Chapter

Chapter 1 Developments in the World Economy

Author(s):
International Monetary Fund
Published Date:
September 1987
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INTRODUCTION

The international economic and financial situation changed substantially during 1986 and the early part of 1987. Economic growth in the industrial countries1 slowed, real primary commodity prices continued to decline, external imbalances widened despite ongoing adjustments in real trade balances, protectionist pressures and actions intensified, and the external financial situation of many developing countries deteriorated further. These developments cast a shadow on the more positive aspects of the situation, including continued progress in controlling inflation, relatively rapid output growth in many non-fuel exporting developing countries, further downward movements in interest rates, the steps taken to strengthen the coordination of policies among the major industrial countries, and the attainment of a pattern of exchange rates among key currencies that better reflects economic fundamentals.

Although the growth of 3¼ percent in world output in 1986 was similar to that in 1985—marking the fourth year of recovery from the 1982 recession—the momentum of growth was weaker than expected. The shortfall in growth mainly reflected developments in the industrial countries, where the growth of real output slowed from 3¼ percent in 1985 to 2¾ percent in 1986; on a fourth-quarter-to-fourth-quarter basis, growth in these countries fell to only 2¼ percent in 1986. This outcome was clearly disappointing in terms of the benefits that had been expected to result from lower oil and non-oil commodity prices, the adjustment of the pattern of exchange rates, and easier monetary conditions. Part of the explanation seems to be that the terms of trade gains of industrial countries were relatively slow to feed through to domestic demand, whereas the corresponding reduction in real net imports of developing countries—and hence the decline in real net exports of industrial countries—was comparatively rapid. A similar asymmetry in the responses to the substantial exchange rate changes that occurred between the first quarter of 1985 and the first quarter of 1987 also contributed to the slowdown, with growth weakening more quickly in countries with appreciating currencies than it strengthened in those with depreciating currencies. These asymmetries in the adjustments to both types of relative price changes appear to have exerted a dampening impact on demand and activity in the short run.

The developing countries’ growth performance was little changed. The moderate acceleration in aggregate growth—from 3.3 percent in 1985 to 4.0 percent in 1986—masked divergent trends among countries. Output in the fuel exporting countries stagnated as a result of the real adjustment necessitated by declining export earnings, whereas growth in the larger non-fuel exporting developing countries in Asia and the Western Hemisphere firmed somewhat, partly in response to improved competitiveness. Growth decelerated and per capita incomes declined in most countries in sub-Saharan Africa.

The continued widening of current account imbalances, particularly among the three largest industrial countries—the United States, Japan, and the Federal Republic of Germany—has become a subject of increasing concern. Because of the threat of protectionism and the risk of financial market unrest, these imbalances are potentially destabilizing, with serious implications for growth throughout the world economy if they were to persist over an extended period of time. As a reflection of these concerns, the major industrial countries have taken a number of steps to enhance the coordination of policies with a view to promoting more balanced growth and reducing current account imbalances. Following the Plaza Accord of September 1985, which emphasized the need to achieve exchange rate relationships that better reflected underlying fundamentals, the Tokyo Economic Declaration of May 1986 called for a significant strengthening of multilateral surveillance through the use of economic indicators. More recently, the Louvre Accord of February 1987 further intensified efforts to coordinate economic policy. In particular, it outlined the commitments of surplus countries designed to strengthen domestic demand and to reduce external surpluses while maintaining price stability, and of deficit countries to encourage steady, low-inflation growth while reducing their domestic imbalances and external deficits. Given these undertakings, the Louvre Accord also stated the participating countries’ intention to foster stability of exchange rates around current levels following the substantial realignment that had taken place since the Plaza Accord. These policy intentions were subsequently reaffirmed by heads of state or government of the seven major industrial countries in the Economic Declaration issued following the June 1987 summit in Venice (see Box 1).

Box 1.RECENT INTERNATIONAL ACCORDS ON THE GLOBAL ECONOMY

The Plaza Accord. The members of the Group of Five (the ministers of finance and central bank governors of France, the Federal Republic of Germany, Japan, the United Kingdom, and the United States) met at the plaza Hotel in New York on September 22, 1985. In a joint statement issued following the meeting (the “Plaza Accord”), the participants recognized that “significant progress” had been made in promoting the convergence of favorable economic performance among the participating countries, and went on to set out the policy intentions of these countries to achieve increased and more balanced growth, as well as exchange rate relationships that better reflected economic fundamentals. Following this agreement, a number of the countries concerned engaged in coordinated exchange market intervention and, in early 1986, also undertook concerted discount rate reductions.

Tokyo Economic Declaration. At their twelfth economic summit held in Tokyo on May 4-6, 1986, the heads of state or government of the seven major industrial countries (Canada, France, the Federal Republic of Germany, Italy, Japan, the United Kingdom, and the United States) renewed the commitment to “close and continuous coordination” of their national economic policies. They established a new Group of Seven finance ministers to work together more closely and frequently in the period between summit meetings. In their communiqué, known as the “Tokyo Economic Declaration,” they called on the ministers to review collectively in their meetings economic objectives and forecasts and proposed that they use a set of indicators of economic policies and performance “with a particular view to examining their mutual compatibility.” The participants also reaffirmed the intention of their governments to cooperate with the Fund in strengthening multilateral surveillance, stressed the continued importance of the case-by-case approach to international debt problems, and called for the early launching of a new round of trade negotiations under the General Agreement on Tariffs and Trade.

Louvre Accord. The finance ministers and central bank governors of six major industrial countries (Canada, France, the Federal Republic of Germany, Japan, the United Kingdom, and the United States) at a meeting on February 22, 1987 at the Palais du Louvre in Paris agreed to intensify efforts at economic policy coordination to promote more balanced economic growth and to reduce existing imbalances. In their communiqué (the “Louvre Accord”), the ministers noted that progress had been made since the Tokyo summit meeting in “efforts to achieve sustainable, non-inflationary expansion.” They stated that surplus countries committed themselves to following policies designed to strengthen domestic demand and to reduce external surpluses while maintaining price stability. At the same time, deficit countries committed themselves to encourage steady, low-inflation growth while reducing their domestic imbalances and external deficits. The ministers also observed that exchange rate movements since the Plaza Accord had brought currencies within ranges broadly consistent with underlying economic fundamentals and agreed to cooperate to foster stability of exchange rates around current levels.

Venice Economic Declaration. The heads of state or government of the seven major industrial countries (Canada, France, the Federal Republic of Germany, Italy, Japan, the United Kingdom, and the United States) at their thirteenth economic summit meeting held in Venice, Italy, on June 8-10, 1987 agreed to strengthen the existing arrangements for multilateral surveillance and economic coordination. In their communiqué (the “Venice Economic Declaration”), the participants agreed to strengthen, with the assistance of the Fund, the surveillance would involve (1) a commitment by each country to develop medium-term objectives and projections for its economy, as well as for the group of countries to develop objectives and projections that were mutually consistent, and (2) the use of performance indicators to review and assess economic trends, and to determine whether there were significant deviations from an intended course that would require remedial actions to be considered. The heads of state or government also called on the Group of Seven finance ministers to intensify their coordination efforts, to monitor economic developments closely in cooperation with the Managing Director of the Fund, and to consider further improvements as appropriate to make the coordination process more effective.

Another area of continuing concern is the external financial situation of many developing countries, which deteriorated further in 1986. For some countries, this deterioration was partly attributable to slippages in the implementation of adjustment policies. In addition, many countries were faced with a sharp worsening of their external environment. A cessation of net private international lending to developing countries, related in part to delays in reaching agreement on some major debt negotiations, meant that their external borrowing in 1986 was reduced yet further from the previous year’s levels. This reduction occurred despite exceptionally large losses in some developing countries’ terms of trade, which reached the equivalent of

100 billion for the developing countries as a whole. The resulting shortfall was met partly through drawing on foreign exchange reserves and partly through reductions in net imports, which lowered living standards in many developing countries and hindered growth in the industrial countries. Despite the very low levels of borrowing and declining interest rates, however, ratios of debt and debt service to exports continued to worsen, largely because of declining export prices. The economic and financial situation was particularly difficult for some of the fuel exporting countries and for a number of the low-income countries in sub-Saharan Africa.

In view of the mixed performance of the worl4 economy over the past year, there is a special need for economic policies conducive to noninflationary growth, stable exchange markets, and a gradual reduction in payments imbalances among the largest industrial countries. In particular, there is a need for firm action to reduce the federal budget deficit in the United States, and for industrial countries with large external surpluses, particularly Japan and the Federal Republic of Germany, to promote an adequate rate of growth of domestic demand. Several other industrial countries and some newly industrialized countries may also have room for maneuver in their economic policies to encourage a more rapid rate of growth of imports. In indebted developing countries, policies to mobilize and retain domestic savings need to be strengthened to promote adjustment and growth. At the same time, all countries need to pursue structural reforms aimed at removing market rigidities and improving economic efficiency while encouraging resistance to protectionism.

The remainder of this chapter reviews recent developments in the world economy in more detail. This serves as a background for Chapter 2, which presents the policies and activities of the Fund.

DOMESTIC ACTIVITY AND POLICIES

INDUSTRIAL COUNTRIES

Policy Setting

Both the orientation and thrust of economic policies in industrial countries have been modified significantly over the past eighteen months. The changes have taken place in the context of enhanced efforts to coordinate economic policies among the major countries and can be seen as a natural evolution of the medium-term strategy that has guided policy since the beginning of the 1980s. A key objective of this strategy has been to reduce inflation to an acceptable level, a goal that has been substantially achieved in a number of countries. More recently, exchange rate and balance of payments considerations have received increased emphasis, together with the need to sustain activity while safeguarding the progress made in containing inflation. As a result, policy stances have also changed, with monetary conditions being allowed to ease significantly and budgetary policies becoming less restrictive in some countries where budget consolidation efforts have already met with a degree of success. At the same time, fiscal policy has tightened in countries with large budgetary or external deficits.

The strengthened coordination of policies among the major countries has had a number of beneficial effects. The changes in the mix and stance of policies Jiave been instrumental in promoting a more sustainable pattern of growth among countries. The policy changes have also been supportive of the substantial realignment of key exchange rates that occurred in the wake of the Plaza Accord, and of the subsequent efforts to stabilize exchange rates in the months leading up to and following the Louvre Accord, furthermore, even though current account imbalances continued to widen in 1986, particularly among the three largest economies, the policy adaptations envisaged in the Louvre Accord should be conducive to a substantial reduction of the external imbalances over the medium run.

Recent budgetary developments in the United States are an important element of the new policy configuration. Since the passage by the U.S. Congress of the Balanced Budget and Emergency Deficit Control Act (the so-called Gramm-Rudman-Hollings legislation) in December 1985, the budgetary situation has improved significantly even though the Act has not operated fully as originally intended. While there is continued uncertainty about the pace of deficit reduction, as well as about the means to achieve it, current estimates of the federal budget deficit for the fiscal year 1986/87 imply a significant improvement relative to previous trends. It is the U.S. Administration’s intention to achieve a further substantial deficit reduction in the fiscal year 1987/88.

Fiscal policy has also been modified in the other major industrial countries. In Japan and the Federal Republic of Germany, countries that have been steadily reducing their budget deficits since the beginning of the decade, the budgetary position eased in 1986. Measures or intentions announced in the wake of the Louvre Accord in February 1987 suggest that fiscal policy will be expansionary in both countries in the near term. Moreover, fiscal policy has become less restrictive in the United Kingdom and—at the level of general government—in France. In contrast, a substantial budgetary tightening has occurred in Canada and Italy, following a sharp rise in their budget deficits during the first half of the decade (Table 1). Among the smaller industrial countries, fiscal policy was tightened significantly in Australia, Denmark, Spain, and Sweden, reflecting balance of payments constraints, inflationary pressures, or budget consolidation objectives. Fiscal policy was also tightened in Norway, where the budgetary situation nevertheless deteriorated markedly as a result of lower royalties and tax revenue from the energy sector. Overall, budgetary developments in the industrial countries suggest that there was a small withdrawal of fiscal stimulus in 1986, in contrast to the generally expansionary thrust experienced from 1982 to 1985.

