through December 1986. For the post-reactivation era the Government envisaged a second phase, where the focus would be on investment and exports, so as to switch from demand-led output expansion into sustainable growth. This strategy, however, was never fully articulated, nor was there an established cutoff date to change strategies. 4. The Results in 1986-87. The initial response of the economy to the program was an unparalleled output expansion. GDP expanded 9.5 percent in 1986 and 6.9 percent in 1987. Along with output, employment in the formal sector of the economy grew by a cumulative 10 percent in the twoyear period. With the price freeze, inflation declined from 200 percent in the twelve-month period before the freeze to 63 percent in 1986. These positive results, however, were reached at the expense of growing financial and external imbalances and also of increasing misalignments in key relative prices. These imbalances, in turn, indicated that the model followed was unsustainable and that in the absence of corrective measures the economy would lapse into a critical state. First, total public sector revenues dropped by a cumulative 17 percent of GDP in 1986-87. In turn, foreign exchange and financial losses of the Central Bank--resulting from the operation of multiple exchange rates and from interest rate subsidies, respectively--grew rapidly to a level of 2.8 percent of GDP in 1987. As a result, and notwithstanding a reduction in public expenditures (particularly investment), the public sector deficit--as gauged by total Public Sector Borrowing Requirements (PSBR)--more than doubled, jumping from 5.1 percent of GDP in 1985 to 11.2 percent in 1987. Second, the real exchange rate appreciated by 44 percent between July 1985 and October 1987. This, together with booming aggregate demand, rendered GDP expansion to be highly import intensive and, since exports declined, the external current account went from rough equilibrium in 1985 into a deficit of about 5 percent of GDP in both 1986 and 1987. The ultimate effect of this was a sustained drop of gross international reserves from a peak of US$2.5 billion in March 1986 to less than US$1 billion in December 1987. Finally, the focus on boosting consumption ruled out the potential for investing the surplus gained by the moratorium, thereby trading-off shortrun expansion for future sustainable growth. The Strategy Revisited. In 1987, inflation picked up fueled by 5. the pressure of the domestic financing of an overly expansionist budget on a narrow financial sector. Tllus, inflation accelerated from 63 percent in 1986 to 115 percent in 1987. During 1987-88 several adjustments to prices and tariffs were effected but these lagged considerably behind inflation. By contrast, wage hikes continued to be granted regularly--every four months--with the idea of keeping real wages on a steady rise. In July 1987, commercial banks, finance firms, and insurance companies were nationalized on the grounds of "democratizing credit allocation and breaking the links between industrial groups and financial institutions." In October and then again in December 1987, in view of the deteriorating international reserve position, the Central Bank devalued the weighted average of all exchange rates--at that time there were as many as nine rates for commercial transactions alone--by a cumulative 78 percent. However, the spread between the lowest and the highest rates widened and exchange
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