services by 4.5.
supplying ever-increasing requirements outs, although subject to modification as During the past 70 years, however, min-
for ever-increasing numbers of people. human needs dictate, while the rest of eral consumption (including fuels) grew
Attempts at worldwide population con- her treasures must be won through the by a factor of about 12, population by
trol have not been very successful, so application of capital, labor, technology, 2.4, and per capita consumption by 5.3.
that progress—and our belief in it as the and constant search. "Nonrenewable Demand for mineral raw materials in-
natural order of things—has been largely natural resources" are those inorganic creased somewhat more (13-14 times)
sustained by technology. materials extracted from the earth that than demand for fuels (11-12 times) in
cannot be replenished within any period the present century.
High Inventories of time short enough to be of significance The trends for individual ores and
The resource picture for the world as a to human planning. metals vary widely and point up the
whole is not discouraging; inventories of Although unquestionably supply prob- dynamics of resource conservation and
most major resources are at least as high, lems of food and energy at present loom creation—something that does not emerge
by any count, as they were 20-30 years large too, the question of mineral raw from the composite picture. For example,
ago relative to projected requirements, world consumption of pig iron between
and technology is expanding. Yet there is Bension Varon
1900 and 1970 increased 10-11 times,
very real pessimism. This is more because while steel production expanded by a fac-
of changed attitudes than of changed tor of roughly 20, reflecting an increased
physical parameters. The widespread use of scrap. Similarly, consumption of
sense of insecurity is brought on in part new copper rose 14 times, but use of
by the realization that there are costs to be a citizen of Turkey, copper metal increased 20 times, as the
paid in terms of pollution and the quality was a Senior proportion of secondary (recycled) copper
of life, even for beneficial technological Economist in the expanded from 10 per cent at the turn
advances. And we are even seriously Policy Planning of the century to 35 per cent in 1970.
Division of the Policy
questioning whether human ingenuity The growth factor for zinc was 11.4, but
Planning and Program
can, in fact, keep in step with human Review Department of the Bank when that for lead only 4.5, again partly due
reproduction and requirements. Further- this article was written. He is now to expanded scrap utilization, which rose
more, faith in the role of the price mecha- Assistant Director, Policies and Projections from 8 per cent in 1910 to over 40 per
nism either for tempering demand or for Branch of the Centre for Natural cent (in the United States) at present.
bringing forth additional supplies has Resources, Energy and Transport, at the The upward trends for the traditional
eroded; as a result, there is lessening United Nations. minerals were checked by the introduc-
reliance on the "invisible hand" to achieve tion of new raw materials, chiefly alumi-
18

©International Monetary Fund. Not for Redistribution

num and nickel, which are counted
among the most important in modern
industrial production. Aluminum con-
sumption rose from negligible quantities
in 1900 to 10 million tons in 1970, and
nickel consumption jumped from a simi-
lar base in 1900 to nearly 600,000 tons
in 1970. Apart from new metals, the
dynamic change in growth patterns was
also wrought by a thirtyfold increase in
the use of alloying metals such as chro-
mite, manganese, molybdenum, tungsten,
and cobalt, as the direct result of ad-
vances in metallurgy.
Consumption growth slowing
Apart from recycling, there are already
signs—historically verified and theoreti-
cally anticipated—that consumption of
most minerals is now growing at a decel-
erating rate, and considerably slower than
the gross national product (GNP) in the
United States and other industrialized
countries, as saturation levels are being
approached. The interaction of income
growth, structural change, and accumula-
tion of "stock" (capital goods in service)
in these countries is bringing about a
decline in the "intensity of use" (require-
ments per unit of GNP) of most minerals.
There are, of course, exceptions, such as
aluminum, fluorspar, and certain alloys,
which are either continuously displacing
other metals or go into highly dynamic
industrial end-uses, such as aviation,
refrigeration, and pollution control; but
these exceptions do not invalidate the
general statement. Yet, there is basis for
concern, for the consumption base of the
world is so very large now that even
moderate rates of growth can create an
intolerable strain on the world's total
resource base over the long run.
This concern is based on assumptions
of predetermined needs according to pres-
ent patterns and fixed resources according
to present knowledge. But need is rela-
tive. It can be modified by changes in
tastes, relative prices, and in the material
composition of goods. For example, nickel
is used to manufacture stainless steel;
stainless steel to manufacture bumpers;
bumpers go on cars; cars are needed for
transportation. While under the present
system and technology of production each
input at each stage would be conceived
of as representing a "need," in reality
they represent nothing more than derived
demand which can be met with alterna-
tive inputs (cobalt instead of nickel, rub-
ber instead of stainless steel). More
significantly, the end product, the private
car, represents a choice about transporta-
tion, rather than a need.
©International Monetary Fund. Not for Redistribution
Therefore, a deceleration in the growth
of demand can be brought about in a
variety of ways, by a variety of factors,
and changes in what we commonly mean
by "way of life" need not have negative
connotations.
The supply base
Reserves for a large number of min-
erals have increased tremendously over
recent decades, despite massive consump-
tion: reserves of copper have risen by 3.5
times since 1935; of bauxite 7 times since
1950; of iron ore 11 times, potash 23
times, and chromite 6—7 times since the
late 1940s; and while reserves of lead
and tin are relatively small, their pro-
jected reserve lives—20 years—are still
the same as they were 40-50 years ago.
Furthermore, "potential resources" exceed
reserves (ores that can be economically
mined at present) quite significantly in
many cases, and their inventories have
increased also.
Obviously, some minerals such as sil-
ver, tin, and zinc are scarcer than others.
But their trends are not independent of
other concurrent developments. Because
of advances in understanding and altering
the molecular structure and composition
of minerals, the range of combinations
for using metals is ever expanding. Con-
sequently, in terms of utilization, the
total resource base does not have fixed
boundaries. Its physical limits, too, are
being expanded at present with the explo-
ration and anticipated exploitation of the
ocean beds' vast mineral resources. In
this sense, the oceans are a true frontier
whose potential yields may be so vast as
to make it impossible at this stage of
development to assess definitively their
ultimate impact upon the total supply pic-
ture.
Costs and prices
Even where ore grade deteriorated in
metal content, no hard historical evidence
of sharply rising costs is to be found. For
example, while the metal content of cop-
per ore is estimated to have declined from
8 per cent in the sixteenth century to less
than 1 per cent (in the United States) at
present, copper costs declined from about
$10 a pound four centuries ago to ap-
proximately 30 cents a pound around
1940 and have risen only moderately
since then. Therefore, one can state that
the surge in metal prices in 1973/74 (now
reversed), had little to do with the sheer
physical depletion of natural resources. In
fact, buoyant demand, disruptions of
supplies, problems at the processing end,
currency adjustments, and speculation
contributed to the price hike. While the
cost-push factor for exploration and min-
ing has been operative till now, in the
future reserve depletion, by itself, will be
only one of the factors determining the
long-term level of prices. Other factors
will include the stance taken by produc-
ing countries, technological change, anti-
pollution, and land conservation meas-
ures, energy costs, and finally policy
decisions affecting the pace, distribution,
and productivity of global investment in
exploration and mining as well as in
processing.
The scarcity scare
Yet, the worry persists: How long into
the future can resource expansion and
technological advances proceed with prices
remaining within tolerable levels in rela-
tion to consumption and development
goals? Attempts have been made to define
the situation, the most famous being
the study on the "Limits to Growth,"
(March 1972) sponsored by the Club of
Rome and conducted by a team of sys-
tems analysts from the Massachusetts
Institute of Technology headed by Pro-
fessor Dennis L. Meadows. This study
lacked truth in packaging: the team pos-
tulated as fixed those variables and rela-
tionships which in fact cannot be taken
as fixed. While this was increasingly
understood after initial excitement over
the MIT study had subsided, the advent
of the energy crisis revived doubts and
fostered a feeling of insecurity about all
natural resources. There is, however, a
post-energy-crisis view expressed by Mr.
M . Claude Guillemin, Director of the
national geological service of France, in
an interview in 1974. When asked if the
world is on the "eve of catastrophe" with
regard to natural resource availabilities,
Mr. Guillemin replied: "In the case of
energy resources, perhaps. In other min-
eral resources, surely not." Referring to
the now famous "water lily in a pond"
illustration of the dynamics of exponen-
tial growth in the MIT study, he stated
that the illustration is "mathematically
correct, but biologically false," since if
there are too many lilies in a pond, there
will be also other organisms which will
attack them and block their exponential
growth. He went on to liken economic
reaction to biological reaction, highlight-
ing the opportunities for conservation and
especially the difference between oil and
other minerals in terms of reusability—"a
copper bar, for example, can exist eter-
nally." ("La Fin du Gachis" (The End of
Waste), L'Express (Paris), April 22-28,
1974.)
19

