The Global Economy
- International Monetary Fund
- Published Date:
- January 1994
Main Developments in the World Economy
The world economy showed a modest recovery in 1993, with total output increasing by 2.3 percent compared with a rise of 1.8 percent in 1992, largely owing to strong growth in the developing countries. At the same time, growth in the industrial countries fell slightly to 1.2 percent in 1993 from 1.6 percent in 1992 and the unemployment rate rose by half a percentage point. The growth of world trade slowed to 2.4 percent from 4.5 percent.
The overall decline in the growth of output for the industrial countries during 1993 masked a number of encouraging developments in some major economies. In the United States, the recovery became firmly established. The recovery also strengthened in Canada, while consumer demand spurred an economic turnaround in the United Kingdom. Economic activity was restrained in Japan as industrial production declined. Likewise, conditions remained weak in continental Europe.
The growth registered by the developing countries as a group in 1993 was a sign of improved conditions in many countries, although there were substantial disparities across different regions. Growth rose in Asia, the Western Hemisphere, and—slightly—in Africa. In the Middle East, growth declined to a more sustainable pace.
Economic conditions in most of the transition economies of Central and Eastern Europe and in the Baltic countries improved on average during 1993. In most of the economies of the former Soviet Union, output fell further in 1993. Russia’s GDP fell 11½ percent during the year, despite efforts to contain the decline.
Worldwide inflation declined owing partly to a drop in oil prices. In many industrial countries, inflation fell to near thirty-year lows. Inflation rose in the developing countries as a group, owing to increases in Asia, and in the economies in transition.
Monetary conditions generally eased in 1993 and early 1994. Market interest rates remained relatively low in the United States during 1993, although they rose in the first quarter of 1994. In Europe, monetary conditions eased gradually, while in Japan the official discount rate remained at a historically low level.
The combined current account position of the industrial countries swung to a surplus of $12 billion in 1993 from a $43 billion deficit in 1992. The deficit widened in the United States, however, as economic growth strengthened relative to that of partner countries; by contrast, in Japan the current account surplus increased and the combined current account position of countries in the European Union (EU) moved from a moderate deficit in 1992 into approximate balance in 1993.
In the developing countries, current account positions tended to deteriorate in 1993 owing to rapid growth of domestic demand and imports, continued weak growth in industrial countries, and unfavorable terms of trade developments. Net external financing to developing countries increased by about $30 billion, in part because of a sharp rise in external capital flows to Asia.
Economic Activity and Employment
World economic activity was buoyed by continued strong growth in the developing countries in 1993 (Table 1). Growth declined slightly in the industrial countries and cyclical divergences remained pronounced. Aggregate output continued to decline in the countries in transition, but by much less than in 1992, and several countries experienced positive growth. World trade expanded moderately by 2½ percent, well below the rate in 1992, reflecting the weakness of activity in Japan and continental Europe. Part of this moderate expansion appears to have reflected a temporary underreporting of trade flows in European industrial countries (associated with changes in customs procedures within the European Union).
|Other industrial countries||2.8||0.9||0.9||—|
|Middle East and Europe||4.2||1.9||7.5||4.7|
|Economies in transition||-3.3||-11.8||-15.5||-8.8|
|Central and Eastern Europe||-7.0||-12.7||-8.3||-1.4|
|Other transition economies||-2.0||-11.6||-17.8||-11.9|
|World trade volume||4.6||2.4||4.5||2.4|
|In U.S. dollars a barrel||22.05||18.30||18.22||16.13|
|Countries in transition||32.4||104.3||766.9||687.2|
|Six-month LIBOR(in percent)4|
|On U.S. dollar deposits||8.4||6.1||3.9||3.4|
|On Japanese yen deposits||7.8||7.2||4.3||3.0|
|On deutsche mark deposits||8.8||9.4||9.4||6.9|
Economic growth in the industrial countries declined moderately to 1¼ percent in 1993 (Chart 1) and unemployment rose from 7¾ percent to 8¼ percent. The recovery in the United States, which was initially very sluggish, became firmly established in 1993. Capacity utilization reached 83 percent by the end of 1993; the average workweek remained above previous postwar highs; employment in manufacturing began to increase more consistently; and unemployment declined further. The recovery also strengthened in Canada, supported by strong investment and export demand. In the United Kingdom, consumer demand fueled an economic turnaround, reflecting lower household debt-income ratios and lower interest rates. Economic conditions also improved considerably in Australia and New Zealand in 1993 owing to increases in both domestic and external demand, and recovery started in the Nordic countries.
Chart 1Major Industrial Countries: Real GDP
1 Through 1991, west Germany only; thereafter, IMF staff estimates for unified Germany
Economic activity in Japan was restrained by the aftereffects of asset price declines, continued weakness in investment, the strength of the yen, and depressed levels of confidence. As a result, output stagnated in 1993, the worst performance since the first oil shock. Although there were some signs of an improvement in the economic situation in early 1994, recovery remained uncertain. In continental Europe, economic conditions remained weak in 1993 and early 1994, despite the gradual easing of monetary conditions. Economic activity in Germany remained subdued owing to low consumer confidence in the face of uncertain job prospects, increases in fuel and social security taxes, reductions in public spending, and continued weak growth in Germany’s European trading partners. In France, real GDP declined in 1993, and unemployment increased markedly to about 12 percent of the labor force. Output also declined in Italy, despite a strong boost from exports, because domestic demand was restrained by lower wage increases, higher taxes associated with fiscal reform, and continued labor shedding. Partly reflecting these weak economic conditions, most of the other economies of the smaller European industrial countries also experienced further output declines, although much less so than in 1992. However, by mid-1994 there were increased signs of economic recovery.
Sustained growth in the developing countries in 1993 was indicative of the improved conditions in many countries and of the growing economic interactions among developing countries. The share of developing country exports going to other developing countries increased steadily. Moreover, economic expansion in many developing countries helped to compensate for the lackluster demand growth in the industrial countries: since 1990, exports to developing countries have risen significantly as a share of industrial country exports (Chart 2).
Chart 2Developing Countries: Contribution to Regional Export Flows
1 As a percent of total dollar value of developing country exports.
2 As a percent of total dollar value of industrial country exports.
Despite the strong growth registered by developing countries as a group, substantial disparities existed in performance among the various developing country regions in 1993. Growth declined to a more sustainable pace in the Middle East, following the post-crisis surge in output in 1992. Among the developing economies of Asia, growth reached 13½ percent in China in 1993 despite efforts to contain the unsustain-ably rapid expansion. Economic activity remained moderate in India, strengthened in Korea, and expanded at a relatively robust pace in Indonesia, Malaysia, Pakistan, Singapore, Taiwan Province of China, and Thailand. Growth in the Western Hemisphere increased to 3½ percent in 1993, largely reflecting a turn around in Brazil and relatively robust growth in Argentina, Chile, and Peru. In Venezuela, political uncertainty and a drop in investment contributed to a decline in output, while in Mexico restructuring efforts in manufacturing and the need to reduce inflation contributed to a marked slowdown in economic activity.
In Africa, economic activity increased only slightly in 1993, reflecting the effects of the drought, continued uncertainties related to the political transformation process in some countries, and country-specific problems, such as the decline in oil prices and shortages of foreign exchange and associated difficulties in obtaining imported inputs. Economic activity in the African countries of the franc zone (CFA) declined by almost 2 percent in 1993. In January 1994, the CFA franc was devalued by 50 percent in terms of the French franc and the Comorian franc by 33 percent, which improved conditions for a resumption of stronger growth during the period ahead (see Box 1). Growth strengthened to about 3½ percent in the African countries that, at the end of 1993, had arrangements under the Fund’s structural adjustment facility or enhanced structural adjustment facility.
Economic conditions improved in most of the transition countries of Central and Eastern Europe and the Baltic countries during 1993. Recoveries in Albania, Poland, and Slovenia continued, while there were promising signs that the economies of the Czech Republic and Hungary were beginning to turn around. In contrast, output declined in Bulgaria because of financing constraints and the adverse impact of the embargo on the Federal Republic of Yugoslavia (Serbia and Montenegro), and in the Slovak Republic following the dissolution of Czechoslovakia. Unemployment generally remained in the 10-16 percent range, except in the Czech Republic where it stabilized below 5 percent.
