Chapter

Chapter 1 Developments in the world Economy

Author(s):
International Monetary Fund
Published Date:
September 1986
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INTRODUCTION

The world economy during 1985 and the early part of 1986 presented a mixed picture. On the positive side, inflation receded further, world output increased at a moderate pace, and interest rates declined significantly. At the same time, the slowdown in industrial countries, particularly in the United States, was sharper than expected, world trade was sluggish, protectionist pressures intensified, real primary commodity prices declined steeply, and the developing world experienced a setback in its efforts to achieve growth with adjustment. By early 1986, several developments had combined to improve economic prospects. International interest rates in nominal terms had come down to their lowest level in eight years, a more sustainable pattern of exchange rates had been attained, and initiatives to coordinate policies and to strengthen the debt strategy had been launched.

The 3 percent rate of growth recorded for world output in 1985 represented a considerable slowdown from the 4½ percent rate of the previous year. While a moderation in the pace of expansion had been widely anticipated, the slowing of the U.S. economy from 6½ percent growth in 1984 to 2¾ percent in 1985 was much more marked than expected. Little further progress was made in reducing unemployment, and in most European countries joblessness increased from its already high level. The slowdown in the growth of industrial countries’ output led to a marked deceleration in the growth of world trade and, in combination with plentiful supplies, a sharp fall in real primary product prices. As a result, the export earnings of developing countries stagnated and their debt ratios, which had begun to recede in 1984, rose again in 1985 to reach record levels. Reflecting the less favorable external environment, per capita output in developing countries, which, after several years of decline, had finally shown an increase in 1984, advanced only moderately.

A more positive development was the continuing reduction in inflation. In part because of declining prices for oil and other primary commodities, the average rate of increase in the GNP deflator in industrial countries declined to below 4 percent in 1985, and to an even lower rate in the early part of 1986. The majority of developing countries also had declining inflation, although some larger countries where price pressures were particularly strong recorded sizable increases. Several of these high-inflation countries, however, have now taken radical steps to deal with their inflation problem. Another positive development in 1985 was the convergence of growth rates, especially among industrial countries. As a result, shifts in current account balances were typically much less pronounced in 1985 than they had been in the previous three years. However, current account imbalances remained substantial, particularly among the three largest countries.

In the second half of 1985 and the first part of 1986, positive steps were taken to address these imbalances with a view to reducing the risks and uncertainties in global economic prospects. One of the first was the agreement among the Group of Five countries (France, the Federal Republic of Germany, Japan, the United Kingdom, and the United States) reached at a meeting at the Plaza Hotel in New York on September 22, 1985. The agreement, while recognizing the progress that had been made in promoting convergence of favorable economic performance among the participating countries, set forth the policy intentions of these countries to achieve increased and more balanced growth, as well as exchange rate relationships that better reflected underlying economic fundamentals. Following up on this agreement, several countries engaged in coordinated exchange market intervention and, in early 1986, undertook concerted interest rate reductions. The commitment to policy coordination was renewed and strengthened by the heads of state or government of the seven largest industrial countries at their economic summit in Tokyo in May 1986. Another important step was the adoption by the U.S. Congress of the Balanced Budget and Emergency Deficit Control Act (the so-called Gramm-Rudman-Hollings legislation) that significantly improved the prospects for the curtailment of the U.S. fiscal deficit. Together, these actions led to an improved pattern of exchange rates and a marked decline in interest rates. In the field of financing and debt, a major step was the initiative proposed by the United States to encourage financial flows to developing countries in support of growth-oriented economic adjustment.

International economic prospects were also significantly affected by the decline in oil prices that occurred in the first half of 1986. The effects of this decline, which was of a magnitude comparable to the increases of 1979–80, are complex and are likely to vary considerably across sectors and countries. The decline in oil prices contributed to a further lowering of inflation and interest rates and should result in a significant firming of domestic demand growth in oil importing countries. Reflecting these prospects, financial markets in industrial countries exhibited considerable strength in the latter part of 1985 and early 1986. For oil exporting countries, on the other hand, the effects of the oil price decline are generally highly adverse, given the importance of oil income to them as a source of budgetary revenue and export receipts. The difficulties these countries already faced in 1985 have now been greatly exacerbated by the need to adjust spending to levels more in line with the reduced level of export earnings.

The remainder of this chapter of the Annual Report considers recent developments in the world economy in more detail. This review serves as a background for the discussion, in Chapter 2 of the report, of the policies and activities of the Fund.

DOMESTIC ACTIVITY AND POLICIES

INDUSTRIAL COUNTRIES

Policy Setting. The economic policies of industrial countries have for some time been directed toward re-establishing the conditions for sustained noninflationary growth. In pursuit of this objective, the major industrial countries have sought to bring about a gradual reduction in the growth rates of specified monetary aggregates and to limit the share of real and financial resources absorbed by the public sector. At the same time, efforts have also been directed toward improving the functioning of markets through a variety of structural reforms. This general strategy, which was initiated at the beginning of the 1980s, continued to characterize the policies of the industrial countries in 1985 and the early part of 1986.

The strategy has been most successful in the area of inflation control. In 1985, the average rate of increase in the GNP deflator in the industrial countries as a group declined for the fifth consecutive year and was under 4 percent for the first time since 1967. By early 1986, inflation by this measure had fallen even further. As for other key objectives, such as fiscal consolidation and structural economic reforms, results have been more mixed, often reflecting slippages in policy implementation. There have been significant differences among countries in both economic performance and financial conditions, which have at times led to potentially unsustainable exchange rate and balance of payments developments. Since the latter part of 1985, however, a number of important steps have been taken to reduce financial imbalances and to enhance the coordination and consistency of policies among countries. The improved pattern of exchange rates to which these policies contributed, together with the sharp decline in oil prices in the early part of 1986, has strengthened the prospects for balanced noninflationary growth in 1986 and beyond.

It is in the field of fiscal policy that developments have differed most among the major countries in recent years. On the basis of internationally comparable indicators, budgetary consolidation efforts have been most successful in the Federal Republic of Germany and Japan, which have succeeded in narrowing their fiscal deficits significantly since the beginning of the decade, despite unfavorable cyclical conditions (Table 1). In France and the United Kingdom budget deficits tended to stabilize in 1983—84 following some increases early in the decade, while in Canada, Italy, and the United States deficits widened substantially or remained high.

Table 1.Major Industrial Countries: Fiscal Balances and Impulses, 1981-851(In percent of GDP/GNP)
Central Government2General Government3
1981198219831984198519811982198319841985
Fiscal balance (+ surplus, - deficit)
Canada−2.2−5.3−6.2−7.0−6.9−1.6−5.0−6.2−6.3−6.1
United States−2.4−4.1−5.6−4.9−5.1−1.0−3.5−3.8−2.9−3.5
Japan−5.9−5.9−5.6−5.0−4.4−3.5−3.6−3.7−2.2−1.6
France−2.6−2.8−3.3−3.4−3.3−1.8−2.7−3.1−2.9−2.6
Germany, Fed. Rep. of−2.1−2.1−2.0−1.8−1.1−3.7−3.3−2.5−1.9−1.1
Italy−12.8−15.1−16.4−15.5−16.3−11.9−12.6−11.7−13.0−14.0
United Kingdom−2.9−2.7−3.2−3.4−2.5−2.8−2.4−3.7−4.2−3.1
Seven major countries above−3.6−4.6−5.4−5.0−5.0−2.6−3.9−4.1−3.4−3.5
Seven major countries except the United States−4.5−5.0−5.3−5.2−4.8−3.8−4.2−4.4−4.0−3.5
Fiscal impulse(+ expansionary, - contractionary)
Canada−1.10.80.91.60.4−0.7−0.41.41.50.7
United States0.31.60.40.2−0.50.50.60.60.5
Japan−0.5−0.3−0.5−0.3−0.5−1.2−0.1−0.2−1.2−0.5
France1.10.1−0.1−0.30.60.3−0.5−0.6−0.8
Germany, Fed. Rep. of−0.8−1.3−0.10.5−0.5−0.9−2.1−0.80.4−0.6
Italy0.70.6−1.00.82.2−1.1−2.41.01.0
United Kingdom−1.5−0.60.80.2−0.4−2.9−0.91.70.6−0.6
Seven major countries above−0.20.80.2−0.6−0.20.20.20.1
Seven major countries except the United States−0.3−0.30.1−0.3−0.6−0.7−0.2−0.1−0.3

The fiscal impulse is a measure of the thrust of budgetary changes. In general, the impulse points to an expansionary thrust to the extent that, relative to the previous year, revenues increase less rapidly than actual GNP and/or expenditures increase more rapidly than potential GNP. For a detailed description of the fiscal impulse measure, see World Economic Outlook: A Survey by the Staff of the International Monetary Fund (Washington: International Monetary Fund, April 1986), pp.121-23. Composites for the country groups are weighted averages of the individual national ratios for each year, with weights proportionate to the U.S. dollar value of the respective GDPs/GNPs in the preceding three years.

Data tor Canada and the United Kingdom are on a national income accounts basis. Data for Japan cover the consolidated operations of the general account, certain special accounts, social security transactions, and disbursements of the fiscal investment and loan program (FILP) except those to financial institutions. Japanese data other than FILP transactions are based on national income accounts. Data for France are on an administrative basis and do not include social security transactions. Data for Italy refer to the state sector and cover the transactions of the state budget as well as those of several autonomous entities operating at the state level. They also include the deficit, but not the gross transactions, of social security institutions, and part of that of local authorities.

Data are on a national income accounts basis.

The fiscal impulse is a measure of the thrust of budgetary changes. In general, the impulse points to an expansionary thrust to the extent that, relative to the previous year, revenues increase less rapidly than actual GNP and/or expenditures increase more rapidly than potential GNP. For a detailed description of the fiscal impulse measure, see World Economic Outlook: A Survey by the Staff of the International Monetary Fund (Washington: International Monetary Fund, April 1986), pp.121-23. Composites for the country groups are weighted averages of the individual national ratios for each year, with weights proportionate to the U.S. dollar value of the respective GDPs/GNPs in the preceding three years.

Data tor Canada and the United Kingdom are on a national income accounts basis. Data for Japan cover the consolidated operations of the general account, certain special accounts, social security transactions, and disbursements of the fiscal investment and loan program (FILP) except those to financial institutions. Japanese data other than FILP transactions are based on national income accounts. Data for France are on an administrative basis and do not include social security transactions. Data for Italy refer to the state sector and cover the transactions of the state budget as well as those of several autonomous entities operating at the state level. They also include the deficit, but not the gross transactions, of social security institutions, and part of that of local authorities.

Data are on a national income accounts basis.

This general pattern continued in 1985, with the underlying fiscal position—as measured by the fiscal impulse (Table 1)—moving in the direction of larger deficits in the three last-mentioned countries, and toward smaller or unchanged deficits in the other large countries. Overall, the combined general government deficit of the major countries was unchanged in relation to GNP from its 1984 level of 3.5 percent. This pattern of year-on-year developments, however, obscures the effect of a number of developments that occurred during the course of 1985 and early in 1986, which have strengthened the likelihood of more effective budgetary consolidation efforts. Most important, the United States adopted a medium-term plan to eliminate its federal budget deficit. Canada proceeded with its program, announced in November 1984, to strengthen its budgetary performance and achieved a small reduction in its deficit in 1985. With France and the United Kingdom continuing to follow policies of budgetary restraint, and the Federal Republic of Germany having introduced a tax cut, some of the earlier divergences in the thrust of fiscal policies now seem to be in the process of being moderated or reversed.

A major factor underlying the divergent trends in fiscal positions in recent years has been the varying degrees of success countries have had in limiting the share of real resources absorbed by the public sector (Table 2). The share of general government expenditure, including transfers, in GNP has increased in most of the major countries over the period since 1979. Nevertheless, there are significant differences among countries. In Germany and Japan, the increasing relative size of the government sector has been wholly or partly reversed since 1983 and the shares in 1985 were much the same as in 1979. In the other five countries, the increases over the six-year period ranged from 3½ percentage points to 13 percentage points of GNP. In 1985, reflecting the taking hold of policies of fiscal restraint, most countries succeeded in diminishing the share of government spending, although there was a further increase in Italy and the United States.

