Chapter

Chapter 1 Developments in the World Economy

Author(s):
International Monetary Fund
Published Date:
September 1974
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AT mid-1974, the world economy was in the throes of a virulent and widespread inflation, a deceleration of economic growth in reaction to the preceding high rate of expansion, and a massive disequilibrium in international payments. This situation constitutes perhaps the most complex and serious set of economic problems to confront national governments and the international community since the end of World War II.

After more than a decade of generally rising rates of price increase, inflation accelerated rapidly in the past two years. This acceleration was compounded by the upsurge of most primary commodity prices in the wake of the widespread economic boom and by the recent sharp escalation in the price of oil. The average annual rate of inflation in industrial countries, already 7 per cent in 1973, reached 12 per cent (in terms of GNP deflators) in the first half of 1974, when even those countries with the lowest rates of price increase were experiencing inflation on a scale considered unacceptable. This course of developments, marked by the formation of a deeply embedded inflationary psychology, has brought into focus the need for countries—especially the largest ones—to pursue a strategy to curb inflation before it leads to serious and prolonged damage to the world economy.

Such an essential strategy must be instituted at a time of marked economic slowdown in the industrial countries. Under the impact of cyclical influences and of developments relating to oil, the volume of total output in the industrial countries suffered an outright (though small) decline in the first half of 1974, and the effects of this unusual development were in process of spreading to the primary producing countries. Notwithstanding a general expectation that expansion of the main industrial economies will be resumed in the second half of 1974, diagnosis of the balance of expansionary and contractionary forces in the world economy is uncommonly difficult and the pursuit of anti-inflation programs centering on policies of financial restraint involves, of necessity, the incurrence of certain risks.

Severe balance of payments problems are arising from the overlay of higher oil prices upon an international payments situation still characterized by some sizable imbalances at the end of 1973, despite the marked improvement that had occurred in the position of the United States. Unusually large changes are occurring in the current account balances of individual countries and in the whole structure of balance of payments relationships between oil importing and oil exporting countries. These changes, together with the associated—but still highly uncertain—shifts in capital flows, may tax the capacity and adaptability of the financial institutions and arrangements available for the necessary channeling of funds from countries with current account surpluses to those with current account deficits. Already clearly evident is the urgent need—magnified by years of decline in the relative magnitude of official development assistance—for a greater flow of capital on concessional terms and of grant assistance to the numerous developing countries that have been severely affected by the higher prices of oil and other commodities.

The unprecedented combination of circumstances sketched above calls for international cooperation of a quality rarely achieved in the past. In its absence, the pursuit of unduly nationalistic policies in disregard of their impact on other countries could greatly exacerbate the problems now confronted; taking such forms as competitive exchange depreciation and trade restrictions, such policies could cause an international recession and make the eventual adjustments much more costly to all concerned. Resolute and effective cooperation, on the other hand, could minimize those costs and avert the risks of precipitate and short-sighted actions. Appeals for international cooperation and mutual understanding have been made in previous Annual Reports, but never with greater urgency than at the present time.

In light of the appearance of such grave uncertainties on the world economic and financial scene, the Committee of Twenty shifted the priority of its work on international monetary reform to the reaching of agreement on numerous important aspects of reform affecting the immediate interests of both developed and developing countries. Furthermore, although the results of the Committee’s work on longer-term reform were less comprehensive than had been hoped for when the Committee began its work in September 1972, a substantial measure of agreement has been achieved on the broad objectives of a reformed system; and the program of action initiated at the final meeting of the Committee in June 1974—as described in Chapter 3—provides the basis for an evolutionary process of reform which could be of great help in dealing with current international payments problems, and which could prove, in itself, a significant step in the evolution of the international monetary system.

Particular comment is called for regarding developments over the past year in the exchange rate field. In an environment of continuing flexibility of exchange rate arrangements, progress has been made toward fulfillment of the need—emphasized in the 1973 Annual Report—”to bring exchange rate policies and practices under the framework of a system founded on international agreement and commanding general support.” A major step in that direction is part of the Committee of Twenty’s program of immediate action, and is reflected in the recent decision of the Executive Directors (summarized in Chapter 3) recommending that members should endeavor to observe certain guidelines for the management of floating exchange rates. These guidelines will help to ensure that countries conduct their exchange policies in the light of an internationally agreed code of behavior and will provide a framework for a continuing international dialogue on the appropriateness of countries’ balance of payments policies.

The three following sections of the present chapter, under the headings of Problems of Domestic Policy, World Trade and Payments, and External Policies and Adjustment, trace the sequence of developments that have led up to the current situation, analyze its key features, and discuss the economic and financial policy issues with which the authorities of member countries are contending.

Problems of Domestic Policy

Trends in Growth and Inflation

Even before the abrupt change in the oil situation late in 1973, a marked slowing of output expansion in the industrial countries was clearly under way and was expected to extend into the first half of 1974. In most of these countries, absorption of the slack in resource utilization that developed during the 1970-71 slowdown had progressed far enough by mid-1973 to force a tapering of the rate of growth in total output toward closer conformity with the longer-run growth rate of productive capacity. Moreover, the high rates of price inflation that accompanied the expansion of economic activity during the latter part of 1972 and early 1973 had led the authorities of many industrial countries to introduce or tighten policies of financial restraint, and the impact of such policy actions on real activity had clearly begun to take effect in some of the larger countries.

For the industrial countries as a group, the growth of real GNP dropped from an annual rate of 8 per cent in the first half of 1973 to about 3 per cent in the second half (Chart 1). The increase for the year as a whole over 1972—6½ per cent—was still unusually large; and, indeed, 1973 was a year of high economic growth throughout most of the world (Table 1). Total output in the less developed areas is estimated to have expanded by 7½ per cent from 1972 to 1973, compared with a 5½ per cent average annual rate of increase over the 1960s.

Chart 1.Semiannual Changes in Output and Prices in Industrial Countries, First Half 1971–First Half 1974

(Percentage changes in real GNP and GNP deflators from preceding half year, seasonally adjusted, at annual rates)

1Include, in addition to the countries shown separately in the chart, Austria, Belgium, Denmark, Luxembourg, the Netherlands, Norway, Sweden, and Switzerland.

Table 1.Growth of World Output, 1960-73(Percentage changes in real GNP)
Annual Average 1Change from Preceding Year
1960-701960-651965-7019691970197119721973
Industrial countries4.85.14.54.82.63.75.66.4
Canada5.25.64.85.32.55.65.86.8
United States4.04.93.22.7−0.43.36.25.9
Japan11.110.112.112.110.36.88.910.5
France5.95.85.97.76.05.55.46.1
Germany, Fed. Rep. of4.95.04.88.25.82.73.05.3
Italy5.65.35.95.74.91.63.15.9
United Kingdom2.73.32.11.61.82.32.36.0
Other industrial countries 24.95.04.76.15.63.24.64.2
Primary producing countries5.65.35.87.06.45.65.77.1
More developed areas 35.85.95.87.36.05.75.66.3
Less developed areas 45.55.15.86.96.65.65.77.5
World55.05.14.85.23.44.15.66.5
Sources: National economic reports, secretariat of the Organization for Economic Cooperation and Development, secretariat of the United Nations, U.S. Agency for International Development, International Bank for Reconstruction and Development, and Fund staff estimates.

Compound annual rates of change.

Austria, Belgium, Denmark, Luxembourg, the Netherlands, Norway, Sweden, and Switzerland.

Comprise Australia, Finland, Greece, Iceland, Ireland, Malta, New Zealand, Portugal, South Africa, Spain, Turkey, and Yugoslavia.

Comprise Fund member countries not listed above as “Industrial countries,” or as being in “More developed areas” (footnote 3, above). In some of the other tables in this chapter, the less developed countries are subdivided to distinguish the “major oil exporters” (Algeria, Indonesia, Iran, Iraq, Kuwait, the Libyan Arab Republic, Nigeria, Saudi Arabia, and Venezuela) and “other developing countries.”

Fund member countries (listed in Appendix Table I.1) plus Switzerland.

Sources: National economic reports, secretariat of the Organization for Economic Cooperation and Development, secretariat of the United Nations, U.S. Agency for International Development, International Bank for Reconstruction and Development, and Fund staff estimates.

Compound annual rates of change.

Austria, Belgium, Denmark, Luxembourg, the Netherlands, Norway, Sweden, and Switzerland.

Comprise Australia, Finland, Greece, Iceland, Ireland, Malta, New Zealand, Portugal, South Africa, Spain, Turkey, and Yugoslavia.

Comprise Fund member countries not listed above as “Industrial countries,” or as being in “More developed areas” (footnote 3, above). In some of the other tables in this chapter, the less developed countries are subdivided to distinguish the “major oil exporters” (Algeria, Indonesia, Iran, Iraq, Kuwait, the Libyan Arab Republic, Nigeria, Saudi Arabia, and Venezuela) and “other developing countries.”

Fund member countries (listed in Appendix Table I.1) plus Switzerland.

The counterinflationary policies that have been widely adopted in the industrial countries did not slow the advance of prices in 1973. Under conditions of mutually reinforcing booms, shortfalls in agricultural production, and a steep upsurge in primary commodity prices fueled by these and other factors, the upward movement of prices was accelerating on a broad scale in the second half of 1973. As measured by the comprehensive GNP deflators, the annual rate of price increase in that period (over the first half of 1973) averaged 10 per cent for the industrial countries—a level of inflation that was extremely high in historical perspective (Table 2 and Chart 2).

Table 2.Price Increases in Developed Countries, 1960-73(Percentage changes in GNP deflators)
Annual Average 1Change from Preceding Year
1960-701960-651965-7019691970197119721973
Industrial countries23.42.64.24.75.95.44.87.2
Canada3.01.94.24.54.83.14.87.6
United States2.71.44.04.85.44.53.45.6
Japan4.84.94.74.16.74.55.112.1
France4.34.14.46.65.55.45.77.2
Germany, Fed. Rep. of3.53.63.43.67.18.06.06.0
Italy4.55.53.54.36.66.65.810.5
United Kingdom4.23.55.05.47.38.97.77.5
Other countries 2,34.44.34.54.35.97.27.38.3
More developed primary producing
countries24.84.74.94.46.29.09.413.2
Australia2.92.23.63.94.66.67.911.6
Spain5.86.65.03.54.97.48.910.7
Other countries 2,45.25.05.44.97.410.610.215.0
Sources: National economic reports, secretariat of the Organization for Economic Cooperation and Development, and Fund staff estimates.

Compound annual rates of change.

Average of percentage changes for individual countries weighted by the U.S. dollar value of their GNPs at current prices in the preceding year.

Austria, Belgium, Denmark, Luxembourg, the Netherlands, Norway, Sweden, and Switzerland.

Finland, Greece, Iceland, Ireland, Malta, New Zealand, Portugal, South Africa, Turkey, and Yugoslavia.

Sources: National economic reports, secretariat of the Organization for Economic Cooperation and Development, and Fund staff estimates.

Compound annual rates of change.