Box 1New Strategy for Growth in the African Franc Zone
The 14 countries that comprise the African franc zone—members of the Central Bank of West African States (BCEAO) and of the Bank of Central African States (BEAC) and the Comoros—have embarked on a new strategy for growth centered on comprehensive adjustment programs to revitalize their economies. An important element of the new strategy is the realignment of the parities of the CFA franc—issued by the BCEAO and by the BEAC-and the Comorian franc, with effect from January 12,1994. The parity adjustments amount to 50 percent in foreign currency terms for the CFA franc and 33 percent for the Comorian franc.
The realignment of the CFA franc was announced on January 11,1994 in Dakar by the chiefs of state and the heads of government of the African countries that are members of the BCEAO and the BEAC. The decision was welcomed by Michel Camdessus, Managing Director of the Fund, who commented that the realignment, together with the supporting measures, “should greatly facilitate the re-establishment of the competitiveness of these countries, the restoration of economic growth, and the solution of their balance of payments difficulties.”
As various indicators showed, the CFA franc and the Comorian franc had become overvalued, which severely eroded the competitiveness of the franc zone countries. Since the mid-1980s, their economic situation had deteriorated markedly—there was no economic growth and per capita incomes fell by an average of 20 percent. Repeated efforts at internal adjustment failed to bring about the needed turnaround.
Between 1985 and 1993, the terms of trade of these countries fell by almost 50 percent, mainly because of sharply lower world market prices for their chief exports, particularly cocoa, coffee, cotton, and petroleum. Arrangements to guarantee the convertibility of the CFA franc and the Comorian franc at 50 CFA francs and 50 Comorian francs per French franc had benefited the countries for a considerable period, but since 1985 the French franc had appreciated substantially against the currencies of their main trading partners and competitors, which exacerbated the loss of competitiveness. Various structural and sectoral bottlenecks, in particular, relatively high wages, also contributed to the shrinkage of the economy.
In conjunction with the exchange rate realignment, the franc zone countries’ economic programs encompass a variety of fiscal, monetary, wage, structural, and social measures designed to stimulate lasting and stable growth. Although each program is tailored to the specific circumstances of each individual country, there are a number of common elements.
The programs emphasize prudent monetary policy, accelerated structural reforms, and tight fiscal policy, including a restrictive public sector wage policy adopted in the context of civil service reform. Extensive reforms of the tax system are also being planned. The most vulnerable segments of the population are being protected through social safety nets, but nonproductive expenditures are being curtailed severely.
The Fund is supporting the economic programs with policy advice and financial assistance. Following approval of arrangements supporting each of these countries’ adjustment programs by the Fund’s Executive Board, the country will be able to seek debt-rescheduling agreements with official creditors under the auspices of the Paris Club.
Most countries of the former Soviet Union, with the notable exception of Turkmenistan, experienced further substantial drops in output in 1993, because of ongoing disruptions to interstate trade, failures to implement stabilization policies, and armed conflicts in several countries. Russia’s GDP is estimated to have fallen by 11½ percent in 1993, against a background of continued rapid inflation.
Inflation and Commodity Prices
Inflation generally declined in the industrial countries, and in many countries inflation fell below levels last seen in the 1960s. In particular. Australia. Canada, Denmark, Ireland, Japan, Finland. France, Iceland, the Netherlands, and New Zealand all recorded inflation of about 2 percent or less in 1993 (as measured by increases in the GDP deflator). In the United States, consumer price inflation remained unchanged at about 3 percent, whereas price pressures continued to ease in many countries in Europe owing to anti-inflationary monetary policies and large margins of unused capacity.
Average inflation increased to 46 percent in the developing countries, even though half of the countries in this group experienced inflation of 7 percent or less. Inflation declined in many countries in Africa, reflecting a drop in commodity prices and good price performance in the CFA countries. Moreover, in many Southern African countries inflation declined in 1993 as a result of the ending of a severe drought. Inflation also declined in most countries in the Western Hemisphere, reflecting successful economic policies; an important exception, however, was Brazil, Average inflation in Asia rose to 9½ percent, with a significant rise in inflation in China. In the Middle East and Europe, despite low inflation in many countries, average inflation remained at about 24 percent, mainly because of high inflation in Turkey, the Islamic Republic of Iran, and other smaller countries in the region.
There was only modest progress in reducing inflation in the countries in transition in 1993, except in the Baltic countries where the monthly rate of inflation fell to low to mid-single digits. Inflation rose in the Czech Republic, Romania, and the Slovak Republic, although this was partially the result of increases in indirect taxes. Inflation performance was much less encouraging in Russia, where weak credit control was reflected in monthly price increases of over 20 percent during 1993. Very high inflation also characterized most other countries of the former Soviet Union.
A further decline of oil prices in 1993 contributed to a reduction in average worldwide inflation. Oil markets reflected subdued industrial country demand, continued supply increases, and uncertainties about the timing of the reentry of Iraq into oil markets. Except for metals and minerals, dollar prices of nonfuel commodities generally stabilized and then rose in the second half of 1993 because of weather-related supply reductions of some commodities and shifts of productive capacity to other uses. Nevertheless, by the end of 1993 nonfuel commodity prices were still well below previous peaks reached in 1988.
Foreign Exchange and Financial Markets
Market interest rates remained relatively low in the United States throughout 1993. In early 1994 as the economic recovery gained momentum, the Federal Reserve Board raised the target for the federal funds rate by a total of ¾ of 1 percentage point in three stages—in February, March, and again in April—bringing it to 3¾ percent; U.S. market interest rates, particularly long-term rates, also rose. Later, in mid-May, the Federal Reserve Board raised the discount rate and the federal funds rate by 50 basis points. The official discount rate in Japan was reduced to a historical low of 1 ¾percent in September 1993, and both short and long-term market interest rates continued to decline during the year.
Monetary conditions were eased gradually in Europe in 1993 and early 1994. In the course of 1993, the Bundesbank reduced the discount rate by 2½ percentage points, to percent; further reductions through May 1994 brought the discount rate to 4½ percent. Through the end of 1993, both short- and long-term market interest rates declined, but in early 1994 long-term rates rose while short-term rates continued to decline. Interest rates in other European countries generally followed those in Germany.
In foreign exchange markets, the U.S. dollar rose about 3½ percent in nominal effective terms in the 12 months through the end of April 1994. During this period, the dollar appreciated between 4 percent and 8 percent against the deutsche mark, the French franc, the Italian lira, and the pound sterling, reflecting relative cyclical positions and changes in interest rate differentials in favor of the U.S. currency. The U.S. dollar also strengthened by 9 percent against the Canadian dollar. From February 1993 the yen continued its upward trend until the middle of August 1993, rising by 25 percent against the U.S. dollar and by 20 percent to 35 percent against the four main European currencies. Part of this appreciation was reversed in the latter part of 1993 but the yen again strengthened during the first four months of 1994, to stand at a record ¥ 102.50 per U.S. dollar at the end of April 1994. Reduced interest rate differentials in favor of assets denominated in European currencies contributed to the strength of the yen; a large trade surplus and associated trade tensions with the United States also appear to have been a factor in the rise against the dollar.
In Europe, following considerable turbulence within the European Monetary System (EMS) from mid-1992 through July 1993, tensions abated significantly after the widening of the exchange rate mechanism (ERM) intervention band in August 1993. Following initial weakening, the currencies of several of the ERM countries gradually strengthened to above their pre-August 1993 intervention floors relative to the deutsche mark, even as interest rate differentials with Germany narrowed. Outside the ERM, the pound sterling strengthened significantly vis-à-vis the deutsche mark after early 1993, reversing the sharp depreciation that followed the suspension of the pound from the ERM, although the interest rate cut in February 1994 led to some weakening. By the end of 1993, the Finnish markka reversed about one third of the decline against the deutsche mark that occurred in the six months following the decision to float the currency, with the improvement in late 1993 reflecting increased confidence, emerging signs of recovery, and prospects for lower inflation. The Swedish krona declined by about 12 percent during 1993, in nominal effective terms, but strengthened somewhat in early 1994.
