Promoting employment and structural change in developing countries: A dual mandate for macroeconomic policy managers

Iyanatul Islam, Chief, Employment and Labour Market Policies Branch, Employment Policy Department, ILO, Geneva

Anis Chowdhury, Director, Macroeconomic Policy and Development Division, UN-ESCAP

Introduction

The traditional discourse in development economics focussed on issues of underemployment, poverty and structural transformation. However, these issues receded into the background with the onset of the structural adjustment era of the 1980s and 1990s when the preoccupation of international financial institutions and the donor community was with the rectification of macroeconomic imbalances as a pre-condition for growth and employment creation. By the 2000s, the structural adjustment era was terminated, but what emerged eventually as the Millennium Development Goals (MDGs) entailed a benign neglect of productive and decent employment. ‘Full and productive employment’ was included as one of the targets only in 2005 under MDG 1. Even then, unlike other targets, no time-bound numerical benchmarks were specified.

With persistent high informal and vulnerable employment leading to entrenched poverty and rising inequality in the developing world, the focus of macroeconomic policies has to turn to productive employment and structural change. Indeed, productive and decent employment and structural change are featuring prominently in discussions on the post-2015 United Nations Development agenda. However, this should entail more than mere aspirational statements. The creation of productive and decent jobs as well as structural change would require going beyond the conventional macroeconomic policy framework focused on a ‘single mandate’ of macroeconomic stability in terms of low single digit inflation, fiscal and external sustainability. The urgency for reorientation of macroeconomic policies has also become obvious in the wake of 2008-2009 global financial crisis and the consequent prolonged recession in major economies that saw unemployment and vulnerable employment soar.1 This commentary highlights basic features of macroeconomic policies that would enable governments of low and middle income countries to adopt a ‘dual mandate’, that is, act as guardians of macroeconomic stability as well as agents of inclusive development.2

Macroeconomic stability and structural transformation: A developing country perspective

Being a guardian of stability does not merely mean passively accepting exogenous targets on debts, deficits and inflation derived from a ‘one-size-fits-all’ approach. It means upholding the principles of reasonable price stability, fiscal and financial sustainability using a country-specific approach. It means protecting people from the vagaries of business cycles and other exogenous shocks through consistent counter-cyclical policies based on a mix of automatic stabilizers and discretionary interventions. This point is particularly important because developing countries, on average, suffer from greater output and inflation volatility than their developed counterparts (Agenor and Montiel, 2008).To make matters worse, developing economies are prone to running pro-cyclical macroeconomic policy (Ilzetski and Veigh, 2008; Vegh and Vuletin, 2014).

The notion of macroeconomic policy managers as agents of inclusive development entails exploring ways in which policy-makers can facilitate the process of structural transformation. One way of engaging with this issue is to identify binding constraints on sectors with the most potential for productive job creation. The subsequent discussion will elucidate some practical policy implications arising from the above assessment, particularly in a developing country context. The analysis will start with exchange rate policies and capital account management, followed by monetary and financial policies and afterwards turns to fiscal policy.

Exchange rate policy and capital account management for employment creation and economic diversification

Central banks can promote economic diversification and employment creation through appropriate management of the exchange rate. The latter can play a dual role: as an anti-inflation tool and as a tool for resource allocation between the traded and non-traded sectors. Managing the dual role is a core macroeconomic policy task, especially as recent evidence has shown that so-called ‘hard pegs’ (entailing fully fixed exchange rates) can significantly increase the vulnerability of countries to ‘growth collapses’. (Ghosh et al, 2013).

What matters is to manage nominal exchange rate flexibility in a way that avoids real exchange rate misalignments on a sustained basis. An overvaluation of the real exchange rate is expected to impede economic growth; it can harm domestic firms’ competitiveness in international markets and lead to an unsustainably high current account deficit.

The interaction between the exchange rate and the capital account should not be overlooked. A study by Galindo et al. (2006), based a panel dataset for nine Latin American countries, shows that the positive effect of real exchange rate depreciations is reversed, and can be negative, with increasing liability dollarization (where both the government and the private sector borrow on a significant scale in foreign currencies while assets are denominated in national currencies). Similarly, for Mexico, Lobato et al. (2003) find that the balance sheet effect outweighs the competitiveness effect engendered by currency depreciations. While the balance sheet effect is not undisputed (see, for instance, Bleakley and Cowan, 2002; Luengnaruemitc, 2003), liability dollarization poses a risk to contractionary depreciation and thus a decline in employment. Therefore, a reasonable policy to avoid possible adverse effects of both under and overvaluation would be to keep the real exchange rate at a stable and competitive level that is consistent with economic fundamentals.