"unlike the food situation, pressure on
raw materials resources will not come
from population growth in developing
countries"
Scenarios that venture into the indefi-
nite future have little application to viable
planning periods and to mechanisms of
management as we now know them. For
our own planning time frame, 30 years at
best, the more pressing question centers
on the distribution of both consumption
and production of raw materials between
rich nations and poor nations, and the
problem of scarcity that arises in this
relationship.
The distribution problem
Developing countries consume less than
10 per cent of the world's annual output
of mineral raw materials. Yet, they pro-
duce 33 per cent of the total output and
possess 40 per cent of all known reserves.
Through exports, which account for four
fifths of their output, they supply 50 per
cent of the domestic requirements of
industrialized nations (both market ori-
ented and centrally planned economies)
and 70 per cent of their import require-
ments. While these figures point up the
producer-consumer dichotomy, they are
in keeping with the obvious link between
development and raw material based pro-
duction. Underconsumption of raw mate-
rials of such proportions on the part of
the developing countries reflects their
severe underdevelopment.
A simple calculation based on available
forecasts covering the next 25-30 years
reveals that of the increment in antici-
pated world raw materials consumption,
over half would result from increased
per capita consumption in industrialized
nations (both market oriented and cen-
trally planned economies); one fifth from
additional population growth in these
countries; at most a quarter (but probably
much less) from increased per capita con-
sumption in developing countries; and
only 5-10 per cent from population
growth in these countries. Unlike the
food situation, pressure on raw materials
resources will not come from population
growth in developing countries—that
popular alarm factor in all equations
describing the future. Therefore, despite
some narrowing of the gap, a child born
20
©International Monetary Fund. Not for Redistribution
in an industrialized country stands to
consume on the average at least 10 times
more mineral raw materials in the year
2000 than a child born in a developing
country. In light of this, and because they
control 40 per cent of world mineral
reserves, it is not surprising that devel-
oping nations resist diagnoses and impli-
cations of the problem of scarcity from
the point of view of present large con-
sumers.
There has been talk recently of the
possibility that the dichotomy between
the have and have-not nations might
result in new pricing policies for raw
materials. Developing countries hardly
have to demonstrate their urgent need for
additional revenues. But it is not far-
fetched to suggest that the notion that
their raw materials deserve higher prices
is also based on the concept of scarcity
per se. To be aware of potential resource
scarcities is one thing; it would be a
mistake, however, to infer that so loose
a contingency ought to be somehow
reflected in current prices, which would
mean differentiating between the impor-
tance and longevities of individual re-
sources on the basis of subjective and
imprecise knowledge.
LDCs complaint
Developing countries, in essence, are
complaining less about prices and more
about their level of underdevelopment. At
the heart of their argument is the propo-
sition that they were denied opportunities
as well as the means, such as technology,
capital, and market access to develop on
all levels.
To illustrate one aspect of the basic
problem, the value of developing coun-
tries' current mineral output is about 30
per cent of the market value of the fin-
ished products. And this refers only to
the processed, metal ingot stage, not to
the manufactured end products. High
profits (and external economies) come
from processing, since value can be
increased by as much as four times
through semiprocessing and by as much
as 20 times through full processing up to
the metal bar stage. If the entire current
mineral output of developing countries
were to be processed up to this stage, the
value of their aggregate output could be
as much as $10-12 billion higher. This is
not to suggest that no progress has been
made toward the local processing of min-
erals, nor that processing should be pur-
sued without regard to comparative
advantage or investment priorities. This
illustration does portray the difficulties
that arise when only one or two sectors
of an economy grow, having little feed-
back effect on the economy as a whole
which lacks enough internal strength or
external support to respond quickly to the
initial stimulus. And it symbolizes the
difference in the stages of development
between the developing and developed
countries, which, in turn, affects their
trade relationship.
The economic benefits of trade have
long been understood and amply demon-
strated. In the postwar era trade has been
recognized as a valuable avenue for pro-
moting peaceful political relations by such
nations as the United States and the
Soviet Union, the Federal Republic of
Germany and the German Democratic
Republic, Japan, and the People's Republic
of China. Nations must now take fuller
advantage of trade as the handiest tool
for bridging the gap between the haves
and have-nots, on the one hand, and for
assuring efficient global exploitation and
utilization of resources, on the other.
However, despite decades of publicized
commitment to free and expanded trade,
trade remains highly sensitive to black-
mail, manipulation, and pressure from
special interest groups.
The answer
Where does all this leave us? Without
a categorical answer to the original ques-
tion. On a manageable scale of assessment
there seem to be no major or insurmount-
able long-term problems of scarcity of
industrial raw materials if we count
advances in resource creation and utili-
zation, and the application of every man-
agement tool, such as planning, tech-
nology, trade, and conservation. Making
large allowances for human ingenuity in
dealing with problems that are recognized
to be important is perhaps an act of
faith, but not of blind faith. We know
we have a global problem on our hands.
The faith that we can handle resource
management well will gain substance only
if the world demonstrates that it can deal
with the pressing problem of narrowing
the gap between the rich and the poor
countries.
The World Bank Group may now be expected to increase its
lending to the mining sector. The pressure to find and develop
new mineral resources is increasing the risk of mining
ventures at every stage. The author, a Bank attorney, discusses
previous lending for mining in the context of guarantees both
to mining companies and to the developing countries where
the mines are located.
David M. Sassoon The World Bank Group has advanced
$721 million for mining ventures in the
developing countries since it began extend-
ing financial assistance for such purposes
in 1957. Of this amount $609 million was
lent by the Bank and the International
Development Association (IDA) and the
balance has taken the form of invest-
ment and lending by the International
Finance Corporation (IFC). An increasing
amount of Bank Group loans to the min-
ing sector can be expected in the decade
ahead, as capital requirements grow and
as known resources are depleted and
demand rises.
The Bank's limited involvement in the
mining sector up to now (slightly less
than 2a/2 per cent of total Bank Group
lending) is due to a number of factors.
Mining operates at levels of physical,
commercial, and political risks that are
normally significantly higher than those
of other industries. Mining projects
Financing the
mining sector:
the Bank's role
©International Monetary Fund. Not for Redistribution
require extremely heavy investments, not
only in physical and social infrastruc-
ture facilities, but also in preinvestment
expenditures on exploration and metal-
lurgical testing, which, because there
is no certainty of discovery, will often be
written off as a loss. In addition, much
of the requisite technical expertise has
been, and still is, concentrated in the
hands of a relatively small number of
multinational corporations with free access
to the capital markets of the world on
their own account. The investment cli-
mate was, until recently, more stable, and
nationalization and expropriation of for-
eign-controlled mines less customary than
now. Mining was thus more readily fi-
nanceable without Bank participation.
And finally, the Bank itself used to be
reluctant to finance governmentally owned
and managed industrial enterprises, fur-
ther curtailing its limited involvement in
the sector.
A commitment to the member
country
As a rule, mining projects have been
financed on a project-by-project basis,
rather than in the framework of a bal-
anced sector approach. Most projects
were referred to the Bank from the out-
side, generally after the bulk of the con-
tractual arrangements between the for-
eign private participants and the host
country had been at least substantially
completed. If arrangements for financing
a project appeared unfair to the member
country, the Bank simply refused to par-
ticipate. The Bank's policy in this area
has been very clear.
Where the safety of the Bank's own
investment was concerned, the Bank was
duty bound to influence the terms and
conditions of the transaction between the
private foreign investors and the host
government. Beyond that, however, it did
not act as the advocate of the govern-
ment in its negotiations with foreign
investors, but it did make sure that the
government had competent legal and bus-
iness advice. When necessary, the Bank
has made the retention of outside legal
and other counsel a requirement for its
participation in mining projects and,
where appropriate, has been willing to
include the cost of such services as part of
its loan. Whether the Bank's attitude in
this area will change and become more
active, and if so, what particular form
this involvement may take, remains to
be seen.
The Bank's procedure with mining proj-
ects, irrespective of the portion it was
asked to finance, was first to be satisfied
that the whole project was fair to the
Bank member country where it was lo-
cated, that the allocation of benefits and
risks was properly balanced, that the proj-
ect made economic sense, and that the
investment was secure. The Bank would
be unwilling, for instance, to participate
in financing a railway, port facility or
township which depended on a mine for
its justification, without being satisfied
with the project as a whole, and vice
versa.
This was Bank practice in the Falcon-
bridge ferro nickel mine in the Dominican
Republic, where the Bank financed the
power facilities as well as in the Miferma
iron ore project in Mauritania, where the
Bank financed the railway and port facil-
ities. In these cases the loans were made
to the mining company directly, which of
course was the project entity. But the
same total project appraisal was made for
the Burfell power project in Iceland, serv-
ing the Alusuisse aluminum smelter, and
22
©International Monetary Fund. Not for Redistribution
the Volta power project in Ghana, serv-
ing the Valco aluminum smelter. Here the
loans were made to the member country's
government or to one of its agencies
responsible for the operation of the infra-
structure facilities in question. These two
forms of financing—direct financing of
the project entity and indirect financing of
the supporting outside infrastructure fa-
cilities—involve different legal and finan-
cial problems and techniques, but the
choice of the form is essentially irrelevant
to the Bank's evaluation of the project as
a whole. In all cases, the companies oper-
ating the mining facilities were the real
parties to which the Bank looked for
assumption of the risk and for security
of its loan repayment. The Bank has,
therefore, financed infrastructure facilities
as well as production facilities proper,
and depending on the particular circum-
stances, has lent money to a private cor-
poration which was the project entity, as
well as to a member country's govern-
ment or to one of its agencies.
Choice of borrower
Of the 26 projects financed by the
Bank Group to date, 4 financed infra-
structure, 11 production facilities, and the
remainder both. Lending by the IFC was, of
course, exclusively for private enterprise,
while Bank loans went about equally to
the private and government sector, al-
though in the majority of projects control
of the mines was in private hands. The
Bank of course has certain preferences in
this area. It prefers to lend directly to the
entity or enterprise that will be responsi-
ble for the construction and operation of
the project, so that any problems are
attended to immediately. If the project is
to be carried out by a private corporation,
or if any of its infrastructure facilities
are to be controlled or operated by the
private corporation, the guarantee of the
David M. Sassoon
is an Israeli attorney
with the Legal
Department of the
Bank who has held
professorial posts
in universities in Israel
and the United States, and is the author
of several books and articles on subjects
related to international business, commerce,
and shipping.
member country ( a requirement of the
Bank's Articles of Agreement) will nor-
mally be confined to the payment of the
debt service of the loan. The member
country will not be required to ensure the
full performance of all of the borrower's
undertakings, nor to agree to provide all
of the funds and other facilities required
to complete the project, which is the case
where the government is the borrower or
where the loan is made to a state corpora-
tion or enterprise. All that the guarantor
government will usually be requested to
covenant in this case is: "not to take,
cause, or permit to be taken any action
which would prevent or interfere with the
construction and operation of the project
or with the performance of the bor-
rower's obligations."
The choice of borrower under each
loan will be resolved by reference to the
particular portion of the project which
the Bank is asked to and is willing to
finance. Under the Articles of Agreement,
the Bank would normally finance the
foreign exchange cost of projects; financ-
ing local costs in these types of projects
is exceptional. The Bank's participation
in projects which require large foreign
exchange expenditures-and mining proj-
ects in the less developed countries al-
most invariably fall into this category—
are therefore on the whole confined to the
financing of imported equipment and ma-
terials. This may have a bearing on the
portion of the project that the Bank is
willing to finance, and it is also a factor
to keep in mind in the choice of bor-
rower.
The terms of the loans
In the past, where the borrower was
privately owned, a commitment of sub-
stantial shareholder equity or subordinated
debt was required, and shareholder guar-
antees for cost overruns and repayment
were normally sought. These usually in-
cluded financial commitments to provide
all funds necessary to complete and op-
erate the project, and to repay the loan,
quite apart from other more customary
types of security such as mortgages of
plant. In the case of the Shashe project
in Botswana, the private party, a sub-
sidiary of Roan Selection Trust, was even
made to assume one half of the cost of
the engineering studies of the infrastruc-
ture, financed by the IDA under a $2.5
million credit to the government, in case
it did not proceed with the project.
In addition, because the Bank's prac-
tice is to charge as low a lending rate as
is consistent with its own financial condi-
tion (currently SVz per cent), and because
there is no reason to give the benefit of
this low rate to a private investor, the
Bank has insisted that the member coun-
try's government, which must guarantee
the Bank loan, charge the private party a
guarantee fee equal to the difference be-
tween the Bank's and the market interest
rates. On the other hand, where the
loan was made to the government or
to one of its agencies in support of a
mining venture, the lending rate was of
course the Bank's usual uniform low
lending rate. But this does not mean that
the government was seen as the real pro-
vider of the funds to cover the debt ser-
vice of the loan. In all these cases, as the
infrastructure facilities were designed to
service the mining operation or enter-
prise, the Bank insisted on adequate ar-
rangements to ensure that the govern-
ment receive sufficient guarantee from the
private participants in the mining venture
to repay the debt to the Bank.
Forms of security
Security arrangements in these cases
have taken different forms. The Bank has
occasionally insisted on obtaining liens or
pledges which could be enforced directly
against third parties who were, for exam-
ple, to be the purchasers of the mining
product. Shareholder guarantees running
directly to the Bank are also in this cate-
gory because the Bank can enforce them
by being a party to the contract. When
the Bank is not a party to the arrange-
ment, the security will run directly from
the consumer or from the shareholders to
the borrower, not involving a right that
the Bank can enforce directly, but in
effect producing a somewhat similar fi-
nancial guarantee for the borrower.
From the legal point of view, a distinc-
tion can clearly be made between ar-
rangements which give the Bank direct
rights and remedies against a third party
(other than the borrower), and those
which do not establish a direct contrac-
tual relationship between the Bank and a
third party. Financially, that distinction is
perhaps less significant, because the latter
arrangements, by aiming to strengthen or
safeguard the financial position of the
borrower, also contribute, though more
indirectly, to the protection of the Bank's
investment.
The security
"Take or pay" long-term purchase con-
tracts are a frequently encountered form
of security arrangement in this type of
loan. They consist, broadly speaking, of
the obligation of a third party to purchase
a product or service or to pay for it, even
if it is not purchased—and this third party
©International Monetary Fund. Not for Redistribution
undertaking is often assigned to the Bank.
In some cases, the obligation to pay ex-
ists, even if the product involved has not
been produced. The third parties involved
may be the shareholders of the borrower,
as in the Falconbridge project. In other
instances, they are outsiders interested in
a steady supply of the product, for ex-
ample, an Argentinian state agency as a
buyer of gas transported through a Bank
financed Bolivian pipeline. In some cases
payments for the service or product are
made to a trustee who must earmark and
apportion the receipts between the various
creditors, and often the government also,
in accordance with priorities agreed upon
before transferring any money to the
private producer. There is no established
pattern.
No matter what form the particular
security takes, the infrastructure, if pub-
licly owned, has to be secured by the
mining operation and its sponsors. The
obligation of the government as a bor-
rower or guarantor in these cases will
protect the Bank's loan, but this protec-
tion is in addition to, and not in lieu of,
the security which the private investors
must furnish. The specific security ar-
rangements are in effect designed to pro-
tect the government as guarantor (or as
borrower) as much as they are designed
to protect the Bank as lender. There is
less likelihood of the Bank having to
invoke the government's direct obligation
in these circumstances, and it is for this
reason that such projects can receive
Bank rather than IDA financing, though
the country itself may normally have
access to IDA funds only. Even in the
unlikely circumstance of the Bank enforc-
ing the government's direct obligation,
the government will usually be subro-
gated to the rights and benefits of the
security arrangements.
Force majeure
Although World Bank Group lending
since 1957 accounts for less than iVz
per cent of the total investment in mining
in the developing countries, this has been
estimated to represent a 6-8 per cent in-
volvement in total mineral expenditures,
and a contribution of between 20-25 per
cent of costs. The discrepancy arises
because the object of requesting the
Bank's financial participation in the past
has frequently been not lack of money,
but the inability to raise it without the
World Bank's presence in the deal, sought
for what might be termed its stabilizing
influence.
However, private parties furnishing se-
curity want to be free from their commit-
ment if government interference causes
enforcement of the security, and insist
on limiting their obligations to cover
technical or commercial but not political
risks. The subject is known in Bank par-
lance as the "force majeure" exception.
Many security arrangements contain force
majeure exceptions, releasing the private
parties from their obligations to supply
funds (irrespective of the technique used)
for cost overruns or repayment of the
loan capital in the event of political inter-
ference.
Loans to governments vs. loans
to private companies
Many covenants found in loans to pri-
vate parties will not apply in cases where
the borrower is a government or a gov-
ernmental agency providing infrastructure
or production facilities for mining with
the assistance of Bank financing. Where
the borrower is a private corporation, its
debt/equity ratio will normally be subject
to limitations imposed by the Bank, So,
too, a restriction on dividends to share-
holders or on interest on shareholders'
advances, and a commitment to keep
working capital at adequate levels will
be necessary. And there will normally be
some real or personal security required.
With governments, or governmental
agencies, liens on specific revenues or
assets as security for loans valid against
third parties will not generally be sought,
unless they are obtained by another credi-
tor or lender participating in the financ-
ing, or where specific unencumbered
assets may be seized by another creditor
outside the member country. As already
noted, a typical form of security that the
Bank seeks in lending to a private inves-
tor in the mining sector is precisely of
this kind—namely a shareholder's com-
mitment or an assignment to the Bank
of a contract to take or pay for the mining
product or both.
It is the Bank's usual policy not to
require specific security for its loans to
governments or governmental agencies,
and to permit the government in these
cases to borrow on the basis of its
general credit. Regarding mining projects
in what would otherwise be IDA coun-
tries, the Bank relies on the security the
government has—directly or indirectly—
obtained from the beneficiaries of the
particular project. The Bank does not,
however, wish other lenders to take spe-
cific security or to acquire preferences or
priorities of payment which could put the
Bank in a subordinate position, or make
payment to the Bank by a member coun-
try (either as borrower or as guarantor)
more difficult than payment to another
continued on page 41
23
 "Indexing"
Brazil's

Jack D. Guenther
During the past seven years, inflation in
Brazil has averaged over 20 per cent a
year, but this has not impeded economic
growth in real terms of about 10 per
cent a year. This success in "living with
inflation" frequently has been attributed
—in part, at least—-to the system of
indexing or "monetary correction" adopted
in 1964 which provided for wages, finan-
cial obligations, taxes, the exchange rate,
and other economic variables to increase
pan passu with the general level of prices,
thereby minimizing the distortions usually
associated with inflation.
However, indexing in Brazil is not as
all-embracing as is sometimes suggested
and almost nothing is indexed through a
simple 100 per cent link to prices. In the
case of wages, for example, prices are
only one element in the wage formula,
which itself has undergone several revi-
sions during the past decade to keep
it in line with the Government's general
wage policy. In the case of financial obli-
gations, only about one fifth of the lia-