The combined current account position of the industrial countries swung from a deficit of $43 billion in 1992 to a surplus of $12 billion in 1993, with substantial shifts in current account positions across regions. The nonsynchronous nature of cyclical patterns among industrial countries was a decisive factor shaping trade patterns, driving import demand higher in recovering countries and lower in the economies in recession, as were changes in real effective exchange rates. In the United States, the current account deficit widened considerably in 1993 as economic growth in the United States strengthened relative to that in partner countries. Bycontrast, Japan’s current account surplus increased in 1993, and the combined current account position of the countries in the European Union moved from a deficit of $68 billion in 1992 to approximate balance in 1993.
Current account positions in the developing countries tended to deteriorate in 1993, owing to both the strength of demand and activity relative to the industrial countries and unfavorable changes in the terms of trade related to weak commodity price developments and adverse exchange rate movements Net external financing increased by about $27 billion in 1993, to $148 billion, in part because of a sharp increase of $16 billion to Asia; other regions also received greater external financing in 1993. The combined current account of the Central and Eastern European countries moved into deficit in 1993, mainly because of strengthening domestic demand and increased capital inflows. In contrast, and despite a significant real appreciation of the ruble, Russia’s current account position moved from a deficit in 1992 to a surplus in 1993, reflecting depressed domestic demand, reductions in import subsidies, and financing constraints.
Aggregate measures of developing country indebtedness and debt burdens improved in 1993 (Charts 3 and 4). This favorable overall trend is representative of developments in Asia, the Middle East and Europe, and the Western Hemisphere, where both debt and debt-service ratios were well below the peaks reached in the mid-1980s. In Africa, however, partly reflecting the weakness of export earnings, debt ratios have risen further, and earlier declines in debt-service ratios have been partially or wholly reversed. External assistance has helped many sub-Saharan countries to service their external debt; official transfers corresponded to roughly 80 percent of debt-service payments in 1993.
Chart 3Developing Countries and Countries in Transition: Net External Financing Flows
Source: International Monetary Fund, World Economic Outlook, May 1994 (Washington, May 1994), Statistical Appendix, Table A32.
1 The sum (with opposite sign) of balance on current account, excluding official transfers, change in reserves, asset transactions, and errors and omissions, net.
2 The sum of official transfers and direct investment
Chart 4Developing Countries and Countries in Transition: External Debt and Debt Service1
1 Debt service refers to actual payments of interest on total debt plus actual amortization payments on long-term debt.
Between May 1993 and June 1994, Paris Club creditors concluded debt-rescheduling agreements with Algeria, Benin, Bulgaria, Burkina Faso, Cameroon, the Central African Republic, the Congo, Costa Rica, Côte d’lvoire, Ecuador, Gabon, Guyana, Jordan, Kenya, Niger, Peru, Russia, Senegal, and Viet Nam. The debt initiatives associated with the devaluation of the CFA franc included a proposal by France to write off development aid loans of the poorest CFA countries and to reduce by half the aid loans of the middle-income CFA countries. Commercial bank creditors completed agreements on debt and debt-service reductions with Bolivia (May 1993), Brazil (April 1994), and Jordan (December 1993). Ecuador agreed on a term sheet with its bank creditors in June 1994. As of June 1994, it was anticipated that Bulgaria, the Dominican Republic, and Poland would complete their agreements during 1994. Negotiations continued between Panama and Peru and their respective Bank Advisory Committees.
World Economic Outlook
Global economic developments and policies are reviewed regularly by the Executive Board and the Interim Committee, based on World Economic Outlook reports prepared by staff. These reports contain comprehensive analyses of short-term and medium-term prospects for the world economy and for country groups and provide the basic framework necessary for assessing the interaction of economic policies of individual member countries.
In the period covered by this Annual Report, the Executive Board held two discussions on the World Economic Outlook, in September 1993 and in April 1994. Both sessions covered a wide range of topics. In September 1993, Directors focused on the pressing need for further progress in implementing the global cooperative medium-term growth effort adopted by the Interim Committee at its meeting in April 1993 to bolster confidence and strengthen prospects for a durable, nonflationary world expansion. In April 1994, issues considered by Directors included recent economic policy advances in many parts of the world, indications that the world economic slowdown that had begun in 1990 was coming to an end—even though conditions remained weak in many industrial countries and countries in transition—and the policy challenges that remained in the period ahead.
In September 1993, in discussing obstacles to recovery and the systemic risks associated with a prolonged period of economic weakness, Directors singled out among these the pervasive increase in protectionist sentiment that had accompanied the rise in unemployment in industrial countries since the late 1980s. They stressed the essential role of trade and competitive forces in the growth process of all countries. Free trade increased growth prospects in developing and newly liberalizing economies, and, at the same time, it stimulated productivity and growth in the industrial world by opening it up to competitive pressures.
In April 1994, Directors welcomed the successful conclusion of the Uruguay Round of trade negotiations, emphasizing that this would give new impetus to world trade, increase efficiency in the use of resources, and help to bolster business and consumer confidence worldwide (see Box 2). Directors recognized the important contribution of increased trade as an engine of economic growth and development in all countries. In this connection, they stressed that reduced protection in agricultural sectors, especially lower agricultural subsidies in industrial countries, would help to reduce distortions in world agricultural production and trade. Many Directors viewed the successful completion of the Uruguay Round as the single most important step toward enhancing growth prospects in the period ahead and into the medium term.
During the discussion in April 1994, Directors noted the encouraging progress made in implementing several elements of the agenda set out by the Interim Committee in April 1993. Fiscal consolidation programs had been announced by several countries; interest rates in Europe had fallen significantly, and tensions in the EMS had abated; Japan had taken further measures to support its economy; in many Asian and Latin American countries stabilization and reform efforts had led to sustained, robust growth; and the Fund’s new systemic transformation facility (STF) was supporting the reform process in many of the countries in transition and in some the first signs of recovery were becoming evident.
In view of these developments, Directors generally concurred with the staff’s projections for a gradual strengthening of world trade and activity in the World Economic Outlook report (published in May 1994). But many Directors also emphasized the critical problems that remained for the world economy in generating vigorous and sustainable growth for the broadest range of countries. In many industrial countries, wide margins of slack, high unemployment, large government deficits, and increasing public debt ratios were evident and long-term interest rates were rising despite low actual or expected inflation in most of them. Among many of the poorest developing countries standards of living were falling because of unfavorable external developments or inadequate reform efforts. And, finally, in only a few of the countries in transition was meaningful recovery evident, and in many others financial stabilization was yet to be achieved.
During the discussions held in September 1993, a number of Directors welcomed the staff’s review of global trends in military expenditure and its analysis of the potential beneficial effects for all countries—particularly for developing countries—from downsizing military outlays. They encouraged the staff to continue to examine how countries could best avail themselves of such potential benefits (see Box 3).
Industrial Country Policies
In April 1994, in discussing economic conditions and prospects for industrial countries, Directors highlighted the continuing divergence in cyclical conditions between two groups of countries: in one—including among others, Australia, Canada, New Zealand, the Nordic countries, the United Kingdom, and the United States-recovery was either well established or was clearly under way;in the other—including continental Europe and Japan—although the cyclical decline had bottomed out, the prospects for recovery remained fragile. Many Directors, therefore, were concerned that the resumption of economic activity in Europe and Japan might be slow and that recovery in Europe would depend heavily on external demand.
Box 2Uruguay Round
After 97 months of complex negotiations, 125 participants concluded the eighth round of multilateral trade negotiations with the signing of the Uruguay Round Agreements in Marrakech, Morocco, on April 15, 1994. By doing so they improved market access and broadened the reach of the multilateral trade system to encompass virtually all areas of trade and strengthened its rules and disciplines as well as its dispute settlement mechanism. Last, but not least, they gave permanency to the multilateral trading system by establishing the World Trade Organization (WTO), fifty years after the need for such an organization had been expressed at the Bretton Woods conference. The WTO will, among other things, provide the vehicle for trade negotiations on an ongoing basis.
While it was perhaps the last in the series of comprehensive trade negotiations, the Uruguay Round was a first in generating the active involvement of almost all participating countries—developed, developing, and those in transition. This had not been evident at the time the Round was mandated at Punta del Este in 1986, when many developing countries were reluctant to engage in such broad and complex negotiations and when the mode of operation of centrally planned economies severely limited their effective participation. However, over time, and especially as the convergence of economic policy formulation toward market-oriented allocation of resources became evident, their participation in the Round greatly increased.
