The World Economy
- International Monetary Fund
- Published Date:
- January 1989
The world economy performed strongly in many respects in 1988 and early 1989. On the domestic front, output growth in industrial countries exceeded expectations, but inflation was up a little. Tighter monetary policies were associated with a rise in interest rates; progress toward fiscal balance was generally modest. Developing countries as a group experienced one of their highest rates of growth in the past decade, mostly because of buoyant exports of manufactures by Asian economies. Inflation accelerated in developing countries, especially in those that are having difficulties servicing their debt. Some countries achieved considerable fiscal adjustment, but others continued with unsustainable fiscal deficits. The structural adjustment policies being implemented in a number of countries should help to reduce impediments to higher future growth.
On the international front, growth in the volume of world trade was the fastest in a decade, supported by strong import demand in industrial countries; the United States and the newly industrializing countries continued to gain market shares. Some progress was made in reducing external imbalances between the industrial countries, but there were signs in late 1988 and in early 1989 that the adjustment process was slowing down. Many developing countries had difficulty borrowing abroad; bank lending remained weak while net flows of official credit fell. Many countries continued to make substantial net transfers of real resources to their creditors. The total debt of developing countries receded slightly, and their debt-to-export ratios fell.
Box 1World Economic Outlook
The April 1989 edition of the World Economic Outlook provides a comprehensive analysis of developments in the world economy, including a discussion of alternative medium-term economic scenarios. It is the product of a comprehensive interdepartmental review by the Fund’s staff, which is conducted twice a year and draws on the staffs consultations with member countries as well as on its econometric modeling techniques. This publication is available from the Fund’s Publication Services (price $25.00). The next World Economic Outlook, comprising revised projections by the staff, will be published in October 1989 (price $20.00).
1. Domestic Economic Activity and Policies
Growth, Employment, and Inflation
Output in the industrial countries rose by just over 4 percent in 1988, ¾ of 1 percentage point more than in 1987 (Chart 1). The expansion was led by a broadly based surge in business fixed investment. Growth in nominal demand showed up mainly in increased output; inflation picked up only moderately because of weak oil prices, higher productive capacity owing to the rise in investment, the longer-run effects on productivity of structural reforms, and continued monetary restraint. Toward the end of 1988 and in early 1989, growth in North America, Japan, and the United Kingdom slowed to rates more in line with estimates of potential growth, but in continental Europe, the momentum of economic activity continued (Chart 2).
Chart 1Output Growth and Investment, 1981–88 Chart 2Major Industrial Countries: Real Output and Total Domestic Demand, 1983-First Quarter 1989
Economic activity in 1988 was stronger than most observers expected, partly because the stock market decline in late 1987 had less serious deflationary effects on demand than initially feared. The unexpected strength of investment also helped. This was in response to the pressure on productive capacity in many economies and was facilitated by lower capital costs (especially for high technology capital goods) and higher profitability, the latter supported by wage moderation and declines in the prices of oil and certain other commodities. At the same time, business confidence strengthened.
Strong economic activity led to employment growth in industrial countries of nearly 2 percent in 1988, with particularly rapid growth in North America, the United Kingdom, Australia, and Spain. In many European countries, rising output mostly reflected increased labor productivity. Unemployment and vacancy rates also suggest some tightening of labor markets in recent years; the aggregate unemployment rate for industrial countries fell to 7 percent in 1988 from 7.5 percent in 1987 because of large declines in Canada, the United States, the United Kingdom, and Australia. Unemployment remained high in continental Europe, dropping only to 9.7 percent from a peak of 10.4 percent in 1985–86. Vacancy rates approached recent historical peaks in North America and Japan, but remained relatively low in much of Europe.
Despite a modest tightening of labor markets in some countries and increased rates of capacity utilization, inflation rose little in 1988 (Chart 3). In the first quarter of 1989, consumer price inflation showed signs of moderate acceleration in most countries, reflecting higher world oil prices and (outside the United States) the appreciation of the dollar.