Table 1.Major Industrial Countries: Fiscal Balances and Impulses, 1982-861(In percent of GNP/GDP)
Central Government2General Government3
1982198319841985198619821983198419851986
Fiscal balance
(+ surplus, - deficit)
Canada-5.4-6.2-6.9-6.8-4.9-5.7-6.6-6.6-6.6-5.3
United States-4.1-5.6-5.1-5.1-5.0-3.5-3.8-2.8-3.3-3.5
Japan-5.9-5.6-4.7-4.0-3.6-3.6-3.7-2.1-0.8-0.6
France-2.7-3.2-3.3-3.3-2.8-2.8-3.2-2.7-2.9-2.9
Germany, Fed. Rep. of4-2.4-1.9-1.6-1.3-1.2-3.3-2.5-1.9-1.1-1.2
Italy-13.2-14.0-13.2-14.0-12.3-11.3-10.7-11.5-12.2-11.2
United Kingdom-2.7-3.0-3.1-2.3-2.3-2.3-3.6-3.8-2.6-2.8
Seven major countries above-4.6-5.3-5.0-5.0-4.5-3.9-4.1-3.4-3.3-3.3
Seven major countries except the United States-5.0-5.1-4.9-4.6-4.0-4.3-4.4-3.9-3.3-3.0
Fiscal impulse
(+ expansionary, - contractionary)
Canada1.40.61.50.5-1.51.10.91.50.9-0.8
United States0.31.70.70.3-0.30.50.60.60.70.3
Japan-0.3-0.5-0.6-0.5-0.7-0.1-0.2-1.2-1.0-0.7
France0.60.1-0.1-0.2-0.51.6-0.2-0.8-0.1
Germany, Fed. Rep. of-0.7-0.20.2-0.3-1.9-0.50.4-0.60.3
Italy1.4-0.2-0.50.8-1.5-1.4-1.70.80.9-0.9
United Kingdom-0.80.70.3-0.40.2-1.11.60.5-0.70.4
Seven major countries above0.20.70.30.1-0.50.20.20.2-0.1
Seven major countries except the United States-0.1-0.1-0.1-0.6-0.4-0.1-0.2-0.3-0.3

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/GDP and/or expenditures increase more rapidly than potential GNP/GDP. For a detailed description of this indicator, see Peter S. Heller, Richard D. Haas, and Ahsan S. Mansur, A Review of the Fiscal Impulse Measure, Occasional Paper No. 44 (Washington: International Monetary Fund, May 1986). 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 GNPs/GDPs in the preceding three years.

Data for Canada and the United Kingdom are on a national income accounts basis. Data tor 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 and the Federal Republic of Germany 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.

In discussions of fiscal policy the German authorities normally refer to the financial position of the territorial authorities, which include federal, state, and local authorities but exclude social security (the latter being included in the definition of general government). The deficit of the territorial authorities amounted to 2.1 percent of GNP in 1985 and 2.2 percent of GNP in 1986 as compared with 4.4 percent of GNP in 1982.

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/GDP and/or expenditures increase more rapidly than potential GNP/GDP. For a detailed description of this indicator, see Peter S. Heller, Richard D. Haas, and Ahsan S. Mansur, A Review of the Fiscal Impulse Measure, Occasional Paper No. 44 (Washington: International Monetary Fund, May 1986). 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 GNPs/GDPs in the preceding three years.

Data for Canada and the United Kingdom are on a national income accounts basis. Data tor 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 and the Federal Republic of Germany 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.

In discussions of fiscal policy the German authorities normally refer to the financial position of the territorial authorities, which include federal, state, and local authorities but exclude social security (the latter being included in the definition of general government). The deficit of the territorial authorities amounted to 2.1 percent of GNP in 1985 and 2.2 percent of GNP in 1986 as compared with 4.4 percent of GNP in 1982.

Monetary developments in the industrial countries in 1986 reflected the broadening of the policy considerations mentioned above. While the need to maintain downward pressure on inflation remained an important objective, the better fiscal outlook and the continued improvement in price performance provided monetary authorities with scope for some discretion, particularly when they judged that there had been shifts in velocity associated with reductions in inflation expectations or with financial deregulation and innovation. As a result, monetary growth was fairly rapid in most of the major countries in 1986, despite a significant deceleration in the growth of nominal GNP, particularly on a through-the-year (fourth-quarter-over-fourth-quarter) basis (Table 2).

Table 2.Major Industrial Countries: Monetary Aggregates and Nominal GNP, 1984-861(Annual changes, in percent)
FourthQuarter2
19841985198619851986
Narrow money (M1)3
Canada3.44.24.98.45.4
United States7.09.213.412.115.3
Japan2.85.06.93.010.4
France11.47.87.06.45.5
Germany, Fed. Rep. of3.24.88.05.17.6
Italy12.313.710.110.510.7
United Kingdom14.717.825.621.722.1
Seven major countries above7.08.611.59.812.8
Broad money4
Canada4.49.48.710.79.0
United States7.99.18.08.88.9
Japan7.88.48.78.79.2
France9.88.35.45.74.5
Germany, Fed. Rep. of3.84.95.95.16.8
Italy12.313.99.011.29.4
United Kingdom9.214.418.617.718.8
Seven major countries above7.89.28.59.09.1
Nominal GNP
Canada9.87.66.47.95.1
United States10.86.35.66.64.5
Japan6.46.34.36.03.2
France8.87.56.98.45.5
Germany, Fed. Rep. of5.04.85.54.75.5
Italy14.111.811.012.39.8
United Kingdom7.29.76.69.96.0
Seven major countries above9.26.95.97.04.8

Composites for the country groups are averages of percentage changes for individual countries weighted by the average U.S. dollar value of their respective CNPs 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 4- certificates of deposit (CDs), 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 + CDs 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 CNPs 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 4- certificates of deposit (CDs), 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 + CDs 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.

Exchange rate considerations and concerns about the pace of output growth played a significant role in the conduct of monetary policy in 1986 and early 1987. These considerations were instrumental in bringing about the two rounds of coordinated discount rate reductions involving several major countries in early 1986. Subsequently, in an effort to support domestic activity and stabilize the yen-dollar exchange rate, Japan decided to reduce its discount rate by a further 50 basis points to 3 percent on October 31, 1986, in conjunction with the announcement of policy coordination understandings with the United States; a further reduction to 2.5 percent was decided upon on February 20, 1987 (with effect from February 23), prior to the Louvre Accord. These discount rate reductions supported a general trend toward lower interest rates that lasted through the opening months of 1987. Over the past year, exchange rate uncertainty temporarily led to increases in short-term interest rates in the United Kingdom, France, and several of the smaller industrial countries. However, such increases were subsequently reversed.

The tendency toward a narrowing of interest rate differentials in favor of non-U.S. securities that began in 1984 (Chart 1) was arrested in early 1987, following the decision of the major countries to stabilize exchange rates. The continued downward pressure on the U.S. dollar during March and April 1987 was accompanied by substantial intervention in foreign exchange markets. At the same time, interest rates began to rise in the United States, whereas they continued to decline in most other countries. These developments also reversed the declining trend of the London interbank offered rate (LIBOR) on six-month U.S. dollar deposits, which at the end of April 1987 stood at 7.3 percent, rising from 6.1 percent in the fourth quarter of 1986 but still substantially lower than the 11.3 percent registered in 1984.

Chart 1.Major Industrial Countries: Interest Rates, 1980-First Quarter 1987

(In percent)

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

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

3 France, Italy, the United Kingdom, and Canada.

4 Interest rates deflated by an average of the increase in the GNP and the private final domestic demand deflators in the current and the following two quarters; for the most recent periods, fund staff projections of the deflators are used.

Efforts to enhance the functioning of markets with a view to improving resource allocation continue to be pursued in all the industrial countries. In addition to the deregulation of financial markets, programs of privatization of public sector enterprises have been implemented or announced in a large number of countries. Governments have also turned their attention to the distortions created by tax systems, and major tax reforms have been implemented or are planned in several countries. However, despite the growing list of achievements in the area of structural reform, much remains to be done, both to reduce labor market rigidities—particularly in Europe—and to dismantle trade barriers—in all countries. In this context, large subsidies to agriculture and to certain industrial sectors remain major impediments to an efficient allocation of resources, both within individual industrial countries and on a global scale.

Domestic Activity

The growth of real GNP in industrial countries slowed to 2¼ percent in 1986 on a through-the-year basis, the lowest growth rate since the current upswing began in late 1982 (Table 3). The deceleration in growth can be traced primarily to asymmetries among countries in their responses to the pronounced changes in terms of trade and exchange rates in 1986. In particular, because declining oil and commodity prices had a rapid and vigorous contractionary impact on developing countries’ imports, the industrial countries experienced a sharp deterioration in their real net exports. In contrast, the impact of the terms of trade gain on domestic demand in industrial countries was relatively moderate. Moreover, the decline in oil prices adversely affected industrial countries and regions with large energy sectors. Finally, activity appears to have slowed more quickly in countries with appreciating currencies than it strengthened in those with depreciating currencies. Preliminary indicators for the first half of 1987 suggest that growth continued at a relatively moderate pace in most countries.

Table 3.Industrial Countries: Changes in Output and Prices, 1969-861(Annual changes, in percent)
AverageFourth Quarter3
1969-7821979198019811982198319841985198619851986
Real GNP
Canada4.83.91.53.7-3.23.26.34.33.34.01.8
United States2.82.5-0.21.9-2.53.66.83.02.93.32.2
Japan5.85.34.33.73.13.25.14.72.54.22.0
France44.53.51.10.31.90.71.41.72.22.52.0
Germany, Fed. Rep. of3.53.91.5-1.01.83.02.52.42.22.4
Italy43.44.93.91.10.20.53.52.72.73.02.6
United Kingdom52.22.7-2.5-1.41.53.33.03.43.02.63.8
Other industrial countries3.63.12.30.50.41.73.32.92.22.62.0
All industrial countries3.43.41.31.4-0.42.74.93.22.73.22.2
Of which,
Seven major countries above3.43.41.11.6-0.52.85.23.22.83.32.3
European countries3.53.51.50.61.62.72.62.52.52.5
GNP deflator
Canada7.210.010.610.88.75.03.33.23.03.83.2
United States6.78.89.19.66.43.83.73.22.63.22.2
Japan8.23.03.83.21.90.81.21.51.81.71.3
France48.510.412.211.912.59.67.25.84.65.73.5
Germany, Fed. Rep. of5.64.04.84.04.43.22.02.23.12.43.0
Italy412.115.920.718.516.215.210.38.88.09.07.1
United Kingdom511.814.519.911.57.65.14.16.03.57.12.1
Other industrial countries9.07.79.19.49.77.66.75.65.75.55.3
All industrial countries7.88.29.48.97.25.14.23.83.33.92.8
Of which,
Seven major countries above7.68.29.48.86.84.73.83.53.03.72.5
European countries8.89.111.39.99.47.65.85.34.75.54.0

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.

From fourth quarter of preceding year.

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.

From fourth quarter of preceding year.

GDP at market prices.

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

In the United States, the slowdown in growth to 2¼ percent in 1986 on a through-the-year basis, despite buoyant consumer spending and residential construction, reflected declines in business fixed investment and inventory investment and continued weakness of net exports. The decline in business fixed investment was in large measure attributable to a drop in investment in the petroleum industry, in the wake of plunging oil prices, and some initial negative effects of tax reform on business investment. In the latter part of 1986, consumer spending decelerated and the real external balance began to improve. Final domestic demand remained weak in the first quarter of 1987, but output growth picked up, reflecting a surge in inventories and a marked improvement in the real foreign balance. In Canada, under the dampening influence of a sizable terms of trade loss, weakening foreign demand, and a significant fiscal correction, domestic demand and output growth also slowed markedly during 1986.

Japan experienced a significant deceleration in growth in 1986, largely reflecting a marked decline in real net exports—the first since 1979. Domestic demand growth accelerated slightly, as the terms of trade gain, which was equivalent to more than 2 percent of GNP, fed through only gradually. Whereas the growth of government consumption and residential construction accelerated significantly, private consumption was relatively subdued compared with developments in other industrial countries. Overall, real GNP growth slowed from 4¾ percent in 1985 to 2½ percent in 1986; from the fourth quarter of 1985 to the fourth quarter of 1986, growth slowed to only 2 percent.

Growth in the major European countries was also weaker than expected and overall remained unchanged from the previous year at some 2½ percent. Italy and the United Kingdom recorded the strongest growth rates. Growth in the Federal Republic of Germany and France was similar to or only slightly below the average for other industrial countries. The terms of trade gains, easier fiscal policies in some countries, and lower inflation and interest rates contributed to a perceptible acceleration in the growth of domestic demand in each of the major European countries, with annual rates of increase in the 3-4 percent range. However, this quickening in the pace of domestic demand growth was largely offset by sharp deteriorations in real net exports in all of these countries.

The performance of the smaller industrial countries was also disappointing, with real GNP growth slowing from close to 3 percent in 1985 to 2¼ percent in 1986. Again, this deceleration was attributable primarily to a decline in net exports and occurred notwithstanding a modest acceleration in domestic demand growth. For most of the smaller industrial countries, growth ranged from 1½ percent to 2½ percent. Denmark, Norway, and Spain realized growth of 3 percent or more, whereas growth slowed significantly in Australia—partly reflecting a marked deterioration in its terms of trade. In Ireland and New Zealand, the level of output fell slightly.

