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EC1-022-A-I

ECONOMIC POLICY SIMULATOR. COUNTRY 1
Original written by professor Gayle Allard at IE Business School.
Original version, 13 May 2005. Last revised, 23 October 2008.
Published by IE Business Publishing. Mara de Molina 13, 28006 Madrid, Spain.
2005 IE. Total or partial publication of this document without the express, written consent of IE is prohibited.



JUGGLING DEBT AND DEVELOPMENT: EXPERT ADVICE FOR A PRESIDENT

It had been a particularly hard day at the office, and the tall man in a rumpled business suit closed
the door, lowered the blinds and took the phone off the hook in an effort to clear the confusion of
the moment and set his thoughts in order. The events of the day spun around his mind as he sank
into his chair. This morning it had been the announcement that the unions, once his most loyal
allies, would join in a mass protest against his pension reform plan. Before lunch, there was the call
from the International Monetary Fund requesting an urgent meeting to discuss why he had failed to
meet the targets of his stabilization plan. In the afternoon, the latest inflation figures two full
percentage points above what his advisors had expected were released, and the currency,
already reeling from the recent U.S. decision to raise interest rates, took a beating on international
markets. Then the representative of the business organization requested an audience to express
concern over government plans to liberalize international trade. And he had just walked out of a
meeting where he and his top cabinet members debated for more than four hours over how to cut
government spending in order to bring down a budget deficit that continued to defy control.
Unsurprisingly, there was no agreement; no one would be the first to volunteer to cut the budget of
his ministry.

How could a picture that looked so bright only months ago, when he had sailed into the presidency
by popular landslide, turn so dismal, so fast? The crowds that packed the streets to welcome him
on the day he took office had believed that he could perform the miracle of reducing widespread
poverty and severe inequality while inspiring confidence among foreign investors, whose funds the
country so badly needed. The tumult of the crowd had been music to his ears. He, too, had waited
all his life for this opportunity. And in the first months, even in difficult negotiations with foreign
bankers and multilateral institutions, he had clung to his optimism. There was a way to achieve
social justice while keeping the country financially solvent. It only required a person with enough
charisma, enough heart, enough imagination and enough confidence from the people of this
country. It could be done.

And here he was now, watching his illusions collapse one after another. Maybe the critics were
right. Maybe a large, poor, half-industrialized but still backward country like this one has to make a
choice between serving social needs and serving foreign investors and banks. Maybe the juggling
act just cant be performed.

His eye alights on the report on his desk that was handed to him this morning, with official
projections for the main economic indicators
1
. There is some good news: GDP growth is beginning
to bounce back after near-zero growth last year. This should make a dent in an unemployment rate
that is intolerably high to a president who promised jobs for the masses. The dark side of the
picture is that inflation, always lurking in the background, is likely to turn out higher than the 4% his

1
See Table 1 in the Statistical Appendix for full information on the main economic indicators in the previous and current
years (Year 4 is the current year), and projections for the next two years (Years 5 and 6).
IE Business School
ECONOMIC POLICY SIMULATOR. COUNTRY 1 EC1-022-A-I


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government had hoped for. And the budget deficit looks like it will also overshoot the target set in
the IMF agreement.

The patterns he sees in the data are not new. Over the past four years, the country had also
alternated between slow growth and high inflation, always accompanied by high unemployment
rates. Economic experts had explained that the root cause of the high inflation and high
unemployment was the countrys lack of good infrastructures to support the strong growth needed
to create jobs. In the transport and power sectors, bottlenecks are encountered whenever real GDP
growth accelerates past 3.5%-4%, and these bottlenecks generate immediate pressure on prices.
The experts estimate that to avoid these bottlenecks, investment has to be sustained at between
22% and 25% of GDP. Last year, total investment was just over 18% of GDP, with about 11% of
that figure coming from foreign investors.

How different the future of this country had appeared when it first began to industrialize, some four
decades ago! Then it was widely perceived as the great promise of the 20
th
century. Import-
substitution policies had given it a strong middle-technology industrial sector which still attracts
some foreign investment, but which never fulfilled the dream of being able to compete on
international markets. Now, rising labor costs and fierce competition from other developing
countries, particularly in Asia, have made the industrial sector even less competitive, and some
businesses in the vulnerable footwear and textiles sectors are actually relocating production to
China in order to compete. Where export growth is now strongest is in commodities, due to soaring
Chinese demand, and while the rising prices and strong sales are welcome last year this country
showed its first trade surplus in several years--, the change seems to turn back the clock on the
dream of finally joining the club of industrialized economies
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.

Still, it seems it would be possible to juggle the pressure of Chinese competition, domestic social
needs and scarce financial resources if only the country were free of debt. But the high foreign debt
is its starkest reality. In those optimistic years when it appeared that everything was possible for a
developing country like this one, both clean and corrupt governments had obtained huge loans to
finance development from overly optimistic international bankers. With the economic slowdowns of
the 1970s and 1980s and the rise in international interest rates and dollar values, the size of the
debt relative to GDP had exploded, and nearly half of it 45% this year was owed to foreigners.
This means that developments on international financial markets are now the governments most
pressing concern. Hong Kong is so far away, yet a run on the Hong Kong dollar could easily
produce a collapse of this countrys currency. And negotiations with the IMF over stretching out the
repayment of the debt owed to foreign bankers are the single most important factor in determining
the governments economic policy.