Chart 3Major Industrial Countries: Consumer Prices, Unit Labor Costs in Manufacturing, and Commodity Prices, 1980-First Quarter 1989
1Three-month centered moving average of 12-month inflation rates. Consumer prices are measured in local currencies and are averaged using GNP weights. The commodity price index is a global export-weighted basket of 40 commodities that includes oil and gold, using the same average exchange rate as the one used for the composite inflation index.
Consumer price increases in the industrial countries edged up from 3.0 percent in 1987 to 3.3 percent in 1988. Moderate increases in labor costs in most countries helped keep inflation down. Although wages rose in several countries (in nominal terms), their rates of increase remained well below those of the first half of the 1980s and were largely offset by strong gains in labor productivity. For the industrial countries as a group, unit labor costs in manufacturing were essentially unchanged in both 1987 and 1988, following increases of 2 percent in each of the previous two years and of about 7½ percent a year in the 1970s and early 1980s. Vigorous productivity growth in 1987–88 appeared to reflect primarily the remarkable strength of business investment.
Trends in the world oil market also helped to moderate price increases during much of the period under review. Average oil prices in 1988 were sharply lower than in 1987, mainly because of a significant increase in production by members of the Organization of Petroleum Exporting Countries. Following an OPEC agreement of November 1988, however, total output dropped and prices recovered, so that by April 1989 the average monthly spot price for crude oil was about 64 percent above the low of October 1988. Aggregate prices for commodities other than oil rose in 1988, but stabilized in early 1989. Prices for the main commodity groups diverged considerably, however, partly reacting to different supply influences. Although food and metal prices increased, tropical beverage prices remained depressed, and the prices of agricultural raw materials fell from their late-1987 peak.
Monetary policy played a dominant role in short-run macroeconomic management in 1988. Following some easing of monetary conditions in the immediate aftermath of the October 1987 stock market correction, short-term interest rates rose in most countries, reflecting the authorities’ intention to resist upward pressure on prices; in some other countries where the risk of inflation was less acute, short-term interest rates were also increased, mainly because of concern about exchange rates. The rise in short-term interest rates was greatest in the United Kingdom, but was also substantial in the United States, Australia, Canada, and the Federal Republic of Germany. As German rates rose, other European short-term rates, both within and outside the European Monetary System, followed. In Japan, short-term interest rates edged up during the spring of 1989.
Long-term interest rates, by contrast, were relatively stable in most countries during 1988, although they too showed some upward movement in early 1989. Consequently, the difference in average yield between short-term and long-term instruments narrowed in 1988. The yield differential between long-term bonds and equities widened during 1988, but the gap remained substantially narrower than in mid-October 1987, just before the global stock market decline.
With some exceptions, less progress was made in the fiscal area in 1988 than in previous years, as conflicting objectives slowed movement toward the achievement of medium-term consolidation. In the United States, the federal budget deficit declined slightly as a percentage of GNP in the fiscal year ended September 30, 1988, although it widened somewhat in dollar terms. In Germany, the fiscal position of the territorial authorities (the Länder) showed little change despite a tax cut in early 1988. However, in early 1989, Germany implemented an increase in excise taxes equivalent to almost ½ of 1 percent of GNP. In Japan, the fiscal balance improved despite a cut in personal income taxes, owing to a large cyclical increase in tax receipts combined with cautious spending policies; in April 1989, a tax reform package was also introduced, substituting a general consumption tax for most specific commodity taxes and reducing reliance on direct taxes. In the United Kingdom, a budget surplus was recorded in 1988, allowing repayment of public debt. Canada also continued to make progress in fiscal consolidation in 1988, but at a somewhat reduced pace. Italy’s central government budget deficit remained high at 11½ percent of GNP. Among the smaller industrial countries, fiscal policy was generally restrictive in 1988, reflecting concerns over inflation and, in some cases, external or budgetary deficits. Several of the smaller countries also announced reforms of their tax systems.