Despite the moderation in the pace of output growth, employment growth in the industrial countries accelerated marginally to 1.6 percent in 1986, compared with 1.4 percent in 1985. Canada and the United States once again recorded the largest increases in employment among the major industrial countries. However, employment growth also strengthened in Europe, reflecting, at least in part, the completion of a period of adjustment to earlier disturbances and a trend toward lower real wage increases. Extensive job training and employment schemes introduced in some countries, particularly France and the United Kingdom, also contributed. Among the smaller industrial countries, employment increased by 2.4 percent in Spain, after nearly a decade of significant declines, while Australia recorded employment growth of around 3½ percent. Ireland and Finland were the only industrial countries to experience a decline in employment in 1986.

While the strength of employment in 1986 was encouraging, it was offset by an increased number of new entrants to the labor force so that the overall unemployment rate in industrial countries remained unchanged at 8 percent. Since demographic pressures on labor markets generally have begun to diminish, this acceleration in labor force growth was due entirely to an increase in participation rates which appears to have been triggered by the improved employment prospects. For Europe as a whole, the unemployment rate remained unchanged at 10.7 percent in 1986. In contrast, the unemployment rate continued to decline in the United States, falling in early 1987 to 6.3 percent—almost 4 percentage points lower than in the major European countries (Chart 2). In seven of the European countries—France, Italy, the United Kingdom, Belgium, Ireland, the Netherlands, and Spain—unemployment rates have remained in double digits. In Japan, reflecting the difficulties experienced by the manufacturing sector, unemployment has increased steadily in recent months, reaching 2.9 percent in early 1987, an unusually high level by Japanese standards.

Chart 2.Major Industrial Countries: Unemployment, 1967-First Quarter 1987

(In percent of labor force)1

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

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

Inflation

The marked reduction in inflation and inflation expectations since 1980 has been one of the major accomplishments of the medium-term economic strategy pursued by the industrial countries. Price increases have decelerated in each year of the current expansion, in sharp contrast to the upward ratcheting of inflation rates experienced during the recoveries of the 1960s and 1970s. In 1986, consumer prices in the industrial countries as a group increased by only 2.3 percent, the lowest rate since the early 1960s and less than one fifth of the rate in 1980. To an important extent, the additional decline in many price indicators in 1986 can be attributed to the sharp decline in oil prices and the persistent weakness in non-oil commodity prices. Some rebound in consumer prices was observed in the early months of 1987 in several countries as these favorable price effects began to wane (Chart 3). Nevertheless, domestic cost pressures have remained quite moderate.

Chart 3.Major Industrial Countries: Consumer Price Inflation, 1980-April 1987

(In percent)1

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

While the consistent anti-inflationary stance of macroeconomic policies and the benefits of earlier structural reforms, particularly in labor markets, have established a favorable underlying trend in inflation in recent years, price developments in 1986 were dominated by the sharp declines in the prices of oil and other commodities, as noted above. For the industrial countries as a group, import prices decreased by some 12 percent in 1986, with Japan recording a particularly sharp decline of almost 36 percent. Virtually all of the industrial countries benefited from this reduction in imported inflation. However, consumer prices were affected more in some countries than in others as a result of changes in exchange rates and because of differences in policies and institutional arrangements affecting the extent and timing of the pass-through. For example, in several countries, the rate of increase of the implicit GNP deflator accelerated in 1986 because the business sector (producers as well as distributors) raised its profit margins. International oil prices and the prices of non-oil commodities in U.S. dollar terms began to recover in late 1986 and early 1987. However, the delayed effects of the previous terms of trade changes continued to exert a favorable influence on consumer prices in many countries in the opening months of 1987.

Domestically generated price pressures also moderated further in 1986, albeit by less than in previous years. For the industrial countries as a group, the rate of increase of hourly wages in manufacturing fell from 5.6 percent in 1985 to 4.0 percent in 1986. This deceleration in wage inflation was widespread, with the most pronounced reductions occurring in the United States, Japan, France, and Italy among the major industrial countries. Nevertheless, because of slower productivity growth, particularly in the three largest economies, economy-wide unit labor costs for the industrial countries as a whole rose by 3.5 percent, only slightly less than the increase of 3.9 percent recorded in 1985; the rise in unit labor costs in manufacturing decelerated, from 1.9 percent in 1985 to 1.4 percent in 1986.

On balance, these external and domestic developments led not only to a further decline in inflation in the industrial countries as a group but to a further convergence in inflation performance as well. Among the larger countries, France and Italy, which experienced relatively high inflation rates during the first half of the 1980s, recorded particularly marked reductions in their inflation rates. In Japan and the Federal Republic of Germany the decelerations were less marked. Despite its depreciating currency, the United States also registered a further deceleration in the rate of increase of consumer prices in 1986, largely as a result of the decline in world oil prices and the fact that the increase in U.S. import prices was relatively moderate, suggesting that foreign suppliers have reduced their profit margins in an effort to maintain their share of the U.S. market. However, in early 1987 the rate of increase of consumer prices in the United States accelerated again under the influence of rising import prices.

Inflation rates decelerated in the smaller industrial countries as well, but generally by less than in the major countries. In Austria, Belgium, the Netherlands, and Switzerland, consumer price increases in 1986 were below the average for the major countries. In the other smaller industrial countries, inflation generally declined, but remained higher than in the major countries. Australia and Norway were the only industrial countries that registered a deterioration in inflation performance last year.

DEVELOPING COUNTRIES

Policy Setting

Policy adjustments varied widely among developing countries in 1986, but in most cases appear to have been largely prompted by the changes in the external circumstances facing these countries. For many countries, external developments were adverse. The most important of these adverse developments was the sharp deterioration in many countries’ terms of trade resulting from the decline in the prices of oil and non-oil commodities relative to manufactures. The resulting losses in export receipts led not only to a worsening of current account positions but also to a weakening of fiscal revenues, which often depend heavily on taxes based on receipts from foreign trade. These difficulties were accentuated by financing constraints, as net private international lending to developing countries, which had been shrinking rapidly since the onset of the debt crisis in 1982, came to a halt in 1986. Although partially offset by the decline in international interest rates and a strong rise in the volume of exports to industrial countries, the negative factors often were dominant. The resulting tightening of the foreign exchange constraint spurred a large number of countries to intensify their adjustment efforts and to curtail absorption.

In the fuel exporting countries, which were the hardest hit by the deterioration in the external environment, the revenue losses resulting from lower oil prices led to large cutbacks in government expenditures and imports, especially in those countries with limited capacity to borrow or to liquidate foreign assets. Despite the efforts to adjust to the loss of export earnings, the budgetary situation of these countries deteriorated sharply. Because of the weakness of commodity prices, many primary product exporting countries also experienced losses in export-related fiscal revenues, which carried over into budget positions. As a result, the central government deficit for developing countries as a whole rose from 4.5 percent of GDP in 1985 to 6.2 percent of GDP in 1986.

However, external influences were not uniformly adverse for developing countries in 1986. The decline in international interest rates eased the pressure on the expenditure side of the fiscal accounts in countries that carry a large volume of floating rate debt. Moreover, for oil importing countries and especially those that export a significant amount of manufactures, the decline in oil prices alleviated the external constraints and allowed greater flexibility in policy options. For several countries in this group, notably some of the Asian exporters of manufactures, the decline in interest rates and oil prices, aided by a strong export performance, permitted an easing of the restrictive fiscal stances that had been in place for some years and the achievement of improved creditworthiness through reserve accumulation and debt repayments. However, several other oil importing developing countries that also benefited from the relaxation of the external and fiscal constraints did not use the opportunity to consolidate their adjustment efforts. While these countries often initiated measures of fiscal and monetary discipline, results were typically modest because of policy slippages. Instead, the externally generated real income gains were used to bolster domestic demand, particularly consumption.

Many low-income countries in Africa faced a generally difficult external environment and, having less latitude in their policy choices, were compelled to initiate corrective economic measures. As exporters of primary commodities, most of these countries incurred sizable losses in export receipts and in associated fiscal revenues. At the same time, they did not benefit much from the decline in international interest rates, since their external debt is mainly on concessional, fixed-rate terms. Consequently, their budgetary situation worsened despite some efforts to limit the growth of expenditures. Nevertheless, the decline in oil prices, together with improved weather conditions that contributed to lower food prices, provided these countries with an opportunity to dismantle price controls. In general, the implementation of structural adjustment measures, including efforts to correct overvalued currencies, which had flagged in preceding years in some countries, appears to have been strengthened in 1986. Aimed at giving market forces and the private sector a greater role in promoting development, these reform packages were initiated in some cases as a prerequisite to the allocation of additional official aid.

Monetary and credit policies in the developing countries have continued to be directed at dampening inflationary pressures. The sharp deceleration in the growth of broad money for all developing countries in 1986 largely reflected the reductions achieved in a small group of high-inflation countries (including Argentina, Bolivia, Brazil, and Israel) as a result of wide-ranging anti-inflationary measures. The reduced overall availability of domestic credit continued to impinge heavily on the private sector as the cessation of net private international lending to developing countries and a desire in many cases to limit recourse to external borrowing compelled governments to rely increasingly on domestic sources of borrowing for meeting their financing needs.

Domestic Activity

Reflecting the difficult external circumstances faced by many developing countries and the policy responses they brought about, output growth remained quite subdued in much of the developing world in 1986. Moreover, because of the sharp reduction in the purchasing power of exports, increases in output were insufficient to prevent significant declines in living standards in many countries. For the developing countries as a group, the growth of GDP recovered from 3¼ percent in 1985 to 4 percent last year, mainly reflecting stronger growth in some of the larger countries in Asia and the Western Hemisphere (Table 4).

Table 4.Developing Countries: Growth of Real GDP, 1969-861(In percent)
AverageFrom Preceding Year
Weights21969-78319791980198119821983198419851986
Developing countries1006.04.33.41.61.61.64.13.34.0
Memorandum
Median growth rates5.34.83.63.01.61.63.02.82.9
By region
Africa125.13.33.82.01.0-1.61.42.10.8
Asia325.84.55.45.55.27.67.96.46.3
Europe115.93.81.11.94.02.43.6
Middle East188.21.8-2.5-2.10.30.10.2-1.11.2
Western Hemisphere275.86.16.10.1-1.0-2.83.63.54.4
By predominant export
Fuel exporters317.83.71.00.80.1-2.00.80.3-0.1
Non-fuel exporters695.44.54.32.02.43.45.74.75.8
Primary product exporters335.24.84.90.50.4-0.13.93.25.4
Exporters of manufactures305.94.33.73.64.47.38.16.66.4
Service and remittance countries64.84.44.22.13.32.93.34.24.3
Memorandum
Fifteen heavily indebted countries326.16.15.5-0.5-3.22.53.13.8
Countries with recent debt-servicing problems445.55.34.20.1-0.3-1.93.02.73.5

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.

The generally weak performance largely reflected the recession in the fuel exporting countries, which suffered a deterioration of 47 percent in their terms of trade in 1986. Because the contractionary effects of the fall in export prices were mitigated only in small part by higher export volumes and a pickup in oil production, government spending and imports were sharply curtailed. Consequently, domestic demand fell sharply and output stagnated.

Output growth was better sustained outside the group of fuel exporting countries. In these countries, the real income losses brought about by commodity price declines were largely offset by lower oil import bills and reduced interest payments on external debt, while the declines in primary product exports experienced by some countries were more than matched by the surge in exports of manufactures and services experienced by others. Overall, therefore, output growth in non-fuel exporting countries averaged 5¾ percent in 1986, 1 percentage point better than in 1985.

The differentiated character of the external environment facing many countries, as well as their diverse domestic policy responses to that environment, also helps to explain the output performance of the main regional groupings of developing countries. The situation of the Asian countries was particularly favorable from both points of view. A number of these countries, especially exporters of manufactures whose currencies are linked to the U.S. dollar, recorded significant increases in export volumes in 1986, reflecting improvements in their competitive positions. This external stimulus to output and demand reinforced the expansionary impact of real income gains from declines in oil prices and interest rates and an easing of the fiscal stance. The expansionary impact of these factors was reflected in an acceleration of the growth rate of the region (excluding China) from 3¾ percent in 1985 to 5¾ percent in 1986. Growth slowed somewhat in China but continued to outpace that of the region as a whole.