©International Monetary Fund. Not for Redistribution

versus discretionary action-
fight againstinflation
How far can indexing help in reducing the distortions of
inflation? The author examines this question, in detail, with a
view to correcting some popular beliefs about the nature
and extent of indexing in Brazil.
bilities of the Brazilian Treasury and
financial system outstanding at the end
of 1973 was indexed—mainly government
bonds and mortgage paper—and the pro-
cedure for linking these obligations to
prices also has been changed several times
when the system was not providing
results consistent with the interest rate and
other policies being pursued by the Gov-
ernment. Finally, in the areas of the
exchange rate and charges for public
sector services, there is no formal system
of indexing; these important prices are
adjusted upward frequently, but at the
discretion of the authorities after taking
account not only of movements in prices
but also of other factors. A survey of the
system shows, therefore, that prompt
discretionary action by the Brazilian
authorities has probably been more
important than indexing in adapting the
economy to inflation. In fact, with the
resurgence of inflation to over 30 per
cent in 1974, the problems produced in
Brazil by indexing became more acute
and led to its abandonment even in some
of the limited areas where it was pre-
viously applied.
Review of past trends
The main features of Brazil's economic
and financial crisis prior to 1964, which
led to the introduction of indexing, are
well known. Price increases, which had av-
eraged about 20 per cent a year during the
1950s, began to accelerate rapidly in 1959.
Strong trade unions negotiated succes-
sively larger wage adjustments, credit was
granted liberally to accommodate higher
costs, and the resulting wage-price spiral
pushed inflation to over 80 per cent in
1963. As the Government tried to sup-
©International Monetary Fund. Not for Redistribution
press inflation, the distortions in relative
prices also became more severe. Exports
stagnated because of delays in adjusting
the exchange rate; apartments were left
empty as rent adjustments lagged; and
electricity, telephone, and other public
services deteriorated as the charges for
these services were kept artificially low.
Interest rates, although nominally high,
were negative in real terms, and savers
sought protection in real estate or the
transfer of funds abroad. Finally, Brazil's
public finances were seriously weakened,
because all charges for public sector serv-
ices and certain minor taxes were spe-
cific rather than ad valorem; moreover,
taxpayers delayed payments to take
advantage of the loss in purchasing power
of the cruzeiro.
Faced with this combination of high
inflation and serious distortions in rela-
tive prices, the new Brazilian Government
which took power in April 1964 adopted
a medium-term plan to: (1) eliminate
inflation gradually over a period of four or
five years; and (2) minimize inflationary
distortions during the transition period.
While the reduction of inflation was
slower than expected, the program to
minimize the distortions arising from
inflation has been more successful: most
real interest rates have been positive; the
exchange rate has been adjusted regularly
to compensate for increases in domestic
costs relative to those abroad; and rents,
tax revenue, charges for public services,
and other key economic variables all have
roughly kept pace with inflation. Saving
and investment in the economy have been
high, output has risen at an unprece-
dented rate, and the balance of payments
has been strong.
Readjustable treasury bonds
Readjustable treasury bonds, which
were indexed for inflation in addition to
paying a small nominal interest rate, were
issued in 1964: these bonds have set the
pattern for most other forms of
"monetary correction" of financial assets,
although such indexing has not spread
very widely in the private sector. The
1964 law did not prescribe what index
would serve for adjusting the bonds, but
in practice the bonds were linked to the
wholesale price index with a lag of sev-
eral months. Initially the treasury bonds
were not well received, and most Bra-
zilian savers preferred to continue con-
verting their idle funds into foreign
exchange. To meet this problem, the Gov-
ernment offered a new series of bonds
in May 1965 which gave purchasers the
option of monetary correction based
either on the wholesale price index or
on the exchange rate with respect to the
U. S. dollar, whichever was more favor-
able. This option could be chosen ex post,
but after the crawling peg exchange sys-
tem was adopted in 1968, the rate of
depreciation of the cruzeiro in relation to
the U. S. dollar was always less than the
rate of increase in wholesale prices, and
monetary correction based on wholesale
prices was consistently the more favor-
able option.
One of the most troublesome problems
encountered in Brazil's indexing has been
the lag between price increases and the
subsequent adjustment of the indexed
paper. For various operational reasons,
the average lag in adjusting treasury
bonds to inflation was about five months
until 1972. In 1973, with inflation declin-
25
ing, this lag was considered to be inter-
fering with the efforts to control inflation.
The Government, therefore, temporarily
eliminated the lag by using "projected"
inflation for the current months where
statistics were lacking, thus introducing
a departure from the practice of linking
to actual prices.
In the late 1960s and early 1970s,
sales of these indexed treasury bonds to
the Brazilian private sector were relatively
small, and their role in Brazil's capital
market remained quite limited. At the
end of 1973, only about 15 per cent of
the outstanding bonds was held by the
general public. Most of the bonds were
"indexing of private sector financial
obligations other than those related to
housing finance remains rather
limited"
in the hands of the commercial banks
(which are permitted to use them to ful-
fill part of their minimum legal reserve
requirements) or the National Housing
Bank (which receives indexed deposits
and therefore needs indexed liquid assets
until the funds are lent for housing).
With the acceleration of inflation in 1974,
however, indexed bonds for the first time
became more attractive to the private
saver than nonindexed paper. This caused
considerable problems in domestic capital
markets, as private savers drew funds out
of nonindexed accounts to purchase the
bonds. In response, the Government tem-
porarily discontinued the sale of indexed
bonds and switched exclusively to treasury
bills. These treasury bills, which circulate
in Brazil much more widely than the
bonds, have an average maturity of six
months and have never been indexed on
the grounds that linking such a short-
term asset to a price index would not be
administratively feasible.
Housing finance
Apart from treasury bonds, the only
other major financial transactions that
have used indexing extensively are those
pertaining to housing finance. Since 1964
both assets and liabilities in the housing
sector have been linked to either a price
or wage index and adjusted monthly,
quarterly, or annually in accordance with
movements in the index. There have been
frequent changes in the system of index-
ing, however, and, as in the case of
26
©International Monetary Fund. Not for Redistribution
treasury bonds, the Government has
enjoyed wide freedom to change the index
in order to meet the needs of its housing
policy or its overall economic policy.
As a result of the system of indexing,
the Brazilian mortgage market, which was
almost nonexistent in 1963, has grown
substantially in the past decade. The sys-
tem has had a series of problems, how-
ever, including at various times a high
level of defaults, and this has led to a
gradual movement away from full index-
ing. The most frequent (although incom-
plete) explanation for these defaults was
that the family incomes of some mort-
gagees did not grow pari passu with the
mortgage obligations. The problem became
so severe that in 1972 the system
was revised to ensure that mortgage pay-
ments declined in real terms over time.
All obligations continued to be indexed,
but the initial service schedule on mort-
gages, which previously involved equal
total payments (amortization plus inter-
est) over the life of the contract, was
switched to one of equal amortization
payments. Under this system, because
real interest payments became smaller
over the life of the loan, total monthly
payments declined in real terms despite
the indexing.
When inflation rose to over 30 per
cent in 1974, the Government again
revised the system of mortgage financing
to reduce the "burden" produced by
Jack D. Guenther
a U. S. citizen, is a
graduate of 'Yale and
Harvard, and also
studied at Kings
College, Cambridge.
Since joining the
Fund staff in 1960, he has worked mainly
on Brazil, Argentina, and the Caribbean
countries, and is presently an Assistant
Director in the Western Hemisphere
Department.
indexing. Under a new system of tax
rebates, the effective adjustment of mort-
gages in 1975 will be equal to inflation
minus 10 percentage points. The rebate
is at least Cr$240 per year, and the relief
from indexing, therefore, is greater than
10 percentage points on those mortgages
in which annual service payments are less
than Cr$2,400 (about US$300). Indeed, on
many small mortgages, even the nominal
service payments will decline in 1975
under the new system. Because the sav-
ings instruments that finance housing
continue to be fully indexed, the Treasury
in effect will have to subsidize the Hous-
ing Bank by paying the rebates from the
budget.
Other financial assets
Contrary to popular belief, indexing of
private sector financial obligations other
than those related to housing finance
remains rather limited in Brazil. At the
end of 1973 only about 19 per cent of
the total financial obligations issued by
the Brazilian Treasury and the Brazilian
financial system was indexed (Table 1).
The Brazilian treasury bonds accounted
for half of the indexed paper, and the
remainder was mortgage bonds and sav-
ings deposits, which are used almost exclu-
sively to finance housing. On several
occasions during the past decade, the
Government, in its efforts to develop a
medium- and long-term capital market in
Brazil, has tried to encourage the spread
of indexing into other parts of the private
sector, but the movement appears to
have been resisted by borrowers. Financial
institutions, of course, are unable to accept
indexed deposits unless they can find bor-
rowers willing to contract loans with
indexing. Private firms, however, gener-
ally have been reluctant to assume such
"open-ended" obligations, apparently pre-
ferring the certainty of rates fixed in
nominal terms, even if these rates are
high, rather than rates fixed in real terms
where the nominal interest might turn
out to greatly exceed their projections.
The erroneous impression that index-
ing is very extensive in Brazil's private
sector is partly due to the ex ante mone-
tary correction advertised by Brazilian
commercial banks on their time deposits.
This ex ante correction for inflation
merely means that a certain projected
rate of inflation presumably has been
allowed for when setting the total inter-
est rate. The practice of ex ante monetary
correction originated partly to circumvent
Brazil's usury law, which limited interest
to 12 per cent; the borrower would agree
to pay, for example, 12 per cent interest