During the past decade, industrial countries have looked mainly to structural or microeconomic policies, within an appropriate macroeconomic policy framework, to eradicate the causes of the low growth and high inflation of the 1970s and early 1980s. Trade liberalization, elimination of industrial and agricultural subsidies, and reduction of taxes that discourage employment and work incentives all aim at more efficient use of resources. Interest rate ceilings have been eliminated to stimulate private savings and capital formation. Measures to allow prices to respond efficiently and speedily to changes in market conditions have focused largely on improved functioning of labor and financial markets; removing subsidies in product markets has also contributed to more efficient resource allocation. Progress on these fronts is encouraging; however, much remains to be done to remove obstacles to a more efficient allocation of resources among and within countries. In this context, the strength of protectionist pressures remains of particular concern.
Growth and Inflation
For the developing countries as a whole, real GDP rose by 4.2 percent in 1988, one of the highest growth rates in the past decade. However, various country groups shared unequally in this performance.
Buoyant investment and strong growth were largely concentrated in Asia, among the exporters of manufactures. In the newly industrializing economies—the Republic of Korea, Taiwan Province of China, Hong Kong, and Singapore—output grew at an average of almost 10 percent in 1988, as exports rose strongly and domestic demand was buoyant. Malaysia, Thailand, and India also saw economic activity pick up. In China, rapid output growth continued, reflecting the strength of investment and consumption.
Investment and growth were weak in much of the rest of the developing world, particularly in middle-income countries of the Western Hemisphere and the poorer countries of Africa, most of which have difficulty in servicing their debts. In Argentina and Brazil, for example, GDP growth stagnated despite strong exports, and investment slowed because of rapid inflation, an uncertain policy outlook, and a large debt burden. In Mexico, slower growth reflected tighter financial policies. Bolivia, Chile, and Colombia sustained growth at a comparatively high rate. Although activity in the fuel exporting countries picked up somewhat in 1988, it remained slower than in other developing countries because of past losses in terms of trade. In sub-Saharan Africa, the rate of growth remained low in 1988, and per capita income continued to decline, partly because world prices for coffee and cocoa were weak. In some countries, delays in putting adjustment programs into effect probably contributed to the fall in output. Exceptions to the general pattern in Africa included Ghana, Kenya, Morocco, and Senegal, where timely adjustment programs and far-reaching structural reforms sustained growth at 5 percent or more.
Inflation accelerated sharply in the developing countries in 1988, mainly reflecting difficulties in the implementation of fiscal and monetary policies in many heavily indebted countries. Inflation also increased because of expansionary policies in some countries and the measured inflation rate showed a temporary rise in others because of the response of newly liberalized prices to strong pent-up demand in others. The oil exporting Middle Eastern countries, where adjustment to deteriorating terms of trade reduced demand, were the main exception to the overall pattern of consumer price increases.
In 1988, many developing countries, including Mexico, Ghana, and Senegal, achieved substantial fiscal adjustment. However, fiscal deficits remain unsustainable in many other countries, reflecting an inadequate policy stance, including an insufficient response to unfavorable external developments. Many countries have difficulty sustaining a fiscal position that is consistent with noninflationary growth and with meeting their foreign obligations. Some countries have succeeded in broadening their revenue bases, but a number of developing countries continue to rely disproportionately on the taxation of external trade. Nigeria and Côte d’Ivoire exemplify this dependence and have experienced fiscal deterioration, partly as a result of low commodity prices. Moreover, as servicing both domestic and external debt makes heavy demands on domestic budgets, movements in world interest rates are influencing budgetary outlays in many debtor countries. Countries facing persistent constraints on external borrowing have often responded to a deteriorating fiscal position by curtailing public investment and by issuing currency to finance the fiscal deficit.
Monetary management in developing countries is complicated by this tendency to finance fiscal imbalances through monetary expansion. Argentina and Brazil, for example, saw inflation accelerate sharply in 1988 primarily for this reason, and subsequent policy measures have failed as yet to restore price stability. In some cases, the liquidity effects of debt conversion instruments have not been fully offset, thereby contributing to increased inflationary pressures. China has experienced inflation as credit expansion accommodated excessive growth of investment and consumption. In Chile, where financial policies stressed fiscal balance, the money supply grew more slowly, and inflation was correspondingly lower than in most other countries in the Western Hemisphere.
