Economies benefit from international trade, but joining the world market also exposes them to external shocks. How can the government in Eastern European and developing countries reduce their vulnerability to such shocks? What are appropriate policy responses? The authors examine how external shocks (such as commodity price changes, variations in global demand, and fluctuating interest) affect economic performance, and how those effects are mitigated by the right policy responses at the right time. They introduce a methodology for measuring the effect on current account of external shocks and apply it for the Philippines. They rationalize balance of payments responses to external shocks and domestic policies in a theoretical model of a small open economy. Did the Philippines choose the appropriate policies when faced with balance of payments disequilibrium? Among comparable Asian countries, the Philippines in 1970 enjoyed a relatively high per capita income that has since failed to keep pace. Why? Adverse shocks did not help, but other countries in the region experienced similar shocks and performed better. The Philippines relied heavily on external flow, which fueled an investment boom. Given low real interest rates at the time, this seemed a reasonable approach - but there were two flaws to it. First, the investments were poorly conceived, were mismanaged, failed to produce appropriate returns, and became a burden on the state. One large nuclear power plant has yet to yield a return. Second, with so many external resources available, the government ignored the need for meaningful structural reform, especially in trade and public resources and distortionary trade policies can absorb more than all the gains from favorable shocks. When external conditions improvedin the mid-1980s, the Philippines could not take advantage of them because of its heavy external debt and its cumbersome trade regime. Had authorities introduced structural reform (liberalizing trade, strengthening public finance, and freezing up factor markets), the economy could have more easily absorbed the impact of unfavorable shocks. In 1991, the IMF gave the Philippines a stand-by credit. Authorities are now addressing some structural problems by liberalizing the exchange rate, removing import tariffs, and restructuring the public sector, including the Central Bank. Perhaps this will allow more sustainable growth and an economy that can more readily absorb external shocks.