Table 1
Principal financial obligations
issued by the Treasury
and the financial system
outstanding at end of 1073
Per
Billions cent
of of
cruzeiros total
Total 218 100
Nonindexed 176 81
Sight deposits 77 35
Bills of exchange 37 17
Time deposits 28 13
Currency in
circulation 17 8 the Brazilian authorities first tried to off-
Treasury bills 17 8 set by fiscal measures reducing the taxa-
Indexed 42 19
Treasury bonds 21 10
Savings deposits 14 6 to suspend temporarily the sale of treasury
Mortgage bonds 7 3
Source: Central Bank of Brazil.
and a further 15 per cent allowance for
inflation. At times the portion correspond-
ing to inflation also received a different
tax treatment from the remainder of the
interest—on the grounds that "interest"
which merely permitted the saver to keep
pace with inflation should not be con-
sidered taxable income. The fact is, how-
ever, that the total return paid on instru-
ments with ex ante monetary correction
is agreed in advance, and the instrument
is not indexed in the sense that the
return varies with the actual behavior of
prices.
Index of business loans
The National Development Bank is at
present the only major source of indexed
loans to business. This bank uses mainly
its own capital and part of the resources
of the social security system to make
fully indexed loans. Late in 1974, how
ever, borrowers from the bank became
alarmed as their obligations began to be
adjusted upward in line with the accel-
eration of inflation. Consequently, the
demand for loans began to lag. The bank
authorities were concerned that this might
deter investment and announced, there-
fore, that adjustment of annual service
payments on its loans will in future be
limited to a maximum of 20 per cent
regardless of the rate of inflation. The
loan principal will continue to be fully
indexed, however, which will require the
borrower to make additional service pay-
ments beyond the original maturity of the
loan.
The coexistence of indexed and non-
indexed financial assets has led to con-
siderable problems, particularly when the
©International Monetary Fund. Not for Redistribution
rate of inflation varies significantly. The
recent upsurge in Brazil's inflation caused
indexed treasury bonds to become more
attractive than fixed-interest securities for
the first time in over five years. During
the course of 1974, the total return on
indexed treasury bonds rose from 17 per
cent (13 per cent monetary correction and
4 per cent interest) to almost 40 per
cent, while interest on nonindexed time
deposits increased only from 21 per cent
to 27 per cent. This shift in favor of
indexed paper led to an outflow of funds
from many financial institutions, which
tion of interest on nonindexed assets.
Finally, however, they made the decision
bonds to the public between August 1974
and February 1975, when sales were
resumed on a limited basis. Also, to par-
tially offset the changed flow of funds,
the Central Bank early in 1975 diverted
resources from the housing system, which
was capturing indexed funds greatly in
excess of its needs, to the investment
banks, whose nonindexed offerings were
unable to attract private savings. The
Central Bank reportedly will pay the dif-
ference to the Housing Bank between the
indexed return required on their invest-
ments and the nonindexed rate that will
be paid by the investment banks.
Wages
After 1964 the new Brazilian Govern-
ment eliminated strikes and collective
wage bargaining and ordered that future
"restraint on wages undoubtedly was a
major reason for Brazil's success in
reducing inflation rapidly"
wage adjustments in the industrial sector
be made in accordance with an official
formula. Total employment in the union-
ized sector, for which the wage formula
was designed, was less than 2 million
workers out of a work force of 30 million.
This sector included, however, the strongly
organized groups, and the purpose of
using the standard formula for these
groups was to ensure relatively uniform
wage adjustments rather than adjustments
dependent on the relative strength of each
union. Other wages in the economy con-
tinued to be set by the Government
independently of the formula (as in the
case of the minimum wage and the
wages for national and local government
employees), or remained completely free of
control (as in the areas of services and
agriculture).
The official wage formula used in
Brazil since 1965 is quite different from
a cost of living escalator clause operating
during the life of a wage agreement. Each
contract is signed for a 12-month period,
and contract renewals for the various
industries are spread throughout the year;
once the wage is determined there is no
link to prices and no adjustment in
nominal wages is made until the contract
expires. The rise in the cost of living is
taken into consideration only when a new
annual contract is signed. Furthermore,
in the mid-1960s even the new contract
did not include full compensation for past
inflation. The formula was specifically
designed, in fact, to break the previous
pattern of fully compensating for past
inflation which, together with escalator
clauses during the contract period, had
been largely responsible for the wage-cost
spiral under the previous system of col-
lective bargaining. The formula was based
on the recognition that the maintenance
of average real wages did not require full
compensation for past inflation when
inflation was declining.
Specifically, wage increases granted
under the 1965 formula reflected three
components, which were designed to (1)
raise the real wage up to the average of
the previous 24 months; (2) provide for
the maintenance of this average wage by
granting an additional amount equal to
one half of the "projected" inflation dur-
ing the year covered by the wage agree-
ment; and (3) allow a small additional
amount for higher productivity. The
allowances for future inflation and prod-
uctivity were announced each year by
the Ministry of Planning. Not surpris-
ingly, the estimate of future inflation
always was less than the actual inflation
turned out to be. For example, in the
year beginning August 1966, the pro-
jected inflation used in the wage formula
was only 10 per cent, whereas the actual
increase in the cost of living was 30 per
cent. As a result, average real wages
declined during 1966 and 1967, despite the
professed goal of the formula to main-
27
tain them (Table 2). This restraint on advance wage boost of 10 per cent to all
wages undoubtedly was a major reason workers whose contracts had been signed
for Brazil's success in reducing inflation in the period January—June 1974 and
rapidly in these years—from 90 per cent whose wage adjustments, therefore, had
in 1964 to about 25 per cent in 1967— not yet fully reflected the mid-year
while at the same time increasing invest- upsurge of inflation. At the same time,
ment and strengthening the balance of they further liberalized the formula to
payments. provide in future a straightforward in-
crease in real wages of 4 per cent a
year. These latest discretionary wage
Table 2 boosts were taken at a time when con-
Wages and prices sumer demand was showing signs of
Average increase
granted In
weakness and output in some sectors of
Cost
yearly wage manufacturing was declining for the first
settlements
of
living
made during time in almost ten years.
month 2
used in After 1968 Brazil's revised wage for-
wage Private Public
formula ' sector sector mula probably tended to perpetuate past
Percentage price rises without any significant effect
increase
during
in either accelerating or decelerating the
previous
12 months In per cent
rate of inflation. There were occasions
during that period, however, when exoge-
December
1966 41.9 30.0 3
30.03 nous forces tended to change the rate of
1967 25.5 20.1 20.1 inflation. For example, in 1972, relatively
1968 22.8 24.5 25.1 good harvests led to a decline in the rate
1969 24.5 28.2 26.4
1970 22.1 22.0 22.4 of price increases; and more recently, the
1971 19.8 22.0 22.6 sharp increase in world prices of petro-
1972 17.9 19.4 20.0 leum and other commodities, together
1973 13.9 16.6 16.6
1974 29.5 35.0 35.5 with excess domestic demand, produced
Sources: Getulio Vargas Foundation; arid
an acceleration in Brazil's inflation. Once
Ministry of Labor. these price trends were set in motion,
* Refers to previous month; figures for either increasing or decreasing the pre-
December represent the increase In prices
during
1
the 12 months ended in November. vious rate of inflation, the wage formula
under the official wage formula.
9
Estimate based on partial data. tended to reinforce the trend. However,
this reinforcement of price trends prob-
ably was less pronounced than under the
system of collective bargaining and
Wage formula revised escalator clauses that existed before the
Brazil's wage formula was revised in 1964 reform. This is because—except for
1968, and since that date real wages the advance in December 1974—the Bra-
granted under the formula have risen zilian formula adjusts wages to compen-
gradually. The major change was the sate for actual price trends only when the
introduction of a new component in the 12-month contract expires, which means
formula to compensate for the excess of that wage payments do not fully reflect
actual inflation over projected inflation new price trends until a full year has
during the previous contract period: in elapsed.
calculating the real wage base for the
coming year, the revised formula used not Other areas of indexing
the actual real wage received in the past Apart from wages, treasury bonds, and
year but the intended (higher) real wage mortgages, the other principal areas
that would have been received if inflation where some form of indexing is used in
had been as projected. Also, the allow- Brazil are house rents and certain fiscal
ance for the growth in productivity was transactions.
raised gradually from zero to 3 per cent. During the late 1960s and early 1970s,
Because of these 1968 adjustments to the three schemes existed for adjusting house
formula, real wages granted under the rents, depending on when the contracts
formula rose by an average of about 2 were signed: (1) contracts signed between
per cent a year from 1968 through 1973. 1964 and 1967 were adjusted each year by
Because wage contracts are signed for two thirds of the percentage increase in
12 months, a temporary decline in real the minimum wage; (2) contracts signed
wages still can occur with an upsurge prior to 1964 were adjusted by the full
increase in the minimum wage plus an
of inflation during the life of the con-
tract. To deal with this problem, in additional 10 percentage points; and (3)
December 1974 the authorities departed contracts signed after 1967 were free of
from the formula and granted a special controls. By 1974, however, most rents
28
©International Monetary Fund. Not for Redistribution
payable on pre-1964 contracts had been
brought up to the market level, and
almost all rent contracts are now freely
negotiated. In practice, however, many of
these freely negotiated contracts have
clauses which link payments to the read-
justable treasury bonds.
In the area of public finances, several
types of indexing have been introduced.
One of the first acts of the new Govern-
ment, in July 1964, was to index unpaid
taxes and related liabilities. Taxpayers
had used many devices to delay paying
taxes, including testing the assessments
in the courts in order to benefit from in-
flation while the case was under consid-
eration. The 1964 legislation provided that
all tax liabilities not paid in the calendar
quarter when they became due would be
subject to monetary correction. The post-
1964 tax laws also provided for the an-
nual revaluation of fixed assets and
working capital; the revaluation of the
fixed assets was made mandatory, while
the revaluation of working capital was
optional. At present, after several changes,
the index for readjustable treasury bonds
is used for all these purposes.
Indexation has been used also—but
rather sporadically—for income tax brack-
ets in Brazil, in order to ensure that the
brackets are adjusted upward roughly in
line with inflation. This policy antedates
the 1964 reform, for already in 1961 the
income tax brackets were defined as mul-
tiples of the minimum wage and were,
therefore, adjusted automatically each
time the minimum wage was changed.
This link to wages proved unsatisfactory
after 1964, when minimum Wages for
two or three years were adjusted upward
by a lower percentage than the increase
in prices, which would have resulted in
increased income tax burdens at all levels
of real income. This increase in tax rates
was not desired by the Government, and
in November 1964 the law was modified
to provide that the income tax brackets
be adjusted in accordance with move-
ments in prices rather than the minimum
wage. In 1973 and 1974, the procedure
again was modified, and the Government
departed further from indexing. In 1973,
as part of the policy to improve income
distribution, the upper brackets were
increased by 15 per cent and the lower
brackets by 26 per cent; and again in
1974 the upper brackets were raised by
12 per cent and the lower ones by as
much as 41 per cent. Thus, the authori-
ties have exercised a considerable amount
of discretion in adjusting the tax brackets
in the past decade. Although the brackets
have been changed regularly, the size of
the increase has been dictated by general
policy considerations rather than by rigid
adherence to an index.
The system of minidevaluations
There are two other areas—the ex-
change rate and charges for public ser-
vices—where regular adjustments also
have been made to offset the effect of
rising prices, but without any rigid sys-
tem of indexing.
"one of the most important
achievements in Brazil since 1964 has
been the strengthening of public
sector finances"
In August 1968 the cruzeiro was depre-
ciated by 12 per cent in terms of the U. S.
dollar, and the authorities announced that
in the future it would be depreciated
frequently by small amounts. The criteria
used for adjusting the rate would be
price changes in Brazil compared with
those abroad, the level of international
reserves, and the behavior of exports.
Although the cruzeiro has been de-
valued roughly in line with price differ-
entials in recent years, this has not been
done through a formal system of index-
ing, as is sometimes suggested. The eco-
nomic authorities have been free to
devalue by somewhat more or less than
indicated by price differentials if that
course seems advisable in the light of
overall policy considerations. In Decem-
ber 1971, for example, the cruzeiro was
depreciated fully in line with the U. S.
dollar; but in February 1973, at the time
of the second U. S. dollar devaluation,
with Brazil rapidly gaining reserves and
struggling to control inflation, the cruzeiro
was appreciated by 3 per cent with respect
to the U. S. dollar. The Brazilian deci-
sions on these occasions were made after
considering all the advantages and dis-
advantages of following the U. S. devalua-
tion (particularly the effects on the bal-
ance of payments and domestic prices)
rather than by a predetermined link of
the exchange rate to price indices.
Any attempt to rigidly index the
exchange rate would encounter formida-
ble difficulties. For example, there would
be the problem of selecting which price
series to use in Brazil and in other coun-
tries, particularly in a world of floating
©International Monetary Fund. Not for Redistribution
currencies. The Central Bank has stated
that the value of the cruzeiro now is
being set mainly in relation to a trade-
weighted package of currencies rather
than in relation to the U. 5. dollar alone,
but the composition of the basket and the
weighting of the currencies in the basket
have not been announced.
Although the exchange rate is not
formally indexed, the authorities have
been able through the system of mini-
devaluations at frequent, irregular inter-
vals to convince exporters, borrowers, and
foreign lenders of their firm intention to
maintain a realistic exchange rate. Pro-
ducers are prepared to undertake long-
term investments in the export sector,
with the confidence that the exchange rate
will be adjusted roughly in line with rela-
tive costs and that export prospects
will continue to be attractive when the
investment is completed. This new policy
toward exports, which traditionally was
lacking in the Brazilian economy, un-
doubtedly contributed to the tripling in
the U. S. dollar value of Brazil's exports
between 1968 and 1973 and particularly
to the rapid development of manufactured
exports.
Charges for public sector goods
and services
One of the most important achieve-
ments in Brazil since 1964 has been the
strengthening of public sector finances,
which had seriously deteriorated during
the years of high inflation. This improve-
ment was aided by indexing tax arrears
to discourage taxpayers from delaying
payments. Probably the most important
innovation in this area, however, has
been the policy of frequently adjusting
the charges for public sector goods and
services—such as electricity, transporta-
tion, water, wheat, and petroleum—in
line with rising costs.
After 1964, charges for all public sector
services were adjusted upward by amounts
greatly exceeding current inflation. It was,
in fact, the necessity for a large amount
of such corrective inflation that caused
the Government to opt for a gradual
rather than an abrupt halting of inflation
after 1964. By the early 1970s the charges
for public services in Brazil were high
even by international standards, and the
large public sector investment programs
being carried out in electricity, transpor-
tation, steel, and other areas are now be-
ing financed to a substantial extent by
user charges.
It is important to point out that while
these charges for public goods and ser-
vices have risen roughly in line with
inflation in recent years, this is not a
result of any system of indexing, but
rather of discretionary action. As in the
case of the exchange rate and most inter-
est rates, the adjustment for inflation in
this area is accomplished by administra-
tive decision rather than by an automatic
link to prices.
Conclusion
Brazil's experience gives strong support
to the view that the removal of distor-
tions caused by inflation is essential if a
high rate of economic growth is to be
achieved. In particular, where economic
development has high priority, those eco-
nomic variables that are important for
encouraging saving, investment, and ex-
ports cannot be permitted to lag behind
general price increases. The Brazilian case
does not, however, provide much evidence
that widespread indexing is the most
appropriate way to achieve this goal.
Rather, it seems to show that discretion-
ary action by economic managers was the
main
Jackelement in Brazil's success, and that
D. Guenther
the indexing was highly selective, flexible,
and subordinated to general
During the past seven years, policy con-
inflation in
siderations.
Arabic edition
Finance & Development is now
available in an Arabic edition.
Readers who wish to receive
the Arabic language edition
should send their current
address label and include their
address in Arabic. New readers may
also send their requests to:
The Editor
Finance & Development
(Arabic edition)
International Monetary Fund Building
Washington. D.C. 20431
29
 John W. Lowe Speculative booms in property values
have occurred in recent years in both
developed and developing countries. It is
often argued that the resulting transfer of
resources is a considerable deterrent to
economic growth.
But what are the real economic conse-
quences of land speculation? The answers
are complex. While any specific conclu-
sions depend on the underlying features
of a specific economy, this article tries
to show that in general the main implica-
tions of a rise in the price of land are
indirect and are quite distinct from the
effects commonly assumed.
The discussion is limited to significant
short-term upswings in the price of land
(generally, in a small area, such as an
urban center). Over the long run, as
population and income grow, the value of
land increases secularly in line with the
value of many other assets in an econ-
omy. This trend is disregarded here. A com-
prehensive analysis of the relationship of
land values to all other variables in an
economy is a part of general value theory,
which is beyond the scope of this article.
Land speculation is seen here primarily
in the context of developing countries.
However, the issue may be given dimen-
sion by the example of the increase in
land values that has occurred in London.
Prior to the recent fall of the market
there, it was commonly said that property
values had generally doubled and in many
cases tripled over the last five years.
Prime freehold property in the City of
London is currently valued at about $50 a
square foot. If it is assumed that average
land in London is worth about $10 a
square foot, but that this is twice what it
was worth five years ago, then the aggre-
gate increase in the market value of all
of London—some 600 square miles—has
been on the order of $84 billion over the
past five years. This compares with a
gross national product for the United
Kingdom of $145 billion in 1972.
Land speculation
Does it have
real economic consequences?
30
©International Monetary Fund. Not for Redistribution
In downtown Teheran, Iran, where
investment in land is very popular, prime
property currently sells for about $70 a
square foot, exceeding the value of the
best property in London, even though
per capita income in the United Kingdom
is between five and six times that of Iran.
Misconceptions
The waste of private savings "going
into land" is a common cry of anguished
development officials. To use a Keynesian
metaphor, the implication is that people
are digging holes and burying their hard-
earned money there. This is not, of
course, the way land transactions work.
X pays Y for a piece of land at price P;
then Y takes X's money and deposits it
in his bank. The savings thus flow through
the land transaction and continue circu-
lating in the economy, just as with any
transaction, whether a loaf of bread or a
piece of land in central Teheran is in-
volved. One must look beyond the moner
tary transactions to identify the real
economic consequences.
Here it is not difficult to embark on
another misleading train of thought.
Acquisition of land holdings is commonly
viewed as an alternative to the accumula-
tion of industrial capital. It would seem
that any increase in the value of land
would imply a decrease in the rate of
acquisition of industrial capital. Conse-
quently, it might seem that potential
goods production would suffer during a
land boom.
To analyze this proposition, it is neces-
sary to separate what is capable at any
given moment of producing output in an
economy from a bidding up of the market
value of an item in that economy. In
other words, the stock value of productive
capital (which includes land) should be
considered as distinct from the value of
the flow of goods produced by this capi-
tal.
In the simplest terms, growth in output
in an economy depends on increases in
the capital stock that produces the output
(disregarding for the moment such factors
as capacity utilization and changes in the
capital-output ratio). To identify the
effects of land speculation on output and
growth, one must identify the impact of
short-term increases in the price of land
on aggregate savings and on the invest-
ment of savings in additional productive
capital.
Output and price
The total capital stock of an economy
can produce a given output, whatever its
monetary value. Clearly, changing the
aggregate price at which any one of the
capital components is valued does not
directly affect the aggregate of real goods
that the stock is capable of producing. A
doubling or tripling of the price of land,
in other words, does not in itself make
land more (or less) capable of growing,
say, more wheat. (The inducement to
grow wheat more intensively because
land is more expensive is considered sepa-
rately below.)
The relative price of any form of capi-
tal, such as land, ordinarily bears a rea-
sonably consistent relationship to the
relative value of what that form of capital Traditional economic theory
is capable of producing, such as (continu-
ing the above example) wheat. But this tors in analyzing land
relationship is not necessarily fixed. The speculation in the
ratio between the price of the stock of
land and the price of its output (its
"price-earnings ratio") can vary widely.
This latter term is familiar stock
exchange jargon, and an analogy with
stock transactions is relevant in this
instance. The value of securities on a
stock exchange is periodically bid to great
heights. But the increase in the market
value of outstanding securities (disregard-
ing for the moment the impact on encour-
aging new issues) has no direct relation-
ship to the productive capacity of the
firms the securities represent. The effect
is simply to increase the price the investor
is willing to pay in relation to the under-
lying earning power of the asset. This
may be because the investor anticipates
increases in the future value of real out-
put and bids up the current price accord-
ingly. Or, if the investor is relying mainly
on anticipated increases in price, he may
care little or even not at all what the
earnings of the asset are. In the latter
case it hardly matters whether the under-
lying capital generates any earnings at
all. This may be termed "pure" specula-
tion.
It is useful to discuss some other fac-
framework of traditional economic theory.
It will be evident, however, that the
greater the speculative motive for land
acquisition, the less reliable are the con-
clusions to which traditional theory leads.
Traditional economic theory would sug-
gest that an increase in land values would
lead to an increase in the supply of land.
Of course the total stock of land is fixed,
but bidding up existing land values may
lead to the extension of usable land area,
for example, by draining swamps or ferti-
lizing and irrigating arid land. In an
urban context, marginal land areas may
be reclaimed and developed.
But in practice, a rise in land values
will not greatly induce a supply of addi-
tional land, particularly in the short run.
In both developing and developed coun-
tries today, the most dramatic instances
of land speculation have
been in central