Table 2.Major Industrial Countries: General Government Expenditure, 1979-85(In percent of GDP/GNP)
19791983198419851
Canada40.247.948.948.7
United States30.635.033.935.2
Japan31.033.432.432.1
France42.949.250.049.7
Germany, Fed. Rep. of48.048.848.447.6
Italy45.657.758.259.2
United Kingdom41.845.846.445.4

Preliminary estimates.

Preliminary estimates.

Monetary conditions in the industrial countries eased significantly during 1985 and early in 1986, reflecting a combination of lower inflation, the cyclical slowdown of growth in the United States, and the increasing confidence of market participants that the U.S. federal budget deficit would be curtailed. In addition, as monetary authorities have acquired greater credibility in their commitment to control inflation, they have been able to respond to slower output growth by a somewhat more accommodative monetary stance, even where this has involved exceeding monetary growth targets. Narrow money (Ml) in the seven major countries increased by 10 percent in 1985, 2½ percentage points faster than in 1984; the acceleration in the growth of narrow money was even more pronounced on a fourth-quarter-to-fourth-quarter basis (Table 3). The growth of broad money also accelerated, from 7.9 percent in 1984 to 9.0 percent in 1985 on a year-on-year basis. By comparison, nominal GNP growth slowed, from 9.0 percent in 1984 to 6.6 percent in 1985.

Table 3.Major Industrial Countries: Monetary Aggregates, 1983-851(Annual changes, in percent)
Fourth Quarter2
19831984198519841985
Narrow money (M1)3
Canada10.13.34.20.39.4
United States11.27.09.15.411.9
Japan3.62.85.06.910.0
France11.311.98.710.86.1
Germany, Fed. Rep. of10.23.34.75.75.3
Italy15.112.313.812.411.5
United Kingdom12.814.716.718.718.0
Seven major countries above10.37.59.98.212.1
Broad money4
Canada5.74.49.57.210.7
United States12.58.09.18.08.6
Japan7.47.88.47.88.0
France11.510.48.49.45.5
Germany, Fed. Rep. of6.63.94.94.75.1
Italy16.512.313.912.111.2
United Kingdom10.59.212.99.515.2
Seven major countries above10.77.99.08.08.6

Composites for the country groups are averages of percentage changes for individual countries weighted by the average U.S. dollar value of their respective GNPs over the preceding three years.

From fourth quarter of preceding year.

M1 is generally currency in circulation plus private demand deposits. In addition, Canada excludes private sector float; the United States includes traveler’s checks of nonbanks and other checkable deposits and excludes private sector float and demand deposits of banks; the Federal Republic of Germany includes demand deposits at fixed interest rates; and Japan includes government demand deposits and excludes float.

M1 plus quasi-money—generally M2, except for the United Kingdom, Japan and the Federal Republic of Germany, for which the data are based on sterling M3, M2 + CD (certificates of deposit), and M3, respectively. Quasi-money is essentially private term deposits and other notice deposits. The United States also includes money market mutual fund balances, money market deposit accounts, overnight repurchase agreements, and overnight Eurodollars issued to U.S. residents by foreign branches of U.S. banks. France also includes government savings bonds. Sterling M3 is M1 plus private sterling time deposits. For Japan, M2 + CD is currency in circulation plus total private and public sector deposits and installments of Sogo Banks plus certificates of deposit. For the Federal Republic of Germany, M3 is M1 plus private time deposits with maturities of less than four years plus savings deposits at statutory notice.

Composites for the country groups are averages of percentage changes for individual countries weighted by the average U.S. dollar value of their respective GNPs over the preceding three years.

From fourth quarter of preceding year.

M1 is generally currency in circulation plus private demand deposits. In addition, Canada excludes private sector float; the United States includes traveler’s checks of nonbanks and other checkable deposits and excludes private sector float and demand deposits of banks; the Federal Republic of Germany includes demand deposits at fixed interest rates; and Japan includes government demand deposits and excludes float.

M1 plus quasi-money—generally M2, except for the United Kingdom, Japan and the Federal Republic of Germany, for which the data are based on sterling M3, M2 + CD (certificates of deposit), and M3, respectively. Quasi-money is essentially private term deposits and other notice deposits. The United States also includes money market mutual fund balances, money market deposit accounts, overnight repurchase agreements, and overnight Eurodollars issued to U.S. residents by foreign branches of U.S. banks. France also includes government savings bonds. Sterling M3 is M1 plus private sterling time deposits. For Japan, M2 + CD is currency in circulation plus total private and public sector deposits and installments of Sogo Banks plus certificates of deposit. For the Federal Republic of Germany, M3 is M1 plus private time deposits with maturities of less than four years plus savings deposits at statutory notice.

The decline in short-term interest rates was particularly significant in the United States (chart 1). By the end of 1985, U.S. interest rates had come down by 3½ percentage points from their 1984 peak; the decline continued in the opening months of 1986. Reflecting the emphasis on exchange rate considerations in the implementation of monetary policy, short-term interest rates in the other major countries initially fell by less than in the United States, or even firmed somewhat. There was thus a pronounced narrowing, or in some cases a reversal, of short-term interest rate differentials during 1985. The decline in long-term interest rates during 1985 and the early part of 1986 was even more pronounced than that in short-term rates. As a result, there was a notable flattening of the yield curve in most countries, particularly in the United States. This development seems to indicate a marked change in inflationary expectations, reflecting the absence of inflationary pressures in most countries together with the increased confidence of financial investors that efforts to bring down budget deficits in the United States and in the other major industrial countries will be more successful than in the past.

Chart 1Five Major Industrial Countries: Interest Rates, 1978-April 1986

(in percent)

1 Monthly averages of daily rates on money market instruments of about 90 days’ maturity.

2 Monthly averages of daily or weekly yields on government bonds, with maturities ranging from 7 years for Japan to 20 years for the United States and the United Kingdom.

3 The United States, Japan, France, the Federal Republic of Germany, and the United Kingdom.

4 Interest rates deflated by a weighted average of the increase in the private final domestic demand deflator in the current and the following two quarters; for the most recent periods, Fund staff projections of the deflator are used.

Structural policies have remained an important facet of the economic strategy. The aim of such policies is to improve the functioning of markets for labor, goods, and financial services, in order to encourage a better allocation of resources and to strengthen the responsiveness of supply. The methods that have been used in pursuit of these aims include deregulation, privatization of publicly owned firms, and specific measures to improve the functioning of labor markets. Structural policies have had a measure of success in some areas, notably the widespread liberalization of financial markets, deregulation of important segments of the transport and telecommunications industries in the United States, and the modification of wage indexation systems in several European countries. However, there have also been setbacks. In some countries, government subsidy expenditures have declined by less than had been hoped, and in much of Europe labor markets continue to be characterized by rigidities that retard a return to high-employment conditions.

Although the record of policy implementation in recent years has thus been a mixed one, a number of steps were taken in the second half of 1985 and early in 1986 that promise a significant improvement in the coordination and consistency of policies among the major countries. These steps constitute an important change in the economic setting and had already begun to have a favorable impact on the economic environment in the first half of 1986. They include the September 22, 1985 agreement among the Group of Five countries seeking to bring key exchange rates more in line with underlying fundamentals (the Plaza Agreement); the adoption by the U.S. Congress of the Gramm-Rudman-Hollings legislation in December 1985, which stipulates reductions in the federal deficit for each fiscal year from 1986 to 1991 so as to achieve a balanced budget in 1991; and the coordinated reduction of official interest rates in several of the major industrial countries in March and again in April 1986. In addition, the seven largest countries entered into a commitment at the Tokyo economic summit in May 1986 to strengthen economic policy coordination. Partly as a result of these developments, some of the major uncertainties that had threatened the prospects for sustained growth have diminished. In particular, the prospect that the fiscal and current account deficits of the United States would be brought under better control, together with the decline in oil prices, induced a further reduction in inflationary expectations. As a result both short-term and longterm interest rates declined further in early 1986. By April 1986, nominal short-term interest rates in the five major industrial countries had fallen to about 6.5 percent, their lowest level since 1972. In inflation adjusted terms, both short-term and long-term interest rates had declined to their lowest levels since early 1981 (chart 1).

Domestic Activity. The overall pace of economic activity in industrial countries moderated in 1985, after the strong expansion recorded in 1984. The slowirfg was largely attributable to a sharp deceleration of growth in the United States. The pace of expansion also dropped back slightly in Canada and Japan, while it remained little changed in Europe. Overall, real GNP in the industrial countries rose by 3 percent in 1985, roughly in line with the estimated rate of growth of potential output but significantly below the 4.7 percent growth recorded in 1984 (Table 4).

Table 4.Industrial Countries: Changes in Output and Prices, 1968-851(In percent)
AverageFrom Preceding Year
1968–77219781979198019811982198319841985
Real GNP
Canada4.73.63.21.13.3−4.43.35.04.5
United States2.75.32.5−0.21.9−2.53.66.42.7
Japan6.55.25.34.33.73.13.25.14.5
France34.53.83.31.10.51.80.71.51.3
Germany, Fed. Rep. of3.73.34.01.5−1.01.53.02.4
Italy33.82.74.93.90.2−0.5−0.22.82.3
United Kingdom42.33.82.2−2.3−1.31.33.61.93.3
Other industrial countries4.02.03.12.10.40.31.73.33.0
All industrial countries Of which,3.64.23.31.21.4−0.52.64.73.0
Seven major countries above3.54.63.31.11.6−0.62.84.92.9
European countries3.73.03.31.4-0.10.41.62.42.4
GNP deflator
Canada7.26.710.311.410.610.45.32.83.2
United States6.27.38.89.19.66.53.74.23.3
Japan8.34.83.03.83.21.90.81.31.6
France37.99.410.412.211.912.59.67.25.9
Germany, Fed. Rep. of5.34.34.04.84.04.43.21.82.2
Italy310.913.915.920.718.317.814.910.88.8
United Kingdom411.011.214.519.811.77.45.03.96.1
Other industrial countries8.59.67.79.19.39.77.26.65.4
All industrial countries Of which,7.37.78.19.38.87.34.94.33.8
Seven major countries above7.17.38.29.38.76.94.54.03.6
European countries8.28.99.011.19.89.47.25.65.2

Composites for the country groups are averages of percentage changes for individual countries weighted by the average U.S. dollar value of their respective GNPs over the preceding three years.

Compound annual rates of change.

GDP at market prices.

Average of expenditure, income, and output estimates of GDP at market prices.

Composites for the country groups are averages of percentage changes for individual countries weighted by the average U.S. dollar value of their respective GNPs over the preceding three years.

Compound annual rates of change.

GDP at market prices.

Average of expenditure, income, and output estimates of GDP at market prices.

The slowdown of growth in the United States, from 6.4 percent in 1984 to only 2.7 percent in 1985, was principally accounted for by stockbuilding, which fell sharply as producers and retailers adjusted inventory levels to expectations of slower growth of final sales. However, the continuing deterioration in the net external balance, reflecting the strong dollar and the accumulated growth differential between the United States and its trading partners, also contributed. In contrast to the weak performance of stockbuilding and net exports, final domestic demand continued to grow at a relatively strong pace, reflecting a decline in the household saving ratio and the rapid growth of defense spending. Fixed investment also continued to expand, albeit at a slower pace than in 1984.

Growth in Japan and in Canada suffered only moderately from the slowdown of growth in the United States. In both countries, real GNP increased by 4½ percent in 1985, only slightly less than in the previous year (5 percent). In Japan, the contribution of the foreign sector declined during the course of 1985, and economic growth became increasingly dependent on stronger expansion in domestic demand, particularly business investment. In Canada, the strong growth of output was mainly domestically generated, with both private consumption and investment, particularly residential construction, sustaining expansion.

The pace of recovery remained modest in most of the major countries in Europe, with some acceleration in the growth of private consumption being offset by slower investment growth and a reduced contribution from net exports. France, the Federal Republic of Germany, and Italy all recorded a deceleration in output growth from the previous year, owing largely to the continuing sluggishness of domestic demand. Nevertheless, following the setback caused by the unusually harsh winter in 1984—85, both France and Germany had a significant rebound of demand and activity in the second half of 1985. The United Kingdom registered a relatively strong rate of growth of aggregate output in 1985 (3.3 percent). However, because of the influence of the one-year strike in the coal industry, which came to an end early in 1985, the underlying trend may have been somewhat weaker than the recorded overall growth rate.

