Policy Credibility Case Summary

A Decree Encouraging Private Investment in Bolivia

A stabilization program enacted in Bolivia in the fall of 1985 succeeded in bringing about macroeconomic stabilization. Inflation was reduced from an annualized rate of 20000% in August, 1985 to about 60% in 1986 and 11% in 1987. The public sector deficit was reduced from 10% of GDP in 1985 to 4% of GDP in 1986. Exchange rate volatility was also largely overcome, with the exchange rate depreciating relatively steadily at a rate of about 15% per year from 1986-1991.

Nonetheless, in some respects economic developments in Bolivia have been disappointing. GDP grew only about 3% per year from 1987 to 1989. Dollar denominated deposits in the banking sector, now legalized, rose from 30% of total banking sector liabilities in 1986 to about 80% in 1990. Despite the post-hyperinflation stability of the Bolivian currency, residents do not seem to want to hold that currency. In addition, private investment remains at low levels. Excluding public sector capital expenditure, gross domestic investment in the late 1980's was only about 4% of GDP.

In January, 1990, President Jaime Paz Zamora issued a decree intended to encourage private investment. The decree guaranteed that foreign and domestic property rights would be respected, that there would be no restrictions on capital transfers, that the convertibility of the boliviano would be maintained, and that foreign investors would have the same rights and be subject to the same taxes as domestic investors. Such rules are generally recognized as very helpful for encouraging private investment.

However, the credibility of rules, and not just their substance, is key to economic development. Private investors may not believe that the general principles set forth in the President's decree will be implemented in practice. Investors may also worry that if the President can simply grant rights by decree, he can also take them away with another decree. As Borner, Brunetti, and Weder note in the their book, Political Credibility and Economic Development, "There is hardly anything worse for investor confidence than discretionary power with no institutional safeguards to prevent arbitrary changes in policy. Credibility cannot be established by decree."

Policy Credibility Learning Module