©International Monetary Fund. Not for Redistribution

 urban areas, where the supply of land is
relatively fixed. Within any reasonably
short time reference, the supply of land is
therefore inelastic.
Traditional theory would suggest two
further considerations. First, as land
prices increase in relation to earnings,
there is a decrease in earnings in relation
to price or yield. Investors, comparing
the yields on alternative investments,
would then probably turn to other pur-
chases with higher yields. As a result, the
price of land—for want of demand—
would drop to a more normal relationship
with other assets. However, if investors
are relying primarily on a continued rapid
increase in land prices, the long-term
consideration of slightly lower yield may
be minor. Investors may purchase despite
a low yield, driving prices even higher
(and yields lower).
Second, it might be assumed that an
investor paying a high price for a low-
yielding asset would be induced to in-
crease its output—for example, by using
fertilizers to increase the output of wheat.
In an urban context, the land purchaser
might build a taller or newer building to
generate higher rental incomes. The activ-
ities thus stimulated may give rise to sub-
stantial increases in demand for related
investment, such as fertilizer production
or building construction (continuing the
above examples). Again, however, purely
speculative motivations may vitiate these
assumptions in the short run. If the land
purchaser is looking primarily to short-
term speculative gains (and ignoring tax
disincentives and the like), he may be
indifferent to leaving his land in an
unimproved state. Thus areas in some
major cities (for example, central Tehe-
ran) remain conspicuously undeveloped.
Inflation and speculation
A characteristic of land acquisition is
the impact of inflation on it. Land has
almost always fared well as a form of
protection against inflation. It is probably
safe to say that the value of land often
increases more than proportionately in
inflationary environments. This may be
explained partly by economics and partly
by psychology. Land, like gold, is a very
basic savings medium as perceived by
most savers. Few assets represent real
capital more visibly or tangibly. In the
uncertainty of rapid inflation, people tend
to fall back upon fundamentals and
acquire land to protect their savings. As
more and more people turn to land acqui-
sition for this reason, increases in land
values relative to other assets can become
self-accelerating. Speculative motivations
32
©International Monetary Fund. Not for Redistribution
may then compound the protection-of-
assets motivation for land acquisition.
The extent to which inflation may
account for a sustained increase in land
values depends upon how widely expecta-
tions of continued price increases are
shared. A generally anticipated drop in
the rate of inflation may account for the
end of a boom in land prices.
Distribution of wealth
It has already been shown that bidding
up land values in the short run bears at
best a tenuous relationship to the factors
affecting the formation of real productive
capital in an economy. Over time, a
higher price of land is likely to induce
capital formation in the form of greater
use of tractors and fertilizers on the farm,
a greater density of buildings in the city,
and so on. But a short-run increase of a
more speculative nature is less likely to
produce these results. Rather, the main
short-run effects will be indirect, resulting
from changes in the distribution of
wealth enjoyed by landowners relative to
nonlandowners. These may in turn affect
the determinants of savings and produc-
tive investment in an economy.
It is often assumed that the net effect
of an increase in land values is to make
the rich richer, since they are more likely
to own land. In many countries, however,
land is a very widely held asset. Land
ownership may have been passed down
in small parcels for generations so that
broad segments of the population may
enjoy the benefits of an increase in land
values. In land booms in some developing
countries, prime lots of land have been
syndicated or broken up into small seg-
ments and sold to small individual savers.
John W. Lowe
a U. S. citizen, is an
Investment Officer in
the Department of
Investment Promotion
and Special Projects of
the International
Finance Corporation.
Mr. Lowe joined the staff of the World
Bank Croup in 1970. He holds an
undergraduate degree in physics from Yale
University and a masters degree from
Harvard Business School. In 1973 Mr. Lowe
was on leave of absence researching capital
markets development issues at the London
School of Economics.
In such circumstances, a land boom may
actually improve the distribution of
wealth. More often, however, areas where
the most dramatic increases in land
values have taken place, such as central
urban areas, are held by relatively
wealthy individuals. Clearly, the ultimate
result of the effect of increases in the
value of land on the distribution of
wealth is dependent on who owns the
land.
Two refinements may be added to the
above points. First, while any individual
holding a small piece of land may be
said to enjoy increases in its value, an
individual cannot generally benefit until
the plot is sold. But if such an individual
sells his property, he will have to pay
more for a new one. If the individual has
to pay more for new property or, notion-
ally, to himself to retain property he has
(foregone capital gain), it makes little net
difference to his well-being if the prop-
erty he has is suddenly worth more. His
wealth has increased, but so has his cost
of living. On the other hand, those with
land in addition to what they need to live
on can benefit directly from increases in
land values by selling off extra land hold-
ings. In this category the wealthy are
especially likely to predominate.
A second consideration is that it is
generally easier for the wealthy to borrow
to purchase land and to borrow against
increases in the value of their land. In
summary, the wealthy can often accumu-
late land more easily, and can more easily
enjoy increases in its value. These factors
tend to worsen the distribution-of-income
effects of a general increase in land prices.
Savings and motivation
Among both rural and urban house-
holds, the acquisition of land is a major
motive for saving. Bidding up land values
relative to incomes earned by wage earn-
ers may have an important effect on sav-
ings motivation in an economy. If prices
escalate slightly, there may be an induce-
ment to save more money for home own-
ership. On the other hand, if they escalate
rapidly, wage earners may think it futile
to save to acquire property and savings
may drop accordingly.
Entrepreneurial motivation may also be
affected. In rural areas, increases in
land values relative to income puts the
acquisition of farm property by tenant
farmers more and more out of reach. The
man who tills the soil is then more likely
to remain a tenant rather than an owner,
and he may therefore become indif-
ferent to adopting new agricultural tech-
niques or to increasing the productivity of
his farming methods. in the value of land may also attract capi- visions in the tax code for loss carry-
Analogous consequences may result in tal inflows from abroad. At least in the backs.
urban areas when city workers see the short run, this would have a compen-
price of land escalate beyond their ability sating effect on the balance of payments. Government policy
to save and borrow to acquire it for The net effect of capital inflows from The effects on distribution of income
homes. As the proportion of owner- abroad for land purchase will depend (as and on aggregate savings, investment,
occupiers of homes decreases, the upkeep with many of the other considerations and output in an economy as a result of a
and maintenance of urban property will that have been examined) upon how the rapid bidding up of land values, it has
deteriorate. In both urban and rural areas, funds are ultimately used. Capital from been seen, are diffuse, tend to be felt only
when fewer and fewer people are able to abroad may make available to the domes- with the passage of time, and may in any
own their own property, feelings of tic economy resources that can be used event be overshadowed by other factors
alienation and bitterness are likely to for the importation of highly productive or events. Certain sectors of the popula-
increase. equipment, or it may be diverted to con- tion enjoy increases in relative wealth.
At this point, the social character of sumption. The results are determined There may be a flurry of transactions, but
some of the effects of a rapid bidding up primarily by the persons receiving the these are not likely to be the source of
of land values should be evident. In any resources (that is, who sell the property) much immediate discontent or tension. By
society, output is not only a product of and how they in turn utilize the proceeds contrast a collapse in land values after
the size of the capital stock but also of of the transactions. the build-up of a rapid boom has imme-
how effectively that stock is used. The diate repercussions. In the end, the prob-
ability to acquire land may significantly Taxation lem of the cyclical nature of an unusually
affect the aggregate motivation of work- Taxation of the transfer of land, al- rapid bidding up of land values is what
ers and thus the magnitude of their out- though it tends to reduce the liquidity of usually prompts most governments to
put. wealth in the form of land holdings, does take action against land speculation.
Similarly, the status of land distribu- not necessarily stop speculative purchases When land becomes overvalued in the
tion may have a significant dampening of land. Fewer transactions may take sense of not being in long-term equilib-
(or encouraging) effect on potential out- place and thus reduce the availability of rium relative to the value of other assets
put. For example, land ownership by a land to new savers; but each transaction in the economy, then for one precipitating
small elite usually has particular social may take place at a substantially higher reason or another, the land market is
consequences which pervade the produc- price. The end result of high transfer likely to collapse. At this time familiar
tive characteristics of an economy. These taxes on land may be to increase the consequences will follow very quickly. In
effects are complex but well-known and volatility of the property market by general in the balance sheets of indivi-
it is not necessary to discuss them here. decreasing its "depth." duals and companies as well as banks, a
An alternative approach is to include major asset item becomes worth substan-
Demand effects taxation of land based on periodically tially less in realizable values. The net
Increases in the value of land may revalued prices as part of a general worth of those individuals and institu-
induce changes in consumption and sav- wealth tax. Wealth taxes present special tions decreases as a result, and outstand-
ings patterns in an economy, even if difficulties in terms of accurately apprais- ing liabilities increase in relation to net
individuals do not realize cash gains from ing the value of land, particularly if few worth. There is a "reverse demand"
sale of their property. Landholders enjoy- actual transactions are taking place. These effect. As it becomes difficult to dispose
ing increases in the value of their assets problems can be overcome by valuation of land in order to secure cash, a liquidity
may feel wealthier and more secure, and procedures, however, and land taxes squeeze develops, intensifying the drop
as a result may increase the amount of under a property tax system based on in demand. Credit is reduced, and a
consumption out of their current income. capital values, or assessed periodically on general contractionary impulse is felt
Increases in perceived wealth, by increas- increases in land value, are used in many throughout the economy.
ing consumption, may increase aggregate countries. Prompt and appropriate action by pub-
demand. If there is insufficient demand The justice of such taxes is defended lic authorities may reduce these effects
in the economy, output and income will particularly in countries where land is but there will inevitably be some contrac-
increase; if there is too great a demand, acquired as a refuge from inflation or tion in aggregate income and growth.
the result will be inflationary. where land values are increasing dispro- These are legitimate concerns of a gov-
The kind of demand likely to be stimu- portionately in an inflationary environ- ernment and justify measures by the pub-
lated by such effects would depend on ment. By taxing such appreciating land lic authorities to discourage purchases of
the taste of those holding land and enjoy- values, it is argued that a government land for purely speculative reasons.
ing the increase in its value. If landhold- more fairly apportions its costs among It is important to recognize, however,
ing is broad-based, so also would be the those realizing the greatest benefits. Pre- that considerable and sustained increases
demand for goods and the type of goods sumably if increases in land value are in land prices may only reflect real in-
demanded. On the other hand, if land is largely the result of speculation, the same creases in the relative value of land in an
held among a relatively few wealthy indi- argument applies. economy. Interference with this process
viduals, increases in demand are more One consideration that should be kept may only impede normal equilibrium
likely to be in the form of luxury goods, in mind in taxing gains essentially result- adjustment. Particularly in a rapidly
a relatively high proportion of which are ing from such increases is that, if there growing economy, a rapid bidding up of
imported. are subsequent losses from a drop in the land may simply reflect the suddenly
While increases in the demand for market, those who have paid high tax increased capital value of potential earn-
imported goods may adversely affect a assessments may be penalized unduly. ings that properly developed land could
country's balance of payments, increases This could be corrected by adequate pro- produce.
33