For those European countries that are classified as developing countries, the generally favorable impact of external and internal factors permitted an acceleration in output growth in 1986 following the slowdown that had occurred in 1985. With significant shares of manufactures and services in their exports, these countries experienced an improvement in the purchasing power of their export earnings at the same time as they benefited from declining interest payments on their relatively large external debts to commercial creditors. However, because of weaker external positions and higher debt ratios than in the case of many Asian countries, several of these countries were unable to relax adjustment efforts and permit stronger domestic demand growth. Instead, policy actions were directed at enhancing creditworthiness through demand restraint, with a view to permitting the accumulation of reserves and the repayment of debt.

In Western Hemisphere countries taken as a group, output growth accelerated to 4½ percent in 1986, but performances differed widely across the region. Because of the deterioration in their export earnings and constraints on their ability to run down reserves or borrow abroad, the four fuel exporting countries in the region (Ecuador, Mexico, Trinidad and Tobago, and Venezuela) were compelled to tighten policies, with the result that output growth for this group turned negative. The experience of the other countries in the region was more favorable. In Brazil, output increased by 8 percent as a result of a surge in real consumption, and in Argentina output rebounded strongly from the downturn experienced in 1985. Among the remaining countries in this region, output growth averaged 3½ percent, an improvement of 2 percentage points over the preceding year. For a number of these primary product exporting countries, the effects of weak export prices were cushioned by savings in oil import bills, buoyant nontraditional exports, and lower debt service payments as well as by higher agricultural production and incomes generated by good harvests and high coffee prices.

In the Middle Eastern region, the steep decline in oil revenues permitted only a modest rise in output. For the region as a whole, real export earnings declined by 39 percent. Although partly mitigated through running down foreign assets, the loss in export earnings of the fuel exporting countries in this region led to a strengthening of adjustment efforts, which curbed domestic demand and imports. The impact of these developments spread to other countries in the region, in part through reductions in workers’ remittances and official transfers that these countries had been receiving from their fuel exporting neighbors.

In Africa, output growth slackened to less than 1 percent in 1986 (compared with 2 percent in 1985), but the experiences of individual countries again varied considerably across the region. In the fuel exporting countries of this region, output declined severely because of oil-related difficulties. Output also declined or remained seriously depressed in several smaller low-income sub-Saharan African countries owing to large terms of trade losses stemming from the lower prices obtainable for their exports. In any case, the persistence of severe economic imbalances left little room for a relaxation of adjustment efforts so that domestic demand remained subdued in most countries of the group. There were, however, exceptions to the generally bleak picture. In particular, output recovered in those sub-Saharan African countries that experienced a sharp temporary rise in coffee prices early in the year, real income gains from lower oil import bills, and a rebound in agricultural output in response to changes in pricing policies and improved climatic conditions.

The economic performance of developing countries is much weaker than suggested by GDP growth statistics if it is assessed in terms of developments in real domestic absorption, which is a better indicator of national living standards broadly construed. Except for Asia, where living standards rose fairly steadily through the 1980s, real absorption per capita in much of the developing world has yet to recover appreciably from the decline experienced in the early 1980s (Chart 4). The fall in living standards has been pervasive and large in the Western Hemisphere and in Africa, as countries in these regions have struggled to correct domestic and external imbalances in the face of an often unfavorable external environment.

Chart 4.Developing Countries: Real Absorption1 per Capita, by Region, 1979-86

(Indices, 1979 = 100)

1 Real GDP less the real foreign balance.

The improvement evident in the Western Hemisphere since 1985 appears to be primarily a reflection of the stronger growth in domestic demand in a few larger countries and masks the more widespread continuing weakness in most countries in the region. The persistent decline in living standards experienced by most African countries is a matter of serious concern, given that the region suffers from extremely low levels of real absorption in absolute terms as well as high population growth rates. In the Middle East, living standards have been steadily declining since 1982–albeit from high levels in some countries–as a result of the fiscal retrenchment and import cuts necessitated by falling oil revenues.

The share of investment in aggregate spending tended to stabilize in 1986 following a marked decline during the first half of the 1980s in much of the developing world. After rising in the late 1960s and early 1970s, the share of investment in GDP had been fairly stable in the mid-to-late 1970s. Subsequently, however, as external borrowing constraints surfaced in the 1980s, a disproportionate share of the adjustment fell on investment rather than consumption, especially among highly indebted countries. As can be seen from Chart 5, the decline in gross capital formation in recent years has been sharpest in Africa, the developing countries in Europe, and the Western Hemisphere, the regions with the highest debt ratios. Although the share of investment in GDP in these three regions edged upward in 1986, and the efficiency of such investments improved, substantially larger increases are needed to strengthen productive potential in countries in these and other regions.

Chart 5.Developing Countries: Gross Capital Formation, by Region, 1979-86

(In percent of nominal GDP)

Inflation

A positive feature of economic performance in developing countries in 1986 was the sharp reduction in inflation rates in a number of countries where rates of price increase had accelerated to extremely high levels in previous years. Wide-ranging price stabilization programs were instituted in a number of these high-inflation countries, most notably Argentina, Bolivia, Brazil, and Israel. As a result, the composite inflation rate for these four countries was reduced from close to 320 percent in 1985 to 125 percent in 1986 on a year-on-year basis. Owing in large part to the reduction of inflation in these countries, the average inflation rate for the entire group of developing countries slowed to 30 percent in 1986, ending a steadily rising trend that had reached a peak of 40 percent in 1985 (Table 5).

Price increases also tended to recede in other developing countries, but more moderately as underlying inflationary pressures in these countries had been less pronounced. This reduction, stemming from declines in food, petroleum, and other commodity prices, was reflected in a decline of ½ of 1 percentage point in the median inflation rate among developing countries, a more representative measure of the experience in the “typical” country.

Table 5.Developing Countries: Changes in Consumer Prices, 1969-861(In percent)
AverageFrom Preceding Year
1969-78119791980198119821983198419851986
Developing countries216.321.126.626.026.033.238.139.729.5
By region
Africa11.616.616.421.911.419.420.312.813.7
Sub-Saharan Africa313.426.325.232.213.430.422.417.819.3
Asia8.78.013.110.76.36.67.27.67.8
Europe10.822.231.723.634.822.925.125.224.9
Middle East10.911.716.815.212.712.314.812.211.7
Western Hemisphere31.046.654.459.268.0105.9128.5151.189.5
Medians
Developing countries9.111.514.613.410.39.410.48.78.2
By region
Africa9.111.912.513.712.610.911.210.59.0
Sub-Saharan Africa39.312.513.313.512.711.211.210.59.2
Asia7.27.513.912.57.68.17.04.95.7
Europe8.19.615.820.021.020.215.015.111.7
Middle East10.010.610.58.99.15.26.44.110.0
Western Hemisphere10.414.918.114.79.08.812.015.011.4

Compound annual rates of change.

Arithmetic averages of country consumer price increases 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.

Arithmetic averages of country consumer price increases weighted by the average U.S. dollar value of GDPs over the preceding three years.

Excluding Nigeria and South Africa.

Notwithstanding these reductions, the inflation performance of developing countries in 1986 was somewhat disappointing in relation to the success of industrial countries in steadily restraining rates of price increase in recent years. Moreover, monthly rates of price increase in some of the high-inflation countries tended to pick up again in late 1986 and early 1987 as price ceilings were lifted and policy slippages occurred. Inflationary pressures intensified in a number of other countries as well because of difficulties in supporting exchange rate and price adjustments with effective domestic financial restraint.

INTERNATIONAL TRADE AND PAYMENTS

GLOBAL PERSPECTIVES

World Trade

The unusually large shifts in exchange rates and in the relative prices of oil and other primary commodities in 1986 significantly affected developments in world trade volumes. In particular, the sharp fall in export earnings of the fuel and other primary commodity exporting countries necessitated curtailment of their imports. In contrast, the price declines stimulated increased demand for developing country exports, both directly through relative price effects and indirectly by strengthening industrial country income and demand. Separately, the depreciation of the U.S. dollar appears on the whole to have had a favorable impact on trade, as U.S. exports began to recover and foreign suppliers were able, for a time at least, to protect or even increase further their market shares in the United States by reducing profit margins. In addition, the depreciation of the U.S. dollar led to a sharp improvement in the competitive position of some of the newly industrialized countries whose currencies were linked to the dollar. As a result, these countries recorded substantial gains in export performance. Overall, the positive forces dominated, and the growth in the volume of world trade accelerated from only 3 percent in 1985 to close to 5 percent in 1986 (Table 6), notwithstanding the slowing of growth in world output.

Table 6.Summary of World Trade Volumes and Prices, 1969-861(In percent)
Average 1969-78219791980198119821983198419851986
World trade3
Volume6.76.41.20.8-2.23.08.83.14.9
Unit value
(in U.S. dollar terms)10.818.620.1-1.2-4.2-4.8-2.4-2.24.4
(in SDR terms)48.314.919.39.12.3-1.71.8-1.3-9.7
Volume of trade
Exports
Industrial countries7.17.23.93.6-2.13.09.94.32.6
Developing countries4.64.3-4.2-6.0-7.63.27.10.98.6
Fuel exporters3.11.9-13.5-15.1-16.2-3.20.7-5.811.0
Non-fuel exporters6.16.88.45.31.28.211.55.07.8
Imports
Industrial countries6.98.9-1.6-2.0-0.64.712.64.68.4
Developing countries7.23.47.37.8-4.0-2.32.0-0.3-2.5
Fuel exporters15.0-4.613.418.6-1.5-10.1-6.2-11.9-21.0
Non-fuel exporters4.87.25.03.2-5.31.65.74.54.6
Unit value of trade
(in SDR terms)4
Exports
Industrial countries7.611.712.35.82.6-1.01.2-0.2-1.7
Developing countries12.125.036.515.41.9-4.53.9-3.9-25.9
Fuel exporters19.639.962.023.13.1-8.72.7-3.3-49.3
Non-fuel exporters7.313.112.47.20.6-0.94.8-4.3-12.8
Imports
Industrial countries8.115.020.87.70.7-2.40.9-1.0-9.8
Developing countries8.113.617.311.53.0-1.12.7-2.4-11.1
Fuel exporters7.610.812.410.73.1-0.22.1-0.5-3.6
Non-fuel exporters8.114.919.411.92.9-1.53.0-3.2-13.7
Terms of trade
Industrial countries-0.5-2.9-7.1-1.81.91.40.30.89.0
Developing countries3.710.116.33.5-1.0-3.51.2-1.5-16.7
Fuel exporters11.226.344.011.2-8.50.7-2.7-47.4
Non-fuel exporters-0.8-1.6-5.8-4.2-2.20.51.7-1.21.1
Memorandum
World trade prices (in U.S. dollar terms) for major commodity groups5
Manufactures9.613.610.4-3.9-2.1-2.8-3.01.217.9
Oil22.846.063.69.8-4.1-11.7-2.4-4.8-49.8
Non-oil primary commodities10.317.95.5-13.5-9.96.94.2-12.9-1.1

Excluding China prior to 1978.

Compound annual rates of change.

Averages of growth rates for world exports and imports based on data for the two groups of countries shown separately below and on partly estimated data for the U.S.S.R. and nonmember countries of Eastern Europe.

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.

Compound annual rates of change.

Averages of growth rates for world exports and imports based on data for the two groups of countries shown separately below and on partly estimated data for the U.S.S.R. and nonmember countries of Eastern Europe.

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 particularly significant development in world trade was the sharp decline in international oil prices in the first half of 1986. Despite a firming of prices in the second half of the year, oil export prices averaged only

13.40 per barrel in 1986, roughly half the level of the previous year (Chart 6). In real terms, oil prices in 1986 were some 15 percent below the level prevailing in 1978.

Chart 6.Oil Prices, 1972-April 1987

1 Unit value of the oil exporting countries (according to the former analytical categories); in terms of U.S. dollars.

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

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

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

The sharp drop in oil prices in 1986 reflected a change in policy emphasis on the part of the members of the Organization of Petroleum Exporting Countries (OPEC) in late 1985, with the primary objective shifting from that of defending official prices to that of raising OPEC’s share of the world oil market following the substantial reduction that had taken place during the first half of the 1980s. As a result, increased oil production by OPEC members led to oversupply in world oil markets in the short run, and prices declined sharply. However, the extent of the price decline and the highly unstable market conditions led to increasing calls from oil producing countries for the introduction of concerted output restraint, which by the end of the year led to a partial recovery of oil prices. An important aspect of these developments was the willingness of several important non-OPEC suppliers to help limit production and stabilize prices. In December 1986, the members of OPEC agreed to new production quotas that implied a reduction of their output by some 7-9 percent relative to actual production levels in late 1986. They also agreed to reintroduce fixed official export prices, based on a reference price of

18 per barrel. During the first few months of 1987, spot prices stabilized close to this level.

