Chapter 1: General Economic Survey
- International Monetary Fund
- Published Date:
- September 1971
THE performance of the world economy during 1970 and the first part of 1971 was less than satisfactory in certain major respects. Following are the main points to be noted about that performance, which was heavily dominated by developments in the larger industrial countries.
—The expansion of total world output proceeded at a slow and irregular pace, primarily because of the 1969-70 recession and ensuing moderate pickup of economic activity in the United States.
—Inflationary forces remained strong or intensified in the industrial countries, and price increases became larger in most parts of the nonindustrial world as well.
—Domestic price increases in the industrial countries spilled over much more strongly than in the past into foreign trade. Higher prices accounted for a substantial part of the further large expansion in value of world trade, although the increase in volume terms was still somewhat above the long-term average.
—The higher cost of imported goods adversely affected the terms of trade of primary producing countries and contributed to a substantial rise in their combined current account deficit. Nonetheless, because of a renewed surge of capital inflows, both the more developed and the less developed groups of primary producing countries realized substantial surpluses in their overall balances of payments in 1970.1 Within these broad groups, the experience of individual countries varied widely.
—The marked easing of international financial markets that occurred during 1970 and early 1971 was due chiefly to huge flows of short-term capital from the United States. These flows took the form primarily of rapid reductions in Eurodollar liabilities of U.S. banks to their branches abroad; such liabilities had been built up to a total of some $15 billion during previous periods of credit stringency. Capital inflows created a serious problem for domestic monetary management on the continent of Europe, and particularly in Germany, where the authorities were attempting to maintain restrictive monetary policies in order to combat inflation. After these inflows had been swollen by speculative pressures, official exchange markets in a number of countries were closed early in May 1971.
—This action was followed shortly by the announcement of changes in exchange rate policy by Germany and the Netherlands, which floated their currencies; by Austria and Switzerland, which revalued their currencies by about 5 per cent and 7 per cent, respectively; and by Belgium, which altered the regulations concerning its free and official exchange markets so as to render the free market an instrument for discouraging unwanted capital inflows in the future.
—With these moves by Germany and the Netherlands, in addition to the floating of the Canadian currency in May 1970, there are three industrial countries that are not maintaining effective parities in accordance with the provisions of the Articles of Agreement. The Fund has been in close consultation with these members on the question of their early resumption of par value obligations.
—Because of the huge official settlements deficit in the U.S. balance of payments, as well as the placement by other countries of a very large amount of official reserves in the Euro-currency market, there was an unplanned and exceptional increase in the foreign exchange component of international reserves. This was additional to the planned increase in global reserves through the allocations of special drawing rights at the beginning of 1970 and 1971.
This chapter discusses all the above developments with the exception of those in the field of international liquidity, which are covered in Chapter 2. Also discussed here is the continuing close consideration which the Fund is giving to a variety of measures that might make the international system less exposed to disturbances and help to promote smoother adjustment in international payments. The volatile flows of short-term capital that have been experienced in the recent past give particular emphasis to the need for progress in this area.
Output and Prices
The volume of total output on a world-wide basis increased by only about 3 per cent from 1969 to 1970—markedly below the average annual growth of 5 per cent during the decade of the 1960s. However, this result was attributable primarily to developments in the United States, where total output declined, though modestly (Chart 1). For the group of developed countries except the United States, as well as for the less developed countries, the expansion of real gross national product (GNP) from 1969 to 1970 slowed down somewhat but still amounted to 6 per cent; this compared with a trend growth of 5½ per cent over the 1960s for each of these groups of countries.
Chart 1.Changes in Output and Prices in Industrial Countries, 1960-70
Percentage changes in world output in recent years were very similar to, and dominated by, the combined growth rate of the seven major industrial countries represented in Chart 2. As may be seen, this growth rate declined from 1968 to 1970 and then turned up in the first half of 1971 because of cyclical recovery in the United States and Canada.
Chart 2.Changes in Output of Selected Groups of Industrial Countries, First Half 1968-First Half 1971
Throughout most of the world, output changes in 1970 were accompanied by strong inflationary pressures. Price increases were larger in 1970 than in 1969 in almost all the industrial countries; taken together, these countries experienced an overall price rise 2 from 1969 to 1970 of 5¾ per cent, almost twice as high as the average annual rate for the past decade. Outside the industrial countries, the 1969-70 increases in consumer prices—averaging 6 per cent in the more developed primary producing countries and 9 per cent in the less developed countries—were markedly larger in most major areas than those of the previous year.
Inflation became a serious problem in the industrialized world during the latter part of the 1960s, a period also characterized by recurrent crises in foreign exchange markets stemming from the balance of payments disequilibria that arose from time to time in a number of the leading countries. As financial instabilities emerged, they were generally exacerbated by delays in the application of corrective policies, and in numerous instances the authorities were then impelled to adopt stabilization measures that had markedly adverse effects on employment and growth.3 One very important result was the general slowing down of economic activity among industrial countries that occurred from about the middle of 1966 to the middle of 1967—a slowdown that had particularly severe effects in Europe, and especially in Germany, where recessionary tendencies were strongest.