The debt had overshadowed every argument during his cabinet meeting this afternoon. With such
pressing social and economic needs, every minister had reasons to demand to at least be able to
maintain spending in his department. The poverty programs, the infrastructure projects to eliminate
those bottlenecks that cause inflation, the need for better schools and universities, better
hospitals, basic sanitation: who can say no to these? Yet he had no choice but to cut public
spending. In fact, his government had kept spending under such strict control that it currently
shows a primary budget surplus: tax revenues are actually significantly higher than government
spending before the debt payments are made. But the huge burden of interest payments turns this
surplus into a chronic budget deficit, which has to be financed with additional debt, leading to more
interest payments, larger deficits, more debt the vicious cycle appears inescapable. And raising
taxes to reduce the deficit is not an option. Taxes in this country are already quite high fiscal
pressure is 36% of GDP--, and raising them could chase away the private capital that it needs so
badly.

What options does he have to bring the economy out of a situation where debt, social needs and
scarcity press on all sides? Borrowing from the central bank to finance the deficit is no solution, as

2
See Table 2 in the Statistical Appendix for information on the structure of exports and imports. The United States is this
countrys largest foreign market.
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ECONOMIC POLICY SIMULATOR. COUNTRY 1 EC1-022-A-I


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he knows; the country has had disastrous hyperinflation experiences in recent years. To declare a
debt moratorium is tempting, but he knows how that would hurt the countrys credit rating; several
episodes of nonpayment of foreign debt in the distant past still haunt potential investors in this
country. Foreign direct investment could solve some problems, but investors demand not only
economic stability, but structural reform in order to be willing to invest. This country ranks relatively
low on indicators of internal market freedom and protection of private enterprise, and relatively high
on indicators of corruption.
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And he knows that any structural reforms will be fiercely resisted by the
privileged elites of the economy.

Darkness has fallen as he sits at his desk, overwhelmed by the terrible dilemmas faced by his
government. He is an honest man who loves his country, and his deepest hope was to be able to
put it on the road toward greater development and social progress and to lift millions of his
countrymen out of poverty. But that hope is beginning to evaporate.

Then he remembers an independent economist whom he met at the beginning of his presidency,
who assured him that the countrys problems did have a solution. In the euphoria of his first months
in office, the economists offer of help had not seemed necessary. Now he opens the drawers of his
desk and searches for the card that was handed to him at that meeting. There it is! He picks up the
phone and dials the number.

You are the independent economist who answers the phone that evening. You promise the
president that you will review all of the data and come up with a coherent economic policy for the
next two years that will address the countrys problems while keeping it financially solvent and
promoting growth. You plan to structure your report to the president as follows:

1.- Very briefly, you will evaluate recent economic trends, noting which aspects of the countrys
performance are normal and which represent departures from conventional models or rules.
You will explain any departures.

2.- You will also characterize briefly the economic policies and policy mixes that have been
followed recently; and their consequences on the economy, both those you can observe and
those that you anticipate.

3.- You will rank the countrys greatest constraints, in order of importance.

4.- You will outline a coherent program that addresses those constraints and the governments
objectives of economic stabilization, development and poverty reduction.

(You use the attached spreadsheet to experiment with the quantitative effects of your policy
proposals before designing your definitive program for the president. The spreadsheet incorporates
simple relationships among the economic variables described above, omitting the impact of trade
and exchange rates.)

You are in your car on your way to the presidents office on the morning you are due to present
your program, and you hear the news broadcast announcing that the Chinese yuan has been
unpegged from the U.S. dollar, and the dollar is collapsing on international markets. How will this
change your program? You make quick notes in the margins as you approach the presidents
office.

As the presidents door opens, you see that it is not only the president who rises to greet you, but
his entire cabinet and staff of advisors. And suddenly you realize how important this presentation
is. The future of the country is in your hands.

3
See Table 3 in the Statistical Appendix for some institutional indicators for this country, and their comparison with other
countries or groups of countries.
IE Business School
ECONOMIC POLICY SIMULATOR. COUNTRY 1 EC1-022-A-I


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STATISTICAL APPENDIX

TABLE 1: KEY ECONOMIC INDICATORS

Year 1 Year 2 Year 3 Year 4
(current year)
Year 5(p) Year 6(p)
Real GDP % 4.3 1.3 1.9 0.4 4.1 3.6
Government consumption %GDP 19.1 19.3 20.1 20
Budget balance %GDP -3.4 -3.3 -9.8 -4.9
Inflation (% CPI) 7.0 6.8 8.5 14.7 6.5 5.8
Public debt %GDP 49.4 52.6 55.9 57.4
Labor costs per hour ($US) -16.7 -13.3 3.9
Unemployment rate (%) 13.3 11.3 11.7 12.3 11.2
Current-account balance as %GDP -4.0 -4.6 -1.7 0.9
(p) indicates projected values.


TABLE 2: STRUCTURE OF IMPORTS AND EXPORTS FOR COUNTRY 1

Major exports % of total Major imports % of total
Transport equipment and parts 16.4 Machinery and electrical equipment 28.2
Metallurgical products 10.4 Chemical products 18.0
Soybeans, bran and oils 9.8 Oil and derivatives 13.3
Chemical products 1.9 Transport equipment and parts 10.8


TABLE 3: SOME INSTITUTIONAL INDICATORS FOR COUNTRY 1

INDICATOR Score Country 1 Score U.S. Score OECD avg.
Protection of property rights (higher=better protected) 4.9 8.2
Regulation of business (higher=less regulated) 5.0 7.7
Freedom to trade internationally (higher=freer) 6.8 7.8
Number of procedures needed to start a business 17 6
Time needed to fire a worker (days) 152 25
Number of procedures needed to fire a worker 14 4