The persistent weakness of non-oil primary commodity prices also had a major bearing on world trade in 1986. Although commodity prices expressed in terms of U.S. dollars have been relatively stable since late 1985, the depreciation of the U.S. dollar has meant that dollar prices of exports of manufactures have risen by some 18 percent. In relation to export prices of manufactures, non-oil commodity prices thus fell by 16 percent in 1986, following a decline of 14 percent in 1985. By early 1987, real commodity prices had fallen to a level 40 percent below their peak in mid-1984 and 25 percent below the trough in late 1982 (Chart 7).

Chart 7.Developing Countries: Non-Oil Primary Commodity Prices, 1980-April 1987

(Moving three-month averages of indices expressed in terms of U.S. dollars, 1980 = 100)

1 Nominal commodity prices deflated by the index of unit values of manufactures exported by the industrial countries.

The prolonged and pervasive weakness of commodity markets can be attributed to a combination of short-term demand and supply factors and some more deep-seated structural factors. The short-term factors may have had the greatest impact on recent price developments. In the case of agricultural commodities, favorable growing conditions in major producing areas and lagged supply responses to earlier price increases have been instrumental in boosting supply. Relatively weak demand, as illustrated by the sluggishness of industrial production, has also played an important role. In the industrial countries, industrial output rose by only 1 percent in 1986, which dampened demand for metals and some agricultural raw materials. The disinflation of the past few years is also likely to have reduced the speculative demand for commodities.

Beyond such short-term factors, there are indications that the weakness of commodity prices has been the result of longer-term structural factors as well. On the supply side, technological progress and the dissemination of new technology have tended to increase supply, particularly of agricultural commodities. Indeed, some developing countries have not only become self-sufficient in foodgrain production but have also produced export surpluses in recent years. Furthermore, agricultural policies in the industrial countries have protected domestic producers from foreign competition and raised domestic prices relative to world prices, thereby stimulating overproduction. Structural changes have also been important on the demand side. In particular, the shift in the industrial countries away from heavy industry toward light manufacturing and service sectors has generally reduced the demand for commodities. This shift has been reinforced by the development of synthetic substitutes and new materials, together with increased recycling and conservation of metals. The recent decline in oil prices may also have reduced demand for some non-oil commodities for which oil-derived substitutes are readily available.

Reflecting the dominance of oil and other commodities in most developing countries’ exports to the industrial countries, the price declines resulted in an exceptionally sharp deterioration in the terms of trade of developing countries, averaging almost 17 percent for the group as a whole. This decline was almost entirely borne by the fuel exporting countries. Among the industrial countries, most of the gain was concentrated in Japan, France, the Federal Republic of Germany, and Italy—countries that also experienced an appreciation of their currencies.

The adjustment process triggered by the large shifts in commodity prices and exchange rates in 1986 meant that a significant proportion of the terms of trade changes were offset by changes in real trade flows. (The balance of payments adjustment process is described in greater detail in the following sections.) As a result, the combined current account position of the developing countries deteriorated only by some

23 billion, despite a terms of trade loss four times larger. At the same time, the industrial countries’ current account position improved by close to
32 billion and the global discrepancy on current account narrowed by about
7 billion (Table 7). Despite this reduction, which appears to be related in part to the decline in interest rates, the global discrepancy remains large and continues to be of concern as it impinges on the quality of balance of payments statistics and analyses (see Box 2).

Table 7.Summary of Payments Balances on Current Account, 1978-861(In billions of U.S. dollars)
197819791980198119821983198419851986
Industrial countries15.1-23.2-60.5-19.0-22.4-19.8-58.3-50.7-19.0
Canada-4.3-4.2-1.0-5.12.32.52.7-0.9-6.7
United States-15.4-1.01.96.9-8.7-46.3-107.0-116.4-141.4
Japan16.5-8.8-10.74.86.920.835.049.385.8
France7.05.2-4.2-4.6-12.1-4.7-0.8-0.23.4
Germany, Fed. Rep. of9.0-6.0-15.7-5.24.14.28.415.335.4
Italy6.25.5-10.0-9.1-6.21.6-2.4-3.64.1
United Kingdom1.9-1.56.812.56.94.82.14.5-0.2
Other industrial countries-5.8-12.5-27.6-19.2-15.5-2.73.71.30.5
Developing countries-35.06.430.4-48.5-87.1-64.0-33.0-23.9-46.4
By region
Africa-12.8-3.4-1.9-22.4-21.5-12.2-7.3-0.2-8.7
Asia-5.2-9.7-14.4-19.0-17.4-14.9-4.2-14.04.9
Europe-9.7-13.6-15.6-14.3-8.7-5.9-3.2-3.3-1.7
Middle East11.354.292.550.03.0-20.1-15.8-2.2-23.3
Western Hemisphere-19.0-21.1-30.2-42.7-42.5-10.8-2.6-4.2-17.5
By analytical criteria
Fuel exporters-6.151.495.934.8-18.2-19.3-4.73.0-37.1
Other developing countries-29.3-45.0-65.5-83.2-68.8-44.7-28.4-26.9-9.2
Market borrowers-31.8-29.2-35.8-71.9-73.6-29.8-2.77.1-1.5
Official borrowers-7.3-5.7-9.0-12.0-10.5-8.6-9.9-9.4-8.4
Other countries2-9.5-2.70.8-3.02.42.74.82.3-0.2
Total3-29.0-19.5-29.2-70.5-107.1-81.2-86.5-72.3-65.5

Including official transfers.

Covers estimated balances on current transactions only 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 with countries not included.

Including official transfers.

Covers estimated balances on current transactions only 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 with countries not included.

International Capital Markets

While capital flows between financial markets in the major industrial countries continued to expand at a rapid rate in 1986, the flow of funds between industrial and developing countries stagnated. International bonds issued by developing countries declined from

9 billion in 1985 to
5 billion in 1986, and only the most creditworthy developing countries were able to make such placements. Net lending by banks to developing countries (other than offshore centers) had already been relatively small (
10 billion) in 1985, but became negative in 1986 as repayments exceeded new borrowing by
5 billion. As a result, the current account deficits of developing countries, which increased from
24 billion in 1985 to
46 billion in 1986, were financed primarily through the receipt of official lending and non-debt-creating flows.

In other respects, activity in international financial markets was quite brisk, fueled primarily by the large current account and budgetary imbalances of industrial countries, the decline in interest rates, and the structural changes taking place in both domestic and international financial markets. In addition, this expansion of international lending among the industrial countries involved greater reliance on securities markets rather than on bank lending. Total international lending (bond issuance plus bank lending) grew by 70 percent in 1986, compared with 40 percent in 1985. Bond markets accounted for approximately 46 percent of net bond and bank lending (net of interbank redepositing) during 1986, compared with 42 percent in 1985 and 26 percent in 1980-84.

As in the past several years, the rapid expansion of flows between the major financial markets has been accompanied by major structural changes that have arisen as a result of financial liberalization and the spread of innovative financing techniques. In part, these liberalizations have reflected efforts to introduce greater competition into domestic financial markets in order to enhance efficiency. Indeed, liberalization and innovation have tended to increase the efficiency of capital markets by sharply reducing intermediation costs, by facilitating arbitrage between markets in different countries and between different instruments, and by achieving a wider sharing of risk among market participants.

International Liquidity

While international reserves held by countries expanded during 1986, the pattern of reserve accumulation was highly uneven, with some groups of developing countries experiencing sharp declines in their reserve holdings. Overall, non-gold reserves increased by SDR 15 billion.2 The foreign exchange component accounted for the entire increase, with the accumulation of foreign exchange reserves having amounted to about SDR 25 billion. The change in the value of the stock of foreign reserves amounted to only SDR 17 billion, however, since valuation losses due to the depreciation of the U.S. dollar relative to the SDR accounted for SDR 8 billion (Table 8). The industrial countries more than accounted for the increase in foreign exchange reserves, with increases (inclusive of valuation adjustments) of SDR 24 billion in 1986, compared with SDR 3 billion in 1985. In contrast, the foreign exchange reserves of developing countries fell by SDR 7 billion in 1986, following a decline of SDR 4 billion in 1985. The sharp expansion of the foreign exchange reserves of industrial countries principally reflected the intervention policies of governments designed to limit declines in the foreign exchange value of the U.S. dollar. The decline in the foreign exchange reserves of many developing countries, which is masked by the large reserve gains of a limited number of countries, reflected efforts to finance large current account deficits at a time when their, access to borrowed reserves from international capital markets was very limited.

Table 8.International Reserves, Excluding Gold, 1983-86(Annual changes, in billions of SDRs)
1983198419851986
All countries
International reserves, excluding gold3445-215
Of which, foreign exchange12341-117
Accumulation2137825
Valuation effects24-9-8
Industrial countries
International reserves, excluding gold2120323
Of which, foreign exchange11516324
Accumulation1616526
Valuation effects-1-1-1
Developing countries
International reserves, excluding gold1326-5-8
Of which, foreign exchange1925-4-7
Accumulation6214
Valuation effects34-8-7
Memorandum
U.S. dollars per SDR, end of period1.0470.9801.0981.223

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 seven major currencies shown in Appendix Table I.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 seven major currencies shown in Appendix Table I.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.

Table I.2.Share of National Currencies in Total Identified Official Holdings of Foreign Exchange, End of Year 1978-861(In percent)
Memorandum:

ECUs Treated

Separately2
1978197919801981198219831984198519861986
All countries
U.S. dollar76.073.267.371.670.771.569.564.566.655.8
Pound sterling1.72.03.02.22.52.73.03.12.42.2
Deutsche mark10.912.515.213.212.711.912.615.314.813.6
French franc1.21.31.71.41.31.11.11.31.31.2
Swiss franc2.12.53.22.82.82.42.12.31.61.4
Netherlands guilder0.91.11.31.11.10.90.81.01.00.9
Japanese yen3.33.64.44.24.74.95.77.56.96.3
Unspecified currencies33.93.73.93.54.24.55.34.95.518.7
Industrial countries
U.S. dollar86.283.577.678.777.077.573.665.470.653.5
Pound sterling0.70.80.80.70.80.91.62.01.21.0
Deutsche mark7.99.714.413.012.513.115.219.817.615.3
French franc0.40.60.50.50.40.30.40.50.50.5
Swiss franc1.21.51.81.81.81.51.41.80.90.8
Netherlands guilder0.50.60.70.80.70.50.71.00.90.8
Japanese yen2.32.63.53.74.55.26.38.87.66.6
Unspecified currencies30.70.60.60.72.31.00.80.50.721.5
Developing countries4
U.S. dollar62.562.957.164.364.365.265.163.460.360.0
Pound sterling3.03.35.13.74.24.64.54.44.24.2
Deutsche mark14.915.315.913.312.910.610.010.210.410.4
French franc2.22.12.92.42.32.01.82.22.52.5
Swiss franc3.43.64.73.83.83.42.82.92.62.6
Netherlands guilder1.41.41.91.51.61.31.01.01.11.1
Japanese yen4.64.65.34.84.94.75.06.15.95.9
Unspecified currences38.06.97.26.46.08.310.09.813.113.4
Sources: International Monetary Fund, various publications, and staff estimates.

Starting with 1979, the SDR value of European Currency Units (ECUs) issued against U.S. dollars is added to the SDR value of U.S. dollars, but the SDR value of ECUs issued against gold is excluded from the total distributed here. Only selected countries that provide information about the currency composition of their official holdings of foreign exchange are included in this table.

This column is for comparison and indicates the currency composition of reserves when holdings of ECUs are treated as a separate reserve asset, unlike the earlier columns starting with 1979 as is explained in the preceding footnote. The share of ECUs in total foreign exchange holdings was 12.2 percent for all countries and 20.9 percent for the industrial countries in 1986.

This residual is equal to the difference between total identified reserves and the sum of the reserves held in the seven currencies listed in the table.

The calculations here rely to a greater extent on Fund staff estimates than do those provided for the group of industrial countries.

Sources: International Monetary Fund, various publications, and staff estimates.

Starting with 1979, the SDR value of European Currency Units (ECUs) issued against U.S. dollars is added to the SDR value of U.S. dollars, but the SDR value of ECUs issued against gold is excluded from the total distributed here. Only selected countries that provide information about the currency composition of their official holdings of foreign exchange are included in this table.

This column is for comparison and indicates the currency composition of reserves when holdings of ECUs are treated as a separate reserve asset, unlike the earlier columns starting with 1979 as is explained in the preceding footnote. The share of ECUs in total foreign exchange holdings was 12.2 percent for all countries and 20.9 percent for the industrial countries in 1986.

This residual is equal to the difference between total identified reserves and the sum of the reserves held in the seven currencies listed in the table.