In the smaller industrial countries, a general tendency for domestic demand growth to accelerate was more than offset by reduced contributions to growth from stockbuilding and net exports. Real GNP growth consequently slowed somewhat, from 3.3 percent in 1984 to 3.0 percent in 1985. Individual countries’ growth rates ranged from ½ of 1 percent in Ireland to 4¾A percent in Australia.

Reflecting the continuation of recovery, the average unemployment rate in industrial countries edged downward during 1985, and total employment increased by some 1½ percent from 1984 to 1985. Only in North America, however, can it be said that labor market conditions have improved significantly since the recession trough of 1982. In Europe, the unemployment rate has risen in each year since 1979, and stood at 11 percent in 1985, twice the level of six years earlier. Japan, with its somewhat different labor market structure, has fared better, but its unemployment rate of 2½ percent in 1985, while slightly lower than the year before, remains high in historical perspective (chart 2).

Chart 2Major Industrial Countries: Unemployment, 1966–First Quarter 1986

(in percent of labor force1)

1 National unemployment rates weighted by labor force in the respective countries.

2 France, the Federal Republic of Germany, Italy, and the United Kingdom.

A more encouraging aspect of the labor market picture in 1985 and the early part of 1986 is the fact that employment creation in Europe has at last begun to pick up, and the unemployment rate appears to have peaked, with reductions in rates being recorded in several countries. This rise in employment seems attributable, at least in part, to the moderation of real wage increases in recent years, which has reduced the incentive to substitute capital for labor. In Canada and the United States, employment continued to increase strongly in 1985 despite the slowdown in output growth. Only France, Ireland, and Spain, among the industrial countries, experienced further reductions in the number of persons employed, but these reductions were significantly smaller than in earlier years.

By the early part of 1986, the improvement in the economic setting described above had not yet been reflected in actual performance indicators in the industrial countries because of lags. In the United States, after picking up in the first quarter of 1986 to an annual rate of 3.8 percent, real GNP growth slowed to an annual rate of 0.6 percent in the second quarter, reflecting reduced stockbuilding and a renewed decline in net exports. In the United Kingdom and Italy growth firmed somewhat in the first quarter of 1986. In France, however, real GNP growth slowed. And in Japan and the Federal Republic of Germany, real GNP declined in the first quarter, partly because of temporary factors, but also because the negative implications of the appreciations of their currencies appeared to be feeding through somewhat earlier than the positive effects of terms of trade gains and lower interest rates. Nevertheless, in both these countries as well as in most other industrial countries, various indicators, notably those on retail sales, suggested that the rise in real incomes was beginning to stimulate domestic demand, pointing to the likelihood of a strengthening of activity later in the year.

Inflation. As noted earlier, the sustained decline in inflation over a period of some six years has been one of the major achievements of the economic strategy in industrial countries (chart 3). The further moderation of inflation in 1985 and the early part of 1986, more than three years into the recovery, distinguishes the current economic cycle from the upswings of the 1960s and 1970s. These earlier periods of expansion had been characterized by a disturbing tendency for inflation rates to ratchet upward to ever higher levels. In 1985, on the other hand, the rate of increase in the composite GNP deflator of the industrial countries fell to 3.8 percent, the lowest rate recorded since the late 1960s. As indicated by the continuing deceleration of year-on-year consumer price increases in the opening months of 1986—reflecting absolute price declines on a monthly basis in several countries—inflation performance is likely to improve further this year.

Chart 3Major Industrial Countries: Consumer Price Inflation, 1980–April 1986

(in percent)1)

1 Average of consumer price index for three months indicated over corresponding three months a year earlier.

Another important aspect of recent price developments in the industrial countries has been the further narrowing of inflation differentials among countries. The standard deviation of national inflation rates fell from some 3 percentage points in 1984 to 2½ percentage points in 1985, half its size in 1980. This development largely reflected the improved performance on the part of several previously high-inflation countries. Between 1983 and 1985, for example, the rates of increase in the GDP deflator for France and Italy were reduced by 3½ percentage points and 6 percentage points, respectively. Inflation rates in the smaller industrial countries also declined significantly, although they have generally remained above those in the major countries.

Both internal and external factors have contributed to the improved price performance of recent years. Domestically, the most important factor has been the consistent anti-inflationary stance of government policies in general and of monetary policy in particular. In most countries, the monetary authorities have succeeded in curtailing the growth of monetary aggregates and in creating conditions conducive to sustained downward pressure on inflation and inflationary expectations. In addition, many countries have suspended or modified wage indexation arrangements. These changes led to a significant reduction in labor cost increases in manufacturing, from 11.5 percent in 1980 to 5.2 percent in 1985 for the industrial countries as a group. At the same time, the cyclical recovery in 1983-84 was accompanied by sharp increases in labor productivity, so that unit labor costs in the manufacturing sector were essentially flat between 1982 and 1984, permitting a significant improvement in profitability. In 1985, because of slower growth in productivity, unit labor costs increased slightly (by 2 percent), but there was nevertheless still some margin for a further improvement in profitability.

The weakness of prices for oil and other primary commodities has also played an important role in the improved inflation performance of industrial countries. The terms of trade of industrial countries improved in every year from 1982 to 1985, by a cumulative amount of almost 5 percent. The decline in oil prices of the first quarter of 1986 had a marked impact on the level of consumer prices, although the full effect was not always felt immediately and in the case of some countries was reduced as measures were introduced to prevent the drop in import prices from being passed fully on to consumers. Overall, the industrial countries’ import prices were 1½ percent lower in dollar terms in 1985 than in the previous year. In local currency terms they were slightly higher (1½ percent), although they still exercised a significant dampening effect on inflation. With the dollar having declined substantially from its level in early 1985, the combination of exchange rate factors and weak commodity prices was by early 1986 exerting a sizable downward effect on import prices measured in local currency in most industrial countries.

DEVELOPING COUNTRIES

Policy Setting. Since the onset of the debt crisis in 1982, policies in most developing countries have been conditioned by the need to adapt to severe external financing constraints. This initially led to large cutbacks in imports and in the growth of domestic demand, until the strengthening of export performance, particularly in 1984, permitted a recovery in domestic growth. With more moderate expansion in industrial countries in 1985, developing countries once again faced a weakening in their external environment, and had to adapt their policies accordingly. The slowdown in growth in the industrial world in 1985 led to a sharp decline in the growth of world trade and a virtual stagnation in developing countries’ exports. At the same time, the prices of non-oil primary commodities fell steeply, reflecting the relative weakness of activity in the industrial countries, unusually plentiful supplies, especially of agricultural commodities, and increasing protectionism in major markets. These difficulties were compounded by the continued reluctance of private creditors to resume lending. (A discussion of financing and debt in developing countries is provided on pages 27—30.)

The worsening external circumstances made the policy dilemma facing developing countries even more difficult. With exports no longer buoyant enough to provide much support to domestic economic activity, many countries appear to have found it harder to apply fiscal restraint. Thus, central government fiscal deficits, which had declined from 5.1 percent of GDP in 1983 to 4.3 percent in 1984, stabilized overall in 1985, and increased significantly in a number of countries. At the end of 1985, domestic imbalances were still large in many countries, and external creditworthiness remained unsatisfactory despite the substantial progress that had been made earlier in improving current account positions.

The extent to which adjustment efforts were modified in 1985 varied across countries, depending primarily on how much adjustment had already been achieved. In the main, increases in fiscal deficits were concentrated among those countries that had already achieved substantial improvements in their external positions and had thus acquired at least some room for maneuver in policy formulation. Many countries without a history of recent debt-servicing difficulties that had taken effective adjustment measures at an early stage were able to compensate for the softening of external demand in 1985 through a policy stance that helped support domestic demand. Fiscal deficits in a number of the exporters of manufactures, for example, increased in 1985. For countries where earlier adjustment efforts had been inadequate, on the other hand, the deteriorating external circumstances of 1985 compelled an intensification of adjustment policies and further cuts in fiscal deficits and imports. Many primary product exporting countries found themselves in this category. Their budgetary difficulties became particularly pronounced in 1985 because the stagnation in the purchasing power of their exports led to a parallel weakening of their fiscal revenues, which depended heavily on commodity export earnings. The external positions of these countries were such that, despite this weakness on the revenue side, they had to cut fiscal deficits in 1985 by /2 of 1 percent of GDP, on average.

In most developing countries, monetary and credit policies have for some time been geared to a gradual reduction in inflationary pressures. Toward this end, interest rates have generally been raised to establish or maintain positive real rates for both lending and borrowing instruments. Exceptions to the disinflationary pattern have been a few of the high-inflation countries where, until recently, the growing financial demands of the public sector have resulted in accelerating rates of monetary expansion. In virtually all countries, however, the private sector has found its access to credit squeezed. For many governments, the limited access to or willingness to use foreign sources of finance has led to increased reliance on domestic credit to finance public sector deficits. This has tended to curtail the growth of credit to the private sector even where public sector deficits were kept under reasonable control.

The slackening of domestic adjustment efforts that characterized policy implementation in developing countries during much of 1985 gradually gave way to a firmer policy stance in the latter part of the year and in the first half of 1986. In part, this was a response to necessity, as the weakening external environment compelled a strengthening in adjustment efforts. Another important development was a much more radical approach to controlling inflation adopted by several countries during that period (notably Argentina, Bolivia, Brazil, and Israel). The initiatives undertaken by these countries represented a welcome departure from the more accommodative policies pursued earlier.

While recent moves toward a more resolute policy stance have generally improved growth prospects in developing countries, there are nevertheless substantial differences among countries, depending in particular on whether they are importers or exporters of oil. For most oil importing countries, recent developments have eased the external constraints they face. The decline in international interest rates and the drop in oil import bills should lead to gains in real income that permit adjustment efforts to be consolidated. Nevertheless, even in these countries prospects remain modest, especially among the more heavily indebted countries. For oil exporting countries, as well as a number of countries with extensive commercial and financial links with oil exporting countries, the net effect of recent developments has been to accentuate seriously the policy dilemmas already confronted by these countries in 1985. Given the significant fiscal retrenchment and import compression already undertaken by many of these countries in recent years, further adjustment to the sizable loss in export earnings expected in 1986 is likely to be difficult.

Domestic Activity. Because of the deterioration in the international environment, output growth in the developing countries slackened appreciably in 1985, losing a good part of the momentum gained in the previous year. For the group as a whole, aggregate output rose by only 3¼ percent in 1985, down from 4¼ percent in 1984 (Table 5). Growth rates among subgroups of developing countries varied in part according to the severity of the external circumstances confronting them. The fuel exporting countries faced the most difficult situation in 1985, with a decline in the real purchasing power of their exports of 8 percent. As a result, their combined real GDP stagnated. The nonfuel exporters, by contrast, fared considerably better: although the real purchasing power of their exports grew by only 2½ percent (against 13½ percent in 1984), a strengthening of domestic sources of demand enabled real GDP to increase by 4¾ percent.

Table 5.Developing Countries: Growth of Real GDP, 1968-851(In percent)
AverageFrom Preceding Year
Weights21968-77319781979198019811982198319841985
Developing countries1006.25.14.33.52.21.61.44.23.2
Memorandum
Median growth rates5.25.74.93.73.21.41.32.82.5
By region
Africa125.31.13.23.71.80.8−1.71.72.0
Asia335.49.14.45.45.55.07.68.16.0
Europe96.05.43.81.52.32.31.13.52.2
Middle East189.21.72.3−2.2−1.8−0.10.10.9−1.2
Western Hemisphere286.04.16.15.30.9−1.0−3.23.23.7
By predominant export
Fuel exporters328.42.73.71.00.9−0.2−2.01.40.1
Non-fuel exporters685.46.04.64.52.82.53.15.64.8
Primary product exporters345.43.54.64.21.10.3−0.43.73.5
Exporters of manufactures295.79.24.34.64.85.07.48.46.4
Service and remittance countries54.65.95.75.72.53.22.63.34.0
Memorandum
Fifteen heavily indebted countries336.43.46.14.80.7−0.5−3.52.13.3
Countries with recent debt-servicing problems425.63.55.44.51.2−0.1−2.52.62.9

Except where otherwise indicated, arithmetic averages of country growth rates weighted by the average U.S. dollar value of GDPs over the preceding three years.

Weights are calculated on the basis of the average U.S. dollar value of GDPs for 1982-84.

Compound annual rates of change.

