Presentation of the Thirty-First Annual Report1

International Monetary Fund. Secretary's Department
Published Date:
October 1976
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By the Chairman of the Executive Board and Managing Director of the International Monetary Fund—H. Johannes Witteveen

Mr. Chairman, I join you in thanking President Marcos for his cordial welcome, and in expressing our gratitude to the Government and people of the Philippines for the friendship with which we have been received. We are tremendously impressed by this beautiful international convention center, which provides facilities that are perhaps unequaled anywhere else in the world. In greeting assembled delegates and guests, may I extend a special welcome to the Comoros, our newest member, and also to the representatives of the several prospective members who are attending our deliberations for the first time.

In my remarks today, I will deal first with the current economic recovery, and what I see as the principal dangers in the way of a successful transition to sustainable growth. Next, I want to discuss the international adjustment process. I will also report on the work of the Fund and comment on the Fund’s role under the amended Articles.

The Annual Report of the Executive Directors, which I have the privilege of presenting to you, traces a number of encouraging developments since we met last year in Washington. The world economy is completing its first year of recovery from the most severe recession in four decades. Production in the industrial countries has, in general, expanded at a satisfactory pace, and rates of inflation have been brought down from the very high levels of 1974 and 1975. The impact of these improvements in the industrial countries is being felt in primary producing countries throughout the world.

One disturbing aspect of the present recovery, however, is that rates of price increase are still very high. Among industrial countries, inflation is running at an annual rate of 7 per cent this year. The continuing high rate of unemployment is equally a cause for serious concern. Although this rate may be expected to move down as recovery proceeds, unemployment in the industrial countries seems likely to remain for some time at a high level by postwar standards.

National authorities are now confronted with the disturbing prospect that policies to expand production and reduce unemployment may at the same time aggravate the problem of inflation. Assessment of this risk is clouded by uncertainties as to both the degree of existing spare capacity and the response of inflation to the speed with which capacity is absorbed. Although the 1974–75 international recession was severe, the actual extent of available economic slack may be considerably less than would be indicated by unemployment statistics and other conventional measures of the utilization of resources. There is a danger, therefore, that the sense of repugnance we all feel for the social injustice of unemployment might engender political pressures that will work for a more rapid absorption of spare capacity than can be achieved without producing a renewed acceleration of price increases.

I must stress that the social and economic costs of inflation, though less immediate and less obvious than those of unemployment, can prove to be even more corrosive. In present circumstances, continuation of the recovery would be threatened by policies that resulted in higher inflation. In a longer-term perspective, inflation redistributes wealth and income arbitrarily, undermines confidence, reduces investment incentives, and misallocates resources.

One of the elements in this chain of consequences may be a reduction in real profit margins. The recent international recession, which was itself a consequence of various inflationary developments analyzed in the Fund’s Annual Report for 1975, had a particularly unfavorable impact on business profits.

Even before this, the authorities in several of the industrial countries were concerned over an apparent tendency in the past decade or so for profit margins to become eroded. Such a tendency runs counter to the textbook theory that profits benefit in an inflationary environment. But this theory has perhaps not made sufficient allowance for certain phenomena, such as the adverse effects on economic growth of “stop-and-go” demand policies, directed alternately to checking inflation and sustaining expansion, and the strength of cost-push forces in a climate where political pressures often lead to price controls—with a result that the share of profits may not be maintained. Pressures on the profit position, in turn, have tended to undermine the incentive to invest and to retard the growth of economic capacity, thus creating concern over the possible emergence of supply bottlenecks as the current economic recovery becomes further advanced. In some countries, such difficulties may be compounded by the size of the government’s claim on the national product, and a reduction in the growth of the public sector over the medium term may in these cases be a major policy requirement for the achievement of higher levels of saving and investment. For reasons such as these, the growth of output is retarded in an inflationary environment, and the objective of sustained full employment becomes harder and harder to achieve.