Average of percentage changes for individual countries weighted by the U.S. dollar value of their GNPs at current prices in the preceding year.

Austria, Belgium, Denmark, Luxembourg, the Netherlands, Norway, Sweden, and Switzerland.

Finland, Greece, Iceland, Ireland, Malta, New Zealand, Portugal, South Africa, Turkey, and Yugoslavia.

Chart 2.Price Increases in Industrial Countries, 1953-First Half 1974

(Percentage changes in GNP deflators from preceding year)

* Change from first half of 1973 to first half of 1974.

1 Austria, Belgium, Denmark, France, Germany, Italy, Luxembourg, the Netherlands, Norway, Sweden, Switzerland, and the United Kingdom.

The inflationary upsurge in 1973 was by no means confined to the industrial countries. The average rate of price increase in the more developed primary producing countries also rose sharply in 1973, to twice the rate in 1970 (Table 2). In the developing countries, the acceleration of price advances was sharp and pervasive; as measured by consumer price indices, the increase in these countries’ domestic prices from 1972 to 1973 amounted, on average, to about 25 per cent, which was more than double the average annual increase over a period of years through 1971 (Table 3). This acceleration of price inflation took place against the background of a remarkable expansion of the developing countries’ export earnings, sharp increases in the foreign currency costs of their imports, and an effective depreciation (on average) of their currencies since 1971.1

Table 3.Price Increases in Less Developed Countries, 1965-First Quarter 1974

(Percentage changes in consumer prices)1

Annual Average 1965-70Change from Preceding YearFirst Quarter 1973 to First Quarter 1974
197119721973
All less developed countries1310132437
In Africa465714
In Asia18 2571931
In the Middle East3561016
In the Western Hemisphere15152136 248 2
Sources: IMF Data Fund and Fund staff estimates.

Averages of changes in indices expressed in terms of local currency. Weights are proportional to GNP (in U.S. dollars) in 1972.

Excluding one high-inflation country, the Asian figure in the first column would be 7 per cent; with a similar exclusion, the Western Hemisphere figures in the last two columns would be 21 per cent and 19 per cent, respectively.

Sources: IMF Data Fund and Fund staff estimates.

Averages of changes in indices expressed in terms of local currency. Weights are proportional to GNP (in U.S. dollars) in 1972.

Excluding one high-inflation country, the Asian figure in the first column would be 7 per cent; with a similar exclusion, the Western Hemisphere figures in the last two columns would be 21 per cent and 19 per cent, respectively.

The international economic situation and outlook were strongly affected by a sequence of developments relating to oil late in 1973. These developments featured (a) limitations on oil production imposed during October and November by members of the Organization of Arab Petroleum Exporting Countries (OAPEC); (b) a tripling of average export prices for oil, reflecting sharp increases in posted prices of crude oil in October and, particularly, in December by members of the Organization of Petroleum Exporting Countries (OPEC); (c) the easing of cutbacks in oil production that was announced by OAPEC in December 1973 and the further lifting of embargo restrictions against the sale of oil to certain countries in March-April 1974; and (d) a host of measures to conserve oil and otherwise curtail the demand for it, undertaken by virtually all countries dependent on foreign sources of oil, in reaction initially to the prospect of an extended period of acute oil shortage and subsequently to problems of adjusting to the new level of oil prices.

The emergence in October-November 1973 of constraints on the supply of oil occurred at a time when, for other reasons, the economic prospects of the industrial countries for 1974 entailed the combination of a slowdown in growth and an average rate of inflation at least as serious as in 1973. The overlay of the oil cutbacks implied that 1974 might be a year of negligible average growth, or even decline, of GNP in the industrial countries. The significance of the late-December announcements by OPEC countries with respect to oil pricing and production was thus two sided: on the one hand, a worsened outlook for inflation; on the other hand, an easing of widespread fears of protracted international recession due to a shortage of oil. With the further easing of oil supply restrictions in the early part of 1974, and with increases in oil production by certain countries clearly under way, it appeared (a) that OPEC oil supplies might average, for the year as a whole, roughly the same as for 1973 and (b) that this should be enough to sustain some year-to-year growth in overall economic activity in the oil importing countries (given the oil-economizing measures already taken in these countries), provided that the increase in oil prices did not itself have a substantial deflationary impact.

Because of declines of real GNP in the United States, Japan, and the United Kingdom, along with a subnormal rate of increase in Germany, total output in the industrial countries as a group is estimated to show a small decrease in the first half of 1974—by contrast to a “normal” growth rate of 4½–5 per cent and the unsustainable 8 per cent rate of expansion that occurred in the first part of 1973 at the peak of the recent boom (Chart 1). Notwithstanding this change with respect to output, the overall rate of price inflation in the industrial countries, as already mentioned, accelerated to an annual rate of 12 per cent in the first half of 1974. Only in Germany, among the largest countries, was the inflation rate appreciably less than 10 per cent in that period, and the rates for Japan and the United Kingdom were substantially higher than the average.

Price inflation in the industrial countries has accelerated almost steadily since the mid-1960s. The overall rate of 12 per cent in the first half of 1974 was far above the average price increase of about 2½ per cent experienced by these countries in the early 1960s, but the main change occurred quite recently. In 1972, when inflation was already considered a worrisome problem, GNP deflators in the industrial countries rose on the average by some 5 per cent from 1971.

It is only in the past few years that rising costs of primary commodities and fuels have become significant elements in the inflationary trend. From 1965 to 1970, the average annual rate of increase in the prices of primary commodities other than petroleum was about 2 per cent, and the prices of petroleum moving in international trade were stable or declining. Manufactured goods and various services thus accounted for the bulk of the increase in GNP prices.

The record of sharply accelerated inflation in the industrial countries over the past ten years has not been accompanied by any step-up in the growth of real GNP or by any improvement in the utilization of economic resources. On the contrary, the shifting policies intended to cope with recurring problems of overexpansion and slowdown left most industrial countries with higher-than-usual rates of unemployment and/or slack in industrial capacity when the latest boom peaked in the first half of 1973.

For the primary producing countries the statistical picture of the situation evolving in 1974 is much less complete. However, the available price figures show that the rate of domestic inflation increased sharply during 1973 and the first months of 1974 in both the more developed and the less developed primary producing countries. For example, the approximately 25 per cent rise of consumer prices in the developing countries from 1972 to 1973 was far exceeded by the upsurge of nearly 40 per cent that occurred over the year ending with the first quarter of 1974 (Table 3). With respect to both periods, these overall averages reflected relatively high inflation rates in the Western Hemisphere region, as well as in Asia, and considerably more moderate rates in Africa and the Middle East. In a broader time perspective, however, a noteworthy feature of the record is that inflation has developed on a substantial scale in many primary producing (as well as industrial) countries where low or moderate rates of price increase had been customary.

Growth-depressing influences evidently are at work in many of the primary producing countries. Because of slower expansion in the industrial world and other factors, this year’s rise in export volume for non-oil developing countries seems bound to be sharply reduced, following increases averaging more than 8 per cent in recent years. Many of these countries—particularly the ones whose own export prices have not shared in the general upswing—are also being hit by a deterioration in the terms of trade; and growth in the volume of imports essential for development is being inhibited by the upsurge of prices for oil, foodgrains, fertilizer, and many types of manufactured goods.

The major oil exporters are in a very different position by reason of the sharp improvement that has occurred in their terms of trade since 1973. But in these countries, too, inflation looms as a serious problem because of the steadily rising prices of imported goods and the pressures on resources that may emerge in the process of using part of the expanded foreign exchange earnings to accelerate the pace of domestic development.

In the period ahead, trends of prices and activity in the world economy will depend largely on developments in industrial countries. Unfortunately, it is difficult to form a confident judgment as to the balance of contractionary and expansionary forces in those countries. Following, however, are a few of the factors that such a judgment must take into consideration.

—One key question concerns the significance that should be attached to the fact that a slowing down of economic expansion in most industrial countries was already in process in the course of 1973, prior to the sudden emergence of energy problems later in the year.

—The tripling of petroleum prices that took place late in 1973 is adding to inflation through its cost-raising effects. At the same time, this price rise could have a deflationary effect stemming from the much greater increase of imports than of exports (discussed below) that is occurring in the trade of oil importing countries with the oil exporting countries. A deflationary effect will be felt to the extent that larger payments for oil may be financed through diversion from other expenditures; this effect will be averted to the extent that such payments are financed out of current saving, although the resultant incurrence of additional debt or liquidation of financial assets might in various ways affect the behavior of consumers and business enterprises over some uncertain period of time. Some observers view the possible deflationary influence of higher oil prices, superimposed on the cyclical slowdown, as a serious threat to economic expansion. Others believe that expansionary forces, both autonomous and government-induced, will prove sufficiently strong to offset it. Views also differ as to the probable timing of any deflationary impact of higher oil prices—whether occurring quickly or taking a good many months to show up.

—Perhaps as a broader aspect of the difficulty in judging the economic impact of the oil price increases, a larger-than-usual degree of uncertainty surrounds the outlook for private spending. Current rates of price inflation represent an essentially new situation in the postwar period, and it is thus difficult to judge on the basis of past experience how various groups within the private economy will react to them. Also, the comparative newness of the situation creates added difficulties in the area of government policy, both in its formulation and in the assessment of its effects.

—Related to the above points, and partly overlapping them, is the difficulty in gauging how severe an impact the industrial countries’ recent financial policies will have, with an uncertain lag, on the level of real activity; these policies have for many months been generally on the side of restraint in the endeavor to combat inflation. Moves toward more restrictive fiscal positions have recently been made by the governments of several major countries, and monetary policies are almost universally tight. In several countries, notably Italy and the United Kingdom, restrictive financial policies are directed toward overcoming severe balance of payments problems, as well as domestic inflation. However, postures of restraint have generally not been assumed in disregard of considerations relating to employment and growth objectives. The German authorities, for example, acted in December 1973 to forestall the risk of a recession emanating from the cutbacks in oil supply by lifting most of the stabilization measures introduced in the previous May and by taking additional steps to assist sectors experiencing difficulties; and German monetary policy in recent months, while still tight, has not been so restrictive as it was in 1973. Similarly, several of the smaller industrial countries adopted measures designed to maintain the upward momentum of demand in real terms, generally by giving specific relief from adverse effects of price increases or from adverse side effects of counterinflationary actions with respect to domestic credit conditions.

Despite the uncertainties in the picture, most senior officials of industrial countries recently engaged in consultations with the Fund have expressed the view that inflation is the dominant problem of economic policy, and deserving of the highest priority; that the slowdown in economic activity during the first half of 1974 is traceable to the effects of a shift to more restrictive policies during the 1972-73 period, to the emergence of shortages and bottlenecks, and to the impact of the oil situation on particular sectors, rather than to any generalized weakening of demand; and that the underlying demand situation at mid-1974 still appeared to be expansionary. However, there were significant variations around this general viewpoint, involving questions about the probable trends in global economic activity and the degree and timing of the restrictive effect on real output that might be necessary and appropriate for conducting effective anti-inflation policies. There was an awareness, with differing shades of emphasis, that the possibility of international recession could not be ruled out, even though signs of it had not yet appeared.