Both the timing and the impact of stabilization efforts in the late 1960s and in the opening of the current decade differed greatly among the industrial countries. The outstanding contrast in this respect was between the United States and continental European countries.
In the United States, the relatively mild 1966-67 slowdown was reflected in only a limited and temporary abatement of inflationary forces. After the economy had failed to cool off in 1968, despite the adoption of restraining fiscal measures at midyear, the authorities pursued a highly restrictive monetary policy throughout 1969. Mainly because of this policy, the expansion of U.S. output tapered off sharply from 1968 to 1969 and (as mentioned above) gave way to a modest decline in 1970. Monetary policy was relaxed early in 1970, and fiscal policy also became somewhat easier in the course of the year. However, private demand was slow to respond to the substantial easing on the monetary side, as it had been to the earlier fiscal restraints; real GNP in the second quarter of 1971, although rising, was only 1 per cent higher than in the third quarter of 1969. Over this period, the rate of unemployment rose from about 3½ per cent to 6 per cent, while costs and prices registered pronounced increases that showed only small response to the relatively high margin of unused resources in the economy.
On the continent of Europe, the cyclical upswing after the 1966-67 economic slowdown led to a gradual reduction of excess capacity, but not until late 1968 or early 1969 did renewed upward pressures on prices and costs become clearly apparent. Most industrial countries on the European continent tightened credit conditions and raised interest rates during 1969, first in defense against excessive capital outflows stimulated by the unusually tight U.S. monetary conditions and then, as Europe’s own economic expansion gained momentum, increasingly to cope with domestic inflationary developments. However, these monetary actions, like the earlier ones in the United States, often came too late, or with too little support from fiscal policy, to contain quickly the demand pressures that had arisen. Moreover, in several of the European countries, notably Germany, the economic effects of the monetary restraints applied were partially frustrated or delayed by capital inflows, which during 1970 and early 1971 created major problems for maintenance of the desired degree of domestic credit stringency.4 As a result of these influences, together with the rapid advance in wage rates, the rise of prices in the industrial countries of continental Europe continued strongly—and in most cases accelerated—in 1970, when the growth of output also remained relatively high.
In Canada, domestic economic developments during the past several years were broadly similar to those in the United States. However, one significant difference was the generally higher degree of economic slack experienced by Canada; another was the markedly lower rate of price increases that occurred in Canada beginning in early 1970. In Japan, the economic boom that commenced in late 1965 came to an end as the rate of output growth declined considerably after mid-1970 and apparently dropped further in the first half of 1971. This pronounced slowdown was induced by the restrictive monetary policy adopted by the authorities in the fall of 1969 in order to control the rapid rise in demand and check the accelerating price advances. In the United Kingdom, economic stabilization policy reduced the growth of total output well below that of capacity during 1969 and 1970, while increases in prices and wages accelerated strongly. In the 1971/72 budget announced at the end of March 1971, the authorities changed the emphasis of policy in order to counter unemployment, which had reached the highest level in many years; and in July 1971, when it became evident that the economy had been weaker than expected in the first half of the year, action to provide some additional stimulus to demand was taken through a further relaxation of fiscal policy.
At the present juncture, a rise in the rate of expansion of total output in the industrial countries seems to be developing. The combined real growth rate of these countries was limited to only 2 per cent during 1970 because of the U.S. recession but, as noted earlier, it turned upward in the first half of 1971. (See Chart 2.) As it proceeds, cyclical recovery in the United States and Canada could be reinforced by a tendency toward faster output expansion in some other countries under the impact of easier demand-management policies. Pressures on resources, requiring the continuance of restrictive financial policies, are at present strongest in Germany and in the small industrial countries of Europe.
At the same time that the rate of output growth is tending to increase, inflation continues to be a serious problem throughout the industrialized world, and the determined efforts of national authorities will be required to bring it under effective control. Even with due allowance for the lagged effects on prices of the reduction in demand pressures already achieved by restrictive financial policies, it is clear that the overall price rise in the major industrial countries from 1970 to 1971 will be considerably higher than any rate that might be regarded as indicative of reasonable price stability.
A number of countries—particularly the United States, Canada, and the United Kingdom—face the difficult task of combating inflation while simultaneously bringing unemployment down to more tolerable levels. With wage increases substantially exceeding normal productivity growth, cost-push forces are still very strong in the industrial countries even though excess demand has now clearly been eliminated in all the larger ones except Germany. In such circumstances, there is a strong economic justification for the adoption of some form or another of what has come to be called incomes policy 5 to supplement the use of fiscal and monetary policies in the continuing fight against inflation, although it must also be observed that the question of the effectiveness and appropriateness of incomes policy is a controversial one in many countries.
The nature and role of incomes policy were discussed in the 1970 Annual Report (pages 13-14). Here, one general point may be recalled and emphasized. On the question of the form that an incomes policy should take and how it might operate, there is obviously a very wide range of possibilities essentially dependent on the social and political setting of individual countries—on the attitudes of labor and industry, the prevailing institutional arrangements, and the scope for government leadership in the rationalization of price and wage movements.