As testified by the Annual Report, there is now a wide measure of agreement that it would be a mistake to base policies on the assumption of any long-run “trade-off” between inflation and unemployment. As the Report points out, recent experience clearly indicates that the effects of policies aimed at stimulating growth and employment are likely to be short lived unless the currently high rate of price inflation is brought down and inflationary expectations are greatly reduced. Abatement of inflation will not come about unless fiscal and monetary policies are able to achieve and maintain restraint over the rate of growth in aggregate demand. These policies must be adhered to firmly, and policy risks must not be shaded—as they often were in the later 1960s and early 1970s—so as to extract additional output in the short term.

Restraint over the expansion of demand will be more effective, and is likely to command wider support, if it is accompanied by various supplementary policy measures. Depending on the particular circumstances of countries, such measures might include antitrust measures, action on supply bottlenecks, specific measures of relief and retraining to cushion the hardships of unemployment and help reduce its level, and incomes policies to reconcile the claims of competing groups on the national product. These measures, however, must not be allowed to distract attention from the central need to retain control over the national budget and over the rate of monetary expansion.

If faithfully adhered to, this type of policy should enable the industrial countries to lay the basis for sustained economic growth and a reduction of unemployment. These countries have a responsibility not only to their own populations but also to the primary producing countries, whose prospects depend so much on developments in the industrial world. A policy of cautious demand expansion in the industrial countries, although creating the best possible prospects under the circumstances, may nevertheless mean a slower growth of their imports than would have been visualized a few years ago. This change may have particular impact on the non-oil developing countries.

Cautious demand policies in the industrial countries therefore need to be supplemented by measures to improve market access for the exports of non-oil developing countries and to increase the flow of official development assistance. In this regard, it is gratifying that the industrial countries increased the real volume of official development assistance during the recent international recession, thereby reversing the downward trend in previous years, and that the oil exporting countries have sharply expanded their flows of aid. Nevertheless, the general level of assistance being provided remains very inadequate in face of the huge disparities in wealth and income among countries.

The approach to economic policy in the industrial countries that I have outlined focuses attention on the medium-term objectives of policy. It is not an easy strategy to follow, and will undoubtedly be subject to short-term pressures for change. Adherence to this policy will require skill, patience, and courage over an extended period.

I turn now to the international environment more generally. In recent years, trade and capital flows have been affected to an extraordinary degree by abnormal events and cyclical influences: a commodity boom, sharply higher energy prices, accelerated inflation, recession, and now resumption of economic expansion. These developments have taken place in the context of an international monetary system in flux.

The traditional pattern of current account balances that prevailed until 1973 has changed substantially. Particularly striking are the huge increase in the surplus of the major oil exporting countries and the roughly similar increase in the deficit of other primary producing countries.

In 1974, when the surplus of the oil exporting countries rose steeply to some $65 billion, the three largest industrial countries—the United States, the Federal Republic of Germany, and Japan—were embarking on resolute anti-inflation measures. The impact of these measures on their current account positions was dramatic. Oil-related deficits in the three countries were rapidly offset by positive changes elsewhere in the current account; indeed, the non-oil components of their current account balances showed improvements from 1973 to 1974 that totaled more than $30 billion. Inevitably, these big shifts—though not in themselves an objective of policy—put strong downward pressure on the current account positions of other oil importing countries. In particular, the combined deficit of primary producing countries rose from $8 billion in 1973 to $43 billion in 1974.

The deepening and spreading of the international recession during 1975 had further pronounced effects on current account balances. The balances of industrial countries improved as their demand for oil declined and their exports to oil surplus countries grew rapidly. In part because of the recession, but mainly because of rapid import expansion, the combined current account surplus of the oil exporting countries fell substantially in 1975. The non-oil primary producing countries suffered from a weakening of demand in their principal markets and a sharp deterioration in their terms of trade, and their combined deficit rose further in 1975, to more than $50 billion.