At mid-1974, economic policy in the industrial countries was being guided predominantly by the view that provision of stimulus was not needed and would dim the prospects for achieving a deceleration in the rate of inflation. Indeed, national forecasters in most industrial countries (including the three largest ones: the United States, Germany, and Japan) were projecting an upturn of real GNP in the second half of 1974. However, in the forecasts of both national governments and international organizations, cognizance of the uncertainties inherent in the short-term international outlook was reflected in some opinion that performance with respect to total output might well turn out to be weaker than was being generally projected.

Factors in the Current Inflation

While the inflation problem is thus being widely addressed at the national level, as indeed is essential, the origins and continuing dynamics of the present inflation must to a great extent be understood in a global framework. The rapid inflation of prices now in process is world-wide and appears to differ from most prior experience in several important respects. Both its overall scale and the nature of its causes and constituent elements are without close parallel since World War II.

Clearly, one relevant factor was the unusually high degree of coincidence in the phasing of business expansion in many countries during 1972 and 1973. In practically all the developed countries, economic activity accelerated sharply and aggregate demand rose to high levels during this period. Nonetheless, it would be difficult to explain the marked excess of the current inflation rate over earlier rates primarily in terms of a difference in effective levels of real resource utilization. These, as measured by available (and admittedly imperfect) indicators, were not abnormally high by historical standards in most industrial countries, even at the crest of the boom in the first half of 1973.

It is also relevant to recall that the 1972-73 upsurge of global demand was marked by failures or miscalculations in the conduct of monetary and fiscal policies. In relation to the buoyancy of private demand that materialized during the boom period, fiscal policies proved insufficiently restrictive in a number of instances, and rates of monetary and credit expansion permitted by prevailing monetary policies would have to be characterized as excessive from the standpoint of controlling inflation. However, since broadly parallel judgments are applicable also to the boom phases of other major postwar business cycles, it cannot be taken as a certainty that laxity of monetary and fiscal policies contributed more to the excesses of the latest boom than it did to those of previous upswings.

Several distinctive features of the recent boom do appear to offer grounds for an explanation of the differential rate of inflation. Among these were the high rates of price increase sustained through the previous slowdown and the upward momentum thus already prevailing at the beginning of the 1972-73 upswing. The cyclical record of price fluctuations over a long run of years is broadly suggestive of an asymmetrical response pattern in which the rate of inflation seems to subside less markedly with deceleration of growth than it rises with acceleration. This pattern has apparently had a cumulative effect on business and consumer expectations, helping to generate the momentum so readily visible in the record of annual inflation rates over the past ten years or so. Such momentum doubtless reflects the evolution of public attitudes and institutional practices that have become geared to an assured expectation of continuing advances in costs, prices, and rates of remuneration.

Another distinctive feature of the recent boom was the magnitude of the increase in many primary commodity prices (even apart from oil). As described in the next section of this chapter, the upsurge of commodity prices since 1972 has no parallel with earlier peacetime experience—a fact suggesting that to some extent these big increases were independent of the general process of inflation in the world economy. Shortages attributable to crop failures resulting from drought or flood were in that category, as were changes in stock positions emanating from agricultural policy shifts in key countries. In important respects, however, the escalation of commodity prices must be seen as responsive to the boom itself. Commodity prices reacted strongly to the main wave of demand pressures in the industrial countries that reached its crest in the first half of 1973; and these prices also were pushed up erratically—especially during the latter part of 1973 and the early months of 1974—by anticipatory buying in a climate of inflationary expectations, of real or threatened shortages of various materials, and of uncertainties concerning the future values of currencies. Furthermore, it is clear that the shortages of 1972-73 might have produced less dramatic results if they had not occurred in the context of cyclically buoyant demand in the industrial world.

Oil developments, especially the incidence of their cost-raising influences, have affected many price movements since October 1973. The relatively low elasticity of demand for oil and its pervasive use in productive processes throughout the world imply (given also the short-run limitations of supply) that a price increase of the magnitude witnessed at the turn of 1974 will be translated into an escalation of the costs and prices of goods and services produced through use of petroleum as a source of either energy or materials.

For many individual countries, the recent increases in oil and primary commodity prices—like the continuing increases in prices of imported capital goods—represent a form of imported cost inflation that is very difficult to influence or control. Moreover, these elements of cost, in addition to those that are initially generated by internal demand pressures, are in some measure likely to be extended and built into the cost structure through the process of linking wages to prices, both in formal contractual arrangements and in de facto patterns of labor market adjustments. As final-product prices rise, the escalator clauses of existing wage agreements in some countries, together with the cost of living considerations that enter less formally into wage negotiations on a much wider scale, tend to generate largely automatic increases in wage rates to cover the accelerated advances in consumer prices. Moreover, producers usually continue raising their prices to cover at least the additional costs; and they are able to raise them by larger amounts in the many situations permitting imperfectly competitive pricing practices. These processes mean that if incomes policies are absent or ineffectual, and if financial policies are permissive, strong secondary repercussions of the oil and primary commodity price increases must be expected.

Clearly, factors such as those enumerated above are mutually supporting and reinforcing in their effects on prices. Their combined strength has recently reached such proportions, and has become so deeply embedded in public attitudes and expectations, that inflationary pressures are likely to persist for some time, even if the stance of financial policies in all the larger countries were presumed to be wholly appropriate in the light of all legitimate domestic concerns. The problem of retarding the present momentum of price advances is greatly complicated by the ease—as suggested by the phrase “imported inflation”—with which impulses originating in one area are transmitted to other parts of the world. The recent rise in oil prices is only one example—though a major one—of the many changes that tend, through their influence on the cost of living, wage demands, and business costs, to be widely generalized among all the countries concerned, quickly spreading in each of them to many prices not directly affected by the initiatory changes. The price explosion that has occurred in international trade is indicated by the fact that, following a long period of near stability, foreign trade prices went up by 13 per cent from 1972 to 1973 and by no less than 40 per cent from the first quarter of 1973 to the first quarter of 1974.2

Adaptation of Policies

Inflation is a world-wide problem that must be dealt with before it gets further out of hand. Its economic and social effects were already a source of widespread concern several years ago, when the rate of increase in prices was less than half the present rate. Those effects now loom much larger.

Since the inflation problem is world-wide, all countries should be expected to contribute to its solution. But because of their sheer weight in the world economy, the chief responsibility in this regard falls on the industrial countries. However, the rate of price increase in these countries has not shown signs of quickly retreating to an acceptable level—a situation which the public is aware of and which has contributed to the development of a strong inflationary psychology. Maintenance or extension of the recent price declines in many primary commodities would bring some easing of inflationary pressures in the industrial countries; but other elements in the inflationary process remain strong, with price-induced pressures for larger nominal wage increases threatening to become a particularly active force.

Governments in the industrial world, and elsewhere, are profoundly disturbed by the prevailing rates of price increase and, as mentioned earlier, view inflation as the most serious problem of economic policy. The efforts already being made to combat this problem are greatly to be welcomed, and these must be transformed into a clear-cut strategy of policy.

The fundamental need is to bring about and to sustain a better balance between demand and supply—between the growth of aggregate expenditure and the capacity to produce. Although the policy stance may vary from country to country, it will generally be necessary for the industrial countries, over an indefinite period, to maintain a somewhat lower pressure of demand on resources than has been customary. During this cooling-off period, demand management policy should aim for a progressively lower rate of price inflation and—to support this aim—should become less ambitious on the growth side. In addition, complementary measures to improve supply conditions, to strengthen productive capacity and productivity, and to alleviate cost pressures are also clearly called for; without such measures, including those directed specifically to achieving higher levels of saving and investment, the task of general demand management would be rendered considerably more difficult.

Keeping the growth of aggregate expenditure within appropriate bounds will require a new and different approach in national economic policies. Throughout the period since the mid-1960s, the industrial countries have tended to shade policy risks on the side of growth and employment and to push their short-term objectives in those areas beyond a point that was prudent. It is clear that policy decisions must now place more emphasis on controlling inflation and maintaining a climate of financial stability; despite the correspondingly lesser emphasis on growth and employment objectives, such an approach may be expected to make for a better growth and employment record over the longer run.

Persistent application of this approach, despite the setbacks that could occur, would be a very demanding task, requiring strength and continuity of political will over a period of years. In order to change inflationary expectations, policies would have to show results so as to earn and retain the confidence of the public.

Given all the uncertainties involved, governments must be careful to avoid policies that might inadvertently lead to severe recession and stagnation. This important consideration is in line with the resolve of member countries, as expressed in the Committee of Twenty’s communiqué after its January 1974 meeting, to “pursue policies that would sustain appropriate levels of economic activity and employment, while minimizing inflation.”

Table 4.Inflation and Cost Indicators Pertaining to Industrial Countries, 1960-First Quarter 1974

(In percentage changes,1 based on data expressed in terms of local currencies)

Annual

Average

1960-70 2
Change from Preceding YearFirst Quarter 1973

to

First Quarter 1974
197119721973
Unit values of imports1311340
Labor costs in manufacturing
Average hourly earnings811111314
Adjusted for changes in consumer prices55663
Unit labor costs274610
Wholesale prices2341221
Consumer prices364711
Unit values of exports2321024
Sources: National economic reports, International Financial Statistics, and Fund staff estimates.

Averages of changes for individual industrial countries weighted by total trade in 1972.

Compound annual rates of change.

Sources: National economic reports, International Financial Statistics, and Fund staff estimates.

Averages of changes for individual industrial countries weighted by total trade in 1972.

Compound annual rates of change.

Implementation of the demand management policy suggested above requires elaboration, in part to bring out some of the problems and difficulties entailed.

—Because the prevailing rates of price inflation are so steep and inflationary expectations are so deeply embedded, there is only limited room for maneuver and error in the conduct of fiscal and monetary policies in the industrial countries. In order to avoid triggering still more trouble on the inflation front, the authorities will need to regulate their policies with considerable caution for some time to come. One important requirement will be to absorb economic slack gradually, rather than quickly, and to avoid overestimation of the capacity or potential growth rates of the industrial economies. In this regard, allowance should be made for the likelihood that potential growth rates in industrial countries have been reduced, at least temporarily, by the dislocations in specific sectors of the economy caused by higher oil prices, environmental considerations, and other factors.

—In setting their target rates of aggregate demand expansion, it will be necessary for countries to shade decisions in this area on the conservative side as part of the anti-inflation effort. In this context, growth rates somewhat lower than those aimed for in the past might well have to be accepted. Similarly, unemployment might have to be somewhat higher—as it recently has been in most industrial countries—in relation to the traditional targets.3

—In addition to the growth of real GNP, the other element in the target rate of aggregate demand expansion—the price factor—would need to be based on a careful policy decision as to how much the rate of price inflation could and should be reduced in a given period. This assessment would have to take account of special factors operating on prices, as well as the basic influence of fiscal and monetary policies; special influences may be quite important, of course, with respect to the prices of primary commodities. Widespread expectations that any increase in the price level will be accommodated by the authorities will have to be eliminated.