A number of developing countries have in recent years put considerable effort into implementing structural reform. Many countries have adopted more flexible interest rates, introduced greater competition in their financial systems, relaxed controls on external financial transactions, and liberalized foreign exchange markets. They have focused on pricing policy, switching public enterprises to full cost pricing or reducing their subsidies. Reforms have been particularly important in the agricultural sector, where distorted pricing signals from marketing boards have in the past often led to inefficient crop choice and labor allocation and have driven farm families into cities where they have worsened urban problems and become a fiscal burden. Despite these efforts, many structural problems remain to be tackled if economic incentives in developing countries are to be improved. As in the case of the industrial countries, special attention needs to be paid to resisting protectionist pressures and reducing existing trade barriers.
2. Trade, Payments, and Exchange Rates
The volume of world trade expanded by more than 9 percent in 1988, the highest rate of growth since 1976. Continued shifts of trade shares among countries and regions accompanied this expansion.
World trade expanded in response to vigorous import demand in the industrial countries. Import volumes rose by 17 percent in Japan, 15 percent in Canada, and 13 percent in the United Kingdom. Even in the United States, import volumes rose by 7 percent because of growing domestic demand, notwithstanding the increased competitiveness of domestic producers following the significant decline in the value of the dollar since 1985. Import growth was strong among the exporters of manufactures in the developing countries, reflecting robust economic activity and, in some highly indebted countries, reflecting more accommodating domestic policies. Among the exporters of fuels, in contrast, imports remained depressed.
The United States experienced real export growth of 23 percent in 1988 and has now recovered most of the share of world merchandise exports it lost between 1980 and 1985. As part of the adjustment process, much of the counterpart of this gain was a decline in the market shares of Japan and Germany, although both of these countries showed signs of renewed export strength in early 1989. Several other industrial countries registered smaller declines in their shares of world exports.
Box 2Statistical Discrepancy
Since exports by one country correspond to the imports of other countries, and payments by one country are received by others, globally the sums of all payments and receipts should balance. But they do not. Indeed, the analysis of current account trends is distorted by considerable statistical discrepancies. These discrepancies arise from errors, omissions, and asymmetries in reported payments data, primarily on trade in services, and particularly on portfolio investment income flows. In 1988, the global discrepancy increased by about $40 billion to $78 billion, as some of the influences that had contributed to its reduction in 1986–87 were reversed. Both exchange rate changes and movements in interest rates have contributed to large fluctuations in the discrepancy in recent years.
The developing countries as a group also gained export shares in 1988, with the newly industrializing economies of Asia continuing to expand their markets, although less rapidly than before. In addition, some higher commodity prices and strong demand from industrial countries raised the market shares of some primary commodity producers.
Balance of Payments Developments
The combined current account deficit of industrial countries widened by almost $20 billion in 1988, but as a share of GNP remained approximately unchanged at 0.4 percent. Shifting export market shares combined with unequal import growth to adjust the external positions of Japan and the United States (Chart 4). Both the Japanese current account surplus and the U.S. current account deficit fell, to 2.8 percent and 2.6 percent of their respective GNPs in 1988, representing adjustments of over ¾ of 1 percent for Japan and ½ of 1 percent for the United States. In contrast, the current account deficit in the United Kingdom increased from 0.7 percent of GNP in 1987 to 3.2 percent in 1988, while in France it narrowed a little; the surplus in Germany remained at 4 percent of GNP. The combined current account deficit of smaller industrial countries increased a little, led by significant deteriorations in Spain and Australia.
Chart 4Major Industrial Countries: Payments Balances on Current Account, 1980-First Quarter 1989
Since the middle of 1988, there have been indications of a slowing in the adjustment process as the effects of the policy and exchange rate changes that had taken place in the period 1985–87 are beginning to taper off. In the first quarter of 1989, Germany’s current account surplus increased by almost half over the fourth quarter of 1988, while Japan’s surplus was little changed and the deficit of the United States rose.