This was reflected in the upsurge of applications for accession to the General Agreement on Tariffs and Trade (GATT). By the time of the signing of the Uruguay Round Agreements, the number of Contracting Parties to the GATT had risen to 123 and working parties for the accession of a further 21 countries or territories had been established. This drive toward universal membership in the multilateral trading system reflects the recognition, first, that multilateral rules and global trade liberalization provide an essential anchor for the economic reform efforts of many countries and, second, that they play an important role in improving the investment and employment climate in general and the quality of investment decisions in particular.
Over the period of negotiation, it also had become increasingly evident that trade policy no longer concerned border issues only but constituted an integral element of domestic economic policy. This provided a broad agenda for the new WTO. Among the “new areas” proposed for consideration by the WTO are trade and environment, competition policy, and trade-related aspects of other policy areas, including labor standards—all with due regard to the need to guard against these considerations falling prey to protectionist interests. The broadening of the range of policy issues, together with full integration of the agriculture and textile and clothing sectors into the multilateral trading system, the addition of services, the trade-related aspects of investment, and protection of intellectual property rights, all indicate that the interface of the work of the WTO with that of the Fund will be broad and deep.
The Agreements not only set out the relationship between the Fund and the WTO in the area of the Fund’s jurisdiction (i.e., exchange measures) for trade in goods—as did the old GATT-and for the new Agreement on Trade in Services but also seek to define a broader relationship in the Agreement setting up the WTO. The latter includes a specific paragraph instructing the WTO “to cooperate with the Fund and the [World] Bank and its affiliated agencies with a view to achieving greater coherence in global economic policymaking.” Given the linkages between trade policy and a large number of domestic policy issues, cooperation in policymaking among the three institutions is vital to avoid duplication, jurisdictional conflicts, and contradictory policy advice. How to ensure appropriate and effective complementarity of functions and responsibilities is one of the topics to be taken up in the period before the WTO’s entry into force, now foreseen for January 1,1995.
The WTO also will make permanent the surveillance of trade policies of its members that was initiated provisionally in 1989 under the auspices of the GATT Council in anticipation of the conclusion of the Round. The degree to which the trade policy surveillance of the WTO can contribute to the Fund’s general economic policy surveillance remains an open issue; at this stage, both the nature of the WTO’s surveillance—it being on public record—and the rather long intervals between trade policy reviews—two years for major industrial countries, four for smaller ones, and six for developing countries—differ from the practice under Fund surveillance.
The potential gains to world trade and income resulting from the liberalization and the greater predictability of the trading environment embodied in the Uruguay Round Agreements are considerable, although difficult to quantify. They will not be spread evenly across participants, as those with the flexibility to capitalize on new market opportunities will benefit most. There is a view that some countries may be “net losers” because their preferential market access will be eroded, leading to higher prices for their food imports. In reality, however, all countries are likely to gain from the Uruguay Round as a whole because of increased market access and export opportunities.
The greater predictability of the trading environment and the opening of markets across the globe provide opportunities for diversification of exports and markets that are essential to sustained and successful economic reform efforts. Countries that have relied on unpredictable margins of preference in a restricted number of markets would gain from new opportunities to integrate more fully into global markets. As far as net food importers are concerned, the gradual phasing in of agricultural reform in export-subsidizing countries provides time for adjustment and an incentive to rebuild domestic food production.
It is necessary to ensure therefore that the positive effects of the Round are not frustrated by new uncertainties as vested interests mobilize to defend their positions. Successful cooperation between the Bretton Woods institutions and the WTO would help guard against losing what has been achieved. The Fund has long recognized that achievement of its own mandated objectives was intertwined with the successful operation of a multilateral mechanism aimed at achieving freedom from impediments in international trade. Thus, as early as in the 1947 Annual Report, the Board stated that “the importance to the Fund of a successful International Trade Organization can hardly be overemphasized.” However, achieving a more successful implementation of financial and trade policies globally depends upon coherence of policies at the national level. It will be the task of the Fund, the World Bank, and the WTO—each within its own sphere of expertise—to help ensure that consistency and sustainability of policies at both the national and the international levels are not frustrated by inconsistency of policies elsewhere.
An inevitable consequence of the disparity in cyclical conditions among industrial countries was the widening divergence of current account positions, which should be expected to reverse as cyclical conditions became similar. Although large current account surpluses or deficits could indicate inadequate macro-economic or structural policies, moderate surpluses or deficits were not undesirable, to theextent that these resulted from the efforts of investors to allocate their portfolios efficiently across countries. Directors emphasized that trade policy should not be based on bilateral trade and current account positions and that bilateral trade disputes should be settled quickly and according to multilateral principles.
Box 3The Economic Implications of Unproductive Expenditure
Unproductive expenditure in the public sector leads to larger deficits, higher taxes, and lower benefits. Although it is not possible strictly to define programs that are always unproductive, unproductive public expenditures exist when public sector programs or projects are not cost-effective, when they can be implemented more efficiently by the private sector, or when their mix is not appropriate. Military expenditures and producer subsidies on tradable goods lead to a misallocation of resources from a global perspective. It is not enough for countries facing adjustment to consider simply the level of public expenditure; the productivity of that expenditure is critical too. All countries would benefit from improving the efficiency and composition of their public programs. It is estimated that a 1 percent increase in public expenditure productivity worldwide would yield savings of $90 billion a year. Budgetary policymakers should challenge those who formulate government expenditure to raise their efficiency.
The issue of how economic policymakers may approach the topic of unproductive public expenditure was covered by the staff in a background paper prepared for the April 1994 World Economic Outlook discussion. (Subsequently, in July 1994, the subject was considered by the Board.) In a survey of this issue, the staff noted that many attempts had been made to reduce public expenditure, but less attention had been paid to devising ways in which to allocate public resources most efficiently.
Furthermore, it may be difficult to measure the degree of unproductive expenditure when there is no alternative provider and when the output is not readily or immediately quantifiable. For example, national security and criminal justice are hard to value.
Other public programs may have multiple objectives that make them hard to evaluate or positive externalities that benefit the private sector. However, proxies do exist in many cases, such as literacy rates for primary education and infant mortality rates for primary health care. Also, comparisons can be made with the cost and outcomes of programs in comparable countries.
The public sector acts both as a producer and as a provider, often in conjunction with the private sector. Improving public expenditure productivity would lead to large resource savings that could be used to reduce the deficit, lower taxes, or enhance productive programs. Budgetary policymakers should examine programs proposed by various ministries to ensure that their objectives are met in the most cost-effective manner. In order for resources to be allocated efficiently, governments need to ensure that the private sector supplies the goods and services that it can provide more effectively. Governments also need to ensure that their aggregate expenditure is sustainable and not overly dependent upon a temporary or unstable set of circumstances.
Unproductive expenditure may be caused by many factors: the lack of a well-trained civil service; the political asymmetries between taxation and expenditure; the transitory nature of politics that discourages projects with substantial long-term benefits but short-term costs; lobbying by interest groups; and corruption. Such factors may not all be easily eliminated. Systematic efforts should be made, however, to improve analysis. For example, a cost-benefit analysis of expenditure programs amenable to quantitative analysis would be helpful. This would require the collection of more data, but the potential return could be substantial. Also, there would be worldwide benefits from coordinated reductions in military expenditure.
Some public programs have particularly negative implications relative to the amount of resources they command. Consumer subsidies lead to wasteful consumption, and can also lead to lower domestic production if producer prices are controlled. They can, therefore, lead to higher imports, which in turn increases demand for foreign exchange. Subsidized exports lower the market price of goods and reduce foreign exchange receipts. Some programs try to address too many objectives; others do not use an appropriate mix of resources—for example, too few textbooks relative to teachers, too few nurses to doctors, or too many generals for enlisted soldiers. Some cases of unproductive expenditure are glaringly obvious, but not all. “White elephants” may be attributable to several factors, including a lack of coordination and poor maintenance, but unproductive programs are not always on a large scale—the aggregate effect of a multiplicity of ineffective small programs should not be underestimated.
Politicians need to enlist public support in rationalizing government expenditure programs, many of which are poorly targeted. General subsidies help the middle class more than the poor: other forms of targeted assistance should be used. Care should also be taken to ensure that generous or unsustainable programs are not established that will cripple future government budgets. Fund surveillance activities and adjustment assistance can facilitate more efficient use of Fund resources by making more transparent the costs of unproductive spending and encouraging institutional and policy changes that focus on improved fiscal efficiency.