—Of the many issues involved in the question of how fiscal and monetary policies should be deployed in carrying out an effective demand management policy, perhaps most important is the need for governments to secure better control over the national budget. In the past, fiscal policy has sometimes been so inadequate that it worked at cross-purposes from monetary policy, adding to problems of achieving economic stabilization. Also of importance is the growing need to focus the incidence or impact of fiscal measures. In the industrial countries this year, such selectivity in the implementation of fiscal policy may be called for by circumstances in which tight supply conditions may be present in certain sectors while other sectors have idle capacity and manpower. Of course, care would have to be taken to avoid impeding needed intersectoral adjustments.

—One special problem of demand management at the present time is to assess and deal with the possibly deflationary effect of higher oil prices. Despite the international attention this phenomenon has attracted, it is not possible to make global generalizations about the appropriate reaction of national governments to it. Depending on their differing situations, some may need to offset it while others may welcome it for its disinflationary value.

With respect to the complementary measures referred to above, there undoubtedly are numerous areas in which policy actions could help to increase the supply of goods and services and thereby contribute to the dampening of inflationary pressures. Such actions typically yield their full impact only after some time, but this should not diminish the interest in seeking to remove artificial restraints on production and generally to increase the scope for operation of competitive forces. The recent upsurge of interest in supply conditions, because of the onset of widespread shortages, provides an opportunity to spur renewed activity in this neglected area of economic policy.

In some, but not necessarily all, countries, the present circumstances also call for renewal of the search for effective approaches to incomes policy—for efforts to exert direct influence upon the movement of wages and prices in the public interest. Such measures are difficult to devise and implement, and they would have to be geared in each country to its own institutions, traditions, and situation. In their absence, however, it may prove very difficult to limit the effects of cost pressures on prices and to achieve price moderation except at the expense of greater slack and unemployment. By helping to counter the forces of imperfect competition so prevalent in modern industrial economies, appropriate incomes policies could serve as useful adjuncts to fiscal and monetary policies, which must bear the main brunt of the anti-inflation effort.

Although the foregoing discussion of domestic economic policy issues has been oriented toward conditions in the industrial world, the relevance of key points to current problems of developing countries is obvious. One reason is that any significant improvement in the management of economic policy by the industrial countries would ease the inflationary pressures on developing countries and facilitate the handling of their own problems. Because of demand, price, and cost factors influenced partly by developments in the industrial centers, an important share of the inflationary pressure felt by many developing countries in recent years has been external in origin.

Nevertheless, developing countries are also contending, in varying degrees, with inflationary pressures of domestic origin. In some parts of the world, these pressures have arisen from droughts or other catastrophes. But in many developing countries inflation is attributable in large measure to insufficient restraint of aggregate demand, often stemming from an understandable desire to push economic development as rapidly as physically possible or from an inadequate control of the expansionary domestic effects of sharp rises in export earnings. In these cases, some of longstanding character, stress must be laid on the avoidance of unduly expansionary monetary and fiscal policies, which have frequently proved counterproductive for developmental purposes in the longer run.

The broad approach to stabilization policy discussed above is thus as applicable to most developing countries as it is to the industrial countries. But in the application of economic policy principles, of course, account must be taken of the special circumstances faced by the developing countries. For example, constraints on the total labor supply—though not those with respect to particular skills—are frequently less severe in developing countries than in the developed countries, while rigidities due to supply bottlenecks are often more intractable.

There are important differences among developing countries with respect to the problem of dealing with the current inflation and related economic difficulties. In general, those countries that do not now suffer a balance of payments constraint—notably the major oil exporting countries—are the ones that can afford to press hardest for maximum growth. Their ability to draw on foreign resources should provide both added scope for development and a margin of safety. Even these countries, however, must exercise care to control the pace of development so as to minimize such problems as intensification of inflation, generation of bottlenecks, and misallocation of resources.

Among the non-oil developing countries, those that have in recent years achieved both rapid growth and balance of payments surpluses may to a large extent be able to absorb the burden of additional import costs through some moderation of growth rates or of gains in real income and the forgoing of further reserve accumulations. In formulating their economic policies, these countries will have to give high priority to non-inflationary budgetary and monetary policies. They may have to pay particularly careful attention to their effective exchange rates, being cautious about effective depreciation in present circumstances and bearing in mind the possible contribution of a stable or appreciating effective rate to avoidance of strains on domestic resources.

For countries whose income levels are among the lowest and whose capacity for adjustment of trade and production is very limited, cutbacks of either imports or output for domestic use would be both painful and harmful. In these cases, the inadequacy of the economic base underscores a need for both supply and demand measures to minimize strains on overall capabilities. However, maintenance of the imports of fuels, fertilizer, capital equipment, and essential consumer goods that are necessary to maintain supplies and mitigate pressure on prices will be impossible without increased flows of foreign aid and concessional loans.

World Trade and Payments

International trade and payments developments during the period since the previous Annual Report have been dominated by exceptionally large changes in foreign trade prices and values, bringing substantial shifts in the payments situations and prospects of many countries. Some of the changes in trade prices and values have stemmed from the major currency realignments of early 1973 and subsequent fluctuations of exchange rates under a regime characterized by widespread floating. In addition, important sources of increases in foreign trade prices have included the accelerated inflation in the industrial world, the abrupt increases of oil prices in the last quarter of 1973, and the rise in primary commodity prices that began much earlier and continued into 1974.

The recent price increases of internationally traded goods were largely attributable to the powerful expansion of demand in the industrial countries. Suppliers of many products were not able to meet this surge of demand in the short run, and rapid emergence of an inflationary psychology added to the resultant impact on prices.

Under the impetus of prevailing demand forces, the volume of world trade increased by some 12½ per cent from 1972 to 1973, compared with 9 per cent—a rate of growth close to the long-term average—in the previous year (Table 5). Since about the middle of 1973, however, a tapering of the expansion in world trade has accompanied the slowdown of real economic activity in the industrial countries. For a number of primary products moving in international trade, limitations of current supply—including those stemming from droughts and other natural forces—also appear to have been a factor in this deceleration (as well as a factor contributing to the upward pressure on prices). The rate of expansion of world trade in real terms in the first half of 1974 was probably much below the trend rate, in sharp contrast to the experience in 1973.

Table 5.World Trade Summary, 1960-731(Percentage changes in volume, in U.S. dollar value, and in unit value of foreign trade)
Annual Average 1960-70 2Change from Preceding Year
1970197119721973
World Trade 3Volume996912½
U. S. dollar value1014½121837
Unit value 415822
Imports
VolumeIndustrial countries109611½11½
Other developed countries913117
Less developed countries
Major oil exporters121220
Other developing countries6
Unit value 4Industrial countries122½
Other developed countries20
Less developed countries
Major oil exporters145818½
Other developing countries146819½
Exports
VolumeIndustrial countries13½
Other developed countries81116
Less developed countries
Major oil exporters9118712½
Other developing countries67
Unit value 4Industrial countries65819½
Other developed countries2441325
Less developed countries
Major oil exporters−1222½1139
Other developing countries5−127½
Sources: National economic reports, IMF Data Fund, and Fund staff estimates.

For classification of countries in groupings shown here, see Table 1 (and especially footnotes 2-4).

Compound annual rates of change.

Fund member countries (listed in Appendix Table I.1) plus Switzerland. Based on approximate averages of growth rates for world exports and world imports.

Based on indices in U.S. dollar terms.

Sources: National economic reports, IMF Data Fund, and Fund staff estimates.

For classification of countries in groupings shown here, see Table 1 (and especially footnotes 2-4).

Compound annual rates of change.

Fund member countries (listed in Appendix Table I.1) plus Switzerland. Based on approximate averages of growth rates for world exports and world imports.

Based on indices in U.S. dollar terms.

Changing currency relationships, varying movements of commodity prices, and differences in domestic demand conditions and in supply capabilities all contributed to substantial shifts in the external current account balances of individual countries from 1972 to 1973. Moreover, much larger shifts are taking place in 1974, especially because of the sharply higher level of oil prices. These developments, in combination with differences among countries with respect to monetary conditions and interest rates, and against a background of wide swings in financial market attitudes and expectations, have produced major changes in the magnitude and direction of international capital flows. Despite the absorption of many of the resultant exchange market pressures through fluctuations in floating rates, there have also been large shifts in overall payments balances and reserve positions of many countries. These shifts are discussed below, following reviews of the exchange-rate, commodity-price, and terms-of-trade developments that have underlain most of them.

Exchange Rate Developments

An important feature of the past year’s international trade and payments developments has been the interaction between balance of payments flows and exchange rates under the prevailing situation of flexible currency values. External current account transactions and international capital flows not only have exerted a variety of pressures on exchange markets but also, in turn, have been affected by the succession of exchange rate fluctuations since early 1973.

The exchange market turbulence in the opening months of 1973, the ensuing major currency realignments, and the mid-1973 outbreak of renewed speculative pressures were described in the 1973 Annual Report. It may be recalled that currencies in the European narrow margins arrangement or closely associated with those currencies appreciated against the U. S. dollar from early May to mid-July of 1973 by amounts ranging from 9 per cent to 18 per cent. (See Chart 3.) For some time thereafter, through most of October, the exchange markets were much calmer, with the U. S. dollar first recovering part of its depreciation against most European currencies and then showing a gradual and moderate decline from about mid-August to late October. From the end of October through mid-January of 1974, however, the dollar firmed quite sharply against most leading currencies, appreciating by some 14 per cent against the continental European currencies and by about 10 per cent against the pound sterling and the Japanese yen (Chart 3). Both sterling and the yen thus rose somewhat in relation to the continental currencies after having depreciated considerably against them during the middle months of 1973.

Chart 3.Spot Exchange Rates, January 1973-July 1974

(Spread from parity or central rate agreed December 1971)1

1 Except for Canadian dollars. All data based on Wednesday noon quotations in New York.

The October-January appreciation of the dollar was in large part a result of improvement in the U. S. balance of payments on current account and an unwinding of currency positions built up during earlier periods of speculative activity. Such unwinding was facilitated and reinforced by a late-1973 firming of U. S. money market conditions and interest rates (Chart 4) coinciding with easier financial conditions in some continental European countries, and particularly in Germany. Following the December 1973 announcement of oil price increases, exchange markets were for several weeks dominated by the view that overall payments positions of most industrial countries would be much more adversely affected by the new situation than would the position of the United States, where disproportionate shares of the funds accumulated by oil surplus countries were expected to be invested. This expectation, coupled with an apparent reluctance of central banks to intervene on the foreign exchange markets to stabilize rates, led to a rapid appreciation of the dollar in trading that was at times hectic. Under the exchange market pressures of that period, the Bank of Japan discontinued support of the yen early in January (although, following a depreciation of the yen by some 7 per cent, it later resumed intervention, as deemed necessary); and the French authorities suspended foreign exchange market interventions under the European narrow margins arrangement, thus permitting an initial decline of about 5 per cent in the value of the French franc in terms of other major currencies. This development put pressure on the Italian lira, which was permitted to undergo a roughly parallel depreciation.