The international spreading of inflation during recent years is clearly reflected in the statistics on world trade. In contrast to the tendency from the mid-1950s to 1968 for average prices of internationally traded goods to rise only slightly, if at all, they showed a marked upturn in 1969 and advanced quite sharply in 1970. The increases in these two years were of a size and generality not witnessed since the Korean War boom nearly two decades earlier.
Of the approximately 15 per cent expansion in value of world trade from 1969 to 1970, some 6 percentage points were attributable to the price component; this increase in the average unit value of traded goods was centered in manufactured products, for which price advances were especially marked in the first half of 1970. In volume, the 1970 trade expansion was not as large as that in either of the two preceding years but still exceeded the average annual rate of increase earlier in the decade of the 1960s. Chart 3 shows the decline in the rate of growth in volume from its 1968 peak, together with the role of prices in maintaining the exceptional rate of advance in the value of trade. During the latter part of 1970 and early 1971, some slowing down in the growth in value of world trade was indicated by import trends of the industrial countries.
Chart 3.Growth of World Trade, 1960-70
The acceleration of foreign trade prices in recent years signified primarily the pervasiveness and intensity of inflationary forces in the main industrial countries. In the United States upward pressures on domestic prices have long tended to be accompanied by similar increases in export unit values,6 and the acceleration of U.S. domestic price increases during 1969 and 1970 proved no exception, being quickly transmitted to U.S. export unit values. In the generally inflationary international environment of the period, there appear to have been marked tendencies for German exporters to maintain profit margins by raising their foreign currency prices after the October 1969 revaluation, and for French exporters to increase their profit margins by maintaining the foreign currency prices of their exports instead of lowering them after the devaluation of the franc in August 1969. Similarly, exporters in other industrial countries found it relatively easy to pass on to their customers a large part of the rapid increase in domestic costs of production then under way. It was a most unusual development in 1970 that nearly all the industrial countries experienced increases in export unit values (expressed in U.S. dollars) at least as large as those in domestic prices.
Because these increases in export unit values were spread so widely, they did not in general greatly affect the terms of trade among the industrial countries. However, there was a marked deterioration from 1969 to 1970 in the terms of trade of the majority of primary producing countries, whose import prices were raised by the continuing price increases in the industrial countries at a time when their own export prices were generally not at all buoyant. After this deterioration, the collective terms of trade of the primary producing countries in 1970—for both the more developed and the less developed groups—were noticeably less favorable than those in the latter part of the 1950s.
The adverse shift in the terms of trade of the developing countries in 1970 curtailed the international purchasing power of their substantial expansion in export earnings. For these countries as a group, the effective purchasing power of such earnings rose by about 5 per cent from 1969 to 1970—a gain that was in line with the long-term trend but fell much below the exceptional increases of 10 per cent in both 1968 and 1969.
In early 1971 the picture with respect to primary product prices and export earnings was a very different one for oil producing countries than for most other groups of less developed countries. For the latter groups, developments during the first several months of 1971 did not suggest an early upturn in the broad indices of commodity prices, while the continuing inflation in industrial countries was still affecting import costs. For the oil producing countries, however, recently concluded negotiations with the international petroleum companies had resulted in new agreements greatly increasing the prices of most petroleum exports, as well as national revenues there from.
The large increase in the value of world trade from 1969 to 1970 was an extension of the cyclical upsurge that began in late 1967, after trade growth had been brought to a virtual standstill by the year-long economic slowdown in the industrial countries. In its earlier stage, through 1968, the upsurge in trade was dominated by a steep rise of imports into the United States; thereafter, the primary impetus to growth of world trade emanated from European and Japanese import demand. For the industrial world as a whole, the expansion of imports proceeded at a consistently high rate of some 15 per cent from the beginning of 1968 through mid-1970 and slackened only moderately in the second half of 1970. Throughout the 1968-70 period, rates of import growth in the industrial countries considerably exceeded the concurrent rates of growth in GNP—a development that apparently reflected a progressively higher degree of integration of world production and trade.
Shifts in trade balances have constituted a significant feature of world trade developments in recent years. As depicted in Chart 7, noteworthy changes from 1969 to 1970 included the substantial rise in the overall trade deficit of the more developed primary producing countries, whose imports soared while export growth was reduced; the marked deterioration in the trade balances of the smaller industrial countries in Europe, as imports advanced rapidly with the emergence of strains on resources; and the large increase in the combined export surplus of the seven largest industrial countries. This increase reflected chiefly a bulge in net exports from Canada, a shift from deficit into surplus on French trade transactions, and some rebound of the U.S. export surplus from its depressed 1968-69 level.
In a somewhat longer perspective, Chart 7 brings out the substantial swing from deficit into surplus of the combined trade balance of the less developed countries;7 the pronounced increase in the trade surplus of Japan, whose strong export performance has been reflected in consistently large increases in export market shares (Table 16); the absence of marked change in the German trade surplus during recent years, after its rapid cyclical expansion to a historically high level; the recovery in the trade position of the United Kingdom since 1967; and, prior to its partial recovery in 1970, the sharp drop in the U.S. trade surplus after 1965 that was induced by domestic demand pressures and probably also by shifts in price differentials favorable to foreign suppliers (which shifts appear to have exerted continuing effects in 1970 and early 1971).