The high level of unemployment in many industrial countries was a central concern of Directors. In September 1993, Directors noted that although the rise in unemployment was cyclical in origin, it might prove difficult to reverse and might lead to a further rise in structural unemployment.
Directors returned to the issue in April 1994 and observed that a failure to reduce unemployment to acceptable levels as rapidly as would be compatible with inflation objectives would not only involve large economic and human costs, but could also threaten the social fabric, erode the credibility of government policies, and jeopardize the achievement of medium-term budgetary and growth objectives. Rigidities in the labor market were a major cause of persistently high unemployment and had contributed to a marked ratcheting up of structural unemployment during the preceding two decades. Therefore, comprehensive labor market reforms were needed to reduce significantly the structural component of high unemployment. Although this need was recognized by the authorities in all countries and some reforms had taken place or were being planned, much remained to be done to create a public consensus supportive of reform and to improve the functioning of labor markets.
Although priorities in labor market reform differed from country to country depending on specific features of a country’s labor market, Directors agreed that better education and training were necessary to improve skills and productivity, especially of workers vulnerable to unemployment. Regulations that discouraged hiring or prevented real wages from reflecting the productivity of low-skilled or inexperienced workers also needed to be reformed. Social benefit programs should not discourage job search and employment. Many Directors agreed that, by protecting insider beneficiaries at a high collective cost, social systems frequently contributed to inequities in society. Therefore, labor market reforms should be carried out simultaneously with appropriate adjustments to tax and transfer systems to meet social concerns.
At the meeting in September 1993, given the difficult circumstances facing many European countries, there was general understanding of the decision by the members of the EMS to widen the exchange rate bands temporarily, and Directors reviewed in detail the background to the prolonged crisis and the broader policy implications of the wider bands. They noted that the pressures on individual economies-arising from conflicting domestic policy requirements and heightened by intense market pressures—had become unsustainable and overly costly in terms of actual and prospective output and job losses. In the view of many Directors, the crisis in the EMS over the past year had been an important factor behind the erosion of business and consumer confidence in Europe. Although it was too early to gauge the full ramifications of the broader fluctuation bands, the response to the developments in July 1993, as well as the gradual steps taken since then, had reduced tensions, and there were signs of a turnaround in confidence, as witnessed by developments in stock markets.
Although Directors saw scope for significant interest rate reductions in most ERM countries, many favored a cautious approach toward easing monetary conditions in Europe, in view of the need for price stability and the objective of continued progress toward convergence and monetary union. Some Directors felt that certain European countries were following an overly cautious interest rate policy and an unnecessarily tight monetary policy and advocated more active use of the flexibility provided by the wider bands. Several Directors recommended the use of a variety of indicators to assess the appropriateness of monetary policy.
The convergence of economic performance and of domestic policy requirements was viewed as an essential condition for returning to narrower margins in the ERM. Many Directors suggested that the weakness of activity and the likely decline in inflation provided scope for further reductions in official interest rates in Germany. For all countries, Directors gave the highest priority to sustainable, credible fiscal consolidation measures, as these will make it possible to ease money market conditions without jeopardizing the hard-won credibility of the commitments to price stability.
In April 1994, Directors agreed that the primary responsibility of monetary policy was to maintain price stability where it had been achieved and to continue to reduce inflation where it was still too high. They observed that in many countries there was further scope for lowering official interest rates to support activity and broadly endorsed the substantial reductions in interest rates that had taken place during the preceding year. In the view of some Directors, a further reduction of the official discount rate in Japan could be considered. In some countries in continental Europe in which recovery was not clearly under way, there was some room for further declines in short-term interest rates without affecting price stability.
However, Directors’ views differed on the scope and appropriate pace of interest rate reduction. Several Directors, noting that inflationary pressures were receding in Germany and that there was increased room in many of Germany’s partner countries for bringing interest rates into line with domestic conditions after the widening of ERM bands, were concerned that the excessively modest pace of interest rate reductions in Germany and the rest of continental Europe might stall the recovery of activity. A number of other Directors believed that the need to safeguard the credibility of the price stability objective and the associated goal of exchange rate stability in some countries justified the cautious and gradual easing of monetary conditions.
All Directors, however, agreed on the need to allow monetary conditions to tighten sufficiently early in the coming expansion to avoid sharper and more pronounced interest rate increases later. Directors endorsed as timely the U.S. Federal Reserve’s steps toward monetary tightening, given that, despite subdued price rises in the United States, economic slack had been absorbed rapidly. They urged the United States to take further measures as needed to ensure a sustained expansion with low inflation.
Some Directors commented that explicit inflation targets had helped the conduct of monetary policy in a medium-term framework in countries that had not been able to maintain exchange rate anchors or that had not found monetary targets to be sufficiently reliable. Canada, Finland, New Zealand, Sweden, and the United Kingdom were cited as examples. Other Directors believed that more experience was needed before judging the merits of inflation targeting. All Directors agreed, however, that monetary authorities had to rely on a broad range of indicators in conducting day-to-day monetary management.
Financial Market Developments
With regard to the recent rise in long-term interest rates, several Directors observed in April 1994 that spillover effects across national markets, along with common factors operating on those markets as a whole, had tended to move yields in the same direction simultaneously. The relative improvement in actual or expected growth performance in industrial countries was likely to have been such a common factor. In the view of a number of Directors, the recent rise in longer-term interest rates might have been an overreaction on the part of financial markets, both in the lowering of rates in 1993 and in pushing them up subsequently. Some Directors stressed that at least a part of the increase reflected a correction from earlier low levels. A number of Directors commented that inflationary expectations seemed to have moved higher in some countries where recovery was firmly established and the differences in the magnitude and timing of recent movements in long-term interest might be explained by that development. Given the strong interest rate linkages across countries, several Directors suggested closer policy coordination, particularly among the major industrial countries.
At both discussions on the World Economic Outlook, Directors commented extensively on fiscal issues. In September 1993, they observed that the fiscal analyses in the staff report (World Economic Outlook, October 1993) had made a strong case for strengthened efforts at budgetary consolidation in the medium term. Several Directors stressed that a margin of uncertainty necessarily attaches to estimates of cyclical gaps and the cyclical responsiveness of budget revenues and expenditures and called for further work in this area, as well as on unfunded net pension liabilities.
In general, however, Directors noted that the estimates of structural deficits and the analysis of the link between current fiscal policies and the sustainability of debt levels illustrated the magnitude of the problem and also provided a useful analytical framework. Despite efforts at fiscal consolidation, in many industrial countries structural budget deficits had reached high levels, and the consequences would be costly unless these imbalances were reversed. Directors also observed that by reducing the burden on monetary policy, attempts at deficit reduction would contribute to more effective policy coordination and greater stability in financial and foreign exchange markets.
Directors welcomed the U.S. administration’s fiscal package, but noted that additional measures would be needed over the medium term to reduce public debt to sustainable levels, to improve national saving and investment, and to increase flexibility in fiscal policy. They commended Canada for its deficit reduction efforts and noted that despite the recession the underlying fiscal situation had continued to improve. The underlying fiscal deficit had been reduced in Italy as well, but the ratio of debt to GDP was not on a sustainable path. The fiscal situation had deteriorated in France, Germany, and the United Kingdom, partly because of cyclical reasons, but corrective policy measures were also required. Although the fiscal outlook had improved in Germany, Directors called for vigilance in controlling unification-related expenditures and cutting government subsidies in order to limit the recourse to tax increases.
During discussions in April 1994, Directors commented that fiscal deficits were unsustainably large in many countries and that there was little scope for expansionary fiscal measures to support recovery in most countries where growth was weak. Further, since public debt had risen sharply in the 1980s and 1990s, vigorous fiscal consolidation would be required in almost all the industrial countries over the medium term. Fiscal policy could best serve recovery by reducing uncertainty about future financial conditions through specific medium-term programs of fiscal consolidation. In 1993, such programs had helped to reduce long-term interest rates in Germany, the United Kingdom, and the United States. However, further efforts would be needed in these and most other industrial countries to improve national saving and medium-term growth prospects. Directors noted that the strengthening recovery in the United States provided an opportunity for further fiscal consolidation. Budgetary consolidation and sound financing of health care reform would help to dampen long-term inflationary expectations and curb increases in long-term interest rates.