Except where otherwise indicated, arithmetic averages of country growth rates weighted by the average U.S. dollar value of GDPs over the preceding three years.

Weights are calculated on the basis of the average U.S. dollar value of GDPs for 1982-84.

Compound annual rates of change.

As noted earlier, a country’s ability to adapt policies to help offset the effects of the deteriorating global environment on domestic activity was largely a function of the strength of its external position. The exporters of manufactures had achieved a considerable strengthening of their current account in earlier years, and were thus able to allow increased domestic demand to compensate for some of the effects of the slowdown in exports. Primary commodity exporters, by contrast, generally remained in a precarious external position, so that when export earnings weakened they had little choice but to limit the growth of domestic absorption.

The interaction of external and domestic factors in the determination of output may also be seen in the divergent performance of the different regional groupings of developing countries. The Asian countries, many of which are exporters of manufactures, suffered a 13 percentage point deceleration in the growth of real export earnings in 1985, stemming largely from export volumes. However, since their initial external position had been relatively strong, they were able to permit some strengthening of domestic demand, and output increased by 6 percent, an impressive outturn both in historical perspective and in comparison with growth in other regions.

Economic growth in other regions was generally much weaker. The European developing countries, a grouping that also includes several exporters of manufactures, experienced a deceleration in export earnings growth similar to that in Asian countries. However, constrained by higher debt ratios and weaker external positions, the European developing countries had less room for maneuver and experienced only 2½ percent output growth in 1985.

Declines in economic growth were also widespread in the Western Hemisphere in 1985. While it is true that the weighted-average growth rate for the region rose from 3.2 percent in 1984 to 3.7 percent in 1985, this acceleration is attributable to the largely policy-induced expansion in Brazil. The experience of most countries in the region is better represented by the 1¼ percentage point deceleration in the region’s median growth rate. Latin American and Caribbean countries are predominantly exporters of primary commodities and they experienced severe terms of trade losses in 1985. Moreover, the volume of their exports also declined as a result of the weakening in the U.S. economy—their major market. Although external deficits had been sharply reduced in earlier years, domestic imbalances continued to be significant, as evidenced by sizable public sector deficits and rapidly accelerating inflation rates in several countries. Even where measures were implemented to correct these imbalances, they frequently involved initial cutbacks in domestic demand growth, which compounded the weakening of activity stemming from the external sector.

In the Middle East, output declined by 1¼ percent in 1985, largely because of continuing declines in the region’s oil revenues. For the region as a whole, the purchasing power of exports declined by 9 percent. Domestic demand remained depressed too, because of the wide-ranging expenditure cuts undertaken by governments in response to the continuing losses in oil revenues, and in non-oil countries because of reductions in remittances and official transfer receipts from the oil exporting countries.

For the African countries as a whole, output growth remained very sluggish, with real GDP increasing by only 2 percent in 1985. But experiences differed within the region. In the two largest economies, Nigeria and South Africa, output declined or remained very depressed—in the former country owing to oil-related developments and in the latter as a result of policies aimed at curbing inflationary pressures and strengthening the current account. Among the other sub-Saharan African countries, however, output developments were somewhat more favorable, with the rate of expansion of GDP increasing from 2¼ percent in 1984 to 2½ percent in 1985. This improvement occurred notwithstanding a sharp fall in real export earnings, mainly as the result of a weather-related recovery in agricultural production from the depressed levels of the previous year.

The weakness of the economic situation of developing countries is, if anything, understated by the statistics of GDP growth rates. The full extent of the worsening in living standards in recent years is more evident in the sizable declines in real domestic absorption, especially when allowance is made for population growth (chart 4). Taking real absorption per capita as a rough guide to average living standards, the only region of the developing world where this measure of economic welfare rose fairly steadily throughout the first half of the 1980s was Asia. All other regions succumbed to the strains of deteriorating external conditions and unsustainable balance of payments positions. The decline in living standards has been particularly large in Africa and in the Western Hemisphere. It should be remembered, moreover, that most sub-Saharan African countries began the 1980s with living standards barely above subsistence levels. In the Middle Eastern countries, living standards grew sharply in the aftermath of the 1979–80 oil price increases but, since 1982, have been declining as a result of the severe cuts in spending necessitated by falling oil revenues.

Chart 4Developing Countries: Real Absorption1 per Capita, by Region, 1978-85

(indices, 1978 = 100)

1 Real GDP less the real foreign balance.

A disturbing feature of economic performance in developing countries during the past several years has been the weakness of investment spending (chart 5). This weakness persisted in 1985. The curtailment of investment in recent years has been the main domestic counterpart to the adjustment in the external current account and has affected both the public and private sectors. In the public sector, because of the sharp rise in interest payments on government debt and the political sensitivity of reducing some categories of current expenditures, capital outlays have borne the brunt of fiscal retrenchment in recent years. In the private sector, investment has frequently been “crowded out,” both by the increased demands of the public sector on domestic savings referred to above and by diminished confidence in the likely returns on investments. As may be seen from chart 5, the decline in gross capital formation has been greatest in Africa, Europe, and the Western Hemisphere. Although there are signs that the decline in the latter two regions may now be coming to an end, a substantial recovery in investment is essential if a sustained improvement in GNP growth rates is to occur. Investment spending has generally been more robust in the Asian region.

Chart 5Developing Countries: Gross Capital Formation, by Region, 1978-85

(in percent of nominal GDP)

The slowing of activity in developing countries in 1985 was accompanied by a renewed weakening of labor market conditions. Perhaps because of lags, however, recorded unemployment rates do not appear to have risen. In the Western Hemisphere, for example, unemployment rates in the major cities actually fell in 1985 (by about ½ of 1 percentage point on average), following cumulative increases of 3-5 percentage points between 1981 and 1984. Nevertheless, in many countries, the setback in growth has clearly accentuated the problems of unemployment and underemployment stemming from adverse external developments and high population growth. In addition, continuing declines in oil revenues in oil producing countries have led to significant reductions in employment opportunities for workers from neighboring countries.

Although 1985 was in many respects a disappointing year for developing countries, developments toward the end of the year and in the early part of 1986 have led to some improvement in economic prospects. For the oil importing countries, the drop in oil prices should serve to sustain real income growth. An even more favorable factor for a number of African and Central American countries was the sharp increase in coffee prices at the turn of the year. Furthermore, virtually all developing countries will benefit from the reductions that have occurred in international interest rates, and from the improved outlook for growth in the industrial world. Against these positive developments, however, it must be recognized that the fuel exporting countries have suffered substantial losses in real incomes that will curtail their growth possibilities. Income losses in oil producing countries are likely to have significant indirect effects on countries with extensive ties (through trade, workers’ remittances, or official transfers) to oil exporters. The oil price decline is thus likely to have a sizable, though unevenly distributed, impact on the developing world.

Inflation. A striking feature of the inflation performance of developing countries in recent years has been the growing disparity between the experience of the majority of countries, which have had declining inflation, and developments in a small number of other countries, where rates of price increase have accelerated to extremely high levels. Inflation in the “typical” developing country may be roughly approximated by the median rate of price increase, which has been on a downward trend since 1980 and which, after a slight upward movement in 1984, declined again in 1985 (Table 6). The widespread nature of the improvement in 1985 is underscored by the fact that it was shared by most of the regional groupings. Nevertheless, at 8½ percent in 1985, the median inflation rate in developing countries remains considerably above that in the developed world.

Table 6.Developing Countries: Changes in Consumer Prices, 1968-85(In percent)
AverageFrom Preceding Year
1968-77119781979198019811982198319841985
Weighted averages2
Developing countries15.218.721.527.126.124.433.037.939.6
By region
Africa10.216.916.716.422.011.419.320.013.1
Sub-Saharan Africa311.822.226.725.633.113.430.422.218.9
Asia8.84.08.013.110.66.36.67.27.4
Europe10.019.825.937.924.123.723.128.028.6
Middle East9.812.611.716.815.212.712.314.711.7
Western Hemisphere27.941.946.554.259.066.4102.6123.3145.7
Medians
Developing countries8.59.911.614.613.310.49.410.08.7
By region
Africa8.410.311.912.913.712.910.911.410.4
Sub-Saharan Africa28.610.312.513.513.513.111.212.010.3
Asia6.95.97.513.912.57.68.17.25.3
Europe8.09.914.316.215.719.013.813.413.0
Middle East9.110.710.610.58.99.25.67.54.7
Western Hemisphere9.810.414.918.114.79.28.811.915.0

Compound annual rates of change.

Geometric averages of country indices weighted by the average U.S. dollar value of GDPs over the preceding three years.

Excluding Nigeria and South Africa.

Compound annual rates of change.

Geometric averages of country indices weighted by the average U.S. dollar value of GDPs over the preceding three years.

Excluding Nigeria and South Africa.

In contrast to the deceleration evident on a median basis, the weighted average inflation rate accelerated to almost 40 percent in 1985, reflecting primarily very high and accelerating rates of price increase in Argentina, Bolivia, Brazil, Israel, and Peru. The composite inflation rate for this group, which had averaged 105 percent in 1981-82 and had risen to 250 percent by 1984, climbed further to nearly 300 percent in 1985. Price increases also accelerated in a number of other countries, notably in the Western Hemisphere, where the interaction between accommodative financial policies, exchange rate depreciations, and indexation mechanisms exacerbated inflationary pressures. Since mid-1985, however, several of the countries with the highest inflation rates have undertaken comprehensive measures, including monetary reforms, to bring inflation quickly under control. While the long-term success of these efforts will depend on the extent to which they are sustained, by early 1986 they had already resulted in dramatic declines in month-to-month inflation rates.

INTERNATIONAL TRADE AND PAYMENTS

GLOBAL PERSPECTIVES

World Trade. One of the more serious consequences of the slackening of economic growth in industrial countries in 1985 was the disappointing outturn for world trade. The export earnings of developing countries were particularly affected, with the prices of primary commodities being especially weak. Against the background of continued financing constraints, these developments produced a decline in the volume of imports into developing countries.

The slowing of world trade growth to about 3 percent in real terms in 1985 was unexpectedly pronounced, following as it did the strong acceleration in 1983 and 1984 (Table 7). For the most part, this deceleration reflected cyclical developments in the industrial countries, and especially the reversal of the inventory cycle in many of these countries. Stockbuilding, which has a high import content, had accounted for well over one fourth of the growth of industrial country demand in 1984. In 1985, on the other hand, the contribution of stockbuilding to demand growth turned significantly negative. As a result, industrial country imports, which had risen by 121/2 percent in 1984, grew by less than 5 percent in 1985. A particularly large share of this deceleration was borne by the developing countries, whose exports, after rising by almost 7 percent in 1984, grew by less than 1 percent in 1985.

Table 7.Summery of Word Trade Volume Prices, 1968-851Annual changes, in percent)
Average
1968-77219781979198019811982198319841985
World trade3
Volume7.75.26.51.20.3−2.42.98.63.1
Unit value (in U.S. dollar terms)9.610.318.720.2−0.9−4.1−4.7−2.3−1.9
(in SDR terms)47.92.915.019.39.42.4−1.61.9−1.0
Volume of trade
Exports
Industrial countries8.05.87.04.13.6−2.02.89.74.3
Developing countries5.74.25.0−4.1−5.9−8.23.06.70.7
Fuel exporters4.7−1.51.8−13.3−15.3−16.5−3.3−0.1−3.8
Non-fuel exporters7.19.68.59.06.30.78.111.53.5
Imports
Industrial countries7.74.58.7−2.1−2.7−0.64.912.44.7
Developing countries9.27.14.78.56.7−4.1−2.61.7−1.1
Fuel exporters16.73.6−4.413.618.6−1.6−10.5−6.4−11.8
Non-fuel exporters6.69.09.36.41.7−5.41.55.43.4
Unit value of trade
(in SDR terms)4
Exports
Industrial countries6.85.511.912.05.72.7−0.71.30.2
Developing countries12.8−3.925.837.216.02.1−4.64.3−3.4
Fuel exporters20.3−6.140.161.723.33.4−8.63.2−4.2
Non-fuel exporters7.4−1.813.612.87.60.6−1.15.1−2.9
Imports
Industrial countries7.82.915.321.48.30.8−2.41.1−0.7
Developing countries7.43.313.517.412.63.0−0.92.8−1.3
Fuel exporters6.35.110.512.310.73.00.32.20.2
Non-fuel exporters7.72.415.119.713.43.0−1.53.1−1.9
Terms of trade
Industrial countries−0.92.5−3.0−7.7−2.41.91.70.20.9
Developing countries5.0−7.010.916.83.0−1.0−3.71.4−2.2
Fuel exporters13.2−10.726.744.111.40.4−8.90.9−4.4
Non-fuel exporters−0.3−4.1−1.3−5.8−5.1−2.40.51.9−1.1
Memorandum
World trade prices (in U.S. dollar
terms) for major commodity
groups5
Manufactures8.215.313.910.6−4.2−2.3−3.1−3.51.1
Oil22.80.445.963.59.9−4.2−11.7−2.1−4.7
Non-oil primary commodities10.8−5.517.85.9−13.9−10.17.13.7−12.2

Excluding China prior to 1978, except where otherwise indicated.