The calculations here rely to a greater extent on Fund staff estimates than do those provided for the group of industrial countries.

Box 2.THE STATISTICAL DISCREPANCY IN WORLD CURRENT ACCOUNT BALANCES

In principle, the world current account should be in balance, with the sum of all deficits being matched by the sum of all surpluses. In practice, however, the recorded balance on world current account has been in substantial deficit for a number of years. From approximate balance in the early 1970s, the global current account displayed an excess of deficits over surpluses of about

20 billion in the late 1970s, which widened sharply to over
100 billion in 1982 before gradually declining to an estimated
65 billion in 1986. This discrepancy is a source of serious concern, as it impinges on the quality of balance of payments data and analyses: it undermines analysis of global saving and investment flows; it hampers surveillance over exchange rates; and, because it indicates a shortfall in net exports, it distorts assessments of developments in world demand and output. Moreover, the discrepancy has given rise to concerns that it may give national financial policies a deflationary bias as national authorities seek to strengthen their external positions.

Prompted by these concerns, and in view of its responsibilities for international balance of payments statistics, the Fund in 1984 established an international Working Party, composed of both balance of payments experts and analysts, to attempt to identify the proximate causes of the discrepancy and to outline steps that could be taken to reduce it. The Working Party issued its final report in December 1986. The main conclusions of the report are as follows: (1) The discrepancy is to be found primarily in the service and transfer transactions. Statistics on merchandise transactions have some deficiencies, but these have not contributed significantly to the sharp rise in the discrepancy. (2) Within the service account, the largest and most rapidly rising component of the discrepancy has been portfolio income. This reflects both the emergence of a large stock of cross-border assets recognized by debtor countries but not by creditor countries as well as the high level of international interest rates that prevailed in the early 1980s. (3) Another major but relatively stable discrepancy within the service account is in the shipping data, reflecting in part underrecording of freight earnings in a number of countries with large maritime sectors. (4) There is also a large, but again fairly stable, asymmetry on official transfers, with payments reported by donors exceeding credits reported by recipient countries. The Working Party did not reach any firm conclusions regarding the distribution of the discrepancy among countries. Nevertheless, tentative adjustments for the main components of the investment income discrepancy do not greatly affect the existing pattern of current account imbalances.

To reduce the discrepancy, the Working Party has recommended several changes in balance of payments compilation procedures that, if adopted by national compilers, would make national balance of payments statistics more consistent with one another and thus permit a gradual absorption of the discrepancy into recorded country estimates. An important part of this effort will be the updating and improvement of the Fund’s Balance of Payments Manual to take into account the innovations in the global financial marketplace.

The principal findings and recommendations were endorsed by the Fund’s Executive Board, and the report, entitled Final Report of the Working Party on the Statistical Discrepancy in World Current Account Balances, was published by the Fund in September 1987.

The growth in reserves during 1986 resulted in higher ratios of non-gold reserves to imports for the world as a whole and for some major subgroups of countries. This represents a continuation of the trend toward increases in these ratios that has been evident since 1981, except for a pause in 1985. For the industrial countries, holdings of non-gold reserves have grown slightly faster than imports, and the reserve-to-import ratio for this group has increased from 16 percent in 1981 to 19 percent in 1986. In 1985-86 when the U.S. dollar depreciated against the other major currencies, interventions in exchange markets by a number of major industrial countries contributed to the accumulation of, reserves, which stabilized the reserve-to-import ratio of the industrial countries in 1985 and resulted in a substantial rise in that ratio in 1986. For developing countries, the ratio of non-gold reserves to imports increased from 26 percent in 1981 to 33 percent in 1985 and to 36 percent in 1986. This rise reflected in part a vigorous rebuilding of reserves in 1982—84 and a decline in the SDR value of imports in 1985-86 and occurred notwithstanding significant negative valuation effects in 1985-86. Since reserve assets denominated in U.S. dollars account for a greater proportion of non-gold reserves, particularly for the developing countries, than the weight of the U.S. dollar in the valuation of the SDR, the SDR value of a given stock of reserves tends to increase when the U.S. dollar is appreciating, as in 1983—84, and decline when the U.S. dollar is depreciating, as in 1985-86. Despite the rise in the reserve-to-import ratio for the developing countries as a group, for the capital importing developing countries with recent debt-servicing problems that ratio fell from 29 percent in 1985 to 26 percent in 1986 as the SDR value of their non-gold reserves declined by about one fourth.

During 1986, the currency composition of foreign exchange reserves continued to diversify albeit at a slower pace than in previous years. The proportion of identified foreign exchange reserves denominated in U.S. dollars, which equaled approximately 80 percent in the mid-1970s, reached 67 percent at the end of 1986.3 The significant decline in the U.S. dollar components of identified foreign exchange reserves during the past decade had, as its counter-parts, increases in the proportions of reserves denominated in deutsche mark (from 11 percent in 1978 to 15 percent in 1986) and in Japanese yen (from 3 percent in 1978 to 7 percent in 1986). The decline in the relative share of U.S. dollar-denominated reserves was greater for the industrial countries (whose U.S. dollar holdings fell from 86 percent of identified foreign exchange reserves in 1978 to 71 percent in 1986) than for the developing countries (whose dollar holdings declined from 63 percent in 1978 to 60 percent in 1986).

INDUSTRIAL COUNTRIES

Exchange Rate Developments

Further progress was made over the past year in bringing key exchange rate relationships better into line with underlying economic conditions in the major industrial countries. Continuing a depreciation that had begun in late February 1985, the effective value of the U.S. dollar declined by 13 percent during 1986, with a further sharp adjustment in early 1987. The other major currencies appreciated in nominal effective terms during 1986, with the exception of the pound sterling and the Canadian dollar (Chart 8). Over the first four months of 1987, the U.S. dollar depreciated in nominal effective terms by 8 percent, while the Japanese yen and the deutsche mark appreciated by about 8 percent and 2 percent, respectively.

Chart 8.Major Industrial Countries: Monthly Average U.S. Dollar and Effective Exchange Rates, 1980-April 19871

(Indices, 1976–85 = 100)

1 Effective rates based on the Fund’ Multilateral Exchange Rate Model.

These exchange rate movements have almost reversed the real effective appreciation of the U.S. dollar (as measured by relative normalized unit labor costs) that occurred during the first half of the decade. Between early 1985—when the dollar peaked—and April 1987, the U.S. dollar has depreciated in real effective terms by about 35 percent and by roughly the same amount in nominal effective terms. Over the same period, the 20 percent appreciation of the deutsche mark has also brought its real effective value back to its 1980 level. The real effective value of the Japanese yen in April 1987 was 31 percent higher than its value two years earlier and about the same percentage above its average value in 1980. The nominal effective appreciation of the yen has been somewhat greater, reflecting a lower inflation rate in Japan relative to the average of its trading partners. In April 1987, the real effective exchange rates of the French franc, the pound sterling, and the Canadian dollar remained lower than their levels in 1980, while the real effective exchange rate of the Italian lira had returned to its level in 1980. The real effective depreciations of the pound sterling and the French franc since 1980 have been smaller than their nominal depreciations, owing to higher domestic cost increases than abroad.

The depreciation of the U.S. dollar against most major currencies since the Plaza Accord seems to have reflected in part efforts to coordinate policies and the associated convergence in economic conditions among the main industrial countries. In the aftermath of the September 1985 Plaza Accord, there was a further depreciation of the U.S. dollar associated with a temporary tightening of monetary policy in Japan and a commitment by the U.S. authorities to reduce the U.S. fiscal deficit in line with the targets stipulated in the Gramm-Rudman-Hollings Act. The dramatic fall in oil prices in the first half of 1986 may also have contributed to the depreciation of the U.S. dollar; this development tended to put upward pressure on the currencies of countries such as Japan and a number of European countries that are relatively more dependent on net oil imports than the United States. In addition, short-term interest rate differentials generally moved in favor of the other industrial countries during 1986 when there was a pronounced decline in U.S. interest rates. During the first four months of 1987, interest rate differentials shifted back in favor of U.S. dollar-denominated assets (Chart 9) which, however, did not prevent a further reduction in the value of the dollar.

Chart 9.Major Industrial Countries: Monthly Average Short-Term Interest Rates, 1987–April 19801

(In percent per annum)

1 The rates shown are monthly averages of daily rates on money market instruments of about 90 days’ maturity, except for Japan, where the discount rate on two-month (private) bills is used.

In the latter half of 1986, an intensification of signs of weakness in the Japanese economy, as well as rising oil prices, exerted downward pressures on the yen. These factors were reinforced by the Joint Statement by the finance ministers of the United States and Japan at the end of October, which, in combination with a reduction in the discount rate of the Bank of Japan, affirmed the two countries’ willingness to cooperate on exchange market matters. This Statement also contained an undertaking by the United States to lower its federal fiscal deficit as provided by the Gramm-Rudman-Hollings Act. In contrast to the weakening of the yen in the second half of 1986, there was considerable upward pressure on the deutsche mark over this period. The strengthening of the deutsche mark was associated in part with a sharp increase in the German current account surplus, a continued narrowing of the interest rate differential vis-à-vis the United States, and speculation of parity adjustments within the European Monetary System (EMS).

In early 1987, there was a further sharp depreciation of the U.S dollar against the major currencies, which may have reflected exchange markets’ reaction to the lack of improvement in the U.S. trade balance. Subsequently, the dollar steadied after a further Joint Statement by the U.S. and Japanese finance ministers. This development was buttressed by signs that real trade balances of the major countries were beginning to adjust. Under the Louvre Accord of February 22, 1987, the major industrial countries reached an agreement that exchange rates had now been brought within ranges broadly consistent with underlying economic fundamentals, given the commitment of surplus countries to follow policies designed to strengthen domestic demand while maintaining price stability, and of deficit countries to reduce their domestic imbalances and external deficits. The major countries also agreed that further substantial exchange rate shifts among their currencies could damage growth and adjustment prospects. They therefore agreed to cooperate closely to foster stability of exchange rates around their current levels. After a period of little movement following the Louvre Accord, the U.S. dollar came under renewed downward pressure, and by the end of April depreciated by an additional 4 percent.

Unlike the currencies of the other major European countries and Japan, the effective value of the pound sterling fell during 1986; between mid-1985 and December 1986, the pound sterling depreciated by about 18 percent in nominal effective terms and by somewhat less in real terms. The depreciation of the pound sterling in 1986 was associated with the sharp fall in oil prices and, toward the latter part of the year, with a rapid growth of sterling M3 as well as a decline in the balance on current and long-term capital account. The subsequent sharp appreciation of the pound sterling in early 1987 was perhaps attributable to market expectations of a lower public sector borrowing requirement, firmer oil prices, and continued relatively strong economic performance. A decline in the base lending rates of the major U.K. banks in early 1987 narrowed the nominal short-term interest rate differential in favor of sterling-denominated assets, compared with those denominated in U.S. dollars, to about 3¼ percentage points by the end of April 1987.

During 1986, the Canadian dollar also depreciated, falling by about 5 percent in nominal effective terms, but appreciating slightly against the U.S. dollar. Despite a sharp rise in the short-term interest rate differential in favor of Canadian dollar-denominated assets in early 1986, by the end of April 1987 the short-term interest rate differential favoring Canadian dollar-denominated assets against U.S. assets had fallen to about 1 percentage point.

Since the July 1985 realignment (which affected the relative position of the Italian lira), the central rates of the currencies participating in the exchange rate mechanism of the EMS have been realigned three times. On April 6, 1986 the central rates of the deutsche mark, the Netherlands guilder, and the Belgian/Luxembourg franc were raised, while that of the French franc was lowered in order to strengthen the relative competitive position of France within the EMS. A second realignment took place on August 4, 1986 when the central rate of the Irish pound was lowered by 8 percent. The Irish authorities requested this change in order to offset the effects of a deterioration of Ireland’s external competitiveness, especially vis-à-vis the United Kingdom and the United States. A further realignment occurred on January 12, 1987 when the central rates of the deutsche mark and the Netherlands guilder were adjusted upward by 3 percent and the Belgian/Luxembourg franc by 2 percent against the other EMS currencies. The realignment of January 1987 reflected in part pressures within the EMS generated by the continuing weakness of the U.S. dollar.

The Nordic currencies, with the exception of the Danish krone, are linked to currency baskets that include the U.S. dollar. This link has tended to stabilize the effective exchange rates of these currencies, in contrast to the appreciations experienced by most other European currencies since early 1985. In addition, Norway devalued by some 11 percent in May 1986 in an effort to offset a loss in competitiveness and to help the economy adjust to the loss of oil revenue. In Spain, the policy of stabilizing the exchange rate vis-á-vis the European Currency Unit (ECU), together with a higher domestic inflation rate relative to that of its trading partners, was reflected in a 4 percent real effective appreciation of the peseta during 1986. Since February 1985, the Swiss franc has moved closely with the deutsche mark and has appreciated in nominal effective terms by 15 percent, returning its real effective value close to its average level in 1980.