Chart 4.Short-Term Money Market Rates, January 1972-July 1974

(Per cent per annum)

Toward the end of January 1974, exchange market trends were reversed again as a number of steps were taken to ease controls on capital flows and thus to facilitate the financing of prospective external payments balances. In particular, the United States eliminated its interest equalization tax, its controls on direct foreign investments by U. S. residents, and its voluntary restraints on foreign lending by U. S. financial institutions. At about the same time, several continental European countries, including Germany, removed controls on capital inflows or liberalized deterrents to foreign borrowing by their residents. These actions contributed to a substantial alteration of both short-term and long-term capital flows during the early months of 1974, and they were reinforced initially (in February) by a relative easing of liquidity conditions and interest rates in the U. S. money market, widely interpreted as presaging further relaxation of U. S. monetary policy in subsequent months. Such expectations were not borne out, as tighter liquidity and strongly rising interest rates in the United States after mid-March contrasted with an opposite trend in some of the major continental centers and the United Kingdom. However, by the time the latter tendencies had become apparent, a re-evaluation of the probable impact of higher energy costs on the various industrial countries had led market participants to the view that the strengthening of the U. S. dollar during January had been exaggerated.

Primarily because of the factors suggested above, the period from late January through early May of 1974 was one of renewed appreciation of most other major currencies against the U. S. dollar. It was also marked by the termination, in March, of the dual exchange markets in France and Italy. During the second half of May, another partial reversal of immediately preceding exchange rate movements occurred. A moderate firming of the U. S. dollar in that period was followed by relatively steady exchange rates during June and July.

The changes in currency relationships sketched above can be meaningfully summarized for each currency in terms of effective exchange rate indices. There are various such indices in use, each having somewhat different characteristics and showing somewhat different numerical measures of effective exchange rate change. However, among the indices most frequently applied, there is broad similarity as to the direction and general magnitude of movements. With respect to the U. S. dollar, these calculations indicate that the effective rate in June 1974 was about the same as that in April 1973 (just before the pattern of the second major currency realignment was disrupted), despite the intervening swings in both directions. Over the same 14-month period, the pound sterling, the French franc, the Italian lira, and the Japanese yen all showed cumulative effective depreciations, though they started at different levels in relation to pre-1973 rates and followed rather different time paths. On the other hand, the effective rate for the deutsche mark in June was significantly above its April 1973 level, after movements upward, downward, and back up again.

Movements of Commodity Prices

The period since about the end of 1972 has been marked by an extraordinary succession of increases in prices of primary commodities. By far the largest of these, in terms of both percentage change and the magnitude of the affected international trade flows, was the approximate tripling of the average export price of crude petroleum from September 1973 to January 1974.4 However, focus on the oil price rise should not be permitted to overshadow the fact that exceptionally large price increases occurred throughout a wide range of commodity categories during 1973 and early 1974. While no single one of these involved a trade magnitude approaching that of oil, many are nevertheless highly important in themselves, and some (e.g., zinc, sisal, rice, wheat, and free-market sugar) have been subject to price increases of an order resembling or exceeding that of oil prices. Some of the largest increases were particularly significant not only as factors in the growth of export earnings of the producing countries but also as elements of the increased costs confronted by importing countries in all major regions.

The recent period has thus witnessed large price rises in many primary commodities produced by countries throughout the world—by industrial countries, as well as by those classified as primary producing countries in this report. From the beginning of 1973 to April 1974, market prices of commodities (excluding oil) exported by primary producing countries rose, on average, by about 70 per cent in U. S. dollar terms (Chart 5). No increase of remotely similar magnitude had previously been recorded during such a short period without the influence of major wars or fears of war, as in the 1950-51 upsurge. In recent months, however, prices of a number of primary commodities—particularly agricultural raw materials and certain metals—have receded from earlier levels; and there were declines in the all-commodity index in June and July, with speculative selling apparently a factor of some importance.

Chart 5.Index of Prices of Commodities Exported by Primary Producing Countries, 1971-July 1974

(1968-70 = 100)

The upsurge in prices and trading activity during 1973 was highly pervasive, being tempered only to a minor extent by relative stability in prices for a few products. Among broad categories, foods were the ones subject to the most sustained and vigorous upward movement, reflecting critical deficiencies in supplies for some major commodities and the emergence of pronounced changes in demand-supply relations for others. Agricultural materials prices rose very rapidly until about the turn of the year, but underwent a marked downward adjustment during the first half of 1974. Prices of metals, which had shown a delayed response to the 1972-73 expansion of industrial demand, continued to rise steeply through April 1974 but turned downward in May after about six months during which market trading often appeared to be subject to intensified speculative activity. However, the recent reversals of earlier upward movements came too late to prevent another sizable increase in the all commodity index in the first half of 1974; for that period, market prices were about 30 per cent above the 1973 average.

These fluctuations in commodity prices have generated difficult problems for many developing countries. Uncertainties and increased inflationary pressures were widely associated with the upswing, while the subsequent reversal has raised the familiar specter of declining export earnings at a time when their purchasing power is being eroded by the continuing rise in prices of imported manufactured goods. Clearly, the longer-term interests of developing countries would, in general, be better served by a steadier and more sustainable improvement of their external trade positions.

In part, the current situation in primary commodity markets can be regarded as one reflecting changed relationships likely to persist for some time. For example, the change in the food situation reflects the impact of higher incomes on per capita consumption of meat products, as well as population growth and the exhaustion of surplus stocks of grains previously available to supplement current production. More generally, cost structures have shifted; competitive relationships among raw materials have been altered; and a number of products have moved into cyclical positions of serious supply imbalance.

Other elements in the recent commodity boom, however, seem potentially reversible when more settled conditions emerge in the world economy and the international financial system. Commodity markets appear to have been subjected to considerable disturbance through speculative trading, partly in reaction to inflation and to exchange rate fluctuations; this was evident even before the advent of the oil crisis, which injected new elements of disturbance, particularly with respect to cost factors. Moreover, in a climate of rapid economic change, the sensitivity of commodity market behavior to the flow of new information has been heightened, as attested by highly unstable short-term movements in prices and much greater trading “velocity.”

Market price quotations are not closely or simultaneously reflected in actual returns for exports, and the volatility of such quotations since early 1973 makes the impact of prices on recent foreign trade values particularly difficult to ascertain with any precision. In general, however, it can be assumed that unit values in foreign trade, as discussed below, are reflecting the price changes just noted only with a time lag and probably with lessened amplitude; for many commodities, market quotations are “spot” prices that cover only a small proportion of transactions and are likely to exhibit greater volatility than unit values.

Changes in the Terms of Trade

The interacting elements of general inflation, oil price increases, and soaring primary commodity prices have strongly influenced recent movements of export and import unit values. Such movements are summarized, for recent years through 1973, in Table 5. In addition, Table 6 traces the evolution of the terms of trade for major groups of countries over the same years. Although corresponding data are not yet available on a comprehensive basis for much of 1974, some inferences about terms of trade shifts beyond the end of 1973 can be drawn from what is known about changes in some principal relevant prices.

Table 6.Terms of Trade Developments, 1960-731(Percentage changes)
Change from Preceding Year
Annual Average 1960-702
1970197119721973
Industrial countries½½−½−2¼
Other developed
countries½−1½−2¼
Less developed
countries
Major oil exporters−2−216¾17¼
Other developing
countries½−1−6¼½6
Sources: National economic reports, IMF Data Fund, and Fund staff estimates.

For classification of countries in groupings shown here, see Table 1 (and especially footnotes 2-4).

Compound annual rates of change.

Sources: National economic reports, IMF Data Fund, and Fund staff estimates.

For classification of countries in groupings shown here, see Table 1 (and especially footnotes 2-4).

Compound annual rates of change.

The increases in unit value of oil since 1970 loom large in the overall picture, especially with respect to the first half of 1974. The resultant large improvement in the terms of trade for the oil exporting countries since 1970 followed a decade of rather steady deterioration, as brought out in Table 6. For 1974, the terms of trade seem almost certain to shift against all major groups of countries except the oil exporters, and particularly against those industrial countries whose oil imports are large and whose exports consist predominantly of manufactured goods. Highly adverse changes in terms of trade are also in prospect for certain developing countries whose own export prices have not shared in the general upward trend. In contrast, the terms of trade of the major oil exporting countries can be expected, despite the moderating influence of significant non-oil exports from such countries as Indonesia and Nigeria, to improve in broad parallel with the increase in the global unit value of oil in relation to that of manufactured goods.

During 1973 and early 1974, unit values of food, like those of oil, were rising substantially faster than unit values of manufactured goods. A similar, though less marked, differential may be noted with respect to other primary commodities (metals and agricultural products other than food). Such differential movements can be seen as broadly favorable, apart from changes in oil prices, to the terms of trade of the non-oil developing countries over the whole period since 1972.

In the end, however, the current year’s record for developing countries other than the oil exporters, as well as for the more developed, primary producing countries, could prove to be one of initial gains quickly eroded. The recent terms of trade gains of these countries were concentrated in the movement from 1972 to 1973, and would be partly reversed from 1973 to 1974 if there should be a continuation of both the present level of oil prices and the recent declines in other commodity prices. Such a development would provide for the industrial countries a partial counterweight, in the form of some gain in their non-oil terms of trade, to the rise in their oil import costs.

International Payments Developments in 1973

The various factors noted above were instrumental in producing a number of important shifts in payments balances from 1972 to 1973. Apart from a rise in the surplus of the oil exporting countries, the main changes in both current account balances and net capital flows were those among individual industrial countries (Table 7), rather than changes in the structure of payments relationships between major groups of countries.

Table 7.Industrial Countries: Balance of Payments Summaries, 1971-73(In billions of U.S. dollars)
Balance on
TradeServices and private transfersCurrent accountCapital Account Balance 1Allocation of SDRsOverall Balance 2
Canada19712.6−2.30.30.50.10.9
19721.7−2.4−0.70.90.10.3
19732.2−2.7−0.5−0.5
United States1971−2.71.5−1.2−29.20.7−29.8
1972−7.0−0.1−7.1−4.10.8−10.4
19730.62.73.3−8.6−5.3
Japan19717.8−1.86.04.30.110.4
19729.0−2.07.0−4.10.13.0
19733.7−3.60.2−6.5−6.3
France19711.1−0.11.02.30.23.4
19721.3−0.31.00.60.21.8
19731.6−1.10.5−2.5−2.0
Germany, Federal Republic of19716.7−4.62.02.20.24.4
19728.2−5.52.82.00.25.0
197314.4−7.86.62.59.2
Italy19710.12.22.3−1.40.11.1
19722.42.4−3.20.1−0.7
1973−4.02.6−1.31.1−0.3
United Kingdom19710.72.33.03.10.36.5
1972−1.72.40.7−4.00.3−3.0
1973−5.83.5−2.32.50.2
Other industrial countries 31971−3.23.60.42.40.33.0
1972−1.24.33.1−0.40.33.0
1973−1.95.63.7−0.73.0
Total, industrial countries197113.10.713.8−15.92.0−0.1
197210.4−1.29.2−12.22.1−0.9
197311.0−0.810.2−12.1−1.9
Sources: Data reported to the International Monetary Fund and Fund staff estimates.