Compound annual rates of change.

Averages based on data for the two groups of countries shown separately below and on partly estimated data for the U.S.S.R. and other nonmember countries of Eastern Europe and, for years prior to 1978, China.

For years prior to 1970, an imputed value of US$1 has been assigned to the SDR.

As represented, respectively, by the export unit value index for the manufactures of the industrial countries; the oil export unit value of the oil exporting countries (according to the former analytical categories); and the index of market quotations for non-oil primary commodities exported by the developing countries.

Excluding China prior to 1978, except where otherwise indicated.

Compound annual rates of change.

Averages based on data for the two groups of countries shown separately below and on partly estimated data for the U.S.S.R. and other nonmember countries of Eastern Europe and, for years prior to 1978, China.

For years prior to 1970, an imputed value of US$1 has been assigned to the SDR.

As represented, respectively, by the export unit value index for the manufactures of the industrial countries; the oil export unit value of the oil exporting countries (according to the former analytical categories); and the index of market quotations for non-oil primary commodities exported by the developing countries.

A further development, which also bore unfavorably on the developing countries, was the renewed deterioration in the prices of primary commodities relative to those of manufactures. With the strong recovery in demand in industrial countries during 1983 and the first half of 1984, primary commodity prices had firmed relative to those for manufactures. In fact, by mid-1984, the relative price of non-oil commodities had regained the value they had at the outset of the global recession in 1980. Subsequently, however, these gains were more than reversed, as the pace of the recovery in industrial countries eased, and supplies of many commodities increased. By the fourth quarter of 1985, non-oil commodity prices were, in real terms, 23 percent below their level of 18 months earlier (chart 6). Oil prices exhibited a somewhat different behavior. Relative to prices of manufactures, the average price of crude oil in 1985 was, on average, only about 5 percent lower than in 1984. Early in 1986, however, oil prices began to fall sharply, and by the second quarter of the year were as much as 50 percent below their average 1985 levels.

Chart 6Developing Countries: Non-Oil Primary Commodity Prices, 1980-First Quarter 1986

(indices expressed in terms of U.S. dollars, 1980 = 100)

1 Nominal commodity prices deflated by the index of prices of manufactured exports of developed countries.

The magnitude of the decline in non-oil primary commodity prices was largely unanticipated and appears to have resulted from an unusual confluence of demand and supply developments. On the demand side, the most important factor was, as just noted, the slowing of growth in the industrial countries and the associated inventory cycle. However, the size of the price decline— which was equal to or larger than those observed during major international downturns—was greater than can easily be explained by the relatively modest deceleration of world output growth in 1985. It seems likely, therefore, that supply factors have also played an important role. Available data on supply developments point to an unusually large buildup of commodity inventories stemming from the largest back-to-back yearly increases in production in at least the past 25 years. Further confirmation of the importance of supply factors is provided by the observation that the largest price declines were registered in those commodities where supply increases were the largest (such as agricultural crops) and the least where the supply situation tended to tighten (such as metals). An underlying factor that has contributed to the abundant supply of agricultural commodities has been the subsidization of agricultural production in a number of industrial countries. Other contributory factors include good weather, increased incentives to the production of primary commodities in developing countries, and lagged supply responses to the high real commodity prices of the later 1970s.

The result of these price trends, taken together with developments in the volume of exports, has been a sharp divergence in the growth of real export earnings of industrial and developing countries. The purchasing power of industrial countries’ exports increased by over 5 percent in 1985, while that of developing countries declined by 1½ percent. Were it not for the tight financial constraints faced by developing countries, such an outturn might have led to significant shifts in the global pattern of current account balances. As it was, however, financing constraints were such that changes in the global distribution of current account balances were quite small. Instead, adjustment took the form of a marked disparity in the import growth rates of the two groups of countries, with imports of industrial countries increasing by 4¾ percent while those of developing countries declined by 1 percent in the aggregate (Table 8). These aggregate developments do not, of course, reveal the considerable variation in the experiences of individual countries within the broad groupings. The relatively stable overall current account balance of industrial countries in 1985, for example, masks a deterioration in the distribution of that balance between the United States, on the one hand, and other industrial countries, especially Japan and the Federal Republic of Germany, on the other. These and other intragroup developments are discussed later.

Table 8.Changes in Purchasing Power of Exports, Import Volumes, and Current Account Balances(Annual changes, in percent or percentage points)
Purchasing Power

of Exports
Import

Volumes
Changes in

Current Account

Balances,

in Percent

of Exports

of Goods

and Services
198419851984198519841985
Industrial countries10.05.212.44.7−2.20.7
Developing countries8.2−1.51.7−1.14.7−1.8

A major development in world trade was the sharp drop in oil prices in the early part of 1986. Although oil prices had been under downward pressure since 1981, a degree of relative stability in the real price was maintained in 1984 and 1985. This apparent stability rested, to a large extent, on the continuing willingness of Saudi Arabia to support the price by acting as the de facto “swing” producer within the Organization of Petroleum Exporting Countries (OPEC). As time wore on, however, this arrangement was increasingly undermined by several developments: (1) OPEC’s gradual loss of market share to non-OPEC producers; (2) the continuing weakness, at prevailing prices, of oil demand; and (3) the increasing needs of OPEC members—a number of which were incurring significant current account deficits—for foreign exchange. In the face of these developments, Saudi Arabia decided in September 1985 to abandon its role as swing producer, and OPEC, at its December 7—9, 1985 meeting, decided to “secure and defend for OPEC a fair share in the world oil market.…” The effect on oil prices of the consequent rise in OPEC output and of destocking in consuming countries soon became apparent. Prices dropped sharply throughout the first four months of 1986, from an average level of some $26.50 a barrel in the fourth quarter of 1985 to well below $15 a barrel by the second quarter of 1986 (chart 7).

Chart 7Oil Prices, 1972–April 1986

1 Of oil exporting countries; in terms of U.S. dollars.

2 Unweighted average of Brent and West Texas Intermediate spot prices in terms of U.S. dollars.

3 Oil price deflated by import unit value of oil exporting countries.

4 Import unit value of oil exporting countries in terms of U.S. dollars.

While the future course of oil prices is very uncertain, the continuation of prices of the order of $15 a barrel would have major implications for international trade and payments in 1986 and beyond. For the oil importing countries taken together, a fall in oil prices to such a level represents an annual terms of trade gain of some $90 billion, equivalent to 6 percent of imports and close to 1 percent of GDP. These terms of trade gains, in combination with lower inflation and interest rates, have substantially strengthened the outlook for domestic demand in oil importing countries.

A rather different prospect confronts the fuel exporting developing countries. For these countries, as well as for others with close ties to them, an already disappointing outturn in 1985 is likely to be followed by an even weaker one in 1986. The loss in export earnings for these countries would amount to some $70 billion,1 which represents about one third of exports and 8 percent of GDP—much larger losses in proportionate terms than the gains of the oil importing countries. Moreover, the secondary consequences of adjusting to these losses through curtailments in government expenditures, exchange rate depreciations, and reduced spending in the private sector are likely to amplify the first-round losses.

International Capital Markets. Capital flows from industrial to developing countries essentially stagnated in 1985. Although international bonds issued by developing countries increased from $5 billion in 1984 to $10 billion in 1985, only a limited set of the most creditworthy developing countries was able to make such placements. Net lending by banks, the most usual source of funds on commercial terms for developing countries, declined to $3 billion in 1985 from $14 billion in 1984 and $51 billion in 1982. For many of the more heavily indebted developing countries, repayments exceeded new borrowing so that bank exposures in these countries declined. Reflecting the limited access of developing countries to commercial sources of borrowing, current account deficits were kept low in 1985. They were financed almost exclusively through the receipt of official lending and non-debt-creating flows.

Although capital flows to developing countries were subdued in 1985, in other respects international capital markets were quite buoyant, with the aggregate volume of transactions reaching record levels. Available measures of international financial activity vary widely depending upon their particular coverage. Nevertheless, they all point to rates of expansion in 1985 of the order of 30 percent or more. The rapid growth in flows among industrial countries, which has been continuing for several years, has in part reflected growing current account imbalances among these countries. A further factor in 1985 was the rapid decline in long-term interest rates, which prompted large-scale refinancings of existing fixed interest rate debt. More generally, innovations in borrowing techniques and the extensive liberalization of financial markets have led many major corporate and sovereign borrowers to seek finance through the issuance of securities rather than through conventional bank channels.2 Thus, the share of syndicated bank loans in international financial market transactions has fallen from some 58 percent in 1982 and 23 percent in 1984 to less than 14 percent in 1985, whereas the share of bonds and note issuance facilities (NIFs) has risen correspondingly, to 84 percent in 1985.

The rapid growth of international capital markets over the past several years has stemmed in part from the extensive financial liberalization and innovation in industrial countries. While the timing and scope of liberalization measures have differed, they have often included removing ceilings on interest rates, allowing the use of new financial instruments, authorizing financial institutions to undertake previously prohibited activities, allowing foreign financial institutions to participate in selected domestic markets, and removing or relaxing restrictions on capital flows. The institutional and regulatory structures of capital markets in different countries are still quite differentiated, but the recent liberalization programs, in combination with the secular growth of the Eurocurrency markets, have significantly increased their degree of integration.

International Liquidity. The rebuilding of holdings of international liquidity that many countries had engaged in throughout 1983 and 1984 slowed sharply in 1985. Excluding valuation effects on existing reserve holdings, foreign exchange reserves increased by only SDR 7 billion after having been built up by SDR 37 billion in 1984 (Table 9). Developing countries slowed their rate of foreign exchange reserve accumulation (before taking account of revaluation losses) from SDR 21 billion in 1984 to SDR 3 billion in 1985, while the rate in industrial countries slowed from SDR 16 billion to SDR 4 billion. Although the behavior of reserves was thus quite similar in the two groups of countries, the underlying reasons were rather different. Among developing countries, the slowing of reserve accumulation was in response to unfavorable external circumstances at a time when many of these countries were unable to borrow at acceptable terms on international capital markets. Several large developing countries that had been able to build up reserves in 1983–84 used them to finance current account deficits in 1985. Industrial countries, on the other hand, except for the United States, were generally in current account surplus in 1985. In any case, they had ready access to credit markets. The slowing of reserve accumulation in these countries reflected instead the intervention policies of governments, first to limit the rise, and later to encourage the decline, in the foreign exchange value of the U.S. dollar.

Table 9.International Reserves, Excluding Gold(Annual changes, in billions of SDRs)
1982198319841985
All countries
International reserves, excluding gold−33345−2
Of which, foreign exchange1-82340- 1
Accumulation−1322377
Valuation effects513−8
Industrial countries
International reserves, excluding gold−120203
Of which, foreign exchange1−614763
Accumulation−815164
Valuation effects2−1−1
Developing countries
International reserves, excluding gold−21325−5
Of which, foreign exchange1-2924-4
Accumulation−57213
Valuation effects323−7
Memorandum
U.S. dollars per SDR, end of period1.1031.0460.9801.098

Estimates shown here pertain to total foreign exchange reserves. The breakdown into accumulation and valuation (i.e., quantity and price) components is based on the data for identified holdings of six major currencies shown in Appendix Table 1.2, adjusted, however, to cover total foreign exchange holdings. The adjustment assumes that the valuation effects on unidentified holdings are proportional to those on identified holdings.

Estimates shown here pertain to total foreign exchange reserves. The breakdown into accumulation and valuation (i.e., quantity and price) components is based on the data for identified holdings of six major currencies shown in Appendix Table 1.2, adjusted, however, to cover total foreign exchange holdings. The adjustment assumes that the valuation effects on unidentified holdings are proportional to those on identified holdings.