©International Monetary Fund. Not for Redistribution

 The
Generalized
System of
Preferences
examined
The first United Nations Conference on
Trade and Development (UNCTAD) that
convened in Geneva in 1964 proposed the
introduction of a system of preferential
tariff rates by developed countries favor-
ing the manufactured and semimanufac-
tured imports from less developed coun-
tries. This was one of a package of global
trade measures instituted to promote the
development process in less developed
countries. The proposal, which came to be
known as the Generalized System of Pref-
erences (GSP), called upon developed
countries to eliminate or reduce tariffs on
all manufactured imports from less devel-
oped countries. All the developed coun-
tries that had agreed to provide preferen-
tial treatment to less developed countries
under this proposal have by now intro-
duced their individual GSP schemes, thus
assuring either free entry or at reduced
tariff rates to manufactures, semimanufac-
tures, and a few primary and agricultural
products which are exported from less
developed countries. The full tariff rate
continues to apply to imports from other
countries. This preferential treatment is,
however, subject to certain stringent quan-
titative limitations and is applicable only
for a period of ten years from their insti-
tution by the preference granting coun-
tries. These countries are the original six
members of the European Economic Com-
munity (GSP introduced from July 1971);
Japan (August 1971); Norway (October
34
©International Monetary Fund. Not for Redistribution
The first ten-year preferential tariff scheme
was introduced in 1971. The author
analyzes the schemes now in operation and
suggests that the time is ripe for improving the system.
1971); Denmark, Finland, Ireland, New
Zealand, Sweden, and the United King-
dom (January 1972); Switzerland (March
1972); Austria (April 1972); Canada (Jan-
uary 1, 1974); and the United States
(proposed for implementation in 1975).
Denmark, Ireland, and the United King-
dom upon joining the EEC, replaced their
schemes with the EEC scheme on January
1, 1974. Some East European countries
have also implemented GSP schemes.
GSP is an important element of the
global development strategy and now that
it is finally in operation a comprehensive
evaluation of the coverage and global
trade effects of GSP is of interest. More-
over, in the light of the Multilateral Trade
Negotiations (MTN) currently under way
that may, through global reduction in
tariffs, reduce the preferential effects of
the GSP schemes, an analysis of these
schemes becomes all the more important
in order to determine the extent of revi-
sions that would be required in the
schemes to compensate for the adverse
effects of the reduction of tariffs.
GSP works in either of two ways, or
in a combination of both. (1) It can
increase the return on exports that are
already being sold in the preference-
giving countries. Such an increase in
returns may be measured by the reduc-
tion in the burden of the nominal tariff
in developed countries borne by the
exporter from a less developed country.
Zubair Iqbal
(2) It can reduce the price of a new
product in the preference-giving country,
thus giving rise to a new line of exports
from the preference-receiving country.
The advantage of preferences accruing to
less developed countries for the export
of manufactured products can be assessed
in terms of the resulting expansion in
export possibilities for these countries,
that is, the trade effects of preferences.
This study seeks to provide an assess-
ment of the global trade effects of all the
schemes, taken individually as well as
collectively, by estimating the trade crea-
tion (that is, the increase in world trade)
and the trade diversion (that is, the
decline in the exports of nonpreferred
countries) effects. These estimates are
drawn upon to determine the basic weak-
nesses of the schemes currently in opera-
tion and to suggest possible ways of
enhancing their effectiveness.
The GSP schemes
The effectiveness of any GSP scheme
is determined by a number of basic fac-
tors, such as the definition of manufac-
tured goods, the extent of tariff cuts, the
tariff quotas, the safeguard measures like
escape clauses, rules of origin, definition
of countries as preference-receivers, and
the duration of preferences. One common
intent of the schemes currently in opera-
tion is to combine these factors in such a
way as to bring about an increase in
 exports of less developed countries bene-
fiting from the tariff preferences without
materially harming the domestic competi-
tors in developed countries which grant
these preferences. The structure of such
schemes should, therefore, be analyzed in
terms of these factors.
• Product coverage
All the schemes cover manufactures
and semimanufactures, a limited number
of primary commodities, and a few agri-
cultural and fishery products as defined
by the Brussels Tariff Nomenclature
(BTN). They include resource-based man-
ufactures, fabrics, chemicals, metalic and
nonmetalic manufactures, equipment, and
finished consumer goods. However, tex-
tiles, leather and its products, and petro-
leum products are excluded from the
schemes in order to protect domestic
producers of these products in preference-
granting countries. New Zealand extends
preferential treatment only to a few pri-
mary commodities, while the EEC excludes
from its scheme all primary commodities
as well as base metals up to the ingot
stage. The manufactures and semimanu-
factures that were not accorded prefer-
ential treatment in 1970 constituted 62 per
cent of all such dutiable products im-
ported by preference-giving countries
from preference-receiving countries. The
exclusion of such a large range of
manufactures from the GSP has limited
the usefulness of the schemes for pro-
moting manufactured exports of less
developed countries.
The few agricultural and fishery prod-
ucts that are included in the schemes are
processed vegetables, fruits, beverages,
and fish and related products. Imports of
these products accounted for only 4 per
cent of the dutiable imports of preference-
granting countries in 1970. Most of the
agricultural products that could be profit-
ably exported from a large number of less
developed countries are excluded from the
schemes.
• Depth of tariff cut
The Nordic countries and the United
States grant duty free treatment to
agricultural and fisheries products, while
other countries grant various degrees of
tariff cuts. In view of the generally high
tariff protection accorded to agricultural
products in preference-granting countries,
the preferential tariff margins would be
larger for those countries that grant duty-
free entry for such products. However, in
the EEC—the largest import market for
agricultural products—the margins amount
to only about 4 per cent because most
of them are excluded from its scheme.
Duty-free treatment is accorded to man-
35

©International Monetary Fund. Not for Redistribution

ufactures and semimanufactures by the
EEC, the Nordic countries, and the United
States. Japan also grants duty-free treat-
ment to such products except some textile
products, clothing, and footwear on which
a 50 per cent reduction of the most-
favored-nation (MFN) rate of tariff is
applied. Austria and Switzerland apply a
uniform 30 per cent reduction, while
Australia and New Zealand apply varying
rates of reduction, depending on the
product. Canada applies a 33 per cent
reduction in the Commonwealth prefer-
ence rates or MFN rates (whichever
is lower) on imports from preference-
receiving countries.
In general, the preferential margins are
relatively high on finished products cov-
ered by the schemes and relatively low on
semimanufactures and raw materials (see
Table 1).
• Safeguard measures
All schemes of preferences provide for
safeguard mechanisms so that preference-

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

EEC' Japan' Norway Finland New Zealand Sweden Canada Switzerland

Tariff GSP Tariff GSP Tariff GSP Tariff GSP Tariff GSP Tariff GSP Tariff GSP Tariff GSP
4
(per cent) status (percent) status (percent) status (percent) status (percent) .status1 (percent) status (per cent) status (per cent) status

Leather goods, semimanufactured

and manufactured 6.8 F« 15.0 Pt, INC 13.0 PT 12.4 PT 13.5 PT, INC 6.8 PT 16.4 PT, INC 4.2 F
Rubber and products 7.3 F 9.1 PT 13.2 PT 12.7 F 29.3 INC 8.7 PT 16.6 PT, INC 2.8 F
Wood and cork in rough 3.9 F 3.8 F 0.0 F 0.0 F 0.0 EXC 0.0 F 13.0 INC 2.3 F
Wood panels 12.7 INC 18.0 PT 11.0 F 2.5 F 42.5 EXC 3.3 F 13.8 INC 18.7 F
Wood and cork, semimanufactured 5.3 INC 9.0 PT 6.6 F 3.7 F 37.3 EXC 2.1 F 10.2 INC 4.9 F
Wood and cork, manufactured
articles 7.9 EXC 11.4 PT 6.1 F 5.4 F 47.5 PT 3.9 F 16.2 INC 7.0 PT
Paper, pulp and paper waste 2.8 F 5.0 F 0.0 F 0.0 F 0.0 EXC 0.0 F 0.0 ING 2.4 F
Paper and paperboard 10.6 F 9.2 F 2.5 F 6.0 F 26.4 PT, INC 2.5 F 13.5 INC 12.9 F
Pulp, paper, manufactured articles 12.4 INC 7.9 PT 8.4 F 10.8 F 38.6 PT, INC 3.8 F 16.0 INC 11.1 F
Wool and its fabrics 11.5 EXC 7.0 F 6.1 PT 10.3 PT 30.9 EXC 8.0 PT 14.9 EXC 4.6 F
Cotton yarn 7.4 INC 7.8 F 5.0 PT 10.9 EXC 15.9 F 8.9 PT 14.2 EXC 5.6 F
Cotton fabrics 13.0 INC 11.2 INC 16.9 PT, INC 24.4 EXC 19.5 F 13.8 PT 17.7 EXC 11.2 I NC
Jute yarn 8.0 EXC 10.0 50J5 0.0 PT 12.6 F 5.0 F 8.0 PT 18.8 INC 8.8 F
Jute fabrics 19.0 EXC 20.0 50J5 0.0 PT 21.2 EXC 23.0 F 9.5 PT 0.0 EXC 9.1 F
Clothing and clothing accessories 11.6 PT 17.3 PT.5075 22.8 PT, INC 36.7 PT 44.6 EXC 14.6 PT 22.9 EXC 10.3 PT
Glass and glass products 13.4 F 10.0 F 10.0 F 26.4 F 21.5 PT, INC 9.0 PT 14.1 INC 6.1 F
Precious stones, metals, and
products thereof 12.5 F 11.0 INC 5.7 F 5.2 F 26.7 PI 2.2 F 11.4 INC 1.0 F
Iron and steel, unworked 4.5 PT 5.5 F 12.8 F 5.4 F 0.0 EXC 3.4 F 12.5 INC 0.1 F
Iron and steel semimanufactured
products 6.8 F 10.2 F 7.3 PT 6.4 F 22.8 EXC 5.9 PT 10.4 INC 6.5 F
Ferro-alloys 5.6 EXC 7.5 F 0.0 F 11.0 F 0.0 EXC 2.3 F 7.2 INC 11.0 F
Copper, semimanufactures 7.4 PT 16.5 F 4.8 F 4.1 F 25.0 PT 3.1 F 9.3 INC 3.1 F
Nickel, semimanufactures 5.1 F 14.5 F 5.0 F 2.0 F 15.3 F 1.5 F 16.0 INC 1.7 F
Lead, semimanufactures 9.2 F 15.6 F 5.0 F 1.8 F 26.5 EXC 0.0 F 11.3 INC 4.2 F
Tin, semimanufactures 4.8 F 6.3 F 5.0 F 1.8 F 23.1 INC 1.5 F 12.5 INC 1.3 F
Aluminum, semimanufactures 10.9 F 14.9 F 11.4 F 3.1 F 20.9 EXC 3.2 F 13.2 INC 11.4 F
Zinc, semimanufactures 9.2 INC 10.4 F 5.5 F 1.0 F 17.8 INC 0.0 F 10.8 INC 1.2 T
Household equipment 7.8 F 14.0 F 6.9 F 9.0 F 42.5 PT, INC 5.3 F 17.1 INC 5.4 INC
Products derived from coal,
petroleum, etc. 4.5 PT 11.5 PT 5.3 F 5.0 F 10.0 PT, INC 0.9 F 13.6 INC 2.6 EXC
Plastic products 11.1 F 12.2 F 15.7 f 16.1 PT 27.9 INC 10.0 F 15.6 INC 4.6 F
Organic chemicals 8.0 F 10.9 F 14.3 PT 17.1 F 17.9 F 9.0 F 11.9 INC 2.1 EXC
Chemical elements, inorganic 5.6 F 8.5 F 10.6 F 7.8 PT 5.8 PT 4.3 F 12.5 INC 1.7 PT
Tanning materials 6.7 PT 6.5 F 12.5 F 0.0 F 22.5 EXC 3.0 F 15.0 INC 0.5 F
Coloring materials 6.9 F 10.1 F 2.8 F 4.8 F 3.5 F 0.0 F 11.3 INC 1.5 F
Paints, varnishes, etc. 6.8 F 9.1 F 10.3 F 8.5 F 39.4 PT 5.8 F 15.2 INC 5.5 F
Essential oils, perfumes, and
materials 5.8 F 8.9 F 6.4 F 0.0 F 27.2 PT 0.0 F 7.5 INC 4.7 f
Other chemicals, semimanu-
factured 5.2 F 8.3 F 12.1 F 5.4 PT 15.1 PT, INC 6.8 F 11.1 INC 1.4 PT
Electrical machines, apparatus 8.4 INC 10.5 F 7.6 PT 9.7 PT 27.1 PT, INC 6.2 PT 15.2 PT, INC 3.2 PT
Nonelectrical machinery 6.2 F 10.8 PT 8.7 F 7.9 F 39.8 INC 5.1 F 14.8 INC 2.1 PT
Footwear 11.1 INC 17.4 50R 17.1 EXC 14.2 PT 38.2 EXC 12.1 PT 21.5 EXC 8.7 F
Travel goods, handbags, etc. 11.3 F 13.3 F 21.4 F 14.4 EXC 50.0 EXC 9.7 F 18.9 INC 8.4 F
Furniture 8.2 INC 12.5 PT 8.0 F 9.6 F 41.9 EXC 8.8 F 18.5 INC 8.6 F
Toys 11.3 INC 10.8 PT 8.8 F 10.8 PT 39.4 Pt, INC 5.4 F 17.5 INC 6.5 F

Sources: UNCTAD, Third Session, Vol. II; Annual neport, 1966/67-1970/71, Tariff Board, Australia; Interhatlanal Customs Journal. No. 29: New Zealand; various UNCTAD and GATT
documents regarding the nature of GSP schemes currently in operation.
1
All imports under the EEC Scheme are subject to ceilings.
1
Most of the products are subject to restrictive ceiling limitations for safeguard reasons.
1
In general, British preferential rates are applied to imports from beneficiary countries.
4
GSP rates under the Canadian scheme are 33 per cent less than the British Commonwealth preferential rates or the MFN rates, whichever is lower.
* All rates under the scheme aie 30 per cent below the MFN rates.
• F: All items within the product group are admitted free of duty.
50 per cent: All items admitted at rate 50 per cent below the general tariff rates.
PT: Part of the items in the group admitted free of duty while others subject to general tariff rates.
INC: All items in the group granted preferential treatment but not at zero rate and/or subject to quantitative restrictions.
PT, INC: Preferential, nonzero tariff rate apply to only a part of the product group; rest not subject to preferences.
EXC: Ail items in the group excluded from the scheme.