Now, however, the resumption of economic expansion and import growth in the industrial world is providing a new and different setting for international payments adjustment. A number of the industrial countries are running current account deficits, and in Italy and the United Kingdom recurrent weakness in the current account was compounded earlier this year by pressures in the capital account. In the United States, the very large current account surplus that was realized in 1975 seems likely to disappear this year—a predominantly cyclical development tending to improve the positions of many other countries. However, according to Fund staff estimates, the traditionally large current account surplus of the Federal Republic of Germany will be maintained in 1976, while the Japanese balance will move from a small deficit in 1975 to a sizable surplus.

With the volume of world trade expected to grow by more than 10 per cent in 1976, prospects for current account improvement are generally more favorable for the non-oil deficit countries than at any time since 1973. It will be very important to seize this opportunity to put the pattern of world payments on a more sustainable basis—a development which will require internationally cooperative policies on the part of surplus countries, as well as effective actions by deficit countries.

Balance of payments deficits present problems of financing and of adjustment. The emphasis that should be given to these two aspects of the problem naturally differs according to the situation. At the time of the oil price increase at the beginning of 1974, the immediate danger was that countries would adopt measures of adjustment that would have been deflationary and self-defeating, inasmuch as it was not possible for the oil exporting countries to absorb, in the short run, sufficient imports to eliminate their surpluses. Therefore, the Fund supported arrangements designed to finance oil deficits for a time and established its own oil facility for this purpose. Undoubtedly, these policies were successful in preventing external restrictions and aggravation of the international recession. But the world economy is now recovering, and is moving into a situation where the main danger is no longer a deepening of recession but a resurgence of inflation.

For this reason, the time has come to lay more stress on the adjustment of external positions and less emphasis on the mere financing of deficits. Additional urgency is lent to this need by the buildup of short-term and medium-term debt resulting from the financing of recent years. This is beginning to affect the creditworthiness of some borrowers and to create the possibility of economic and financial difficulties. I may recall that the central principle of the Fund is the revolving character of its financial resources. It was never intended that these resources should be used to help perpetuate balance of payments disequilibria. They are intended to cushion the costs of adjustment to a more sustainable equilibrium.

The increased flexibility of exchange rates in recent years should help the process of adjustment. Until now, exchange rate movements have compensated fairly well for differences in inflation among countries. But beyond this, they have not contributed as much to adjustment as might have been hoped. There are several reasons for this.

The oil exporting countries want to diversify their economies. Understandably, they have not been prepared to accept an adjustment of their exchange rates that would render their non-oil sectors uncompetitive, and have preferred to accumulate financial assets. Other surplus countries, although not under the same compulsion to protect their competitive position, have channeled their surpluses easily and almost automatically into international capital markets. In this way, real adjustment that might involve a loss of competitiveness for domestic industry has also been avoided by those countries. At the same time, financing has been readily available to deficit countries. And while capital markets have given deficit countries the means to borrow, domestic objectives have given them the incentive. The goal of stemming inflation has prompted some deficit countries to borrow rather than allow their exchange rates to change, because they fear that exchange rate depreciation would give a further twist to the spiral of domestic inflation. This fear is heightened by the knowledge that social and institutional factors, such as wage indexation, can magnify a small price stimulus into an inflationary surge. Thus, there is a temptation to leave adjustment to the future in the hope that conditions may then be more propitious.

In this process, however, the real costs of the inevitable adjustment may, in the end, be increased. Effective adjustment involves a change in the pattern of domestic and foreign demands on national output. Exchange rate depreciation can help to bring about such a change, but cannot make its full contribution if it is used as a substitute for action on domestic demand. In order to make the required adjustment of current account deficits, domestic policies must be arranged so as to restrain domestic demand and to permit a shift of resources to the external sector. At the same time, the adverse consequences for domestic inflation of adjustment of the exchange rate to a level consistent with balance of payments equilibrium need to be minimized by specific measures outside the exchange rate field.

For industrial countries in strong payments positions, adjustment requires in the first place that they ensure an adequate recovery in domestic demand. But, as I mentioned earlier, the growth of demand must be kept within prudent limits in order to avoid a rekindling of inflationary forces. Beyond this, adjustment will have to be brought about by increased flows of long-term capital exports and development aid and, to the extent necessary, by an appreciation of exchange rates.