Among the currencies of the remaining smaller industrial countries, the Australian dollar and the New Zealand dollar experienced particularly large adjustments. During 1986, and especially in the third quarter, the Australian dollar depreciated sharply in nominal and real effective terms, reflecting in part a continuing large current account deficit and the further weakening of commodity prices. Despite some recovery over the preceding six months, the Australian dollar at the end of the first quarter of 1987 stood about 30 percent below its most recent peak of two years earlier. The depreciation of the New Zealand dollar by about 10 percent in the third quarter of 1986 was partially reversed in the fourth quarter, and the real effective exchange rate appreciated during 1986 as a result of significantly higher inflation in New Zealand than abroad.

Balance of Payments Developments

The combined balance on current account of industrial countries strengthened by close to

32 billion in 1986, reflecting the substantial improvement in their aggregate terms of trade, which was only partly offset by the compression of imports in developing countries. This improvement was not, however, uniform across countries. Most notably, the U.S. current account deficit increased by
25 billion, while the current account surpluses of Japan and the Federal Republic of Germany increased by
37 billion and
20 billion, respectively. The United Kingdom and Canada, both oil exporters, experienced deteriorations in their current accounts, while France and Italy recorded improvements. To a large extent, changes in the current account balances of the major industrial countries—exclusive of the United States—reflected the changes observed in their oil trade balances.

Despite the depreciation of the U.S. dollar in real effective terms and the drop in oil prices, the current account deficit of the United States widened in 1986 to reach a level equivalent to 3.3 percent of GNP, compared with 2.9 percent of GNP in 1985 (Chart 10). This change reflected an increase in the merchandise trade deficit. The drop in oil prices led to a reduction in the U.S. oil trade deficit of about

15 billion; however, this reduction was more than offset by an increased deficit on non-oil trade. The marked improvement in the competitive position of the United States since early 1985 contributed to a significant recovery of export volumes, which are estimated to have expanded by 8 percent in 1986.4 However, import volumes continued to expand at a rapid pace, rising by almost 15 percent in 1986, despite the slowdown in the growth of domestic demand in the United States and the depreciation of the U.S. dollar. Some of the reasons for the continued rapid growth of U.S. imports and the apparent insensitivity of the U.S. current account deficit to exchange rate changes are discussed below.

Chart 10.Major Industrial Countries: Payments Balances on Current Account, Including Official Transfers, 1980-First Quarter 198711

(Seasonally adjusted, in percent of GNP/GDP)

1 Data for Italy extend through the fourth quarter of 1986.

In Japan, the current account surplus continued to widen in 1986, reaching a level equivalent to 4.3 percent of GNP, compared with a surplus of 3.7 percent of GNP in 1985. A marked improvement in the terms of trade, generated by the fall in oil prices and the strong real appreciation of the yen, was the main reason for this development. Overall, the terms of trade displayed a 34 percent gain, with the non-oil terms of trade improving by 14 percent. This gain was offset to some extent by a significant deterioration in real net exports. Import volumes were particularly buoyant, rising by 7¼ percent, despite a relatively modest acceleration of the growth of domestic demand, whereas exports contracted by 2¼ percent in volume. However, partly because of the much higher level of exports than of imports, the magnitude of these volume changes was not large enough to counterbalance the gain in the terms of trade.

Current account developments in the Federal Republic of Germany were similar to those in Japan. Germany also experienced large terms of trade gains, both on oil and non-oil trade, and its current account surplus widened to almost 4 percent of GNP in 1986, rising from 2.4 percent of GNP in 1985. The overall terms of trade improvement amounted to 15 percent, while the non-oil terms of trade improved by 7 percent. Although the fall in oil prices contributed to a reduction of over

8 billion in the oil trade deficit, the expansion of the surplus on other merchandise transactions was particularly marked. With a significant acceleration of the growth of domestic demand, as well as a marked deterioration of Germany’s competitive position, the growth in the volume of merchandise imports significantly outpaced that of exports—6 percent versus 1 percent—but not by a margin sufficient to offset the terms of trade gain.

The persistence of substantial current account imbalances among the three largest industrial countries, despite the significant changes in real exchange rates that have taken place since early 1985, has been of concern to many observers. There is evidence that trade volumes adjust only gradually to changes in real exchange rates. This slow adjustment process produces an initial perverse change in trade balances—the J-curve effect—as trade volumes adjust with substantially longer lags than trade prices. Nevertheless, even though it may take three years or more before the volume adjustments are fully realized, it is noteworthy that the process of adjustment was clearly under way in 1986, as illustrated by the significant shifts in real trade balances.

Another factor that may help explain the stickiness of the current account imbalances is the persistence of a significant demand gap among the three major industrial countries. Although domestic demand growth accelerated in the Federal Republic of Germany and Japan in 1986 and decelerated in the United States, the cumulative changes since 1982 continue to show a large gap in favor of the United States. This demand gap can be attributed in part to the divergence of fiscal policy in the three major countries over this period, which has played an important role in the emergence of large current account imbalances. It is also important to note that before the recent depreciation of the U.S. dollar and concurrent appreciations of the Japanese yen and the deutsche mark which began in early 1985, exchange rates had been moving sharply in the opposite direction.

The capital account counterparts to the large current account imbalances among the three largest economies were, for the most part, provided by the private sector, but there was a significant increase in central bank acquisition of dollar assets as well, particularly during the early part of 1987. In 1986, official capital inflows into the United States surpassed

32 billion; a year earlier there had been an outflow of some
2 billion. Japan’s foreign exchange reserves rose by nearly
16 billion in 1986, or equivalent to some 18 percent of the country’s current account surplus. The increase in net foreign reserves in the Federal Republic of Germany was more moderate in 1986—slightly more than
1½ billion—but the pace accelerated in the opening months of 1987; during the first quarter of 1987, German reserves increased by more than
8 billion. In addition to Japan and the Federal Republic of Germany, several other countries also experienced substantial increases in their foreign reserve holdings over the past year.

In 1986, the current account of the United Kingdom shifted into approximate balance from a surplus of 1 percent of GDP in 1985. The major contributing factor was the fall in net export revenues from oil, a fall which equaled the reduction in the overall current account balance. The non-oil trade balance also deteriorated despite the depreciation of the pound sterling in real effective terms, but this was broadly offset by a further improvement in net invisibles, particularly in investment income and earnings from financial services.

Canada’s current account balance also registered a deterioration in 1986, shifting from near balance to a deficit equal to 1¾ percent of GNP. This largely reflected a decline in the merchandise trade surplus as the terms of trade deteriorated and foreign demand for Canadian goods slackened. The drop in oil prices led to a fall of almost

2 billion in Canada’s oil trade surplus. The terms of trade for non-oil products also deteriorated, as agricultural prices fell and the Canadian dollar depreciated.

France recorded a surplus of

3,4 billion on its current account (equivalent to about 0.5 percent of GNP), an increase from a position of near balance in 1985. The drop in international oil prices accounted for this outcome as the net oil import bill narrowed by
6 billion, while the surplus on non-oil trade declined. The acceleration of domestic demand was the principal factor behind the significant rise of import volumes (7 percent), while continued losses of market shares explained much of the stagnation in export volumes.

The current account position of Italy turned around in 1986 to a surplus of

4.1 billion, or 0.7 percent of GNP, from a deficit of
3.6 billion, or close to 1 percent of GNP, in 1985. Although most of the improvement in the Italian current account can be attributed to the decline in oil prices, the non-oil trade balance and invisibles also contributed.

Among the smaller industrial countries, the largest shift in the external balance was experienced by Norway, where the current account shifted from a surplus of over 5 percent of GNP in 1985 to a deficit of close to 6½ percent of GNP in 1986. This deterioration occurred because of a sharp decline in Norway’s terms of trade (due in large measure to the fall in oil and natural gas prices) and a significant increase in the volume of imports. Australia continued to experience a large deficit on its current account, amounting to

9.9 billion (over 6 percent of GNP) in 1986. The current account surplus of Switzerland increased by
2.1 billion to a level equal to 5¼ percent of GNP, largely because of an increase in the surplus on invisibles. The external balances of most of the other smaller industrial countries improved, the most significant case being Belgium, where the current account surplus increased by
3.1 billion in 1986 to reach the equivalent of 3 percent of GNP. The Netherlands and Spain also registered significant current account surpluses in 1986 of
5 billion (2.9 percent of GNP) and
4.2 billion (1.8 percent of GNP), respectively.

DEVELOPING COUNTRIES

Exchange Rates

Exchange rate policies remained an important part of the adjustment and stabilization programs of developing countries in 1986. Quite a number of countries that faced difficult external circumstances in 1986 depreciated their currencies significantly in order to strengthen their balance of payments positions and improve their external competitiveness. Many other countries experienced effective depreciations in 1986, however, because of the traditional pegging of their currencies to the U.S. dollar. As a result of these two factors, the composite index of developing countries’ real effective exchange rates declined by some 14 percent during 1986, following a real depreciation in 1985 of the same magnitude. The cumulative change of the index over this period is the largest change recorded over a 24-month period since compilation of the index began in the mid-1970s. The increased flexibility with regard to exchange rate policy is also evident in the growing number of developing countries that have adopted floating exchange rate arrangements since the period covered in last year’s Annual Report. Ghana and Guinea (previously pegged to the U.S. dollar) and Nigeria (previously under a system of managed floating) adopted independent floating exchange rate arrangements, while China and Madagascar (previously pegged to a currency composite) adopted a “more flexible” exchange rate arrangement under the Fund’s classification of such arrangements.5

The important role of exchange rate changes in the adjustment efforts of the developing world is reflected in the real exchange rate indices for the five regional groups (Chart 11). Within each region, the real depreciations were concentrated in those countries where exchange rate adjustments were most urgently called for or whose currencies were linked to the U.S. dollar. Prominent in the former group were the fuel exporting countries, which initiated or intensified adjustment policies in the wake of the precipitous fall in oil prices and the massive losses it generated in real export earnings. Exchange rate adjustment was, in many cases, a major element of such policies and was designed to correct relative price distortions and to stimulate the production of tradable goods by promoting an expansion of the export base. As a result, nominal and real effective exchange rates of the fuel exporting countries in the Middle East declined significantly during 1986. Among the fuel exporting countries in the Western Hemisphere, Ecuador, Mexico, and Venezuela also took increasing resort to corrective exchange rate action.

Chart 11.Developing Countries: Real Effective Exchange Rates, by Region, 1979-86

(Indices, 1979 = 100)

A large number of countries in Asia, the Middle East, and the Western Hemisphere experienced a real effective depreciation of their currencies because of links to the depreciating U.S. dollar. Some of these countries, notably the exporters of manufactures in Southeast Asia, achieved sizable increases in export market shares, by allowing their currencies to depreciate with the dollar against the currencies of other trading partners, while maintaining (or even improving) their competitive position vis-á-vis the United States.

Many African countries also took important steps to correct exchange rate misalignments and to unify multiple foreign exchange markets. The large exchange rate correction in Nigeria, following the introduction of an auction market, was the cornerstone of the Fund-supported adjustment program adopted by that country in 1986. In a number of African countries, action on exchange rates was facilitated in 1986 by the decline in world food prices and by lower oil prices, which together muted the inflationary impact of the depreciations on consumer prices; at the same time, the depreciations helped raise the domestic producer prices of agricultural exports and thus provided an incentive for increased production of these crops. Producer prices were also increased in those African countries whose currencies are pegged to the French franc, even though they maintained their parities vis-á-vis the franc.

Current Account Developments

The current account position of the developing countries as a whole worsened significantly in 1986 following three years of steadily declining deficits (Table 7 and Chart 12). A sharp (17 percent) fall in their terms of trade, mainly owing to lower oil prices but also reflecting weak commodity markets and rising prices for manufactures, produced a deterioration in the developing countries’ merchandise trade balance from a surplus of

45 billion in 1985 to one of only
7 billion in 1986. This was only partially offset by lower interest payments, which declined by
3 billion, and an increased surplus on other invisibles, which rose by
13 billion. The overall current account deficit almost doubled from
24 billion in 1985 to
46 billion in 1986.

Chart 12.Developing Countries: Trade and Current Account Balances, 1980-86

(In percent of exports of goods and services)

1 Excluding Nigeria and South Africa.

The fuel exporting developing countries were most severely affected. This group, whose terms of trade deteriorated by 47 percent (equivalent to a loss of some

100 billion), mitigated some of the adverse effects through major adjustments in trade flows and domestic expenditures. Nonetheless, the current account position of the fuel exporters deteriorated by
40 billion, moving from a small surplus in 1985 to a deficit of
37 billion in 1986.