36

©International Monetary Fund. Not for Redistribution

 giving countries can retain some degree regulate preferential imports on the basis qualifying processes are listed and these
of control over the trade which might be of past trade performance of beneficiaries are often applied very stringently, there-
generated by the new tariff advantages of (basic amount) plus a certain increment by preventing the beneficiaries from
the preference-receiving countries. Such (supplementary amount). The current obtaining full advantage of the GSP
safeguard provisions can be classified into application of this formula is so restrictive schemes. Australia, Canada, New Zea-
two broad categories: a priori limitations that the actual expansion of preferential land, and the United States base their
and the application of escape clauses. The trade in the future might be negative, that criteria of origin on value-added. Under
a priori limitation formula is intended to is, it might go below the present level. this a transformation is considered sub-
The escape clause, on the other hand, stantial and eligible for preferential treat-
provides grounds for withdrawing the ment by Australia, Canada, and New Zea-
preferential treatment, in whole or in part, land if the value-added exceeds 50 per
when the import of a product from the cent in the beneficiary country. In the
preference-receiving countries increases to United States, the preferential treatment
the point where it can either cause or is granted only if the value-added per-
Austria Australia United States threaten serious injury to domestic pro- centage is at least 35 per cent for individ-
Tariff GSP Tariff GSP Tariff GSP ducers of similar or directly competitive ual countries, or if it is 50 per cent for
(percent) status (percent) status* (per cent) status products in the preference-granting coun- two or more countries that opt to be
tries. Since no criteria for determining treated as one beneficiary.
9.2 INC 10.2 EXC 16.4 F serious injury are clearly defined, the The other main condition for satisfying
14. 0 INC 28.3 PT 9.3 f
5.1 INC 0.0 PT 7.0 f
application of the escape clause is fraught the origin requirements relates to direct
17.0 INC 40.0 EXC 12.6 r with uncertainty. consignment. Preferred goods must be
7.1 INC 37.5 PT 6.6 f The EEC and Japan apply the a priori consigned directly to the preference-
10.5 INC 35.0 EXC 10.4 f limitation formula on manufactured and giving country from the exporting
5.2 me 0.0 EXC 0.0 F semimanufactured products and apply the (preference-receiving) country without
14, S INC 24.0 EXC 6.2 r escape clause for agricultural and fishery passing through the territory of any other
19.1 INC 18.2 PT 6.7 f
13.1 me 11.6 PT 22.3 EXC products. Other countries use the escape country. All preference-giving countries
11.2 EXC 0.0 PT 11.6 EXC clause for all types of products. apply this condition, while Japan requires,
22,8 EXC 49.0 EXC 18.4 EXC
16.0 INC 0.0 INC 10.4 EXC In the United States, the escape clause in addition, that at the time the goods
28. 0 INC 45,0 INC 8.5 EXC takes the form of a "competitive need" leave the country it must be the intention
30.2 EXC 23.4 PT 22.6 EXC formula, which limits imports from major
14.9 INC 15.2 INC 13.4 f
of the exporter to ship them to Japan.
beneficiary countries. The formula lays • Beneficiary countries
8.E INC 18.3 INC 12.5 F down that if a beneficiary country sup- The preferences are, in general, extended
5.3 INC 0.0 INC 4.5 F
plies more than 50 per cent of the total to all less developed countries that belong
8.9 INC 16.6 INC 7.8 PI imports of a particular eligible item, or to the so-called Group of 77 (which now
16.0 INC 0.0 INC 5.6 F
11. 0 INC 15.0 me 8.0 F
supplies to the United States a quantity has over 100 members) and the dependent
8.7 INC 25. 0 me 8.9 f of that article valued at more than US$25 territories of developed countries. How-
13,0 INC 15.0 INC 7.8 F million a year, then that country loses its ever, each preference-granting country
9,3 INC lfi.3 INC 7.B F
15.1 INC fi.O me 7.7 F
beneficiary status. In the preference reserves the right to exclude any country
13.3 INC 20.0 me 7.9 F schemes of Austria, the EEC, Japan, from its list of beneficiaries. For example,
24.4 INC 33. 2 me 10.0 F Sweden, and the United States, action can the U. S. scheme excludes communist
11.2 INC 8.8 PT 9.1 EXC be taken unilaterally and against specific countries unless they are members of the
18,0 PT 22.5 PT 11.1 F countries under the escape clause. International Monetary Fund and are a
PT PT 12.3 F
11. B
10.5 INC
27.5
2.9 me 6.6 F
• Rules of origin contracting party to the General Agree-
10.0 INC 8.3 me 6.5 f To qualify for preferential treatment, ment on Tariffs and Trade (GATT). The
20. B INC 31.9 INC 10.7 F goods must at present satisfy the direct United States also excludes members of
13.5 INC 39.5 INC 10.6 F
consignment rule and comply with the "ori- the Organization of Petroleum Exporting
6,8 INC 9.0 INC 8.5 F gin criteria" specified by the preference- Countries (OPEC), countries which are a
IS. 5 PT 5.4 INC 7.5 F
giving countries. In general, goods are party to any action that results in the
13.3 INC 49.8 INC 8.4 F considered to have originated in a withholding of supplies of vital com-
10.0 INC 45.8 PT 7.0 F preference-receiving country if they have modity sources for international trade or
17.9 INC 40.0 PT 10.fi EXC
19.5 INC 45.0 INC 12.8 F been produced in that country either in the raising of prices of such commodi-
14.8 me 42.5 INC 10.9 F wholly or by substantial transformation ties to an unreasonable level, and countries
17.3 INC 46.5 me 11.4 F
from materials or components that are granting reverse preferences to developed
either imported or are of undetermined countries other than the United States
origin. Austria, the EEC, Japan, the unless such arrangements are to be elimi-
Nordic countries, and Switzerland follow nated before January 1, 1976. Addition-
the "process criterion," which implies that ally, a country that has appropriated U. S.
transformation of the raw materials or property without adequate compensation
components must be enough to lead to loses its beneficiary status. Specifically,
the classification of the exported goods 24 countries and territories are excluded
under a BTN heading other than that by the U. S. scheme at present, including
of the materials or components used in all members of OPEC; Somalia, Uganda,
their production. In order to apply the and the People's Democratic Republic of
process criterion, qualifying and non- Yemen because of financial disputes with
37

©International Monetary Fund. Not for Redistribution

 Table 2
Trade Effects of Tariff Cuts and Quantitative Limitations Under the GSP Schemes Based on 1971 Data
(In thousand U. S. dollars)

Tariff Cuts Only Tariff Cuts and Quantitative Limitations

Trade Increase in Trade
Decline In Increase in creation Decline in exports of creation Trade
exports of exports of as per- exports of less as per- creation
developed less developed centage developed developed centage in the first
countries countries of donor countries countries of donor year of
to donor to donor Trade country's to donor to donor Trade country's operation of
Donor Countries countries countries creation Imports countries countries creation imports the schemes »

Australia 4,033 9,821 5,788 0.78 2,070 4,910 2,840 0.38 3,144
(1974)
Austria 2,150 4,084 1,934 0.27 1,068 1,645 577 0.08 725
(1972)
Canada 12,785 29,262 16,477 0.85 3,421 6,396 2,975 0.15 3,628
(1974)
European Economic
Community 111,805 331,688 219,880 3.04 38,446 59,177 20,731 0.29 1,548
(1972)
Japan 17,528 69,387 51,859 5.29 9,690 11,341 1,651 0.17 -1,787
(1972)
New Zealand 3,075 8,685 5,610 2.83 2,949 8,388 5,439 2.75 4,714
(1972)
Nordic countries 24,094 45,557 21,463 0.97 14,607 25,879 11,272 0.51 11,600
(1972)
Switzerland 4,469 9,194 4,725 0.36 4,084 8,430 4,346 0.33 4,963
(1972)
United States 200,296 878,928 678,632 7.94 71,329 254,366 183,037 2.14 297,794
(1975)
Total 380,235 1,386,603 1,006,368 4.22 147,664 380,532 232,868 0.98 —
Sources: UNCTAD documents on Individual country schemes; UN Statistical Office, World Trade Annual and Supplement, 1971.
1
Projected values. Calculated on the basis of linear-trend approximation at current prices.

the United States; Romania, Hong Kong,
Israel, Spain, Portugal, Cyprus, Greece,
and Turkey are excluded because of their
trade agreements with EEC granting
reverse preferences to EEC members.
Other preference-granting schemes are,
however, not as restrictive as the U. S.
scheme. The exclusion of countries from
preferential treatment for reasons other
than their level of economic development
tends to limit the usefulness of the GSP
as an approach to export promotion for
less developed countries. In addition, it
creates uncertainty about preferential
treatment of a country. Uninterrupted
preferential treatment over an extended
period is necessary in order to ensure
effective implementation of investment
plans prompted by them.
Trade effects of GSP schemes
The UNCTAD secretariat has obtained
some information on the actual operation
of the schemes from both preference-
receiving and preference-granting coun-
tries, with special emphasis on the effects
of preferences on trade flows as well as
the use of safeguard mechanisms in donor
countries. The information collected on
the trade flows of eligible commodities for
Austria, New Zealand, the Nordic coun-
tries, and Switzerland for 1972 and 1973
shows that the introduction of preference
schemes has resulted in a somewhat faster
38
rate of growth of these preference-grant-
ing countries' imports of eligible com-
modities in comparison with ineligible
commodities. This has increased the share
of eligible commodities in total imports
from the preference-receiving countries. In
Finland, for example, the share of imports
from beneficiaries eligible for preferential
treatment grew by 1.2 per cent. For Nor-
way, this share increased by 5.1 per cent
and Sweden had an even higher rate. In
Switzerland, the share remained more or
less unchanged for the first year of its
scheme. Austria showed a significant in-
crease in the share of preferred imports
in total imports, but that was due pri-
marily to a sharp rise in the value of fuel
Zubair Iqbal
a citizen of Pakistan,
is an economist in
the Exchange and
Trade Relations
Department. Before
joining the fund as
a "Young Professional in 1972, he taught
at the Islamabad University in Pakistan. He
holds a Ph.D. from Michigan State
University and is the author of a number
of articles on preferences and other
issues relating to trade and development.
imports for which the preference status
has since ended. No information was
available to the UNCTAD secretariat on
the operation of the schemes of the major
donors like the EEC, Canada, Japan, and
the United States.
As far as the beneficiary countries are
concerned, their exact supply response to
preferences is not known. David Wall
undertook a study for the World Bank in
1973 to determine the reaction of pro-
ducers in the leading beneficiary countries
to lowered tariffs under the GSP schemes.
His findings were based on interviews
with producers in India and importers in
the developed countries, and showed that
both importers and exporters were largely
unaware of the existence of the GSP
schemes. He also found that when
importers were aware of preferences, the
impact of preferences was lessened in the
short run by the inability of the exporters
to meet the increased demand for pre-
ferred goods. In this particular case, not
even one increased or new trade flow
could be identified by importers or pro-
ducers as having resulted from the GSP.
An assessment
While the schemes have not been in
operation long enough to provide a clear
picture of their economic effects, it is
possible to estimate their likely trade
effects. Estimates have been made of the