Changes over the past year or so in trade balances of the major industrial countries were not generally of sufficient magnitude to figure prominently in the outbreak of disturbances on the European exchange markets in May 1971. Indeed, the same generalization is applicable more broadly to changes in “basic” balances, covering all current and long-term capital transactions. The focus, instead, must be on the persistence of imbalances in the basic accounts and the super-imposition upon them of large short-term capital movements. Fundamentally, the recent dramatic events in the international payments situation can be traced directly to the economic developments and policies in the main industrial countries as sketched above, extending over a number of years. There was no single or simple cause of the latest international monetary crisis, the background of which contained several important elements.
(1) The cyclical positions of the United States and continental Europe differed substantially. This difference arose by reason of the fact that, in the strong economic expansion among industrial countries after 1967, inflationary pressures re-emerged more quickly in the United States and, therefore, a restrictive financial policy was applied there earlier. During 1970 and early 1971, the U.S. situation was characterized by sluggishness of the domestic economy, high unemployment, and a stimulative financial policy. But on the continent of Europe during that period, and particularly in Germany, pressures on resources were still relatively strong and policies in most countries had not yet shifted from a phase of restraint to one of stimulus. (Key features of the economic situation in the United States and in Germany are illustrated in Charts 15 and 16, respectively.)
(2) Both the United States and continental European countries put particular emphasis on monetary policy in programs to regulate the domestic economy. Thus, in the absence of sufficient restraint on the fiscal side, monetary policy in the United States showed extreme tightness during 1969, and the degree of easing adopted in 1970 was a reaction both to that tightness (as the monetary authorities considered it necessary to inject some liquidity into the economy when it slowed down more than was intended) and to the maintenance of a rather restrictive fiscal stance in the 1970/71 budget as originally planned. In continental Europe, partly because of underestimation of the cyclical strength of business and consumer spending during 1968 and 1969, the measures of fiscal restraint introduced in the course of 1969 were in most instances belated and relatively weak; and monetary policies, notably in Germany, then had to assume a disproportionate share of the ensuing task of combating inflation.
(3) The divergence in cyclical positions, coupled with the character of the fiscal-monetary policy mixes, led to unusually wide differences in credit conditions and interest rates between the United States and Europe. These differences, in turn, gave rise to sharp fluctuations in short-term capital flows and to extraordinarily wide swings in the balances of payments of individual industrial countries (Chart 4). The overall balance of the United States swung from an exceptional surplus in 1969 to a huge deficit in 1970, while the balances of all the other larger industrial countries moved sharply in the opposite direction, with the bulk of this counterpart movement concentrated in the German accounts. Flows of short-term capital in the early months of 1971 were even larger than they had been during most of 1970, and by April it became increasingly evident that the inflows into Germany and certain other countries were being motivated by considerations relating to possible changes in exchange rate relationships among major currencies. Consequently, the effects of a marked convergence of short-term interest rates in the principal financial markets during April, induced to a large extent by official monetary policy actions, were overriden by a surge of purely speculative pressures. The further rush of funds into European exchange markets in the early days of May was on a massive scale, causing the authorities of Germany, the Netherlands, Belgium, Austria, and Switzerland to cease official intervention in support of their currency parities against the dollar and to close their official exchange markets pending decisions on measures for dealing with the situation.
Chart 4.Balances of Payments of Major Industrial Countries, 1968-70
(4) In addition to the unusual concurrence of cyclical and policy-mix factors that touched off large movements of yield-sensitive capital, the international monetary system was exposed to disturbances because of an underlying payments situation that was not satisfactory. Most important in this regard was the persistence of a U.S. external payments deficit in terms of the basic accounts; this imbalance has, over a long period, been accompanied by a deficit in the overall accounts except at times of exceptionally tight monetary conditions, such as 1966 and 1969. It may be recalled that the Fund’s 1970 Annual Report, after noting the improvements that had occurred in the balance of payments situations of the United Kingdom, France, and Germany, stated that the need to rectify the U.S. payments position was “the most urgent remaining task in the field of international payments.” That judgment is no less valid one year later.
The balance of payments problem of the United States may be viewed as centering in a current account surplus much too small to cover net outflows of private long-term capital and government expenditures abroad. Enlargement of this current surplus remains a key objective of economic policy and will depend fundamentally on the elimination of inflation and the avoidance of renewed strains on resources. In 1970 the surplus on current account was somewhat under $2½ billion, which was about $4 billion less than in 1965 and only $1 billion above the average of the 1968-69 cyclical lows. Further, the 1970 surplus benefited from the fact that the demand for imports was dampened by the prevailing substantial degree of underutilization of resources. This consideration, together with the continuation of official programs of restraint over exports of U.S. capital, is relevant to an interpretation of the U.S. deficit in the basic balance of payments, which amounted to about $2½ billion in both 1969 and 1970. The counterpart of this deficit is to be found in surpluses that are rather widely spread among other countries.