Slower accumulation of new reserves, together with valuation losses on existing holdings of U.S. dollars as the dollar declined against the SDR, led to an actual decline in the value of foreign exchange reserves in 1985 expressed in terms of SDRs. Total reserves excluding gold fell from SDR 406 billion at the end of 1984 to SDR 404 billion a year later. This decline, which stems from valuation factors, was concentrated among developing countries.

The decline in global reserves in 1985 is reflected in lower ratios of non-gold reserves to imports, both for the world as a whole and for some of the major subgroups of countries. This represents a reversal of the trend toward increases in these ratios that had been evident since 1981. During 1983 and 1984, especially, the adjustment efforts of many developing countries had resulted in substantial improvements in their external payments positions. This had led to a rebuilding of reserves as well as, in some cases, a contraction in the value of imports. Valuation factors have also contributed to the changed trend in the reserves-import ratio. Since the U.S. dollar has a greater share in reserves than its weight in the valuation basket of the SDR, the SDR value of a given stock of reserves tends to increase when the dollar is rising and to fall when the dollar is declining. Reflecting these influences, by 1984 the ratios of non-gold reserves to imports for almost all major country groups equaled or exceeded their values at the end of the 1970s. In 1985, by contrast, these ratios tended either to stabilize or, especially among developing countries, to decline.

During 1985, the diversification of the currency composition of foreign exchange reserves accelerated. The proportion of identified foreign exchange reserves3 denominated in U.S. dollars, which had been approximately 80 percent in the mid-1970s, fell to 71 percent at the end of 1984 and to 65 percent at the end of 1985. This decline in the U.S. dollar component of identified foreign exchange reserves had, as its counterpart, increases in the proportions of reserves denominated in deutsche mark (from 9 percent in 1977 to 16 percent in 1985) and in Japanese yen (from 3 percent in 1977 to 8 percent in 1985). The decline in the relative importance of U.S.-dollar-denominated reserves was greater for the industrial countries (whose dollar holdings fell from 89 percent in 1977 to 65 percent in 1985) than for the developing countries (whose dollar holdings declined only from 71 percent in 1977 to 66 percent in 1985). The year 1985 was the first in which developing countries held a greater share of their reserves in dollars than did the industrial countries.

INDUSTRIAL COUNTRIES

Exchange Rate Developments. In the past year, substantial progress has been made in bringing key exchange rate relationships better into line with underlying economic conditions in the major countries. In late February 1985, following more than four years of almost continual appreciation, the U.S. dollar began to depreciate relative to most other major currencies. The dollar’s depreciation was associated with developments among the major industrial countries that led to a greater convergence of interest rates, as well as of output and inflation performance. The downward adjustment of the dollar, partially interrupted in the summer, received a further impetus in the aftermath of the September 22 meeting of finance ministers and central bank governors of the Group of Five countries. All the major currencies appreciated significantly against the U.S. dollar over the 12 months through April 1986, with the exception of the Canadian dollar, which depreciated by 1 percent. In nominal effective terms, the U.S. dollar depreciated by 20 percent over this period, while the Japanese yen appreciated by 27 percent, and the deutsche mark appreciated by 10 percent (chart 8).

Chart 8Major Industrial Countries: Indices of Monthly Average U.S. Dollar and Effective Exchange Rates, January 1982-April 1986

(Average value for 1975–84 = 100)

By the first quarter of 1986, these exchange rate movements had brought the real effective exchange rates (calculated on the basis of normalized unit labor costs) of the yen and the deutsche mark back to the levels prevailing in the first quarter of 1981, shortly after the sustained appreciation of the U.S. dollar began. Nevertheless, the real effective exchange rates of the U.S. dollar and the Italian lira remained higher, and those of the French franc and the pound sterling somewhat lower, than five years earlier. The dollar’s value in real effective terms was 18 percent above that of the first quarter of 1981, about the same difference as indicated by the dollar’s nominal effective exchange rate (which increased by 20 percent). In contrast, the 11 percent real appreciation of the Italian lira since the first quarter of 1981 occurred despite a nominal depreciation of some 30 percent, as the rate of inflation in Italy exceeded by over 40 percent the average in its trading partners during this period. Similarly, the pound sterling’s real depreciation was less than its nominal depreciation over this period, owing to higher price increases in the United Kingdom than abroad.

The sustained appreciation of most major currencies against the U.S. dollar during 1985 and the first part of 1986 reflected in part a move toward convergence in growth, inflation, and financial conditions among the major industrial countries. In particular, interest rate differentials between assets denominated in U.S. dollars and those in other currencies narrowed significantly at the end of 1984 and during the course of 1985, reflecting primarily the fall in U.S. interest rates that began in the second half of 1984. Short-term interest rates in the United States fell steadily, from over 11 percent in July 1984 to less than 7 percent in April 1986. As a result, the differentials against assets denominated in Japanese yen and deutsche mark both fell from over 5 percent to less than 2 percent, although the decline was by no means continuous throughout the period. Real short-term interest rate differentials, which had favored U.S.-dollar-denominated assets during most of the 1981-84 period, also began to narrow during this period and, by April 1986, in fact favored non-U.S.-dollar denominated assets (chart 9). Long-term interest rate differentials in favor of the United States also fell dramatically over the period, and for several countries became negative, as U.S. long-term interest rates fell even faster than those of short-term securities. U.S. long-term government bond rates, which had exceeded those in the Federal Republic of Germany and Japan by about 6 percentage points in mid-1984, were about 2 percentage points higher in April 1986.

Chart 9Major Industrial Countries: Monthly Average Real Short-Term Interest Rates, January 1982-April 19861

(in percent per annum)

1 The rates shown are monthly averages of daily rates on money market, instruments of about 90 days’ maturity deflated by an estimate of the expected rate of inflation, as defined in footnote 4, chart 1. The rate for Japan is the discount rate on 2-month (private) bills.

2 The dashed line represents the average value of the U.S. real short-term interest rate during the period 1975 to 1984.

The decline in long-term U.S. interest rates and the depreciation of the U.S. dollar were probably also influenced, at least from mid-1985 onward, by the prospect of a more restrictive fiscal policy in the United States, as evidenced by the Congressional Budget Resolution in August and the enactment of the Gramm-Rudman-Hollings Balanced Budget Act in December. Against this prospect of fiscal restraint in the United States, the actual as well as the prospective fiscal stance of other major industrial countries remained largely unchanged.

The sharp change in the trend movement of the U.S. dollar that occurred in late February 1985 may also have reflected a shift in investors’ sentiment concerning the exchange rate. In this interpretation, the dollar’s appreciation in early 1985 may have represented speculative pressures whereby the exchange rate became partly or wholly determined over short periods on the basis of the “self-fulfilling prophecies” of market participants, independently of fundamental determinants. The sharp appreciation of the U.S. dollar over that period relative to the deutsche mark and the Japanese yen, despite narrowing interest rate differentials, was indeed anomalous. It has also been argued that the United States has, because of changing circumstances in the rest of the world, at times benefited from a “safe haven” demand for dollar assets. If so, and depending on the investors’ perception of risk, this would be another factor accounting for movements in exchange rates that are not easily accounted for by interest rate movements. Volatility of exchange rates is consistent with the presence of such speculative elements in the demand for different currencies.

The announcement following the September 1985 meeting of the Group of Five countries played an important part in reinforcing the initial shift in sentiment concerning the sustainable exchange rate of the U.S. dollar. It pointed to the desirability of a further appreciation of major currencies against the dollar, to reflect changes in policy and in economic conditions that had already taken place or were in prospect, and indicated the intention of the five countries to cooperate to encourage such a realignment. There was an immediate reaction in foreign exchange markets to this announcement. Moreover, effects on exchange rates continued in the weeks and months that followed as the credibility of the change in official views concerning exchange markets was buttressed by policy actions. Exchange market intervention was conducted by the Group of Five countries in cooperation with other industrial countries, and involved combined sales of U.S. dollars amounting to over $10 billion from September 23 through the end of October. Furthermore, the Japanese authorities permitted a significant, temporary tightening of monetary conditions in late October and November, leading to a rise in short-term nominal interest rates by as much as 2 percentage points.

During the period immediately following the Group of Five’s announcement, the largest exchange rate movement was that in the bilateral rate between the U.S. dollar and the Japanese yen: the yen appreciated against the U.S. dollar by 11 percent from September 22 to September 30, 1985 and by 44 percent from September 22, 1985 to April 30, 1986. This contrasted with an appreciation of 7 percent from March to September 22, 1985. The appreciation of the major continental European currencies against the dollar was also more pronounced after the Group of Five meeting than before, but not to the same extent as that of the Japanese yen.

Exceptions to the pattern described above were the Canadian dollar and the pound sterling. Although both currencies did initially appreciate following the September 22 meeting of the Group of Five, they subsequently fell back. Uncertainty surrounding world oil prices may have been largely responsible for the depreciating trend, in effective terms, of the pound sterling. Rumors of a possible U.K. membership in the exchange rate mechanism of the European Monetary System (EMS) at a central rate lower than the prevailing market rate—although repeatedly denied by the U.K. authorities—also may have affected the exchange rate. In Canada, the size of the budget deficit, the financial difficulties of three small Canadian banks, oil price developments, and a weakening current account appear to have been the principal factors adversely affecting the Canadian dollar. In January 1986, as the sharp decline in world oil prices was occurring, both the Canadian dollar and the pound sterling fell sharply against the U.S. dollar. By early February, the Canadian dollar had reached a record low of US$0.69, although it recovered somewhat thereafter, owing in part to substantial intervention by the Bank of Canada. Between September 1985 and April 1986 the Canadian dollar depreciated by 8 percent and the pound sterling by almost 7 percent in nominal effective terms.

The EMS was relatively stable in 1985 despite continued, albeit narrowing, differences in price performance among participating countries and the depreciation of the U.S. dollar. A realignment occurred in July 1985, but it changed only the position of the Italian lira in the parity grid and did not affect the relative bilateral positions of the other currencies. It had been generally expected that a weakening of the U.S. dollar would be associated with a greater increase in the demand for the deutsche mark than for other EMS currencies, given the deutsche mark’s importance as a vehicle currency for trade and investment flows. Thus, dollar depreciation had been expected to lead to upward pressure on the deutsche mark within the EMS. The deutsche mark did appreciate relative to other EMS currencies after August 1985, but there was no evidence of major strains in I the system even during the early part of 1986, when f the deutsche mark reached the top of the narrow band (chart 10).

Chart 10European Monetary System: Relative Positions of the Currencies Participating in the Narrow Band, March 1985-April 19861

1 Based on weekly averages. The vertical distance between any two currencies is equal to the percentage deviation from their bilateral central parity rate.

A realignment of central rates within the EMS took [ place early in April 1986, at the request of the French authorities. This was the first major realignment since March 1983, which contrasts with the seven realignments that took place over the first four years after the formation of the EMS in March 1979. The realignment, which was effective April 7, 1986, involved an appreciation of the central rates of the deutsche mark and the Netherlands guilder by 3 percent and of the Belgian franc and Danish krone by 1 percent and a depreciation of the central rate of the French franc by 3 percent. The bilateral central rates of the Italian lira and Irish pound were held unchanged. As a result of these changes, the losses in competitiveness (as measured by normalized unit labor costs) of the French franc against the deutsche mark, the Netherlands guilder, the Belgian franc, and the Danish krone that had taken place between the previous realignment in March 1983 and the first quarter of 1986 were substantially reduced.

Balance of Payments Developments. The recorded current account deficit of industrial countries narrowed to $54 billion in 1985, from $64 billion in 1984 (Table 10). In interpreting these figures it should be recalled that the global balance of payments statistics contain a large and variable discrepancy (totaling some $76 billion in 1985) representing unrecorded net receipts. Given the available information, limited though it is, on the statistical roots of this discrepancy as well as the relative size of industrial countries in world trade flows, it is possible that the combined underlying position of these countries was significantly stronger than the recorded figures suggest.4 The strengthening in the industrial countries’ current account position in the past year reflects developments in both merchandise trade and services. The reduction in the recorded deficit on merchandise trade occurred despite higher growth in import volumes than in export volumes and was thus due wholly to an improvement in the terms of trade amounting to 1 percent. The surplus of industrial countries in services and private transfers increased by $9 billion, after a large decline in 1984, while net payments on account of official transfers continued to increase, rising by $3½ billion in 1985.