©International Monetary Fund. Not for Redistribution

decline in exports of developed coun-
tries and the increase in exports from
preference-receiving countries to the
preference-granting countries as a result
of preferences. Thus, the global trade
creation effect, that is the difference
between the increase in preference-
receiving countries' exports and the
decline in developed countries' exports,
can be ascertained. This estimated trade
creation effect may serve as one measure
of the beneficial effects of GSP schemes.
Estimated export supply elasticities and
import demand elasticities were used to
obtain estimates of trade creation for all
the GSP schemes on the basis of 1971
trade data (see Table 2). If one disregards
quantitative limitations such as exclusions
and tariff quotas, then the overall reduc-
tion in exports of developed countries is
estimated to be $380 million while exports
of less developed countries increase by
about $1,386 million, resulting in a global
trade creation equal to $1,006 million, or
over 4 per cent of the developed countries'
imports of products covered by their GSP
Recently, UNCTAD released a report on the GSP which gives an overall view of the
schemes in operation, their trade implications, and future trends. Here is an analysis
of that report:
United Nations Conference on Trade and Development—Operation and
Effects of the Generalized System of Preferences, United Nations, New
York, N.Y., 1974
The Generalized System of Preferences
(GSP) was established by UNCTAD in
response to the proposal of the develop-
ing countries that concessions from the
developed world be centered on trade
rather than aid. The report under con-
sideration was prepared for the first re-
view of the GSP held in April 1973 by
UNCTAD's Special Committee on Pref-
ences. It describes the main features of
the preference schemes introduced by that
date and discusses the implications for
the exports of preference-receiving coun-
tries to the markets of the preference
givers. Individual studies in the report
treat the likely effect on the benefits ac-
cruing under the GSP of the enlargement
of the European Economic Community
(EEC), of the conclusion of free trade
agreements between the enlarged EEC and
the remaining European Free Trade Asso-
ciation (EFTA) countries, and of the Mul-
tilateral Trade Negotiations (MTN).
Other studies describe in some detail the
©International Monetary Fund. Not for Redistribution
schemes in 1971. However, if quantitative
limitations are taken into account, the
estimated trade creation declines to
$233 million, or less than 1 per cent of
the developed countries' imports of pre-
ferred commodities in the same year. This
amounts to less than 5 per cent of external
assistance provided by developed coun-
tries to less developed countries in the
same year and shows the extremely
limited benefits that are likely to flow
from the GSP schemes to the less devel-
oped world. These results tend to show
that the GSP schemes currently in opera-
tion generate very limited incentives for
encouraging manufactured exports from
less developed countries. Products covered
by the schemes comprise only 2 per cent
of the total imports of preference-granting
countries. Quantitative restrictions such as
tariff quotas and exclusions negate the
positive effects which might otherwise
occur.
For the preference schemes to be of
meaningful use to the less developed
world, some basic changes will have to
preference schemes of the EEC, Japan,
and the United Kingdom, and investigate
specific aspects of the GSP such as the
rules of origin requirements, the benefits
of GSP to the least developed among
developing countries, and the effect of
the GSP on countries receiving EEC and
Commonwealth preferences.
In 1970, beneficiary countries' exports
to the preference-granting market econ-
omy countries amounted to $24 billion.
Of these, exports amounting to only $9
billion were subject to customs duty in
the first place, and goods worth only $2.1
billion (or 23 per cent) received prefer-
ential treatment under the GSP. These
GSP schemes excluded from preferential
treatment up to 96 per cent of the dutiable
agricultural imports from developing
countries and up to 62 per cent of dutiable
industrial imports, which include textiles,
leather goods, and petroleum products.
The report argues that even these figures
tend to overstate the share of developing
be effected in their structure. Among the
major shortcomings are the quantitative
limitations, such as exclusions of products
in which less developed countries are
likely to be more competitive, and the
tariff quotas that are built into the
schemes to regulate the flow of preferen-
tial imports into donor countries. These
restrictions are motivated by domestic
considerations in donor countries. The
relaxation of these restrictions would be
the most effective instrument in increas-
ing the beneficial effects of the schemes
for the recipient countries. Efforts in this
direction should not only aim at enlarging
existing quotas but should also extend the
list of eligible items to include products
in which less developed countries special-
ize. Since the Multilateral Trade Negotia-
tions currently under way are very likely
to introduce global tariff cuts, the bene-
ficial effects of preferential tariffs on
imports from less developed countries
will be sharply curtailed unless offset by
liberalization of quantitative restrictions
made by preference-granting countries.
countries' exports benefiting from prefer-
ences. Under the EEC's preference scheme
each exporting country can receive a
preferential margin over the most-favored-
nation (MFN) tariff only for exports
within some quota. Other countries allow
GSP treatment to be revoked under escape
clauses. Rules of origin which exclude
from preferential treatment clothing
manufactured from imported textiles or
radios assembled using imported transis-
tors are considered too restrictive by the
report. Requirement that goods must be
consigned directly from the exporting to
the importing country make it more diffi-
cult for landlocked countries to take
advantage of the schemes.
The report expresses concern at the
erosion of preferential margins during
general tariff reductions that may result
from the MTN. However, it goes on to
suggest various ways in which compensa-
tory concessions could be made to devel-
oping countries. It calls for cuts in the
MFN tariffs and the removal of quantita-
tive restrictions on such goods as tex-
tiles, leather, and agricultural products
which are of particular interest to devel-
oping countries but are now largely ex-
cluded from the GSP. The developing
countries should press for an examination
of "voluntary" restraints on their exports
of manufactures and for stricter criteria
39
 governing the resort to safeguards by
importing countries. It also suggests that
any tariff cuts agreed should be imple-
mented in advance for imports from
developing countries.
A second area of concern centers
around the EEC. The enlargement of the
Community means first of all the replace-
ment of the relatively more liberal GSP
schemes of Denmark, Ireland, and the
United Kingdom by the Community's
scheme. Furthermore, the establishment
of free trade agreements between the
EEC and the remaining EFTA countries
and the movement toward preferential
agreements with Mediterranean countries
means that trade between these countries
Toward a new framework for
international resource
transfers
continued from page 9
national taxation. For the IBRD, it would
be logical that, instead of seeking the
concerned government's permission be-
fore floating its bonds, it should have an
automatic right to borrow in any capital
market where the country has been
enjoying an overall balance of payments
surplus.
While the World Bank has shown con-
siderable vitality in deepening its activi-
ties (by turning its attention to productive
programs for the lowest 40 per cent of
the population), it has not shown the
same vitality in extending the range of its
services, such as buffer stock financing,
export credit financing, and use of its
guarantee powers. These services are
likely to become even more crucial in the
1970s as trade expansion comes to be
recognized as an increasingly important
supplement to resource transfers.
"Third Window" for medium-term
aid
Though the IBRD and the IDA have
served admirably as mechanisms for
channeling assistance to the developing
countries, it is becoming increasingly
necessary to evolve a new mechanism for
obtaining and directing assistance at
terms intermediate between the IBRD and
the IDA. The introduction of a "Third
Window," (which the bank is presently
contemplating) is, therefore, a pragmatic
and inevitable response to the changing
40
©International Monetary Fund. Not for Redistribution
will be placed on a more favorable basis
than the EEC's trade with developing
countries.
Since the studies comprising the report
were all completed between November
1972 and March 1973, the report lacks
any description of the important prefer-
ence schemes of the United States and
Canada. Events in the EEC have also
passed the report by, since it was com-
pleted before the effects of enlargement
could be clearly seen and before the sign-
ing of the Lom£ Convention. In addition,
at the date of completion of the studies,
few figures were available on the actual
benefits to developing countries of the
GSP. Thus, the report is obliged to deal
circumstances.
At some stage, consideration should
also be given to a general review of the
Articles of the World Bank which were
conceived and drafted in the environment
of the 1940s. This is becoming necessary
as the basic economic situation of the
developing countries is undergoing a
fairly rapid change, calling for a greater
measure of flexibility in the Bank opera-
tions. For instance, the original Articles
expected, quite rightly at that time, that
the bulk of the Bank assistance would be
in projects and in foreign exchange, so
that restrictions were built into the rules
of the game against program lending and
local cost financing. The Bank has impro-
vised pragmatically in its actual opera-
tions to get around these restrictions as
the need arose: still the long shadow of
the Articles is always there and the
needed flexibility is sometimes missing.
Program lending and local cost financing
still have to be justified, on a case-by-case
basis, as deviations from a normal trend
which is bound to influence the form and
character of lending. One can find other
instances of such restrictions in the Arti-
cles: for example, procurement of goods
and services restricted only to Bank mem-
bers; extremely limited preference margin
to developing countries for procurement
within their own country; a strict finan-
cial rate-of-return criterion.
The Bank practice has moved consider-
ably, though not sufficiently, away from
some of the restrictive aspects of the
Articles. But the Articles themselves may
have to be reviewed, not only to bring
them into conformity with the actual
only with the potential benefits which it
identifies with the share of developing
countries' exports which receive preferen-
tial treatment under the various schemes.
The benefits of preferential tariffs have
not proved as tangible as was once hoped
and the GSP must be adapted if it is to
remain relevant. "Should the GSP remain
basically unimproved," the report states,
"it will, for practical purposes, have lost
much of its value by 1977." In this first
review attention appears to be moving
from the lacunae of current tariff prefer-
ence schemes to those other trade barriers
whose removal is of vital interest to
developing countries.
Mark Allen
practice but also to build into them
enough flexibility to accommodate the
needs of the 1970s and the fast changing
role of the World Bank in the future. It
should be recognized at the same time
that a general review of the Articles is
likely to be a very difficult and treach-
erous process and can only be undertaken
if the necessary political consensus for
such a step is available. In the mean-
time, there is no alternative to pragmatic
improvisations.
An exercise in futility?
What are the chances of designing and
implementing a new framework for inter-
national resource transfers? Why should
we assume the necessary political will and
the enlightened international attitude that
is needed even to begin traveling down
this road? Is the whole conception a mere
exercise in futility? It is difficult to
answer these questions, and yet they are
the most crucial ones. For the time being,
we can only hope that there will at least
be the beginnings of a serious negotiation
between the rich and the poor nations at
the Special UN Session in the fall of
1975, and one of the elements in this
negotiation will be a new framework for
international resource transfers. While
the negotiations can be expected to be
hard and long and difficult, it would be
useful to develop some negotiating prin-
ciples (which is all that this article
attempts to do) and agree on some nego-
tiating forum in which an orderly dia-
logue can be pursued. No one can predict
the results of such a dialogue. But it is
imperative at least to make a fresh start.
The Euro-currency market
in perspective
continued from page 13
declined by US$12 billion (over 5 per
cent) from their June level. Concern
about the stability of the market, how-
ever, soon subsided—reflecting, in part,
confidence derived from the central banks'
statement of support issued after the
Bank for International Settlements (BIS)
meeting in September 1974—and the
market growth, although moderate, was
resumed in the fourth quarter of 1974
and the first half of 1975.
Major worldwide role
The developments during 1974 are, in
a sense, suggestive of the true nature of
the Euro-currency markets in the context
of the broad structure of the world econ-
omy. The market, which may have
started as a substitute for U. S. markets
and which could have been viewed as an
anomaly or aberration ten years ago, has
now established itself as the major cor-
nerstone of world capital and the mone-
tary scene. Without the enormous expan-
sion of the Euro-currency market in the
first half of 1974, the recycling of oil
funds would have been very difficult, at
least in the short run, and the world
economy would have suffered from addi-
tional pains and strains. The sag in the
market in the third quarter was nothing
but the reflection of the fact that this
market is a short-run and competitive
one, which cannot bear the burden of
medium-term and long-term functions of
recycling, and that even a competitive
Financing the mining sector:
the Bank's role
continued from page 23
creditor. The Bank, therefore, includes in
its agreements with members (whether as
borrower or as guarantor) a "negative
pledge" provision which assures it of
equal and pari passu treatment if specific
security or preference is later given to
another lender. To be sure, the Bank has
sometimes agreed to waive the right to
participate in a security by virtue of the
negative pledge undertaking if the cir-
cumstances justified it; but it would be
less than prudent and it could weaken
its position in the capital markets of the
world if it did not pursue the practice of
including a negative pledge covenant in its
agreements with governments.
What of the future?
A growing Bank role in lending to the
©International Monetary Fund. Not for Redistribution
market needs some overall framework
supported by the official authorities of the
world. In any event, the re-emergence of
New York as a world capital and money
center cannot take away the major role
which the Euro-currency market has
played during the last decade. The Euro-
currency market will continue to function
as a major financial center of the world
and will be integrated more and more
with U. S. markets now that major restric-
tions on U. S. markets have been lifted.
The importance of the Euro-currency
market in the world economy has
increased to such a point that its future
cannot be discussed separately from the
future of world economy as a whole. As
long as the international transactions of
the world, or the integration of the world
economy, proceed as smoothly as they
have in the past, the Euro-currency mar-
ket will continue to play a major role in
the world economic scene. Conversely,
the sound development of the world
economy cannot be maintained without
the smooth functioning of the Euro-
currency market.
Official interventions in the market
The degree of development of the Euro-
currency market, which is also an indica-
tion of the degree of monetary inter-
dependence of the economies of the world,
is such that effective coordination of the
monetary and other policies of, at least,
the major countries of the world seems
essential to the proper management and
monitoring of the world economy. In
this sense, agreements on some form of
coordinated surveillance and official inter-
mining sector can be expected. There is
likely to be more emphasis on local par-
ticipation and on the fairness and open-
ness of agreements governing the rela-
tions between the foreign and local
participants. This would probably involve
different legal and financial problems
from those the Bank has been accustomed
to, but these should not pose any real
difficulties. It will, however, also entail
the assumption of greater risks on behalf
of already overstrained economies. It
would be irresponsible to focus attention
only on the profits of successful ventures
without taking into account the potential
for losses and failure. The bargaining
power, and the geological and relevant
technological knowledge of the producing
countries must be strengthened, and ade-
quate mineral policies and exploration
techniques established so that the eco-
nomic and social benefits of successful
operations might be realized more quickly.
vention in the Euro-currency market may
lay the foundation for further cooperation
in coordinating economic policies of the
countries of the world.
Since Euro-banks are international
financial intermediaries which do not
create money or net liquidity but merely
distribute money created elsewhere in the
system, they primarily serve to increase
the velocity of domestically created
money. In these circumstances, official
intervention in the Euro-currency market
could be directed at controlling this ve-
locity. The volume of international money
can only be controlled by the effective
coordination of the monetary policies of
the authorities of the reserve centers.
Under the present "limping" or de facto
dollar standard only the Federal Reserve
Bank of the United States has the power
to control the supply of U. S. dollars and,
therefore, the supply of international
money. In these circumstances, because
the Federal Reserve is likely to give
priority to domestic considerations, thus
tending to set the supply of dollars in
accordance with domestic needs, the
supply of U.S. dollars may not be con-
sistent with the requirements of other
countries. As a result, there may be
significant scope for other countries to
meet their own policy objectives by inter-
vening in the Euro-currency market in
an attempt to vary the velocity of U. S.
created dollars. The explicit or implicit
agreement by the Federal Reserve on such
intervention could lead a way to more
full-fledged coordination of monetary and
other policies of the countries of the
world.
If the problems which now beset the
industry are to be solved—and many of
them are essentially political in nature—
as everyone is well aware, a closer part-
nership between the mineral producing
and the mineral consuming countries
must be forged. The need for this is very
urgent now because the balance of min-
eral reserves is gradually expected to
shift toward the developing countries in
the future. As a healthier country/corpo-
rate relationship is a precondition to any
progress in the exploration and exploita-
tion of new resources, governments as
well as corporations will have to moderate
some of the positions which have in the
past led to conflict between them. Corpo-
rations will have to be more receptive to
local demands (financial, economic, social,
and political), and governments will have
to minimize the political risks to attract
the capital required for the development
of new sources of surjolv.
41