The current account balance of developing countries shifted into a deficit of about $9 billion in 1988 (about ¼ of 1 percent of GDP) from a small surplus of $4 billion in 1987. Most of this shift resulted from changes in the external positions of the four Asian newly industrializing economies and the fuel exporters. The reduction in the surplus of these economies—from $30 billion in 1987 to $28 billion in 1988—or almost 3 percent of their aggregate GDP, was more than accounted for by a $8 billion drop in the surplus of Taiwan Province of China, based in part on a substantial increase in imports of gold. The external balance of fuel exporters deteriorated because falling world oil prices reduced export receipts, although for exporters in the Western Hemisphere higher export growth of commodities (other than oil) and manufactures—especially in the highly indebted countries—largely offset losses from the fall in oil prices. There was little change in the current account balance of the low-income African countries, notwithstanding the decline in prices of tropical beverages. Estimates of the current account balance in convertible currencies of the Soviet Union and Eastern European countries that are not members of the Fund suggest a deterioration of about $8 billion in 1988.
Cooperative efforts by the seven largest industrial countries—the Group of Seven—to stabilize the exchange rates of the major currencies contributed to greater stability in 1988 and early 1989 than was the case in 1987. Close cooperation in the foreign exchange markets, including several occasions when concerted official intervention was reported, took place within a framework of broader policy coordination among the Group of Seven. After a period of strength from June through September 1988, the U.S. dollar weakened in October and November, apparently because of uncertain prospects for the trade and fiscal deficits (Chart 5). Thereafter, a shift of market sentiment, owing partly to higher U.S. interest rates and an underlying increase in the demand for dollar-denominated assets, strengthened the dollar; by the end of April 1989, the real effective value of the dollar—that is, the nominal exchange rate of the dollar against other currencies corrected for differences in inflation and the pattern of trade—was about 6½ percent above its level a year earlier. Over the same period, the Canadian dollar appreciated in real effective terms by about 8 percent, the pound sterling by 3½ percent, and the Italian lira by 3 percent. On the same basis, both the French franc and the deutsche mark appreciated, by 4½ percent and 3½ percent, respectively, while the Japanese yen remained broadly unchanged from its level a year earlier.
Chart 5Major Industrial Countries: U.S. Dollar and Real Effective Exchange Rates, 1978-April 19891
1Real effective exchange rates are calculated on the basis of normalized unit labor costs in manufacturing.
Within the exchange rate mechanism of the European Monetary System, the parities of January 1987 were maintained, despite tensions arising from divergent current account trends, changing tax regulations, and shifting investment opportunities. Further convergence of inflation rates, concerted interest rate changes, and exchange market intervention relieved these tensions, although the real effective values of some currencies shifted slightly in 1988.
The real effective exchange values of most developing country currencies appreciated during 1988, following large depreciations during 1985–87 (Chart 6). For some countries this reflected significant improvement in their external position arising from more favorable terms of trade. For the fuel exporters in the Middle East, whose terms of trade have continued to deteriorate, the appreciation seems to have reflected the close relationship of local currencies to the U.S. dollar. In some countries with debt-servicing difficulties, the recent appreciation resulted from the failure of changes in nominal exchange rates to keep pace with rapid domestic inflation. The currencies of some Asian exporters of manufactures have appreciated significantly in recent years; during 1986–88, the real effective exchange rate of Korea rose by 10 percent and that of Taiwan Province of China by 12 percent.
Chart 6Developing Countries: Real Effective Exchange Rates, 1979-First Quarter 19891
1Composites for regional groups are weighted averages, where countries’ weights are dollar values of their respective GDPs during 1982–87. Because of the lack of appropriate domestic price data, the countries included for the Middle East and African regions cover only about 50 percent and 85 percent, respectively, of their regional GDPs. For the Western Hemisphere, Europe, and Asia, the coverage is complete.
3. External Financing and Debt
Financing of current account balances of the industrial countries resumed a more normal pattern in 1988, as autonomous private capital flows replaced the changes in reserve holdings that reflected the widespread intervention by the Group of Seven countries during 1987 in support of the U.S. dollar. The aggregate increase in official reserves was small. There were, however, considerable—though offsetting—changes in the reserve positions of individual countries, reflecting in part the more diverse exchange market pressures in 1988. Thus, the foreign exchange reserves of Canada, whose currency was the strongest in the Group of Seven in 1988, grew by $8 billion, an increase of 111 percent. Japan’s reserves also increased, by $16 billion, or 20 percent. In contrast, the foreign exchange reserves of Germany and France, whose currencies were comparatively weak, fell by $20 billion and $8 billion, respectively. The decline in Germany’s reserves was sufficient to offset more than two thirds of that country’s reserve accumulation in 1987.