Table 10.Summary of Payments Balances on Current Account, 1978-851(In billions of U.S. dollars)
19781979198019811982198319841985
Industrial countries14.8-25.3-61.1-18.1-19.7-25.0-64.3-54.4
Canada−4.3−4.2−1.0−5.12.42.42.6−0.4
United States−15.6−1.01.96.3−9.1−46.7−106.5−117.7
Japan16.5−8.8−10.74.86.920.835.049.2
France7.05.2−4.2−4.8−12.1−4.7−0.80.3
Germany, Fed. Rep. of9.0−6.0−15.7−5.24.14.27.013.3
Italy6.25.5−9.7−8.2−5.50.8−2.9−4.2
United Kingdom2.2−1.47.814.09.93.2−0.83.8
Other industrial countries−6.3−14.7−29.6−19.9−15.9−3.92.01.3
Developing countries-34.67.128.6-45.3-83.5-61.5-32.1-18.9
By region
Africa−13.0−3.6−2.1−22.3−21.5−12.1−7.3
Asia−6.7−12.4−18.8−20.7−17.4−15.5−4.2−12.6
Europe−7.1−10.0−12.3−9.9−6.0−4.1−1.9−2.0
Middle East11.254.292.050.13.3−19.0−15.9−0.5
Western Hemisphere−19.0−21.1−30.1−42.6−41.9−10.8−2.8−4.7
By analytical criteria
Fuel exporters−6.051.696.135.2−18.0−17.5−5.6−4.5
Non-fuel exporters−28.6−44.5−67.5−80.6−65.5−44.0−26.5−23.3
Market borrowers−31.6−29.0−35.7−71.2−73.1−29.4−2.68.0
Official borrowers−7.4−6.1−9.3−12.0−10.6−9.1−10.0−9.7
Other countries2-9.5-6.5-4.6-3.3-0.51.12.3-2.4
Total3-29.3-24.8-37.2-66.8-103.6-85.4-94.1-75.7

On goods, services, and total (private and official) transfers.

Covers estimated balances on current account transactions in convertible currencies of the U.S.S.R. and other nonmember countries of Eastern Europe.

Reflects errors, omissions, and asymmetries in reported balance of payments statistics on current account, plus balance of listed groups’ transactions with countries not included.

On goods, services, and total (private and official) transfers.

Covers estimated balances on current account transactions in convertible currencies of the U.S.S.R. and other nonmember countries of Eastern Europe.

Reflects errors, omissions, and asymmetries in reported balance of payments statistics on current account, plus balance of listed groups’ transactions with countries not included.

The divergence between current account developments in the Federal Republic of Germany and Japan, on the one hand, and in the United States, on the other, persisted in 1985. Germany and Japan increased their current account surpluses by amounts equivalent to just under 1 percent of their respective GNPs, to 2.1 percent and 3.7 percent of GNP, respectively. Correspondingly, the United States ran a current account deficit in 1985 of about 3.0 percent of GNP, an increase of 0.1 percent of GNP compared with 1984.

Germany and Japan experienced improvements in their terms of trade in 1985, which contributed to the strengthening of their current account balances. These terms of trade shifts were attributable, in the main, to the changes in relative prices between primary commodities and manufactures that were discussed above. Exchange rate changes for those countries were relatively small on average from 1984 to 1985 and did not play a major role. In contrast, the terms of trade for the United States worsened slightly during the year and contributed to the small rise in the U.S. deficit.

Developments in current account balances also reflect the effects of changes in international competitiveness and in the strength of demand in individual countries. However, competitiveness effects operate with lags extending over at least two or three years. The decline in the real value of the dollar against most other major currencies, which began in 1985, had not therefore had much effect on trade volumes among major industrial countries by early 1986. Indeed, movements in the volume of trade of the three major countries in 1985 appear to have continued to reflect the appreciation of the dollar that had occurred in earlier years, as well as faster growth in domestic demand in the United States than in Germany and Japan. In particular, despite a significant slowdown in U.S. growth in 1985 compared with 1984, U.S. imports rose by 4.5 percent in volume in 1985, while exports rose by only 0.8 percent. Japan’s trade displayed the opposite tendency, with imports falling by 0.3 percent and exports increasing by 4.7 percent. The growth of Germany’s exports, at 6.4 percent, was also somewhat faster than that of imports, which rose by 4.5 percent. The lags in the response of trade volumes, together with the more immediate effect of exchange rate changes on trade prices, gave rise to the familiar J-curve effects on current account balances. In the period covered by this report, these factors served to enlarge current account imbalances significantly, expressed in terms of U.S. dollars, even though it appeared likely that the exchange rate changes that had occurred would eventually tend to reduce them.

A perspective on current account developments that is complementary to that provided by analyses of changes in the terms of trade, in competitiveness, and in incomes is obtained by considering the counterpart developments in domestic financial positions. By definition, the current account of the balance of payments is equal to the sum of the net financial position of the private sector and the net financial position of the public sector. In other words, without implying a causal relationship, the movements in the current account positions of the three major industrial countries can be decomposed into shifts in fiscal positions and changes in the balance between private saving and investment which, however, have been relatively small in recent years. In the Federal Republic of Germany and Japan, general government deficits fell by 2½ percent and 2 percent of GNP, respectively, between 1981 and 1985, while in the United States the general government deficit increased by 2½ percent of GNP during the same period (chart 11). For the most part, the changes in the excess of private saving over private investment oscillated without a definite trend during these years.

Chart 11Three Major Industrial Countries: Fiscal and Current Account Balances, 1980-851

1 General government fiscal balances (+ surplus, - deficit) and external balances on current accounts (+ surplus, - deficit).

Recorded current account imbalances in the other large industrial countries were of a much smaller magnitude in 1985, in both absolute and relative terms, than those in the three largest countries. Both France and the United Kingdom recorded a strengthening of their positions. The United Kingdom had a relatively large improvement, of $4.6 billion or 1.1 percent of GNP, in its current account surplus in 1985. Part of this improvement was attributable to the ending of the coal miners’ strike. The French current account shifted from a small deficit in 1984 to approximate balance in 1985. This improvement was wholly accounted for by the surplus on services. The trade balance was little changed, despite a 2½ percent improvement in the terms of trade.

Italy had a small increase in its current account deficit, of $1.3 billion or 0.3 percent of GNP. The improvement in the terms of trade was only 1.1 percent, and Italy’s oil trade deficit did not change with respect to 1984. Both export and import volumes recorded relatively large increases, while the real value of the lira remained on average almost unchanged. Canada experienced a somewhat larger deterioration in its current account position, moving from a $2.6 billion surplus in 1984 to a $0.4 billion deficit in 1985, a swing equivalent to 0.9 percent of GNP. The weakening on current account seems largely attributable to a terms of trade deterioration of about 1.6 percent—reflecting Canada’s position as a large exporter of primary commodities—together with the relatively faster growth of activity in Canada than abroad.

The current account balances of the smaller industrial countries did not show large movements in 1985, although on balance there was a small strengthening. The major exceptions were Sweden, where the current account position moved from a small surplus to a deficit of $1.1 billion, and Denmark, where the deficit widened by $1 billion, to $2.7 billion. As a group, the smaller industrial countries experienced a marginal worsening in their terms of trade in 1985, while import and export volumes displayed similar rates of growth.

The current account surpluses and deficits of industrial countries are largely mirrored in net flows of private capital, as net changes in reserves were generally small in 1985. The composition of private capital flows out of Japan and into the United States displayed the same trend as in earlier years: acquisitions of longer-term securities continued to grow in importance at the expense of short-term capital and other types of long-term capital. For the United States, net inflows of portfolio investments grew from $29 billion in 1984 to $64 billion in 1985. The balance of other long-term capital flows shifted from a net outflow of $15 billion in 1984 to a net inflow of $9 billion in 1985. In the same period, the short-term capital inflow fell from $45 billion to $20 billion.

DEVELOPING COUNTRIES

Exchange Rates. Two features of recent exchange rate developments in developing countries stand out. First, a growing number of developing countries have opted for a greater degree of exchange rate flexibility as an important element in their adjustment and stabilization programs. Second, the decline in the U.S. dollar against the currencies of the other major industrial countries has had an important impact on the nominal and real effective exchange rates of many developing countries.

Illustrative of the first point is the addition, since the time of the last Annual Report, of Bolivia, The Gambia, Sierra Leone, and Zambia to the list of developing countries, now ten in number, identified in the Fund’s classification as having an independent floating exchange arrangement.5 For those countries that have opted to float in recent years, their prior experience with other exchange arrangements was quite varied, ranging from managed flexibility of the exchange rate as a means of compensating for inflation differentials to pegged arrangements with infrequent changes against a single currency or basket of currencies. Among those developing countries (the great majority) that have not adopted independent floating arrangements, there has also been a greater willingness to adjust exchange rates to correct relative price misalignments and to improve or maintain external competitiveness. Against a background of continuing progress toward lower inflation rates in the major industrial countries, the commitment to more flexible exchange rate policies has been particularly important for developing countries with moderate to high inflation rates. Given the interaction between exchange rate movements and inflation in open economies, such exchange rate management policies need to be carefully coordinated over time with the monetary and fiscal stances adopted. The more recent “shock” approach to disinflation adopted by some of these countries with very high inflation in the latter part of 1985 and early in 1986 has entailed renewed experimentation with fixed nominal exchange rates. In a move to enhance coordination of monetary and fiscal policies and to alter the inflationary expectations process, the authorities in some of these countries have introduced price and wage freezes, including as an important element the stabilization of their nominal exchange rates.

The influence of the depreciation of the U.S. dollar vis-à-vis the currencies of other major industrial countries on the exchange rates of developing countries is seen most clearly in the case of currencies that are linked to the U.S. dollar (chart 12). The nominal and real effective exchange rates of countries in the Middle East, for example, declined significantly during the period under review. Since a number of countries in this grouping are fuel exporters facing lower export earnings in the wake of the sharp fall in oil prices, these exchange rate developments should assist in the process of balance of payments adjustment. The link between the sharp decline in the U.S. dollar and the behavior of developing countries’ effective exchange rates is also apparent in other regions. Most countries in the Western Hemisphere and East Asia, for example, have traditionally given a large weight to the U.S. dollar, or linked their currencies to it. Hence, despite the importance of dollar-area trade, many have experienced substantial real effective depreciation of their currencies. The direct link between the behavior of the U.S. dollar and real effective exchange rates is somewhat less marked for developing countries in Africa and Europe, particularly if the evolution of effective rates is viewed in a longer-term perspective. European countries had earlier evidenced a willingness either to pursue flexible exchange rate policies or to use currency baskets in pegged exchange rate arrangements. These factors, particularly the latter, also influenced outcomes in Africa, but, in addition, links to a single currency other than the U.S. dollar, principally the French franc, were important in determining the evolution of real effective exchange rates.

Chart 12Developing Countries: Real Effective Exchange Rates by Region, 1978-First Quarter 19861

1 Excluding high-inflation countries.

Current Account Developments. The combined current account deficit of developing countries, after declining from $84 billion in 1982 to $32 billion in 1984, declined by a further $13 billion in 1985, to $19 billion. This latest decline was, however, concentrated among the oil exporters of the Middle East, which, through a sharp compression of imports, achieved a small surplus. The combined current account balance of other developing countries changed relatively little from 1984 to 1985 (chart 13 and Table 10). The deficit was virtually unchanged at $21 billion, equivalent to 4 percent of exports of goods and services. Moreover, the changes in major subgroups of capital importing developing countries were all related to large changes for a few large countries—notably a $4 billion improvement in South Africa’s current account and a $13 billion deterioration in that of China. The stability of current account balances from 1984 to 1985 was in marked contrast to developments over the preceding four years, during which the capital importing developing countries had reduced their combined current account deficit from the historically high level of 18½ percent of exports of goods and services in 1981 to only 4 percent in 1984. This adjustment had been necessitated by the 1982 debt crisis and the ensuing contraction in net lending by private creditors. By 1984, however, current account deficits had been brought broadly into line with the reduced availability of external financing, and there was therefore less need for further reductions in deficits in 1985.