This balance is computed residually, as the difference between the overall balance (less SDR allocations) and the current account balance; it includes official transfers and net errors and omissions, as well as recorded capital movements.

Overall balances are measured by changes in official gold holdings, in SDRs, in reserve positions in the Fund, in foreign exchange assets, in use of Fund credit, and, where data are available, in liabilities to foreign monetary authorities, including those arising from “swap” transactions.

Austria, Belgium-Luxembourg, Denmark, the Netherlands, Norway, Sweden, and Switzerland.

Sources: Data reported to the International Monetary Fund and Fund staff estimates.

This balance is computed residually, as the difference between the overall balance (less SDR allocations) and the current account balance; it includes official transfers and net errors and omissions, as well as recorded capital movements.

Overall balances are measured by changes in official gold holdings, in SDRs, in reserve positions in the Fund, in foreign exchange assets, in use of Fund credit, and, where data are available, in liabilities to foreign monetary authorities, including those arising from “swap” transactions.

Austria, Belgium-Luxembourg, Denmark, the Netherlands, Norway, Sweden, and Switzerland.

The current account balance of the United States swung sharply upward, from a deficit of $7 billion in 1972 to a surplus of $3½ billion in 1973, while the Japanese surplus, amounting to $7 billion in 1972, virtually disappeared and the U. K. and Italian current accounts both showed swings of some $3-3½ billion from surplus to deficit. The other principal change was a rise of about $4 billion in the current account surplus of Germany, to almost $7 billion.

The 1972-73 shifts in the U. S. and Japanese current account balances were clearly helpful to the international adjustment process, being broadly consistent with the intent of the 1971 and 1973 currency realignments. Both shifts, however, were much larger than had generally been anticipated—in part because of special efforts undertaken to modify the Japanese-U. S. bilateral balance of trade. The change in that bilateral balance from 1972 to 1973, reflecting both an adjustment of the yen-dollar exchange rate and various special measures, accounted for well over one third of the total change in the U. S. position and more than two fifths of the Japanese shift. Another major element in the improvement of the U. S. trade balance was the spectacular rise in both the prices and volume of U. S. agricultural exports. For Japan, a contributing factor, despite the appreciation of the yen, was a deterioration of the terms of trade, reflecting that country’s particular exposure to the boom in commodity prices.

With respect to the German, Italian, and U. K. current account balances, the 1972-73 changes can scarcely be characterized as welcome from the standpoint of the international adjustment process. Both Italy and the United Kingdom relied heavily on international borrowing by official or semiofficial agencies or enterprises to finance adverse shifts, which stemmed to a large extent in each case from sharp deterioration of the terms of trade. In Italy, major strikes that impeded exports during the early part of 1973 were an important additional factor. The unexpectedly large rise in Germany’s current account surplus reflected comparatively favorable cyclical conditions; under these conditions, the boom in German export market areas raised demand for German products and absorbed potentially competitive outputs, while moderation of domestic demand expansion enhanced Germany’s export supply capabilities and curbed the growth of imports, which was slower in 1973 than in either of the two preceding years. The structure of German exports, involving a high proportion of capital and other durable goods subject to relatively low price elasticities of demand, facilitated the maintenance of sales volume despite the sharp increase in foreign currency prices of German goods associated with appreciation of the deutsche mark. In addition, and especially in combination with the other factors noted, the sharp effective appreciation of the deutsche mark in the first half of 1973 had an upward impact on the terms of trade that worked against reduction of the current account surplus in the period immediately following the appreciation.

For the United States, the United Kingdom, and Italy, swings in capital movements softened or offset the effects of the 1972-73 current account shifts on overall balances, so that the changes in the latter were smaller or more favorable than those on current account alone. For Japan, however, a rise in net capital outflows compounded the effect of the shrinkage in the current account surplus, throwing the overall balance deeply into deficit and bringing rapid liquidation of reserves built up in previous years. Net capital outflows also pushed the overall balance of France from surplus into deficit.

Despite the large shifts of payments balances among individual industrial countries from 1972 to 1973, the combined balance of the whole group with other countries remained relatively steady, both on current account and on capital account. The traditional current account surplus of the industrial countries rose moderately to some $10 billion, compared with $9 billion in 1972 and $14 billion in 1971. With the net outflow of capital from the industrial countries about the same in 1973 as in 1972, their collective overall balance was carried somewhat further into deficit by the nonrecurrence of the SDR allocations received in 1972.

The current account and overall balances of other large groups of countries were almost equally stable from 1972 to 1973 (Table 8). The main exception to pattern was a rise of about $3 billion in the current account surplus of the oil exporting countries. The current account deficit of non-oil developing countries was virtually unchanged (in the $8-8½ billion range), and the small surplus of the more developed primary producing countries that had emerged in 1972 was well sustained in 1973. For this latter group, the salient balance of payments change was a sharp drop in net capital inflows; this centered mainly in Australia and reflected not only reversals of earlier speculative movements in the wake of the revaluation of the Australian dollar in December 1972 but also measures taken by the Australian authorities to restrain overseas borrowing by resident companies.

Table 8.Balance of Payments Summary, 1971-73(In billions of U.S. dollars)
Balance on
TradeServices and private transfersCurrent accountCapital Account Balance 1Allocation of SDRsOverall Balance 2
Industrial countries 3197113.10.713.8−15.92.0−0.1
197210.4−1.29.2−12.22.1−0.9
197311.0−0.810.2−12.1−1.9
Major oil exporters 3197110.6−8.42.21.00.13.3
197212.5−10.62.01.40.13.5
197320.4−15.74.8−0.84.0
Other primary producing countries 31971−14.00.4−13.618.20.85.4
1972−8.21.2−7.019.80.913.7
1973−9.42.8−6.616.0.—9.5
More developed areas1971−5.63.2−2.46.10.24.0
1972−2.74.31.65.70.37.6
1973−4.76.11.30.72.0
Less developed areas1971−8.4−2.9−11.212.10.61.4
1972−5.5−3.1−8.614.10.66.1
1973−4.7−3.2−7.915.47.5
In the Western Hemisphere1971−2.0−2.5−4.54.50.20.2
1972−1.2−3.2−4.47.40.33.2
1973−0.5−3.6−4.17.93.8
In Asia1971−4.10.3−3.84.50.21.0
1972−2.50.4−2.13.70.21.9
1973−2.00.8−1.33.72.4
In Africa1971−0.4−1.3−1.71.4_−0.2
19720.1−1.4−1.31.40.10.3
19730.7−1.3−0.60.80.2
In the Middle East1971−1.80.6−1.21.70.10.5
1972−1.91.1−0.81.50.10.8
1973−2.90.9−2.03.01.0
Total, all countries19719.7−7.32.53.32.98.6
197214.8−10.64.28.93.216.3
197322.0−13.68.43.211.6
Sources: Data reported to the International Monetary Fund and Fund staff estimates.

This balance is computed residually, as the difference between the overall balance (less SDR allocations) and the current account balance; it includes official transfers and net errors and omissions, as well as recorded capital movements.

Overall balances are measured by changes in official gold holdings, in SDRs, in reserve positions in the Fund, in foreign exchange assets, in use of Fund credit, and, where data are available, in liabilities to foreign monetary authorities.

For classification of countries shown here, see Table 1 (and especially footnotes 2-4).

Sources: Data reported to the International Monetary Fund and Fund staff estimates.

This balance is computed residually, as the difference between the overall balance (less SDR allocations) and the current account balance; it includes official transfers and net errors and omissions, as well as recorded capital movements.

Overall balances are measured by changes in official gold holdings, in SDRs, in reserve positions in the Fund, in foreign exchange assets, in use of Fund credit, and, where data are available, in liabilities to foreign monetary authorities.

For classification of countries shown here, see Table 1 (and especially footnotes 2-4).

Inflows of capital and aid received by the non-oil developing countries continued to rise in 1973, when they totaled $15½ billion, compared with $14 billion a year earlier and $12 billion in 1971. This increased capital inflow in a year of stability for the current account deficit of these countries as a group raised their combined overall balance of payments surplus by about $1½ billion, to $7½ billion. Both the rise from 1972 to 1973 and the surplus in the latter year, however, were centered mainly in the Latin American and Far East Asian regions. For non-oil countries of the African region, which together had recorded only a very small surplus in 1972, the change in the overall balance in 1973 was negligible. The net inflow of capital to these African countries dropped markedly in that year, but so did their current account deficit, as a result of improved trade balances. 5 For the oil exporting countries (predominantly in the Middle East), only a minor part of the 1972-73 rise in their current account surplus appears to have been reflected in any further growth of their overall balance of payments surplus. The latter surplus rose by $½ billion, to nearly $4 billion, but the bulk of the increment in current account earnings was apparently absorbed by financial flows other than reserve accumulation (i.e., debt retirement, capital investment abroad, or official transfers to other developing countries). An outward flow of capital (or aid) from this group of countries totaling almost $1 billion in 1973 contrasted with an inflow of $1½ billion in the previous year.

The Current Account Picture

For 1974, the prospect for current account balances is one of startling changes, dwarfing those recorded for 1973. Barring some unforeseen major development in the international economy, these changes will involve not only large swings in the balances of a great many individual countries but also a massive shift in the global structure of balance of payments relationships among broad groups of countries.

On the central working hypothesis that the level of oil export prices prevailing in the first half of 1974 will be maintained throughout the year, the combined current account surplus of the major oil exporting countries will go up very sharply—to perhaps $65 billion as an order of magnitude. The increase of some $60 billion over the enlarged 1973 surplus would have its counterpart in a deterioration of similar magnitude for all other countries combined.6 According to the illustrative estimates shown in Table 9, about two thirds of this total deterioration would be incurred by the industrial countries and one third by the non-oil primary producing countries. 7 Within these two large groups, the impact of recent developments is shaping up as a very uneven one and thereby is creating for many individual countries serious problems of payments adjustment and financing extending well beyond 1974, as discussed in the following section.

Table 9.Summary of Payments Balances on Current Account1,2(In billions of U.S. dollars)
Adjusted for Asymmetries Due to Oil3Change from 1973 to 1974
1973197419731974Total4Oil component5
Major oil exporters5655656060
Industrial countries10−229−31−40−53
Other developed countries1−61−7−8−6
Other developing countries−8−20−8−21−13−7
Total681776−1−6
Sources: Data reported to the International Monetary Fund and Fund staff estimates.

Goods, services, and private transfers.

For classification of countries in groups shown here, see Table 1 (and especially footnotes 2-4).