In view of the continuing underlying imbalance in the international payments situation, it is essential that the authorities of the United States and other leading countries pay particular attention to the implications of domestic monetary and fiscal policies for the level of short-term interest rates relative to those abroad. The need for joint responsibility and action is a practical lesson of developments culminating in the recent currency crisis. For deficit countries, balance of payments considerations clearly militate against undue reliance on monetary policy when it is appropriate to foster domestic economic expansion; this circumstance points to the desirability both of avoiding domestic liquidity creation beyond the immediate needs of a moderate economic upswing and of relying chiefly on fiscal policy for provision of the stimulus necessary to ensure that the economy moves on a suitable recovery path. Similarly, countries with a strong payments position that need to contain an inflationary boom should put main reliance on fiscal restraint rather than on extreme monetary tightness.
In Germany, the other country besides the United States that was primarily involved in the huge capital movements of 1970 and early 1971, the recent floating of the deutsche mark was accompanied by a number of policy measures aimed at stabilizing the domestic economy and warding off short-term capital inflows. (See page 98.) Such inflows, comprised mostly of borrowing abroad by German enterprises but also including accumulations of deutsche mark balances by foreign official institutions, had exceeded $6 billion in 1970 and $2 billion in the first quarter of 1971, with further substantial amounts accruing in April and the first days of May. The massive inflow of short-term funds was the dominating influence in the German balance of payments during 1970 and the first part of 1971 inasmuch as the basic accounts were approximately in balance. After the German authorities, in the face of this inflow, decided on May 9 not to maintain the exchange rates for the deutsche mark within the established margins, the exchange value of the currency appreciated; during the month of June, it fluctuated within a relatively narrow range, about 4½ per cent above parity.
In addition to the sharp changes in the U.S. and German external positions, the continuation of large surpluses in Japan’s balance of payments was a prominent feature of the recent international payments situation. During 1968 and 1969 the Japanese current account balance had strengthened, in contrast to the weakening that had occurred in past periods of rapid economic growth, and the overall balance of payments had recorded substantial surpluses. A somewhat larger surplus was realized in 1970, when the current account surplus again exceeded $2 billion and the net capital outflow declined. Further overall surpluses, on a much higher scale, accrued during the first six months of 1971, partly because of the sharp slowdown in import growth associated with the sluggishness of the domestic economy. At the end of June, official reserves amounted to $7.8 billion, compared with $2.0 billion at the end of 1967; in early June the Japanese Cabinet had formulated an eight-point program designed to broaden and intensify the Government’s efforts to ensure better equilibrium both internally and externally. (See page 93.)
Among the other larger industrial countries, particularly noteworthy was the positive swing of nearly $6 billion in the French overall balance of payments from 1968 to 1970 (see Chart 4); this reflected the rapid improvement that followed the devaluation of the franc in August 1969 and the concurrent reinforcement of restrictive financial policies already in effect since late 1968. Equally striking was the improvement after 1968 in the external accounts of the United Kingdom—an improvement that extended into 1971 and enabled the authorities, as in the case of France, to repay very large amounts of international debt. In Italy, where the balance of payments structure had featured a large current account surplus and a large net capital outflow, the lira came under heavy pressure in the first months of 1970 as the outflow of capital accelerated; the authorities then took a number of successful measures to stem this outflow, and the reserve position strengthened greatly during the latter part of 1970 and early 1971. In Canada an outstanding development was the $2 billion shift in the current account balance from moderate deficit in 1969 to very strong surplus in 1970. The strength of the current account was one of the important factors underlying the decision of the Government in May 1970 to float the Canadian dollar and the subsequent appreciation of that currency; after holding at a level about 7 per cent above the par value during the first five months of 1971, the exchange rate for the Canadian dollar declined during the first ten days of June to about 5¾ per cent above par, where it remained for the rest of the month.
For the group of smaller industrial countries in Europe, balance of payments developments in 1970 were characterized by a marked deterioration in the current account position (because of the rapid increase in imports emanating from strains on resources)8 and by a major swing in the capital account that led to a large overall surplus. In certain instances, the substantial amounts of liquidity injected by capital inflows counteracted monetary policy restraint in a situation of intense inflationary pressures. As noted earlier, four of the countries in this group—Austria, Belgium, the Netherlands, and Switzerland—were directly involved in the international monetary crisis of May 1971.
For all the industrial countries together, there was a balance of payments surplus of $6Vi billion in 1970, compared with approximate balance in 1969. The 1970 figure includes allocations of special drawing rights totaling $2.3 billion, and also reflects various other asymmetries in the recording of balance of payments statistics. Although the records of the industrial countries might seem to suggest a sizable upward movement in their collective overall balance in transactions with primary producing countries, there was no corresponding deterioration in the reported overall balance of the latter countries.9
Actually, available data indicate a substantial 1969-70 increase in the aggregate payments surplus of primary producing countries, even apart from receipts of SDR allocations. The combined surplus of these countries (including SDR allocations totaling $1.2 billion) amounted to $4.2 billion in 1970, compared with $1.6 billion in 1969. This increase stemmed from a sharp rebound in the net capital inflow, the uptrend in which had been interrupted in 1969 by stringent conditions in international financial markets—conditions that for many primary producing countries had noticeable adverse effects in the form of very high interest rates and limited availability of external credit. Although balance of payments developments differed markedly among the primary producing countries individually, it is noteworthy that a substantial increase in the net capital inflow from 1969 to 1970 occurred in all of the broad primary producing areas. (See Table 24.)