Directors noted that the considerable progress toward fiscal consolidation that had been achieved in the 1980s had enabled Japan to take significant fiscal measures to support activity in the face of the prolonged recession. Directors welcomed the latest fiscal package proposed in February 1994 and the authorities’ announced intentions regarding future tax reforms. There were some signs that the downturn had bottomed out, and the latest measures should strengthen confidence and foster recovery. A number of Directors, while mindful of the need for Japan to resume fiscal consolidation after overcoming current difficulties, noted that the present and projected margins of slack were very large and called on the authorities to ensure that the fiscal stimulus would not be withdrawn until recovery was clearly under way.
Developing Country Policies
Directors commented in April 1994 that the strength of economic activity in the developing world had fully accounted for the growth in the volume of world trade in 1993 and had been one of the most encouraging aspects of global trends in recent years. In the same vein, Directors had noted in September 1993 that developing country markets had provided outlets for exports from all countries. The growing integration among developing country economies was viewed by Directors as an important reason for the buoyancy of their trade growth. At the same time, it was also recognized that greater integration of the developing countries had coincided with a growing integration into the multilateral trading system.
In both discussions on the World Economic Outlook, Directors pointed out the wide disparities in economic growth across countries. At their meeting in September 1993, Directors welcomed the robust growth in many developing countries but warned against the buildup of excess demand pressures in some cases, particularly in China. In April 1994, Directors again noted the strong growth in East Asian countries and in China. The performance of the East Asian countries, they stated, illustrated the benefits of sound macroeconomic management and outward-oriented trade policies and was deserving of further staff study.
In many countries in the Western Hemisphere strong adjustment and reform efforts had also been successful, and positive signs were appearing in some of the low-income countries in Africa, but in many other developing countries growth remained inadequate. The devaluation of the CFA franc and the Comorian franc in January 1994 and the policies being adopted in the context of Fund-supported adjustment programs in the countries in the CFA franc zone and the Comoros should facilitate the resumption of growth in these countries (see Box 1). Several Directors were concerned that declining oil prices had lowered prospects for near-term growth in the oil exporting countries. A few Directors also regretted that the reduction in oil prices had been offset in many countries by increased taxation of oil products.
In commenting on the reasons for the low rate of growth in many developing countries, Directors observed that there was rarely only one reason for the failure of a country to realize its economic potential, although an unfavorable external environment was a key factor in many instances. All Directors stressed, however, that inappropriate domestic economic policies were the root cause of stagnant or declining standards of living.
Interrelated obstacles to growth included the absence of a stable economic environment for private and public economic decision making, high and volatile rates of inflation, underdeveloped and distorted financial markets, excessive government intervention in the economy, high levels of subsidies and protection from foreign competition, overvalued exchange rates, rapidly expanding populations, and poor governance. Further, these obstacles had also discouraged needed inflows of official financial assistance and private capital and had worsened the impact of adverse terms of trade developments on insufficiently diversified economies.
Directors observed that the experience of the East Asian countries with regard to the government’s role in the economy merited study. Although certain forms of government intervention could be justified, for instance, with regard to investment in infrastructure and human capital, Directors cautioned against the distortionary effects of excessive state involvement in economic activity. They pointed out that in many countries agricultural controls had often led to lower output and had held back the pace of development.
Directors observed that the bulk of financial flows to developing countries consisted of private capital flows, which was a positive development. It was important, however, to ensure that these inflows were invested efficiently, which would limit the risk of sudden changes in market sentiment. A number of Directors asked the Fund to undertake further work on the experience with capital flows and capital controls, including ways of strengthening the Fund’s role in promoting capital account convertibility.
In analyzing the role of domestic and foreign saving in the growth process in developing countries, Directors noted in September 1993 that domestic, rather than foreign, saving was the most important and reliable source of funds for investment and development. Financial sector reforms and macroeconomic stabilization measures had boosted private saving, which accounted for most of domestic saving. At the same time, many countries had taken measures to strengthen the public sector’s contribution to domestic saving and to reduce the public sector’s claims on private sector saving.
Prospects for Low-Income Countries
In September 1993, Directors noted the continued plight of many of the poorest countries, in which per capita incomes had declined over the past one or two decades. Directors emphasized that improved prospects for these countries would require strong adjustment programs supported by substantial debt-reduction operations and greater official assistance on concessional terms, including through a successor to the enhanced structural adjustment facility. It was also noted that the resumption of allocations of SDRs could make an important contribution in this regard.
Directors acknowledged the overall effectiveness of the debt strategy and welcomed the progress being made in resolving debt-related difficulties, but noted that many of the poorest countries continued to face very difficult debt situations. Although the resurgence of private spontaneous financing to a group of economically successful developing countries had continued and a number of countries had regained market access, experience across countries had been uneven, which underlined the need for sound economic policies and structural reforms that reduced the risk to foreign investors, as well as increased market transparency and efficiency. The poorest countries would still need to rely on official financing from bilateral and multilateral sources, since their prospects for attracting private financing on appropriate terms continued to be remote.
In April 1994, while welcoming the initiation of operations of the enlarged ESAF and the broad support provided by the membership—including financial support from many developing countries—Directors reiterated the importance of greater concessional assistance for many low-income countries, Many Directors also emphasized the need in these countries for debt-stock-reduction operations by official bilateral creditors, and a number of Directors also stressed the need for deeper debt reduction or forgiveness in particularly difficult cases (see also section on Financing Flows and Debt, below).
Policies in Economies in Transition
In September 1993, Directors welcomed the early signs of economic recovery in several countries of Central and Eastern Europe, notably the Czech Republic, Hungary, and Poland. Output had picked up and prices had begun to stabilize in countries that were pursuing appropriate monetary and fiscal policies. Directors commended the progress made in structural transformation in most countries of Central and Eastern Europe and stressed the importance of the fast-growing private sector to the renewal of economic growth. In their view, open trading relationships, both among the countries in transition and with the industrial countries, were crucial for the reform process. Directors noted that the transformation of the enterprise sector was crucial to the structural reform process, but they recognized that enterprise reform had proven to be more difficult than expected. In their view, privatization was a necessary, although not sufficient, element in the process of enterprise restructuring. Other elements might include effective management and hard budget constraints.
Directors also expressed concern about the short-term outlook in most countries of the former Soviet Union. In most of them, more decisive policy actions were needed. They considered that the lack of financial stability and the slow transformation of the enterprise sector constituted serious obstacles to economic reform and to a much-needed recovery of activity. The high inflation in most countries of the former Soviet Union had undermined the ability of the price system to allocate resources efficiently. The excessive creation of credit and unsustainable budgetary policies had led to an inflationary spiral, and Directors urged the authorities to tackle these problems more forcefully.
In April 1994, Directors again stressed that the experience of countries in Central and Eastern Europe, the Baltic countries, Russia, other countries of the former Soviet Union, and Asia illustrated clearly the benefits of sustained policies of stabilization and reform, as well as the cost of delaying needed measures. It was noteworthy that growth was recovering mainly in countries that had brought down inflation and were persevering with major reforms. In contrast, economic contraction was continuing in most other countries in transition. In most countries of the former Soviet Union, output had declined substantially because of ongoing disruptions to interstate trade, failures to implement stabilization policies, and armed conflicts in some countries.
Box 4Economies in Transition: External Financing Requirements and Possible Sources
In April 1994, the Board discussed external financing requirements of transition economies, their potential financing sources, and the scope for larger and more concentrated financial assistance from the Fund.
All Directors stressed that it was impossible to forecast the required financing with any degree of precision, given the limited experience of the international community with this unprecedented scale of transformation and the political and other uncertainties. Moreover, the circumstances of individual countries varied greatly. Some had already achieved stabilization and were attracting ever larger spontaneous private capital flows. Others, however, had hardly begun the transition from command to market economy.
Directors remarked that, even with an optimistic view on private capital flows, the contributions of new money that would seem to be required from official sources remained substantial, especially in the Baltic countries, Russia, and other countries of the former Soviet Union, for several reasons.
There was great need for infrastructure rehabilitation and environmental cleanup. Directors stressed that, following adequate project preparation, it would be important for the multilateral development banks to expand their support for countries adopting strong reform and adjustment programs.
Upward adjustments of the export price of oil from Russia had the effect of eliminating the price subsidy enjoyed by the Baltic countries and other energy-importing countries.