Non-fuel exporters, on the other hand, recorded the fifth successive annual reduction in their current account deficit, which declined to

9 billion in 1986. Within this broad group, most of the gain accrued to exporters of manufactures, who benefited from lower oil import prices, improved competitiveness, and the strength of demand in the industrial countries. Their current account position moved to a surplus of
13 billion, compared with a deficit of
4 billion in 1985. For the remaining developing countries, most of which are predominantly exporters of primary (mainly agricultural) products, the gains from lower oil prices were offset by the weakness of international commodity prices and higher prices for manufactured imports. While the terms of trade of these countries worsened slightly, they maintained their current account deficit at
22 billion, similar to the position in 1985, through volume adjustments.

Part of the developing countries’ adjustment in 1986 was accomplished through a substantial increase in the volume of exports, which rose by 8½ percent in 1986 following minimal growth in 1985. However, the aggregate movements conceal divergent developments among different groups of countries. The fuel exporting countries increased exports by 11 percent, largely by displacing domestic oil production in industrial countries that had become unprofitable at the new lower level of oil prices; much of this gain was registered by countries which had previously experienced large losses of market shares, with the major oil exporters of the Middle East increasing the volume of their exports by some 16 percent. Exporters of manufactures also expanded their market shares significantly, mainly as a result of improvements in competitiveness; their export growth amounted to 13½ percent, compared with 4½ percent growth in export markets. Exporters of primary products fared less well: in the face of slack world markets, their exports stagnated in value terms and declined in volume terms.

The expansion of export volumes did not, in the aggregate, compensate for the adverse shift in the terms of trade, and the purchasing power of developing countries’ export revenues declined by 9½ percent in 1986, compared with an average annual rate of increase of about 7 percent from 1970 to 1984 and a slight decline in 1985. Given the continuing constraints on external financing, this necessitated a significant adjustment in import volumes, which, after remaining unchanged in 1985, fell by 2½ percent in 1986. The decline was concentrated among the fuel exporting countries, which reduced import volumes by 21 percent. Non-fuel exporters, on the other hand, benefited from a 9 percent increase in the purchasing power of their exports in 1986 and were therefore able to strengthen their current account positions while raising import volume by 4½ percent. Much of this growth occurred among the exporters of manufactures, but the primary product exporters also registered a modest increase in imports. However, only in Asia and Europe did the volume of imports stand higher in 1986 than in 1984. The real imports of African countries declined for the fifth consecutive year, those of Middle Eastern countries experienced their fourth successive annual decline, and those of Western Hemisphere countries remained very depressed. For all three regions, the levels of real imports in 1986 were only about two thirds of what they had been in 1981 (Chart 13).

Chart 13.Developing Countries: Import Volumes, 1978-86

(Indices, 1978 = 100)

The sharp fall in oil prices generated a marked deterioration in the external position of the eight major oil exporters in the Middle East (the capital exporting developing countries). These countries recorded a current account deficit of

20 billion in 1986, which was larger than the deficits recorded in 1983 and 1984, and reversed the recovery staged in 1985. The capital importing developing countries, on the other hand, were able to hold their current account deficit to a level (
26 billion) similar to that achieved in the previous two years. While this stability reflected in part the smaller deterioration in the terms of trade experienced by this group (8 percent compared with 53 percent for the capital exporters), it also reflected the reduced availability of external financing.

Financing constraints have impinged primarily on those countries that have relied most heavily on commercial sources of finance (the market borrowers). These countries recorded a small aggregate current account surplus in 1985—86, compared with a current account deficit of some

73 billion in 1981-82. By contrast, the position of the official borrowers was relatively little changed from that in the early 1980s. In 1986, this group’s current account deficit still represented about 23 percent of their exports of goods and services compared with some 30 percent in 1981-82, illustrating the greater stability of officially backed financing as well as its lower sensitivity to market interest rates. (Total interest payments for this group actually rose slightly, reflecting the continued growth of debt outstanding.)

Financing and Debt

Financing developments in 1986 were complex, in large part because of contrasting developments in two groups of countries: the eight Middle Eastern capital exporters that financed the deterioration in their combined current account largely through sales of foreign assets; and the exporters of manufactures of Southeast Asia that accumulated reserves as a result of the substantial improvement in their current account balances. These atypical developments largely cancel out, however, and the overall financing estimates for developing countries are reasonably reflective of developments in a large number of individual countries as well as in the group of countries that have experienced debt-servicing difficulties.

Against this background, the financing picture that emerges is one of a further tightening of financing constraints in 1986, a tightening which led to a small reduction in developing countries’ recourse to external financing, from

80 billion in 1985 to
77 billion in 1986 (Table 9). In the past, such reductions in external financing had been achieved primarily by cutting the deficit on goods, services, and private transfers. In 1986, despite substantial real adjustment, the size of the terms of trade losses was such as to largely foreclose that avenue and, indeed, as noted earlier, the combined deficit of developing countries widened by
23 billion. The tightening of the financing constraint was met therefore not through additional current account adjustment, but through a resurgence in arrears (which increased by some
9 billion) and, especially, a sharp reduction in the pace of foreign asset accumulation. Overall, net overseas claims increased by
15 billion in 1986, compared with an average rise of
39 billion in 1984-85, with reserves (exclusive of valuation effects) increasing by
7 billion against an average of
20 billion in 1984-85.

Table 9.Developing Countries: External Financing, 1980-861(In billions of U.S. dollars)
1980198119821983198419851986
All developing countries
Deficit on goods, services, and private transfers-25569574443761
Use of reserves49-13-39916237
Other foreign asset accumulation, net296111782120209
External financing requirement120155135102808077
Non-debt-creating flows313222622223329
Official flows427404542402729
Private flows581874724131910
Arrears6-161714519
Capital importing developing countries
Deficit on goods, services, and private transfers7611710764384144
Use of reserves24-1812211619
Other foreign asset accumulation, net228383820172010
External financing requirement12815512995767673
Non-debt-creating flows324252423243231
Official flows427384543372626
Use of Fund credit1671151-2
Private flows57886431510177
Arrears6-161714519

In contrast to the presentation in Table 7, official transfers are treated as a financing item in this table.

Net asset transactions by residents plus recorded errors and omissions (on the assumption that the latter reflect 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.

Residual. Mainly net external borrowing from private creditors and short-term flows.

Reflects involuntary “lending” by official and private creditors.

In contrast to the presentation in Table 7, official transfers are treated as a financing item in this table.

Net asset transactions by residents plus recorded errors and omissions (on the assumption that the latter reflect 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.

Residual. Mainly net external borrowing from private creditors and short-term flows.

Reflects involuntary “lending” by official and private creditors.

The critical role of net acquisitions of foreign assets in the overall financing and adjustment picture of 1986 is partly due to the strong asset positions of some of the countries that experienced terms of trade losses. Net asset purchases by the traditionally capital exporting countries averaged some

3 billion in 1984—85 (following a peak of over
90 billion in 1980); in 1986 this group actually liquidated some
14 billion of overseas assets (mostly by reducing official reserves) in order to ease the burden of reductions in import volumes. However, the capital importing countries also reduced their net acquisition of foreign assets, from an average of
37 billion in 1984—85 to
29 billion in 1986. In these countries, most of the change was absorbed by the private sector. Official reserves were rebuilt by
10 billion to
20 billion in each year from 1983 to 1986, while private capital outflows (including errors and omissions, on the presumption that these reflect capital flight) declined from some
18 billion annually in 1984-85 to
10 billion in 1986. The reduction in private capital outflows over this period was fairly widespread and was common both to countries that have and to those that have not experienced recent debt-servicing problems.

The most striking feature in the development of sources of finance during the 1980s has been the decline in private lending to developing countries. From a peak of

87 billion in 1981, net commercial lending to all developing countries fell to
19 billion in 1985 and to only
10 billion in 1986. The recourse of the capital exporting countries to this source of financing remained broadly constant (
3 billion in 1986, similar to the 1981-85 average), and the bulk of adjustment was borne by those capital importing countries that have experienced recent debt-servicing problems. Spontaneous lending to the latter group fell from
60 billion in 1981 to
24 billion in 1982; since then they have made net repayments averaging
12 billion annually. Some additional funds were provided in 1983-84 by concerted lending programs, but by 1986 such arrangements contributed only
3 billion, leaving this group of countries to make overall net repayments to private creditors totaling
6 billion. Capital importers without recent debt-servicing problems were able to attract nonofficial funds averaging
17 billion in 1983-86, although the amount varied considerably over the period. Total private direct investment in developing countries in 1986 (
11 billion) was only slightly less than the average in 1983-85.

Total official financing flows (official transfers, reserve-related liabilities, and long-term borrowing from official creditors) recovered to

52 billion in the capital importing countries in 1986, following the 1985 low of
44 billion; much of this increase was associated with exceptional financing arrangements. In part, the recovery in official flows reflected the success of one aspect of the strengthened debt strategy launched in 1985. World Bank lending to heavily indebted countries increased to levels broadly in line with the goals of the strategy. (Private lending to these countries in 1986, however, fell well short of the envisioned level.) The increase in official lending has been partially offset by net repayments to the Fund of some
2 billion for the entire group of developing countries in 1986, principally because of repurchases by a few relatively large countries that entered into arrangements with the Fund in the early 1980s.

The total dollar value of developing countries’ external debt rose by a further 9 percent in 1986 to reach

1,100 billion, representing 169 percent of exports of goods and services, compared with 120 percent in 1982 (Table 10). Much of the increase in nominal debt in 1986 can be attributed to the weakness of the U.S. dollar, however; the 4 percent underlying increase in developing countries’ liabilities (that is, exclusive of valuation effects) contrasts with average increases of 6 percent in 1983—85 and 19 percent in the years immediately preceding the debt crisis. The debt burden of those capital importing countries with recent debt-servicing problems worsened markedly in 1986 following three years of relative stability. The ratio of debt to exports rose to 301 percent, reflecting the growth in nominal debt and the weakness of export prices. The small low-income countries, three fourths of which are in Africa, had an average ratio of 412 percent.

Table 10.Developing Countries: Debt and Debt Service Ratios, 1980-86(In percent of exports of goods and services, except where otherwise stated)
1980198119821983198419851986
Total debt (in billions of U.S. dollars)6347488499009491,0121,100
Debt ratio8295120134134148169
By region
Africa92119154170170185231
Asia7275889489101100
Europe127137147150145162172
Middle East273346607082123
Western Hemisphere183210273292277293349
By miscellaneous criteria
Capital importing countries114129156165158172184
Official borrowers155179216240255291319
Countries with recent debt-servicing problems152186241255246264301
Debt service ratio13162019202225
By region
Africa15182225272835
Asia9101212121314
Europe21252624252830
Middle East4578101116
Western Hemisphere34425146414350
By miscellaneous criteria
Capital importing countries18222624242527
Official borrowers14161720232532
Countries with recent debt-servicing problems25334037353742

Debt service ratios also reveal significant disparities. The debt service ratio of official borrowers with recent debt-servicing problems rose from 30 percent in 1985 to 42 percent in 1986, while the average for all capital importing countries rose by 2 percentage points to 27 percent of exports of goods and services. The latter rise was, however, wholly accounted for by amortization payments. The interest payment ratio declined by nearly 1 percentage point to 13¼ percent, the lowest level in five years, because of the drop in international interest rates. Estimates of the underlying (pre-rescheduling) cost of debt service for countries with recent debt-servicing problems show a nominal debt service burden exceeding that of other capital importing countries by a factor of 3½. However, debt-rescheduling arrangements have played an important role in alleviating the liquidity burden on such countries, on average covering as much as one third of payments due during 1986. The growing debt burden of the small low-income countries has, despite its concessional terms, raised their debt service ratio to a level which is now approaching that of the heavily indebted commercial borrowers. This points to the importance of increasing the concessionality of financial flows to these countries if economic growth is to be restored.

See Appendix IX for the country classification system used in this Report.

If gold reserves are revalued on the basis of market prices, total reserves including gold increased by SDR 36 billion in 1986.

The currency composition of identified foreign exchange reserves is based on a Fund 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.

This estimate is based on the reported change in nominal merchandise exports according to U.S. balance of payments statistics, less the change in the implicit national accounts deflator for U.S. merchandise exports. According to U.S. census data, which are associated with a number of statistical weaknesses, U.S. export volumes contracted slightly in 1986.

Exchange arrangements maintained by member countries as of June 30, 1987 are detailed in Appendix Table II.1.

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