The resurgence of net capital inflows in 1970 was particularly marked in Australia, South Africa, Finland, and Spain among the more developed primary producers. In the first three of these countries, such inflows had fallen off sharply in 1969; in Spain, adoption of measures of financial restraint to counter inflationary pressures and balance of payments weakness greatly strengthened the capital, as well as the current, account. The majority of the more developed primary producing countries experienced improvement in their overall payments positions from 1969 to 1970; deteriorations were largest in South Africa and Yugoslavia as strong domestic demands led to an accelerated expansion of imports and to much larger deficits on current account. Collectively, the more developed primary producing countries had a surplus of $1.2 billion (including SDR allocations of $0.3 billion) in 1970, after having fallen close to balance in 1969 from an exceptional surplus of $1 ½ billion in 1968.
For the less developed countries as a group, there was a further increase in the current account deficit from 1969 to 1970; however, the rise in the net capital inflow was much larger. The overall surplus of $3.0 billion in 1970—including $0.9 billion obtained through SDR allocations—was the highest on record. It followed surpluses of about $1 billion in 1968 and $1½ billion in 1969, and the strong growth of these countries’ international reserves over the 1960s was thereby extended. (See Table 6 and Chart 6.)
The overall surpluses of less developed countries in recent years were disproportionately concentrated among certain major exporters of petroleum, metals, and manufactured products. The developing countries outside these three groups—that is, mainly countries exporting agricultural products—had surpluses that were proportionately much smaller than their share of the outstanding stock of reserves, which, in turn, was comparatively low in relation to imports. It may be noted that the allocations of special drawing rights to less developed countries in 1970 and 1971 went predominantly to this large group of agricultural exporters.
The balance of payments experiences of primary producing countries in 1970 and other recent years varied widely because of differences in such factors as commodity composition of exports, internal demand and supply conditions, and the nature and effectiveness of policy actions. The discussion in Chapter 5 illustrates the diversity of problems encountered by these countries in their efforts to maintain or achieve external payments equilibrium.
Issues in the International Adjustment Process
The recent disturbances in foreign exchange markets have posed broader issues relating to the international monetary system. For the purpose of indicating an appropriate background for consideration of these issues, several general principles may usefully be reaffirmed.
First, it remains the conviction of the Executive Directors, as stated last year in their report on The Role of Exchange Rates in the Adjustment of International Payments, that the basic principles of the Bretton Woods system are sound and should be maintained and strengthened—a judgment that was endorsed without reservation at the 1970 Governors’ meeting in Copenhagen. The essence of this system is stability of exchange rates around par values agreed with the Fund, changeable on the basis of agreed principles and in accordance with agreed procedures.
Second, support of the Bretton Woods system on the part of member countries calls for them to pursue internal policies to keep aggregate demand within the bounds of available resources, inasmuch as inflationary pressures have been the most frequent source of exchange rate difficulties. Also called for is a willingness, in instances where exchange rate changes are appropriate to restore equilibrium, to make such changes at a time and in a manner most likely to enhance their effectiveness. This consideration is of particular importance because, in present conditions of international mobility of capital, expectations that parities may be changed can lead to large and disruptive movements of funds.
Third, it is clear that the international monetary system cannot function well unless countries generally—and above all the larger ones—play their full part in the international adjustment process. This implies that they should pay specific attention to measures needed to maintain or restore balance in their international payments, and also that they give full weight to the effects on other countries of any measures that they may take to improve their internal economic situation.
Questions concerning the effectiveness of the international adjustment process have often arisen in recent years in connection with the problem of managing short-term flows in a world of convertible currencies and integrated financial markets. Experience has amply demonstrated that sensitivity of capital movements to interest rates and to exchange rate expectations can generate huge flows of funds across national boundaries, with the mobility of capital being facilitated by the Euro-currency market. Such flows may make it difficult for countries to attain their domestic demand targets, to avoid large changes in national and world reserves, and to adhere to an orderly system of exchange rates and exchange rate adjustment.
Analysis of the problem of dealing with volatile capital flows leads to a variety of possible—and not mutually exclusive—approaches, including (a) better international coordination of monetary policies; (b) controls over, or other measures directly affecting, capital movements; (c) somewhat greater exchange rate flexibility; and (d) accommodation of the capital flows. All these matters are now under study in the Fund, drawing on the varied experience of member countries. Here, some preliminary, general views may be indicated with respect to each of the four approaches mentioned. These views are not prescriptions for individual countries; each country is likely to adopt a combination of measures for the purpose of influencing and mitigating disequilibrating short-term capital flows, with the particular combination varying in accordance with the preferences, situations, and capabilities of the country in question.