Chiefly because of time lags between exports as reported by the exporting countries and the corresponding imports as recorded by their trading partners, a global summation of reported trade balances yields an excess of surpluses over deficits when trade values are rising. This asymmetry (as reflected in the first two columns of this table) has increased very sharply in the past few years of high inflation and greatly accelerated advances in nominal values of world trade flows. For 1974, the increase in this asymmetry will reflect the particular impact of the major increases in oil prices that occurred, from the standpoint of the exporting countries, just at the turn of the year but that were reflected in the trade statistics of most importing countries only with a lag. Insofar as this timing discrepancy relates to oil, its estimated growth from 1973 to 1974 has been eliminated (along with certain other oil trade asymmetries of a more technical character) from the data shown in columns 3 and 4 of this table. The resultant figures impute larger deficits to the importing countries than they would in fact report on an unadjusted basis, but have the merit of putting oil deficits and surpluses on a symmetrical basis, in accordance with an accrual concept of balance of payments accounting.

Based on the data after adjustment for asymmetries due to oil.

Defined for this purpose as changes in the net value of trade in oil (vis-à-vis all partner countries), together with net changes in other current transactions in which the oil exporting countries are participants.

Reflects balances of countries covered here with nonreporting countries, plus (quantitatively more important) statistical errors and asymmetries. (See footnote 3, above.)

Sources: Data reported to the International Monetary Fund and Fund staff estimates.

Goods, services, and private transfers.

For classification of countries in groups shown here, see Table 1 (and especially footnotes 2-4).

Chiefly because of time lags between exports as reported by the exporting countries and the corresponding imports as recorded by their trading partners, a global summation of reported trade balances yields an excess of surpluses over deficits when trade values are rising. This asymmetry (as reflected in the first two columns of this table) has increased very sharply in the past few years of high inflation and greatly accelerated advances in nominal values of world trade flows. For 1974, the increase in this asymmetry will reflect the particular impact of the major increases in oil prices that occurred, from the standpoint of the exporting countries, just at the turn of the year but that were reflected in the trade statistics of most importing countries only with a lag. Insofar as this timing discrepancy relates to oil, its estimated growth from 1973 to 1974 has been eliminated (along with certain other oil trade asymmetries of a more technical character) from the data shown in columns 3 and 4 of this table. The resultant figures impute larger deficits to the importing countries than they would in fact report on an unadjusted basis, but have the merit of putting oil deficits and surpluses on a symmetrical basis, in accordance with an accrual concept of balance of payments accounting.

Based on the data after adjustment for asymmetries due to oil.

Defined for this purpose as changes in the net value of trade in oil (vis-à-vis all partner countries), together with net changes in other current transactions in which the oil exporting countries are participants.

Reflects balances of countries covered here with nonreporting countries, plus (quantitatively more important) statistical errors and asymmetries. (See footnote 3, above.)

Among the major industrial countries, all except Canada face sizable adverse swings in the oil component of their current accounts in 1974. For the United Kingdom, Italy, France, and Japan, these swings are being superimposed on current account positions that were already weak or deteriorating in the first part of 1974. On the other hand, early 1974 was a period of strength in current account balances on non-oil transactions for Germany in particular, but also for the United States and some of the smaller industrial countries in Europe.

The collective current account balance of the more developed primary producing countries seems certain to move back into deficit in 1974, following two unusual years of surplus. In addition to a large adverse swing in the oil component of the collective balance, some deterioration in the balance on other current account transactions of this group of countries may result from influences evident in early 1974. These included a significant slowing of the rise in export volume, continuing expansion of import volume, and some deterioration of the average terms of trade, even apart from the rise in oil costs.

The large and heterogeneous group of non-oil developing countries faces the prospect of an adverse current account shift of perhaps $13 billion in 1974, raising their combined deficit to some $21 billion (Table 9).

Most developing countries are net importers of oil. For them, the impact of the rise in oil costs will vary not only with the role of oil in the economy but also with the structure and adaptability of domestic production and foreign trade, as well as with access to external capital. Fortunately, many of these countries entered the period of adjustment to higher oil prices with recently improved terms of trade and relatively high reserves, owing to the 1972-73 upsurge of primary commodity prices. Despite rising prices of imports, the collective terms of trade of the non-oil developing countries are estimated to have improved by some 6-7 per cent from 1972 to 1973. (See Table 6.)

The terms of trade gains for developing countries in 1973, although widespread, were by no means universal, and a list of exceptions would have to include the exporters of tea, jute, bananas, bauxite, and manufactures. Also to be noted in this context is the fact that the 1973 and 1974 price increases for cereals, while boosting export prices for some developing countries (as well as for the developed countries that are the predominant exporters), represented an important negative factor in the terms of trade of other developing countries. Major foodgrains accounted for a larger portion of the rise in the value of imports into developing countries in 1973 than did oil, reflecting the fact that their use of oil, though vital, was in many cases relatively low in comparison with that of the developed countries, while their needs for imported food were in some cases relatively high. Unusual shortfalls of crops because of adverse weather increased such needs in 1973 and the first half of 1974.

Among countries whose prospective increases in the cost of oil imports loom especially large in relation to reserves or total imports, a number are net importers of cereals. Most of these face adverse non-oil terms of trade shifts from 1973 to 1974, and only a few of them (e.g., Korea) have a recent history of buoyant exports. Although some of these countries may find access to international credit markets to cushion the initial impact of the combined increases in their oil and cereals import bills, it is within this group that some of the most severe problems of readjustment seem likely to arise in 1974. Such problems may be especially acute for countries (e.g., India, Bangladesh, and Sri Lanka) whose own export earnings include relatively substantial amounts from commodities that have not shared strongly in the recent primary commodity price upsurge.

External Policies and Adjustment

There are two well-known reasons why the establishment of higher oil prices during the fourth quarter of 1973 has had such a dominant impact on the international payments situation.

First, as noted earlier, there is the fact of the low elasticities of both demand for and supply of oil in the short run. On the side of demand, the higher prices now prevailing will undoubtedly bring about a reduction in the use of oil from the rate that otherwise would have obtained, but this will be a gradual process. The new level of oil prices will also provide substantial incentives for the development of alternative supplies of energy resources but, again, this will take time, and important new sources of supply are unlikely to become available in the next year or two.

Second, the major oil exporting countries will be unable in the short run to raise imports by an amount approaching the prospective buildup in their export earnings. Although the capacity to absorb additional imports differs greatly among major oil exporters, it probably will require a period of years for import growth of these countries as a group to narrow substantially the export surplus that is now envisaged for them in 1974. In this regard, changes in exchange rates between some of the oil exporting countries and other countries might come under consideration from time to time; however, any adjustment of this nature is likely to be of limited significance in the general picture because of the desires of the oil countries to diversify their economies and to obtain earning assets abroad, as against providing the strong stimulus to consumption of imported goods that would result from substantial appreciation of the currency.

Given the increase in oil prices that took place late in 1973, these two factors have perforce led to the emergence of an enormous disequilibrium in international payments on current account—comprising, as discussed above, a surplus for the oil exporting countries estimated at some $65 billion for 1974 and a matching deficit for the rest of the world. This disequilibrium, wholly unprecedented in size and character, requires particular types of policy response on the part of the oil consuming countries as a group; lack of such an internationally cooperative response could seriously damage the world economy. Furthermore, this new disequilibrium also poses problems with respect to capital movements. Funds will flow in huge volume from the oil exporting countries as they dispose of their enlarged current account surpluses; but the question at issue is whether, in the nature of things, these funds may be expected to flow in such a way as to prevent the occurrence of severe payments imbalances or strong exchange rate pressures in many countries.

Policy Implications of the Oil Situation

Adjustment

Oil importing countries may be expected to do what they can to reduce their combined current account deficit through measures relating to the price, supply, and conservation of oil and other sources of energy. However, as indicated just above, such measures will probably yield substantial results only gradually.

In a note presented to the Committee of Twenty at its Rome meeting in January 1974, the Managing Director of the Fund examined the new situation created by the raising of oil prices and drew three main conclusions with respect to the appropriate policy reaction of the oil importing countries: (1) in the short run that group of countries would have to accept the deterioration of the current account in its balance of payments, since attempts to eliminate the additional current deficit caused by higher oil prices through deflationary demand policies, import restrictions, and general resort to exchange rate depreciation would serve only to shift the payments problem from one oil importing country to another and to damage world trade and economic activity; (2) individual oil importing countries would have to make adjustments in relation to each other that took account of the new situation (including the ability to attract capital) and of imbalances previously in evidence—with countries affected more strongly by oil price increases being expected to initiate adjustments through currency depreciation and internal measures, and countries in a relatively more favorable situation having to accept the consequent deterioration in their current accounts; and (3) it was essential in this process that countries strive to achieve close and effective coordination of their external policies. As discussed later, the second conclusion on the need for oil importing countries to make adjustments in relation to each other implies unusually difficult decisions regarding the relative importance to be assigned to financing through private and official capital flows and to adjustment through exchange rate policy and internal measures.

These three policy aspects have, in the new situation, become guidelines of behavior. In its communiqué following the January 1974 meeting, the Committee of Twenty stated that in the present difficult circumstances countries “must not adopt policies which would merely aggravate the problems of other countries” and emphasized the importance of international cooperation and consultation in this context.

To some extent, the distinction between “oil” and “non-oil” current account deficits is not clear in principle, and it will become increasingly blurred over time. Although this point has considerable validity, the distinction in question has been of analytical and practical significance and can continue to serve as an important datum in the determination of balance of payments policy throughout the current year and, perhaps, in 1975 as well.

Statistical projections of the “oil deficit,” and of current account balances in general, are necessarily subject to considerable margins of error. However, in view of the problems encountered in shaping balance of payments policy, such projections do not have to be precise in order to be useful. A quantitative approach involving particular focus on oil transactions should be of assistance in preventing the adoption of inappropriate policies in the present unique and difficult situation.

Financing

After oil prices had been raised in December 1973 and the implications of the impending enlargement of the current account positions of the oil exporting countries were being analyzed, it was widely believed that the reflow of funds from those countries would, especially in the short run, take a relatively liquid form and be placed predominantly in the international capital markets. It was presumed that most of this flow, at least initially, would be directed toward the Euro-currency market, with perhaps substantial amounts going into the U. S. market as well. In broad outline, these expectations seem to have been borne out during the past few months in which the increase in oil prices was for the first time fully reflected in oil payments and capital flows.

Although financial markets appear to have operated reasonably well in the early stages of these flows, an immediate question is whether or not the Euro-currency market will prove adequate over an extended period to the financing task that is envisaged. With the volume of potential flows so great as possibly to strain the market’s feasible limits of expansion, intermediation over any protracted period could prove to be more difficult if the oil surplus countries preferred to invest mainly at short term, since the borrowing countries have a need for at least medium-term finance. For this and other reasons, including judgments regarding creditworthiness, Euro-banks may become increasingly reluctant to accept short-term deposits or to make new or additional investments in some countries badly in need of finance. In these circumstances, some private financial institutions may encounter problems with respect to their capital structure and the relationship between the maturity distributions of their asset portfolios and of their liabilities. Another important question, mentioned earlier, concerns the possibility that capital flows in the new situation might become disruptive, contributing either to the intensification of overall payments imbalances or to the pushing of exchange rates into ranges considered undesirable (or to both).