As noted, the presence of liability dollarization acts as a constraint on the central bank’s ability to influence the path of the exchange rate. This happens because of the reluctance of central banks to engage in depreciation as it leads to potentially negative balance sheet effects that can outweigh the expansionary impact of depreciations. It is thus crucial to attenuate high levels of liability dollarization through active capital account management and prudential regulation of the financial system. Countries must also be willing to impose capital controls if needed when flows reach levels that prevent the central bank from properly conducting its operations. Capital controls enable the central bank to counteract appreciations that move the currency away from its stable and competitive level and thus support employment.

It has to be acknowledged that there is still continuing ambivalence pertaining to official views – as represented by the IMF – on the use of capital controls. There was a time when the IMF was an advocate of full capital account liberalization, but now has offered qualified support to its use (Ostry, et al 2010). The theoretical case for prudential capital controls is well understood. There is recognition that counter-cyclical taxes on short-term capital inflows during a boom can reduce the severity of busts. It is also recognized that there is little evidence supporting the notion that free capital mobility can raise economic growth sustainably (Jeanne, Subramanium and Williamson, 2012).

Country-specific examples can be given of successful cases of prudent capital account management, such as Chile, but what is needed are transparent and widely agreed international rules for capital controls. These controls include price-based measures, such as counter-cyclical taxes on certain types of capital flows. The international community could agree on the type, composition and ceiling on price-based measures pertaining to capital mobility in order to limit any possible harmful side-effects of such measures on economic growth. These codes of conduct could be developed under the auspices of the IMF. The lack of such a global framework means that ‘capital controls are still marked by a certain stigma’ leading to less than optimal outcomes, with some countries, such as China, pursuing capital controls with vigour, while others are much more ambivalent about it (Jeanne, Subramanium and Williamson, 2012). 

Monetary policy and financial policies for structural transformation and financial inclusion

Central banks and financial authorities can support structural transformation and job creation through promoting financial inclusion. Lack of access to finance has been found to constitute a major hindrance to business operations and expansion. In Sub-Saharan Africa, the Middle East and North Africa and Latin America and the Caribbean, more than 30% of the surveyed firms have cited access to finance as a major constraint (Figure 1).3

Figure 1. Lack of access to finance: A major constraint for firms in low and middle income countries

Source: World Bank (2012).
Note: Regional averages were calculated by taking the mean of country-level indicators, including only those country surveys for which the global methodology has been used.

At the household level, more than 2.5 billion people around the world, corresponding to roughly half of the world’s adults remain unbanked. Among those who are adults earning less than $2 a day, 75% are without a bank account (Demirguc-Kunt and Klapper, 2012; World Bank, 2013). Yet, the poorer a household, the greater their need for protection against vulnerabilities – such as illness or unemployment – and for investment in education and health, and thus their need for financial services, such as savings, credit, insurance and remittances. Financial inclusion can also contribute to increasing people’s livelihood through enabling them to engage in entrepreneurial activities.

Overcoming barriers to financial inclusion requires a variety of comprehensive actions, including appropriate changes in the design of monetary and financial policies. While price stability remains an important objective for central banks, promoting an inclusive financial sector, most notably through steering the allocation of credit to underserved areas and targeted sectors, should also be an integral component of their mandate. It is encouraging to note that 67% of central banks across the world cite the promotion of financial inclusion as part of their mandate (Allen et al, 2012). Possible measures include lowering interest rates and providing credit guarantees and subsidized credit to sectors that can contribute to productivity and employment growth, such as small and medium-sized enterprises and export-oriented sectors.4

Public ownership of parts of the banking system can also be a vehicle to realize measures aimed at increasing financial inclusion and supporting employment. In some countries, for example Argentina, Brazil, Malaysia, South Korea and Taiwan, investment banks have played a central role in directing credit to targeted sectors (Epstein, 2007).

Fiscal policy: Reinforcing the redistributive capacity of the state and supporting structural transformation

The role of macroeconomic policy makers as agents of both economic stabilization and development entails the pursuit of counter-cyclical policies on the one hand and the implementation of policies that support structural transformation and core development goals, including equity on the other hand. However developing country governments have limited ability to use fiscal instruments. Perhaps the major reasons behind this are low tax-to-GDP ratios and insufficiently progressive, or even regressive, tax structures in low and middle income countries. Low tax-to-GDP ratios can either reflect low tax rates or narrow tax bases that can result from a number of factors, including a large informal sector, a high degree of tax evasion, and weak tax administration. Over 1992 to 2010, the average tax ratio in OECD countries amounted to 34.5% of GDP compared to 12.4% for a sample of 13 Latin American non-OECD countries.5  The Asia-Pacific region has the lowest tax burden across the developing regions of the world, despite rapid economic growth (UN ESCAP, 2013).

Low tax revenues limit governments’ fiscal space, and consequently its capacity to foster structural transformation and support core development goals. An important aspect pertaining to the relevance of fiscal policy as an instrument to promote structural transformation relates to the role that infrastructure deficits play in inhibiting growth and employment in developing countries. For instance, enterprise surveys by the World Bank (2012) show that inadequate infrastructure, as proxied by the supply of electricity and transport, is a major hindrance to doing business in low and middle income countries across all regions of the world. Roughly 50% of the surveyed firms in Sub-Saharan Africa, South Asia and the MENA region identified major constraints related to the supply of electricity. Lack of transport is a major constraint for more than one-fifth of the surveyed enterprises in Sub-Saharan Africa, the Middle East and North Africa and Latin America and the Caribbean (Figure 2).