(a) On the basis of an analysis of the economic policies that have been pursued by the main industrial countries since the mid-1960s, it would be hard to make a case that the fiscal and monetary policies of those countries have been well balanced or that their monetary policies have been reconciled internationally. A fundamental requisite for improvement in this sphere is a strengthening of the role of fiscal policies, so that monetary policies might be geared relatively more to the external position than has proved feasible in the past. While the instruments of fiscal policy generally are subject to substantial inflexibility because of institutional and political factors, and an improvement of these instruments would be highly desirable, a more active and timely use of fiscal policies should be possible within the existing framework. Moreover, it should also be possible to deal more effectively with the problem of so-called fiscal slippage, which in many industrial (as well as other) countries has involved a tendency for actual government expenditures to exceed budget estimates by a considerable margin. Without progress in the fiscal field, an undue reliance will continue to be placed on monetary policy, with a consequential generation of capital movements that may be disequilibrating to the balance of payments and also limit the effectiveness of monetary policy for domestic purposes.
A point worth emphasizing is that strengthening of fiscal policy and improvement of the mix of fiscal and monetary policies in the industrial countries not only would be helpful from the standpoint of managing the balance of payments, but also would make for better demand management and better overall economic performance. The validity of this proposition stems from the fact that in most industrial countries, because of the comparative inflexibility of fiscal policy, monetary policy has often been used for domestic purposes much beyond the point of its greatest efficiency. Such intensive application of monetary policy has sometimes had untoward effects, within the countries concerned, on the general level of economic activity, on particular sectors of the economy, and on financial markets; and, in the case of the largest industrial countries, especially the United States, it has had well-known repercussions from time to time on the level of world interest rates, on the international adjustment process, and on the economies of many other individual countries.
Thus, there is clearly a considerable scope for better international coordination of policies; and the events of May 1971, which have shown that the lack of at least some degree of interest rate harmonization among the leading countries can be very costly, have provided a spur to more effective efforts in the future. At the same time, the substantive difficulties involved in policy coordination cannot be ignored. It would seem advisable, on balance, to keep searching out ways of achieving greater progress in this area, even though substantial results may not be forthcoming in the short run.
Such a conclusion, in and of itself, would entail the view that there will continue to be, from time to time, a tendency in today’s highly integrated financial world for capital movements induced by interest rate differentials to be much larger than they were in the past. Yet it remains important that yield-induced flows of capital be held within reasonable limits, so as to minimize the resultant strains on domestic monetary management and on external reserves of the countries involved.
(b) Various types of techniques—such as regulatory measures or incentives in the banking field, selective fiscal measures, forward market intervention, and comprehensive or selective restrictions—may be used for the purpose of exerting an influence on capital movements so that countries can be better equipped to maintain independent monetary policies and divergent relative interest rates without evoking disequilibrating flows of capital. The Fund’s Articles of Agreement authorize the exercise of controls on international capital movements, provided that these controls do not unduly delay or otherwise restrict payments for current transactions. In general, however, the risk of restricting or distorting trade and other current payments—given the increasing integration between the major economies—calls for selectivity in the application of restrictions to capital flows.
The views taken on the appropriate role of capital controls have been influenced by changing circumstances. The rapid growth in the size of international markets in short-term funds in the late 1960s, mainly in the form of Euro-markets in bank deposits denominated in foreign currency, induced a number of major countries to impose or extend regulatory measures to influence flows of short-term capital between these markets and their domestic credit markets. However, comprehensive controls on international capital movements were widely considered neither feasible nor, at least in their entirety, desirable.
The integration of the world economy and the rational allocation of resources throughout the world owe too much to wide opportunities for the movement of capital—and the efficacy of capital controls is too dependent on circumstances in individual countries—to justify a general recommendation that countries should have comprehensive exchange controls. At the same time, countries that want to be prepared to head off or moderate occasional large capital movements, and thereby to avoid excessive pressures on exchange rates, should consider developing, at least on a stand-by basis, a set of simple and flexible tools that could be quickly activated to contain disequilibrating movements through the most important channels. These would include regulations on the net positions of banks, on the banks’ reserve requirements against foreign deposits, on foreign borrowing or lending by large domestic enterprises, etc.
In last year’s Annual Report and in this one, attention has been drawn to the rapid growth of the Euro-currency market and to the impact of this on both the effectiveness and the independence of national monetary policies. During recent months a certain measure of agreement has been reached concerning restrictions on the depositing of reserve accruals by central banks in the market, and discussion has also focused on the possibility of additional coordinated efforts aimed at bringing about more orderly conditions in the market and attenuating its growth. Although progress in this general direction would be desirable, it would appear doubtful that regulation of the Euromarkets by itself would go very far toward a resolution of the problems discussed in this section—which would exist even in the absence of those markets.