The external financing needs (defined as the balance on goods, services, and private transfers) of the developing countries as a group rose to about $24 billion in 1988. Although larger than in 1987, recourse to external financing remained significantly below what it had been in each of the previous six years. The rise in aggregate financing needs reflected mainly the increased deficit of the fuel exporters, which was financed by running down reserves. A few countries with strong current account positions, notably the Asian newly industrializing economies, continued to have large outflows of capital. By contrast, the financial position of many of the debt-problem countries remains extremely vulnerable, despite the fact that financial flows to some of these countries that do not add to debt (including official transfers and foreign direct investment) increased considerably in 1988. Accumulated payments arrears rose to an estimated $52 billion at the end of 1988, compared with $41 billion at the end of 1987, although the number of countries with arrears outstanding declined from 55 in 1986 and 1987 to 49 in 1988.
In recent years, developing countries have relied predominantly on official sources for their financing needs; official creditors (governments and international institutions) provided some 65 percent of financing to developing countries in 1985–88, compared with only about 35 percent in 1980–82. Although this pattern continued in 1988, the level of net official disbursements fell sharply; disbursements by multilateral development banks and bilateral sources were smaller, in some cases reflecting slippage in adjustment by indebted countries. Official lending declined most dramatically to those countries, including the heavily indebted middle-income countries, that have borrowed predominantly from commercial sources; official lending to low-income countries was broadly maintained.
Nonofficial lending to developing countries barely rose in 1988 from the depressed level of 1987. Countries in Africa and the Western Hemisphere, especially those with recent debt-servicing difficulties, continued to experience a withdrawal of private funds in 1988. Net lending to Asia declined in response to the lower financing requirements of the newly industrializing economies. In contrast, private lending to developing countries in Europe and the Middle East rose moderately. Exceptional financing flows (comprising arrears and debt reschedulings) remained an important source of relief in debt-problem countries; in some cases swaps and conversions arranged within the menu of options provided additional assistance.
For many developing countries, the low levels of private foreign financing, and the continued burden of heavy net interest payments, imply a substantial net transfer of resources to the rest of the world. The scale of this transfer for the 15 heavily indebted countries, which rely primarily on commercial borrowing, has been particularly large—an average of 3 percent of GDP annually since the outbreak of the debt crisis in 1982 until the end of 1988, in contrast to an average net inflow of 1½ percent a year in the previous five years. For some other groups, such as the low-income African countries, increased official financing has helped to maintain a significant net inward transfer of resources from the rest of the world.
External Debt and Debt Service
The total external debt of developing countries fell by some $3 billion in 1988, the first decline in many years. Changes in the dollar valuation of existing liabilities, which had contributed significantly to the rise in debt in previous years, accounts for part of this decline in the stock of debt in 1988. Liabilities to official creditors rose by about 3 percent during the year, compared with an average growth of 17 percent in the previous three years. Liabilities to the nonofficial sector fell by about 2 percent, compared with an average increase of 5 percent in 1985–87.
The slower accumulation of debt, combined with strong export growth, pushed down the aggregate debt-to-export ratio of the net debtor developing countries, to 163 percent at the end of 1988—still above the level at the end of 1982. Although debt-to-export ratios (Chart 7) declined for most major groups of debtor countries, the debt burden nonetheless remains particularly onerous for the heavily indebted middle-income countries and low-income sub-Saharan African nations.
Chart 7Developing Countries: Debt Outstanding and Ratios of Debt and Debt Service to Exports, 1980–881
1 The debt-service ratio refers to debt service actually paid rather than accrued or contractually due.
The aggregate debt-service ratio changed little in 1988, as the growth of exports broadly offset the impact of the rise in interest payments resulting from the reversal of the three-year decline in international interest rates. However, the debt-service ratio of debt-problem countries rose somewhat, as the increase in export earnings allowed some countries to raise the proportion of debt service due that was actually being paid.