The need for public financing and high-quality programs was generally greatest up front, though Directors noted the lack of precision of the reform calendar in a number of transition economies.
Many Directors considered that the Fund’s contribution would have to be maintained at a high level, and that such an approach would be justified by the Fund’s strong liquidity position and its proven ability in dealing with the challenges and risks that it faced in the economies in transition. It was emphasized, however, that the guiding principle must remain that it is strong programs that deserve substantial financial support. Nevertheless, it was recognized that the risks associated with larger and more concentrated financial assistance should be addressed by the Board so as to preserve the Fund’s liquidity, its monetary nature, and its preferred creditor status. All agreed that if access limits were temporarily raised, the policy would apply even-handedly to the entire membership. In this respect, several Directors also referred to the circumstances in which timely consideration of a quota increase would be needed.
Directors noted that although some of the economies in transition had made considerable progress, much was still to be done. Large budget deficits and high inflation were serious impediments to economic recovery in many countries. Credits and subsidies to enterprises, as well as there-emergence of sizable inter-enterprise arrears, had delayed the transformation process and had impeded the supply response to price reforms. Successful macroeconomic stabilization would require the steady pursuit of enterprise restructuring and other structural reforms, as well as the control of sectoral pressures for subsidies and credits. In a number of countries, advances had been made in the areas of privatization and tax reform. A stable legal framework and financial sector reform would be crucial in furthering the transition process. Well-targeted social safety nets to protect the most vulnerable groups also had an important role in alleviating the social burden of transition at an affordable budgetary cost, and could help sustain broad public support for the transition process.
In mid-April 1994, Directors considered the external financing requirements of the economies in transition (see Box 4).
International Capital Markets
In May 1993, the Executive Board reviewed developments in international capital markets. The discussion centered on three related developments that could have serious and far-reaching implications for the future operation of these markets: recent banking problems in several industrial countries; the systemic risks associated with the continuing rapid growth of banks’ off-balance-sheet activities, particularly in the booming derivatives market; and the evolving pattern of developing country access to international financial markets.
Many countries have experienced surges in net capital inflows in recent years. The Board considered this issue at a seminar that dealt with the causes of such inflows, appropriate policy responses, and the recent experiences of six member countries in dealing with these inflows.
Recent Banking Problems
Directors noted that the frequency and widespread geographical distribution of deteriorating bank balance sheets merited attention. Resolution of these problems could have significant costs for taxpayers, and financial fragility could impose constraints on the stance and effectiveness of macroeconomic policies.
Directors noted that major banking systems were in the midst of a structural transition to a changing environment, and current banking problems were to some extent a reflection of that transition. Although no single solution could address the differing macroeconomic circumstances, institutional structures, and pace of liberalization, a common thread ran through many recent banking crises. Innovations in financial markets and the financial liberalization of the 1980s opened up many financial markets to intense competition for profits previously available only to cartelized banking markets. Faced with a potential downsizing of their operations, many banks responded to the new, less hospitable environment by expanding the range of their activities, so as to maintain their earnings and their market share.
This strategy was encouraged by the explicit and implicit government guarantees that effectively underwrote the increased risk. In consequence, in the years since the financial liberalization of the 1980s, bank balance sheets had expanded rapidly, concentration in loans to single-risk classes (particularly real estate at the expense of lending to traditional manufacturing customers) had grown, and banks’ involvement in the over-the-counter derivatives markets had mushroomed.
Directors stressed, however, that increased competition was not the sole determinant of the relaxed attitude of banks toward risk taking and earnings. Cyclical factors also had a bearing on the current crop of bank problems—particularly the large real estate component of their lending activities. Accommodative monetary policies had led to inflated asset prices; these asset price excesses started unwinding in the wake of a subsequent widespread slowdown in economic activity. As several Directors had noted during the April 1993 discussion of the World Economic Outlook, this experience highlighted the need for policymakers to pay due attention to movements in asset prices when implementing monetary policy.
A key lesson highlighted by the banking problems in industrial countries, most Directors agreed, was that financial liberalization needed to be accompanied—and, according to some Directors, if possible, preceded—by a strengthening of the supervisory and regulatory framework. This lesson was also applicable to developing countries, and had implications for Fund advice on the pace and sequencing of financial reforms. Several Directors alluded to industrial countries that had managed to avoid banking problems and suggested that a review of their experience could provide some useful insights. Directors stressed the importance of preventive measures, and welcomed progress made in individual countries in strengthening the capital base for banking and securities activities; they also reiterated their support for efforts at the international level to create a “level playing field” by coordinating the application of supervisory and regulatory initiatives.
To cope with existing banking strains, Directors discussed various approaches, but noted that specific responses would need to reflect the circumstances of each case. Several Directors, while recognizing the potential systemic effects, recommended that prompt action be taken to close insolvent institutions, although they recognized the difficulties in doing so when such an action might have systemic effects. For many of these Directors, giving troubled institutions time to earn their way back to health—letting them “buy time”—could delay adjustment and undermine incentives for the banking sector to reduce capacity, lower costs, and control risk. Nevertheless, some Directors noted that because of the special role banks play in the financial sector and given the lack of attractive policy alternatives, this approach, if rigorously supervised, might prove workable. Directors in general opposed recourse to artificially high interest rate spreads as a means to ease the strains in the banking system.
Directors were also critical of direct government injection of capital into troubled institutions, which many thought should be used only as a last resort to avoid systemic disruptions. Any such official recapitalization, it was generally agreed, should carry conditions relating to downsizing, cost cutting, and increased efficiency. Further, solvent banks should not be put at a disadvantage.
Growth of Off-Balance-Sheet Activities
The most notable development in the major financial markets during the past five years has been the growth of over-the-counter financial derivative instruments. Directors acknowledged that these activities serve a useful function of hedging price risks and increasing the liquidity of the underlying instruments. However, they also identified the exponential expansion of these markets and the growing involvement of banks in over-the-counter activities as a potential source of systemic risk. Growth of the derivatives markets had added to the interaction and linkages of financial markets, and disturbances could thus more easily spill across the financial system.
Directors welcomed the initiatives undertaken by the authorities in several countries, under the auspices of the Basle Committee, to strengthen supervision of banks’ off-balance-sheet exposures. Several Directors concluded that channeling more of the over-the-counter business to the organized exchanges might also reduce risk.
Developing Country Access to Capital Markets
In April 1994, Directors noted that private capital flows accounted for a major proportion of financial flows to developing countries. That was widely viewed as a welcome development, especially for countries with strong growth prospects and stable policy environments. However, Directors emphasized the importance of sound macro-economic policies to ensure that the capital inflows were invested efficiently and to limit the risk of sudden changes in market sentiment. The importance of capital flows and capital account developments suggested the need for further work on the experience with capital flows and capital controls, including an examination of the role the Fund can play in promoting capital account convertibility.
In September 1993, some Directors stressed that, as debt problems were resolved and as developing countries regained access to financing on a spontaneous basis, it would be important to reaffirm the basic presumption underlying orderly international relations that financial contracts are to be honored. Directors commented that while to date the focus has been on countries’ relations with commercial bank and Paris Club creditors, attention must be paid to the normalization of relations with all creditors, including nonguaranteed suppliers and non-Paris Club official bilateral creditors.
Experience with Surges in Capital inflows
In recent years, many countries have experienced surges in net capital inflows. Although these can be beneficial to recipient countries, they can also pose a risk to macroeconomic stability. Governments wishing to reap the rewards of such surges must therefore formulate a balanced policy response that accommodates the higher investment and growth afforded by the inflows, while at the same time curbing their destabilizing effects.
In a seminar held in July 1993, the Board discussed a staff study that analyzed the causes of surges in capital inflows, the traditional policy prescriptions for accommodating them, and the recent experience of six countries (Chile, Colombia, Egypt, Mexico, Spain, and Thailand).2
Surges in capital inflows ease external financing constraints, push down domestic interest rates, and hold the potential for higher investment and growth. Excessive surges, however, can feed developments that signal overheating and instability and thus become a policy concern. These signals and concerns include a deterioration in the external current account; pressures on prices of goods, real estate, financial assets, and the real exchange rate; and vulnerability to a sudden reversal of the inflows.