(c) The Fund’s current study of the possible need for additional exchange rate flexibility follows from the Executive Directors’ 1970 report on the mechanism of exchange rate adjustment. According to the terms of this report, which rejected those exchange regimes that are inconsistent with the par value system (freely floating exchange rates, substantially wider margins, and automatic adjustment of parities), the possible need that is now being studied relates to a limited increase in the degree of exchange flexibility. This could be expected to have a helpful effect in the discouragement of disequilibrating capital flows, although other considerations would of course also be involved. The matters under review include the advisability of amending the Articles of Agreement to permit a slight widening of margins around par and temporary deviations from par value obligations.
(d) Although measures can and should be taken to damp down short-term capital movements, it is only reasonable to assume that, with increasing financial integration, there will be occasional large-scale movements. The main implications of such a prospect are twofold. (1) Countries should review their monetary techniques with a view to rendering them more capable of offsetting the effects of reserve changes on domestic monetary conditions. Few countries have developed or used to the full the monetary instruments required to achieve maximum results in this respect. (2) Such large movements of short-term capital as occur will be financed in some way or other. One way to do so, which has the advantage that it involves no changes in global reserves, is provided by official borrowing from, or repayments to, capital markets abroad; such financing deserves further attention. Whatever may prove practicable and desirable in terms of financing in this form, there will undoubtedly be occasions on which there will be resort, as in the past, to other forms of financing—use of reserves, fluctuations in the stock of reserve currencies, use of swaps, and Fund transactions—with the frequency and intensity of such resort depending on the extent to which measures against the capital movements themselves are adopted and prove effective.
This chapter has touched on a variety of areas in which the economic policies of the main industrial countries could be improved. A broadly similar survey in last year’s Annual Report was prompted by the serious questions about the adequacy of those policies that had been raised by the heightening of inflationary pressures. Focus on the main industrial countries has been indicated by reason of the fact that it is these countries, because of their economic weight, whose policies primarily determine how effectively the whole international system operates and, at the same time, exert a heavy impact on the economies of the developing nations.
In a world-wide, 118-member organization such as the Fund, the desirability of restoration and maintenance of financial stability in the main industrial countries is seen not least from the standpoint of the benefits that developing nations throughout the world would derive from such an achievement. The record of the past half-dozen years or so clearly indicates a number of ways in which they would stand to gain from an improvement in the economic policies of industrial countries. Thus, the less developed nations have been affected by the higher cost and restricted availability of credit in international financial markets because of the undue emphasis by industrial countries on monetary policy in programs of financial restraint; by a less-than-satisfactory environment for development planning because of the alternating impact of overexpansion and contraction in those countries; and by a sluggishness in the flow of official capital and aid, perhaps in part because of the preoccupation of the industrial countries with their own problems of inflation, balance of payments difficulties, and budgetary pressures. Further, experience has shown that when periods of slack in the industrial countries follow excessive rates of resource utilization, the less developed countries tend to lose earlier gains in the volume and prices of their exports while they may sometimes feel a more lasting impact of cost escalation on prices of the manufactured products that predominate among their imports.
Against this background, the efforts now under way in other international organizations to assist the developing nations by untying aid and by granting preferential treatment to their exports of manufactured products are gratifying and deserve the widest possible support. At the same time, there remains an urgent need for major improvement in the volume and quality of development assistance as a whole. The flow of official capital and aid to the developing nations failed by a substantial margin, as is well known, to keep pace with the relative growth of income in the industrial countries over the 1960s, and in recent years the aid flow has probably declined somewhat in real terms. It is to be hoped that the industrial countries will endeavor to raise the level of development assistance according to their potential; this would be in accord with the interests of the international community as a whole, as well as responsive to the immense needs of the less developed countries.
Anwar Ali, Director (on leave).
For the classification of countries used in this Report, see footnote 2, page 52.
As measured by the GNP deflator.
Because of the widespread failure to make timely shifts in fiscal policy, these belated stabilization measures often took the form primarily of a more stringent monetary policy than would otherwise have been called for.
The structure of international interest rate relationships prevailing in the latter part of 1969 was radically altered during the course of 1970. Whereas the 1969 pattern had tended to draw funds from Europe toward the United States, the pattern that developed in 1970 tended to reverse that flow of funds as U.S. monetary policy eased and European monetary policy tightened because of the emergent heavy pressures on resources.
Including a wide variety of possible measures, ranging from moral suasion to direct controls, to affect the movement of wages and prices in the public interest.
Over the decade of the 1960s, domestic prices (GNP deflators) and export prices moved along nearly parallel paths in both the United States and the United Kingdom. In the EEC countries and Japan, however, increases in domestic prices were accompanied by small or negligible increases in export unit values. For a brief discussion of factors influencing the relationship between domestic prices and export prices, see Annual Report, 1970, pages 54-55.
This swing has been contrary to the tendency for the large deficit on services and private transfers to grow. In 1970, the less developed countries as a group had a trade surplus of well under $1 billion and an overall current account deficit of $8½ billion.
An exception to this generalization was afforded by Belgium, where the external current account in 1970 showed a very large surplus.
For a discussion of this question of asymmetries and errors in the balance of payments statistics for 1970, see pages 81-82.