Chart 13Developing Countries: Trade and Current Account Balances, 1981-85

(in percent of exports of goods and services)

1 Excluding Nigeria and South Africa.

While capital importing countries, as a group, reduced their current account deficits by about three fourths between 1981 and 1984—85, the performance of subgroups of countries varied significantly about this average. Those countries that had relied primarily on commercial sources of external financing (the market borrowers) had recorded very large deficits in 1981-82 (equivalent to 19 percent of exports of goods and services). With the virtual evaporation of external sources of finance, they reduced their combined deficit to under 1 percent of exports in 1984, and recorded a surplus in 1985. The official borrowers, in contrast, were more dependent on relatively stable sources of external financing, and their current account deficit, at 27½ percent of exports in 1985, was only marginally less than it had been in 1982. Nevertheless, some official borrowers also experienced a contraction in net lending because debt-servicing problems curbed their access to officially guaranteed export credits. The sub-Saharan African countries were particularly affected by this factor, and thus had to cut their current account deficit in half from 1982 to 1985.

The large improvement in current account balances during 1982-85 was achieved primarily through an adjustment of the balance on merchandise trade. The capital importing developing countries had converted a trade deficit of $67 billion in 1981 into a surplus of $16½ billion in 1984, before slipping back to a surplus of $9½ billion in 1985. The services balance remained in a fairly, stable deficit of about $70 billion during this period, while net receipts of unrequited transfers were similarly stable.

On a regional basis, the shift in trade balances was especially marked in the Western Hemisphere. The trade surpluses in this region in 1984 and 1985 averaged 35 percent of exports. However, sub-Saharan African countries also recorded a small surplus on trade account on average for those years. The trade surpluses of these two regions reflected the large share of their export receipts that are needed to cover interest payments. In European developing countries, by contrast, deficits on trade exceeded those on current account because of their large receipts of remittances and earnings from tourism. For Asian countries, service and transfer receipts broadly matched the corresponding payments, including interest payments. Thus the trade and current account balances of the Asian region have tended to be quite similar (chart 13).

The stability of trade and current account balances from 1984 to 1985 masked major changes in the rates of growth of the underlying gross flows. The growth of developing country exports, which had accelerated to nearly 7 percent in 1984, dropped to only ¾ of 1 percent in 1985. The slowdown was widespread and affected virtually all countries. The weakest performance was recorded by the fuel exporting countries, whose exports declined by close to 4 percent in volume in the face of continued energy conservation and increases in oil production of other countries. Export volume growth among the non-fuel exporting countries remained positive, but nevertheless slowed sharply, from 11½ percent in 1984 to 3½ percent in 1985. Most of the deceleration was attributable to cyclical developments in the industrial countries, including the reversal of the inventory cycle. However, the intensification of protectionist pressures in industrial countries, together with the unexpected weakness in developing countries’ exports of manufactures, suggested that protectionist barriers may also have played a part. For many countries, the adverse effect of the deceleration in export volumes was compounded by a deterioration in their terms of trade. Overall, the developing countries’ terms of trade deteriorated by 2¼ percent in 1985, but the non-fuel exporters, with a decline of only 1 percent, fared rather better than the fuel exporters, who registered a decline of 4½ percent.

As noted earlier, the combination of stagnating export volumes and deteriorating terms of trade led to outright declines in the real purchasing power of developing countries’ exports and hence in their imports in 1985. Imports, which had increased by 1¾ percent in volume in 1984, declined by 1 percent in 1985. The reduction was especially marked among those countries that suffered terms of trade losses. The imports of fuel exporters fell by nearly 12 percent and those of primary product exporters by nearly 5 percent. As a result, imports into Africa and the Western Hemisphere in 1985 were below the levels of 1980 by close to one sixth and one third, respectively. Imports into Europe and the Middle East were roughly back to 1980 levels. Only the Asian region has been able to achieve a substantial and sustained rise in its imports over the past five years (chart 14).

Chart 14Developing Countries: Import Volumes, 1980-85

(Indices, 1980 = 100)

Financing and Debt. Capital importing developing countries kept their aggregate external financing requirement in 1985 broadly in line with the volume of external financing that they were able to obtain. For the group as a whole, there was therefore the smallest increase in the stock of arrears outstanding since 1980, and net use of Fund credit fell to its lowest level in six years and, indeed, turned slightly negative. But the balance established in 1985 was unsatisfactory because it was based on unsustainably low levels of domestic absorption, particularly investment, in many indebted developing countries, on a large volume of concerted financing, and on a disturbingly low level of spontaneous lending.

The financing situation that emerged for the capital importing developing countries in 1985 was attributable to developments affecting both the sources and the uses of external finance. On the sources side, net borrowing from private creditors stabilized at $8 billion in 1985, and two relatively stable sources of finance—non-debt-creating flows and long-term borrowing from official creditors—provided a further $51 billion (Table 11). Long-term borrowing from official creditors declined, partly in response to reduced needs for exceptional financing and partly because some official flows were converted from loans to grants, thereby contributing to an increase in non-debt-creating flows. The stability in net lending by private creditors was probably the result of two offsetting considerations. On the one hand, commercial banks were unwilling to lend to countries that had not regained creditworthiness, while net new finance was generally not needed by those countries that were creditworthy. On the other hand, although commercial banks might have wished to reduce their exposure in many countries—as evidenced by the need for concerted lending packages in several cases—the countries themselves had not adjusted to the point at which they could make substantial net repayments. There was therefore neither large net lending to creditworthy countries nor large net repayments by countries whose external position remained difficult.

Table 11Capital Importing Developing Countries: External Financing, 1979-85(In billions of U.S. dollars, except as otherwise noted)
1979198019811982198319841985
Deficit on goods, services, and
private transfers6178113104633640
Use of reserves−22−19318−9−21−3
Outflows of residents’ capital1−9−21−32−36−19−14−19
Non-debt-creating flows225242626232531
Net external borrowing679411696684630
From private sources4866754818118
From official sources319283937403321
Of which, use of Fund
credit (net)7677757
Arrears4−12111022
Memorandum
Non-debt-creating flows plus long-
term borrowing from official
creditors45495953555351
As percent of deficit on
goods, services, and
private transfers7363525186147130

Asset transactions, net, plus recorded errors and omissions (the latter are included here on the assumption that the estimates reflect primarily capital flight).

Official transfers, net direct investment, SDR allocations, valuation adjustments, and gold monetization.

Long-term borrowing from official creditors, use of liabilities constituting foreign authorities’ reserves, and use of Fund credit.

Reflects involuntary “lending” by official and private creditors.

Asset transactions, net, plus recorded errors and omissions (the latter are included here on the assumption that the estimates reflect primarily capital flight).

Official transfers, net direct investment, SDR allocations, valuation adjustments, and gold monetization.

Long-term borrowing from official creditors, use of liabilities constituting foreign authorities’ reserves, and use of Fund credit.

Reflects involuntary “lending” by official and private creditors.

The development that most affected the uses of external finance in 1985 was the further abatement in the acquisition of foreign assets by developing countries. This development was due entirely to lower acquisition of official reserves (excluding increases due to revaluation factors), which amounted to only $3 billion in 1985, reflecting the lower priority that many countries gave to rebuilding reserves after the $30 billion increase in 1983-84. The private sector’s acquisitions of foreign assets increased in 1985, but remained relatively moderate by recent standards. Outflows of residents’ capital in 1985—including flight capital—amounted to some $19 billion, or roughly half the 1982 level. The acquisition of foreign assets by the private sector has been curbed by a number of factors, most constructively where action was taken to increase the attractiveness of domestic financial assets vis-à-vis foreign assets, for example by raising domestic interest rates or correcting exchange rate overvaluation. Nevertheless, there remained a worryingly large number of countries where private sector demand for foreign assets remained strong and was constrained only by foreign exchange shortages (chart 15).

Chart 15Selected Indicators of Uses of External Finance, 1973–85

(Cumulated flows, in billions of U.S. dollars)

1 Less cumulated inflow of non-debt-creating flows.

Another significant feature of developments in 1985 was the reduced reliance of capital importing developing countries on exceptional sources of finance. Net use of Fund credit was virtually zero and reliance on debt rescheduling declined from $37 billion in 1984 to $32 billion in 1985. However, as these figures indicate, debt rescheduling continued to be an important source of funds and the amounts rescheduled were still large by historical standards. Moreover, funds supplied through concerted lending packages, although lower than the average of $12 billion provided annually in 1983–84, were nevertheless some $5—6 billion in 1985, and therefore approximately three fourths of the total net private lending to the capital importing developing countries.

Despite the reduction in use of arrears and recourse to Fund credit referred to earlier, some developing countries were not able to contain their financing requirement to a financeable level. Arrears continued to accumulate in Africa and in the mineral exporting countries, and arrears appeared for the first time in recent years in the non-oil Middle East. Moreover, for some developing countries, net use of Fund credit continued at high levels and reserves were depleted.

Another unsatisfactory element of the situation in 1985 was that capital flows remained at a low level. Total net borrowing by the capital importing countries, for example, was equivalent to only 7 percent of imports in 1985. This continued tightness of the external financing situation, for the fourth year in succession, clearly has adverse implications for the long-run growth prospects of the financially constrained countries. Recognizing this, the Secretary of the U.S. Treasury, James A. Baker III, proposed at the Annual Meetings of the Fund and World Bank in Seoul a debt initiative designed to reinforce the debt strategy. This initiative was widely welcomed for its focus on moving to a higher growth path in which larger capital flows from both private and official sources could be justified by structural economic reforms that would permit faster growth of exports and output. In support of this goal, commercial and multilateral development banks were asked to provide additional lending in 1986–88 and the debtor countries were asked to introduce—or to strengthen—policies that would promote growth-oriented adjustment.

Because of the relatively slow growth of lending in 1985, the external debt of capital importing developing countries increased by only 7½ percent in terms of U.S. dollars in that year. Moreover, the growth of debt would have been only about 3½ percent but for the effects of the depreciation of the U.S. dollar on the valuation of the non-dollar component of the debt.

Despite the slow growth of debt, the capital importing countries’ ratio of debt to exports of goods and services reached a new peak of 168 percent in 1985—a reflection of the decline in export earnings. Moreover, the marked regional differences in the debt ratio widened somewhat in 1985 (Table 12). These divergent trends across regions not only indicate differences in the degree of control that countries have maintained over their external borrowing, but also point to underlying differences in the extent to which the debtors have adopted exportled developmental strategies. These differences are also present in the regions’ debt service ratios, though in this case the divergences are muted by the effects of debt rescheduling.

Table 12.Capital Importing Developing Countries: Debt and Debt Service Ratios, by Region, 1981-85(In percent of exports of goods and services)
19811982198319841985
Debt1
All capital importing countries124151160153168
Western Hemisphere210273291276297
Non-oil Middle East144165194205223
Africa112148165165178
Europe117125132129145
Asia7186908498
Debt service1
All capital importing countries2125222324
Western Hemisphere4151424141
Africa1521232527
Europe2123222427
Non-oil Middle East2126272932
Asia1011111213
Memorandum
Capital importing countries, debt service rescheduled1477

Regions are ranked by 1985 ratios.

Regions are ranked by 1985 ratios.

Debt service payments increased by $3 billion in 1985 to $129 billion, bringing the debt service ratio to a record 23.8 percent. Despite the increase in payments, the debt service picture in 1985 was in some respects less difficult than in recent years: interest payments leveled off at $74 billion as a result of the lagged effect of recent reductions in international interest rates. Moreover, the $4 billion increase in amortization payments in 1985 was in part caused by a reduction in the amounts rescheduled, which was a further sign of the general easing of financial pressures in 1985. Nevertheless, the debt service position of many countries remained critical, especially in Africa and the Western Hemisphere.

The remaining $20 billion loss in oil export receipts would be incurred mainly by oil exporting industrial and centrally planned economies.

International bond issues net of redemptions and bank purchases of bonds reached $62 billion in 1985, more than three times the level of such issues in 1980.

The currency composition of identified foreign exchange reserves is based on the Fund’s currency survey and on estimates derived mainly from official national reports. These identified reserves differ from total foreign exchange reserves, which also include the foreign exchange reserves for which information on the currency composition is not available.

The causes and the geographical distribution of the discrepancy are the subject of investigation by a working party established by the Fund for this purpose.

Exchange arrangements maintained by member countries as of June 30, 1986, are detailed in Appendix Table II.1.

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