There is no common formula for policy responses to surges in inflows, because the incidence or extent of the effects of these inflows varies across countries. Whether the effects are realized, and whether they are destabilizing depends on the causes of the inflows. Fashioning an appropriate policy response, in turn, depends on an accurate identification of the causes. Three main causes were identified from the experience of the six countries reviewed in this study: changes in structural or fiscal policies that improved the investment climate; a tightening of domestic credit policies that pushed up domestic interest rates, usually with the objective of reducing persistent inflation; and changes in conditions in external markets.
All three causes were at work in the countries under review, but the mix varied widely. The larger the role of changes in structural and fiscal policy in attracting the inflows, the greater the beneficial effects on investment and growth. The principal role for policy in these circumstances is to improve the absorptive capacity of the economy.
Inflows attracted principally to a tightening of domestic credit had little or no effect on investment and growth, and the hoped-for lowering of inflation did not materialize. An unbalanced mix of tight money, easy fiscal policy, and a fixed exchange rate is likely to be unsustainable.
When inflows are attracted mainly by external influences, such as a lowering of foreign interest rates or recession abroad, the effects may be unsustainable, and there is a risk that such inflows may be reversed, particularly if the inflows finance consumption rather than investment. Policies in this case need to be concentrated on containing or neutralizing the inflows.
Two Major Risks: Overheating and Appreciation
Despite the many beneficial effects of surges in capital inflows, the governments of the six countries under review regarded them as a major shock, to be ignored only at serious cost. The effects that concerned policymakers most were the sizable real appreciations of their currencies and a sharp widening of their current account deficits. In principle, according to the study, policy responses should be dictated by the causes of the inflows; in practice, uncertainty about the cause led each country to respond, at least to some degree, by containing its vulnerability to a reversal of the inflows and by minimizing the risk of overheating, excessive real appreciation, and unsustainable growth of consumption.
Fiscal restraint may be the only way to prevent overheating and avoid a real appreciation in the face of a sustained surge in capital inflows regardless of its cause. In the absence of a sizable fiscal adjustment, most countries would have to accept some real appreciation of their currencies. This is best accommodated by a nominal appreciation, which has the advantage of also containing inflation. However, in the countries under review, the use of exchange rate policy as a means of controlling the effect of surges in capital inflows tended to be limited by the fear that a nominal appreciation would produce larger real appreciations than would have occurred in their absence.
Second-best policy responses include sterilization—narrowly defined as the exchange of bonds, instead of money, for foreign exchange. Sterilization is attractive because it is easy to implement quickly and is often effective in insulating the economy for short periods from some of the unwanted effects of surges in inflows. However, in the experience of the countries under review, sterilization was less effective in reducing inflation and preventing real appreciation. Moreover, the countries that sterilized the most aggressively benefited least from the positive effects of inflows on investment and growth. In general, full sterilization is not feasible on a sustained basis.
All countries practice partial sterilization in the broader sense of restraining the growth of net domestic assets of the central bank when credit needs are being met by inflows. The experiences of the countries reviewed suggest a number of indicators that could form the basis for a decision about the degree of broadly defined sterilization: domestic relative to foreign interest rates; unduly large increases in reserves; and the current account position.
Although the response to the surges in inflows was largely concentrated in macroeconomic policy, microeconomic policies also played a role. Impediments to inflows, such as reserve requirements, controls, and taxes, appeared to slow down inflows for short periods. Like sterilization, impediments are quick and easy to impose, but by locking out inflows, they preclude even future benefits of incipient flows for investment and growth.
By easing the external constraint, surges in capital inflows provide an ideal opportunity for addressing structural weaknesses, moving toward capital account convertibility, and reforming the financial sector. In the countries under review, structural weakness—particularly in the financial sector—were a constraint on the capacity to absorb inflows efficiently and on the ability of governments to give free rein to the private sector’s use of the inflows. In countries where financial sector reform and trade liberalization were in train before the surge in inflows began, the inflows were absorbed much more efficiently. The growing number of adjustment programs that now give rise to surges in capital inflows would argue for a strengthening of the priority attached to structural reform early in the program.
Non-Oil Commodity Prices
Developments in commodity prices are of considerable interest to Fund members, particularly developing countries that are heavily dependent on commodity exports. The decline in non-oil real commodity prices since the early 1980s is therefore of serious concern. In early 1994 the Board discussed a wide range of issues related to this topic, including the causes of the weakness in commodity prices, the future price outlook, the role of government in stabilizing prices, and the use of market-based financial instruments in limiting commodity price risk.
Non-oil real commodity prices have been declining almost continuously since the early 1980s and continue to show weakness (see Chart 5).
Chart 5Real Non-Oil Commodity Prices: Long-Term Developments
Sources: Enzo Grilli and Chang Yang, “Primary Commodity Prices, Manufactured Goods Prices, and the Terms of Trade of Developing Countries: What the Long Run Shows,” World Bank Economic Review, Vol. 2 (January 1988), pp. 1-47; and Carmen Reinhart and Peter Wickham, “Commodity Prices: Cyclical Weakness or Secular Decline?” Staff Papers, International Monetary Fund, Vol. 41 (June 1994), pp. 175-213.
Note: Commodity prices are deflated by the export unit values of manufactured goods
At a Board discussion in March 1994, it was noted that the subject was of particular importance to developing countries and had significant implications for Fund policies and operations.
Directors expressed some concern about the future price outlook, given indications that the most recent slide in non-oil commodity prices appeared to be of a permanent nature and was largely supply driven. Despite evidence of a modest recovery in the near term, it was unlikely that prices would soon recover to their 1980s levels. Also, given the volatility of commodity prices. Directors agreed that any short-term upturn needed to be viewed with caution and probably did not signal a long-term improvement.
Although the continuing weakness in commodity prices stemmed largely from the supply side, many Directors believed that insufficient attention was being paid to the demand side. In particular, consideration needed to be given to the adverse effects that the subsidization of food production in industrial countries had on export prices and earnings in the commodity exporting countries.
Financing and the Appropriate Policy Response
The nature and behavior of non-oil commodity prices in response to shocks had important implications for the type of financing provided to member countries and the design of appropriate policy responses. Directors considered such factors as the increased volatility of commodity prices, the persistence of shocks, and the difficulties of distinguishing early on between temporary and permanent shocks. Compensatory financing would be appropriate to cushion a temporary shock; but a shock that appeared to be of longer duration would require a more conditional and adjustment-oriented approach. Many Directors stressed that the growing volatility of commodity prices called for continued attention to contingency measures that would safeguard Fund-supported programs.
Role of Government
In their discussion of the role of government in stabilizing prices and helping to smooth the income of small commodity producers, Directors acknowledged that some government stabilization policies worked efficiently. Nevertheless, they generally agreed that official intervention tended to become distortionary and that the objectives of stabilization schemes could become unclear and inconsistent over time. It was thus preferable, Directors felt, for private agents to learn to read the signals embedded in market prices. There is some evidence that private agents in developing countries may be more resourceful in handling commodity price risk and finding ways to smooth consumption than is usually believed.
It was also noted, however, that a fully noninterventionist approach might not always be appropriate—for instance, in those countries that lacked access to credit markets. In such circumstances, several Directors supported the use of safety net arrangements to shield low-income producers. Many Dirertors also welcomed the reductions in agricultural subsidies in industrial countries that were to be implemented under the Uruguay Round.
Governments of developing countries often derive considerable revenue from exports of primary commodities. As Directors noted, the volatility of commodity prices had contributed to unstable government revenue in several developing countries. Also, failure to evaluate correctly the temporariness of a price shock could result in costly mistakes with respect to government expenditure, which would be difficult to rectify.
Use of Market-Based Financial Instruments
Market-based financial instruments provide a means for coun tries to limit commodity price risk and the accompanying uncertainty and macroeconomic disturbance and to lessen the impact of volatility on export revenues. Many Directors noted that access to exchange-traded instruments, such as futures and options purchases, was important in helping to limit commodity price risk. However, legal, financial, and technical barriers could limit access by private agents from developing countries to these markets. Directors therefore welcomed the initiative of a number of international agencies that were providing technical assistance in commodity risk management to developing countries.
Directors concluded that commodity exporting countries could reduce their vulnerability to volatile commodity prices and sustained price declines through increased processing of commodities and diversification of production. It was important, however, that diversification not siphon off resources reserved for the production of primary goods, if that was where a country’s comparative advantage lay.