If such concerns are valid, they suggest that the major industrial countries should consider possible ways and means of minimizing the hazards mentioned above and assuring the maintenance of orderly conditions in the Euro-currency market. Although industrial countries have in the past been reluctant to coordinate their financial policies in any formal way, the exigencies of the current situation call for careful watch over the operation of international financial markets and constant readiness to extend, if necessary, the areas of informal cooperation to prevent the eruption of volatile capital flows.

The concerns expressed above also suggest a need—and this is of prime importance—to promote alternative channels of finance, through which capital can flow from the surplus to the deficit countries.8 The Fund’s recently established oil facility is one such channel. Other official facilities or arrangements for the purpose of providing short-term balance of payments financing include the regular or traditional facilities of the Fund; inter-central bank swap arrangements, which for the industrial countries involved are not suitable for the direct financing of oil deficits but could serve to bridge over a period in which such financing was being arranged; and a heterogeneous variety of programs involving the provision of assistance, through both institutional and bilateral arrangements, to the less developed countries.

The extent to which the available official credit facilities, supplementing recourse to private markets, will prove to be adequate for the needs of the developed countries is uncertain, especially when one looks beyond the current year. But in the case of the developing countries, official financing facilities and arrangements are clearly not adequate, even with the Fund’s new oil facility. The main lack relates to the provision of capital on concessional terms or outright grant assistance to those less developed countries—mostly with extremely low income levels—that have been affected most severely by recent international economic developments. The problem is both serious and urgent.

Despite the efforts being made by international and regional financial organizations, the United Nations, and the major oil exporting countries, the needs for concessional capital and grant assistance remain very large, particularly in terms of the prospects for the next few years. In the case of the oil countries, it is apparent that their capital flow to the non-oil developing countries, in the absence of major policy shifts, will rise only slowly because of the time involved in working out organizational procedures and conducting project appraisals in the institutions being established for the purpose. Although these institutions can make a growing contribution to development finance, much of their lending is for projects whereas the main current need is for balance of payments financing. Some nonproject financing, however, is being provided by oil exporting countries outside existing institutional arrangements. Certain proposals have also been made for institutionalizing balance of payments financing on concessional terms.

Current Functioning of the Adjustment Process

As was discussed above, oil importing countries as a group have to accept a sharp deterioration of their current account in 1974, and a large deficit can be expected to persist for at least the next several years. Thus, the main question pertaining to adjustment in the period ahead concerns the distribution of this deficit among individual countries. The aggregate current account deficit of oil importing countries will be distributed or shared, in one way or another, and the pursuit of consistent, mutually agreed policies in this sphere could have a profoundly beneficial influence on world economic and financial developments. Adjustment issues for the oil exporting countries—discussed briefly below—are naturally very different, but also are of great importance in the current setting.

Issues facing the oil importing countries

Any examination of the working of the adjustment process, as determined primarily by the industrial countries, must of course start with an assessment of the macroeconomic setting in which it is to take place. There is general agreement on the need for a certain flexibility of exchange rates to facilitate adjustment, but it is also recognized that such flexibility needs to be complemented by appropriate domestic demand policies. In the past, it has often been thought that countries in a relatively strong external position ought to provide some extra stimulus to domestic demand while those in a relatively weak external position ought to restrain domestic expenditure. However, such a prescription presupposes that there is a fair balance between the forces tending to push up prices and those tending to create unemployment. In the present circumstances of high inflation, it is evident that the customary ground rules are less applicable.

It cannot be argued, for example, that countries must subject themselves to rapid rates of price inflation in the interest of international adjustment. Clearly, countries ought not to be expected to endure price increases of the order of magnitude prevailing in the recent past for the sake of such adjustment. In the Fund’s recent consultations with members, there was general agreement that policies in respect of external adjustment had to be viewed in the context of measures employed to deal with the problem of rising prices; it was felt that countries—especially the largest industrial countries—have an international responsibility, in addition to that arising from their domestic objectives, to make appropriate contributions to the easing of price pressures in the world economy.

Such a view may mean that countries, in deciding on ways to adjust their balance of payments positions, should lean toward choices consistent with the global demand situation and conducive to the abatement of inflation both nationally and internationally. At times of generally high demand pressure, more emphasis on adjustment (restraint) of domestic demand and relatively little reliance on exchange rate adjustment9 might thus typically be implied for countries in externally weak positions, while an opposite emphasis might be useful for countries in externally strong positions. According to these criteria, oil importing countries in a relatively strong balance of payments position would be expected to go as far as they felt was reasonable in expanding demand without weakening the fight against inflation, and thereby to provide support to the growth of world trade and activity. In the externally weaker countries, demand would be restrained enough to shift domestic resources to the balance of payments by dampening imports and facilitating exports.

Besides the macroeconomic setting, more specific elements to be considered in the examination of adjustment problems in present circumstances include the size of non-oil deficits on current account (including those carried over from the period before the oil situation changed), the relative impact of oil, and the ability of countries to attract capital. The assessment of current positions depends critically on the picture for international capital flows. The volume of such flows will probably be much larger than in the past, and their pattern might be quite different, as the oil exporting countries seek investment outlets. To a certain extent the movement of capital will of course be governed by market forces, but recent developments indicate that a sizable portion of the flows may reflect official policies in respect of foreign borrowing.

The evident willingness of countries to borrow in order to cover oil and other deficits suggests that there may be some danger that official financing will bulk too large compared with adjustment, referring here to both exchange rate changes and demand policy adaptations. 10 Unduly heavy official borrowing enables countries to sustain currency values and domestic expenditures higher than they otherwise would be; and, in the current situation of rapid inflation and high capacity utilization on a rather wide scale, the result may be to place undue pressures on the resources of other countries. However, there is also an opposite danger that some countries, reacting to the pressure or prospect of mounting indebtedness, may seek to adjust their current account positions at an unduly rapid pace, to the disadvantage of their trading partners. Thus, a key policy question at present concerns the relative weights to be assigned to adjustment and financing (including special incentives for capital inflows).

It is essential that the various issues pertaining to external adjustment and financing be sorted out and resolved within an international framework. Discussions in the Fund and other international organizations have for some months been directed to this end. However, it is not apparent that countries are in agreement on the policies to be considered appropriate for a satisfactory working of the international adjustment process in the coming period, or on the magnitude and speed with which individual country positions should be adjusted. This situation is perhaps not surprising. In the past, it has been a naturally difficult task for surplus and deficit countries to agree on their responsibilities in the adjustment process; and this time the range of relevant issues confronting the stronger and weaker groups of oil importing countries is even more complex, varied, and difficult to diagnose. But this time, too, the stakes involved in the achievement of a successful adjustment are unusually high.

In present circumstances, for example, it would be a matter of serious concern if failure of the desired shifts in payments positions to materialize caused deficit countries to resort to measures restricting current transactions. Some reactions of this type have already occurred, and generalization of such developments could have grave consequences. It is for this reason that the Committee of Twenty has stressed the importance of avoiding a proliferation of restrictions on trade and payments for balance of payments purposes, and that the Committee made provision, as part of the program of immediate action announced in its communiqué of June 13, 1974, for countries to pledge themselves on a voluntary basis to give effect to that recommendation.

Adjustment issues for the oil exporting countries

On the assumption that present levels of oil prices and production are sustained, comparatively little external adjustment by the oil exporting countries is feasible in the short or medium run. The main general problem they face immediately is how to invest the counterpart of huge current account surpluses outside their countries in ways that are prudent from their standpoint and that do not have undesirable repercussions on others. Beyond the medium run, however, the oil exporting countries differ substantially with respect to the prospects for, and nature of, adjustment.

Approximately one half of governmental revenues from petroleum exports is concentrated in countries which for the most part have small populations, have high ratios of foreign reserves to imports, and in the past have exported some capital—all characteristics which signal the difficulty of their employing domestically any sizable volume of investable resources. These countries with relatively low absorptive capacities may be expected to accumulate large foreign claims over the coming years, as they transform a depletable resource into financial assets or real assets abroad, including those originating in concessionary lending to less developed countries.

However, most of the other oil exporting countries have large populations, have made use of foreign credits in the past to support their domestic investment efforts, and generally can be regarded as having a relatively large potential for domestic economic development. It seems likely that, in time, these countries with relatively high absorptive capacities will be spending a high proportion of their sharply expanded volume of foreign exchange earnings. But, for some time to come, they too will have larger reserves and should be in a position to provide loans or assistance to others, as well as to repay debt contracted in the past. The main task of these countries is to raise the rate of development spending effectively, without intensifying domestic inflation.

This last factor tended to exacerbate the rise of import costs in terms of local currency. The recent association of higher domestic price increases with effective exchange rate depreciation in the developing countries should not be taken to mean that the latter development caused the former, or that the exchange rate actions were unwarranted. In many cases, the causation undoubtedly ran in the opposite direction, with high degrees of domestic inflation being a principal determinant of exchange rate policy decisions.

As measured by import unit values of industrial countries in terms of local currency. (See Table 4.)

In many of the industrial countries, the recently higher levels of unemployment are attributable in large part to structural factors, such as mismatches between the skills and aptitudes of the unemployed and those required by employers. To improve the employment situation, primary emphasis should thus be placed on specific measures; strong expansion of overall demand would serve mainly to fuel inflation and would be relatively ineffective in reducing unemployment. In several Western European countries, a feature of the situation is that unemployment is accompanied by the employment of large numbers of immigrant workers.

This stemmed from a larger increase in “posted” or “tax reference” prices, which for major types of crude petroleum averaged more than 3½ times as high in January 1974 as in the previous September.

As in other regions, this combined result comprised a variety of different experiences on the part of individual countries.

The full counterpart cannot be expected to appear in reported balance of payments statistics of the importing countries in the same calendar year, chiefly because of the time lags mentioned in footnote 2 to Table 9. For present purposes, however, it is more suitable to base the analysis on a symmetrical recording of oil trade flows (incorporated in the “adjusted” columns of Table 9) consistent with an accrual concept of international payments transactions.

Changes in basic balances occasioned by the higher oil export prices will, of course, be smaller, and perhaps substantially smaller, as they will also reflect (inter alia) the oil exporting countries’ long-term capital investments, such as those flowing under commitments recently announced by the Iranian authorities.

Such a need has been pointed up in recent months by the development of an apparently widespread and growing concern with respect to the viability of commercial financing of large and persistent payments deficits.

The appropriate role of exchange rates in the current adjustment process must be considered in the light of (inter alia) the substantial extent to which the effective exchange rates of major currencies have changed during the past few years.

This point is particularly relevant to the major industrial countries. Many developing countries have incurred a substantial amount of debt in the recent past, and they might well find that additional borrowing would not be in their interest, at least on the terms available. For such countries, the substantive and urgent need, as emphasized earlier, is for capital on concessional terms or outright grant assistance.

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