Figure 2. Inadequate infrastructure: A major constraint for firms in low and middle income countries

Source: World Bank (2012).
Note: Regional averages were calculated by taking the mean of country-level indicators, including only those country surveys for which the global methodology has been used.

One can draw on a recent study for the Asia-Pacific region by UN-ESCAP (2013) to highlight the role fiscal policy can play to support the financing of core development goals. It argues that both the composition and levels of public expenditure have important implications for inclusive and sustainable development. The study finds a negative association between the tax ratio and inequality as well as between social spending and inequality. It stresses that inequality has been exacerbated by the lack of progressivity of tax systems and a low tax burden, which is reflected in inadequate public provisioning of basic services, e.g. health, education and housing.

UN-ESCAP also quantifies the fiscal implications of supporting core development goals. The study – influenced by similar exercises conducted by other UN agencies– specifies six elements of a policy package that cuts across the provision of job guarantee schemes, social protection and environmental sustainability. Developing countries in the Asia-Pacific region would need public expenditures ranging between 5 and 8% of GDP per year to meet the resource requirements of such a policy package at the national level. Such public expenditure does not necessarily jeopardize macroeconomic stability as they yield productivity dividends in the long run. Nevertheless, how to implement such public expenditure programmes in an efficient and fiscally sustainable fashion through tax and other revenue mobilization measures then becomes a core issue for macroeconomic policy makers.

Finally, the need for a stable macroeconomic environment to foster growth and job creation requires the adoption of counter-cyclical policies that can smooth out economic volatility. Counter-cyclical policies entail both automatic stabilizers and discretionary interventions. Automatic stabilizers can be linked to social protection, such as unemployment benefits. Yet, due to large informal sectors in the developing world, automatic stabilizers might not reach the poorest (Ocampo, 2011).

Policy measures designed to suit developing country conditions, such as job guarantees and conditional cash transfers, might thus be useful to alleviate the employment consequences of economic downturns. The experiences of some Latin American countries, such as Brazil and Mexico with conditional cash transfers, and the case of India with the world’s largest rural employment guarantee scheme, suggest that it is possible for developing countries to engage in policy innovations with respect to counter-cyclical measures. Vegh and Vuletin (2014) have re-visited the issue and demonstrate, using the experience of eight Latin American countries, that counter-cyclical fiscal policy improve social indicators pertaining to both income and non-income dimensions of poverty.

Getting out of the pro-cyclical trap also requires an ability to build up fiscal space during boom periods and normal periods of growth. A dedicated ‘stabilization fund’ that is activated during recessions might be an instrument to achieve this (Ocampo, 2011). There are successful examples of such initiatives. One can draw attention to Chile’s experience with respect to the prudent and counter-cyclical management of revenues from natural resources (Frenkel, 2012).

Concluding remarks

The persistence of poverty and inequality along with large informal and vulnerable employment and underemployment demands reorientation of macroeconomic policies towards full, productive and decent employment along with structural change. This commentary has argued that governments of low and middle income countries adopt dual mandates for macroeconomic policies that enable them to be (a) guardians of stability and (b) agents of inclusive development. Translated to specific policy actions, this means the use of exchange rate policy and prudent capital account management to promote an agenda of structural transformation; having the capacity to conduct counter-cyclical policies to smooth business cycles; promoting financial inclusion; mobilizing domestic revenue to meet core development goals and attenuating infrastructure deficits.

Authors' note:  Views expressed herein are entirely those of the authors and do not represent in any form those of the ILO or UN-ESCAP or any other UN agencies. The commentary draws on a book chapter prepared for an edited volume that will be published by the ILO and Edward Elgar later this year.

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1 See Blanchard (2013)
2 The notion of the ‘dual mandate’ is often evoked in assessing the conduct of US monetary policy (Federal Reserve Bank of Chicago, June 6, 2014, http://www.chicagofed.org/webpages/publications/speeches/our_dual_mandate.cfm). Here it is being given a broader interpretation that is more in line with developing country conditions.
3 In its survey on Africa, McKinsey (2012) finds that access to finance is among the top three barriers to private sector growth. Besides, the Asian Development Bank (2012) points out that small and medium-sized enterprise frequently face constraints related to accessing finance in Asia.
4 In addition to these measures, modern technology can be harnessed to promote financial inclusion. The successful cases of M-PESA in Kenya and Easypaisa in Pakistan, among others, show how mobile phone technology can be deployed to reach the unbanked (For more information, see Safaricom, 2012 and Easypaisa, 2012).
5 Calculations based on OECD (2013).