These various aspects of adjustment will have to be kept clearly in mind in the Fund’s consultations and in establishing conditions for the use of the Fund credit tranches. They also have important implications for the new task of the Fund under its amended Articles: the surveillance of exchange rate policies. Among their obligations under the proposed Article IV, members are to avoid manipulating exchange rates or the international monetary system in order to prevent effective balance of payments adjustment or to gain an unfair competitive advantage over ether members.

In performing its duty under Article IV to ensure the effective operation of the international monetary system, to exercise firm surveillance over the exchange rate policies of members, and to adopt specific principles to guide members in connection with those policies, the Fund will rely heavily on an intensification of its consultation procedures with members. I can see a close interconnection between the regular consultations that now take place under Article VIII and Article XIV and the role of consultations to be held under Article IV. Furthermore, it will become more important for the Fund to take the initiative to hold special, ad hoc consultations with members whenever, in its judgment, developments related to the exchange rate field warrant this.

To encourage adoption of the adjustment policies I have outlined, it may be desirable for unconditional balance of payments financing to be somewhat less readily available than it has been for some countries in the recent past. The largest amounts of this kind of financing have been provided by commercial banks. Through the financing they provided to member countries in 1974 and 1975, these banks performed a valuable service that helped to sustain world economic activity. However, in the different situation that has now emerged, there is perhaps the risk that too ready availability of commercial bank lending may in some cases retard the needed adjustment. I therefore welcome the increasing tendency for commercial banks to gear their lending to Fund stand-by arrangements.

I know that there is concern in developing countries that balance of payments adjustment might be harmful to development efforts, but there is no reason to expect this to be the case. On the contrary, where domestic prices have moved out of line, exchange rate adjustment is an essential precondition for rapid expansion of exports. Moreover, insofar as adjustment requires a reduction in domestic expenditure, well-designed policies should make it possible to direct this reduction to less essential elements of expenditure, rather than to investment. We have recently seen that a number of developing countries have improved their economic growth after putting into effect a successful program of exchange rate adjustment and domestic policy measures.

The Fund’s role in providing financial support to its member countries must continually adjust to changing conditions. In fact, the evolving pattern of world payments has been reflected clearly in the Fund’s financial transactions. I have already mentioned the oil facility and the role it played in helping overcome the dangers of an overhasty response to the sharp rise in the price of oil. This facility was established in 1974 and terminated, according to plan, in early 1976. During its two-year life, an amount equivalent to nearly SDR 7 billion was channeled through the facility.

In response to the 1974–75 recession, the Fund modified and liberalized its compensatory financing facility in December 1975. During the nine months since then, 40 members have drawn a total of SDR 1.9 billion on the facility, an amount one and a half times as large as the total use of the facility over the 12 preceding years. I would expect that, with the progress of the recovery in world trade, requests for drawings under the facility will subside by the end of this year. The review of the facility set for early in 1977 comes, therefore, at an appropriate time.

The compensatory financing facility has been of considerable assistance in counteracting the effects of export shortfalls after the event. But the recession has also rekindled interest in measures that might help to avoid excessive price fluctuations of primary products, particularly through buffer stock schemes. We have followed with great interest the discussions that have taken place on this subject in various forums. I might recall in this connection that the Fund itself took a decision in 1969 to assist members with the financing of their contributions to internationally approved buffer stocks; this was followed by decisions making the Fund’s resources available to members in connection with buffer stocks for tin and cocoa and, more recently, by a liberalization of the buffer stock facility. Without prejudice to more general arrangements that may be negotiated, the Fund would be able to assist members in connection with contributions to buffer stocks for other commodities that might be established by agreement between producers and consumers.

The oil facility, the compensatory financing facility, and the buffer stock facility were all primarily designed to assist members in dealing with payments difficulties mostly attributable to factors beyond their immediate control. This fact is reflected in the slight degree of policy conditionality that characterizes these facilities. But payments difficulties do not arise from extraneous causes only. They are frequently due, wholly or in part, to inappropriate policies in the deficit country. Even when they are not, adjustment cannot be postponed indefinitely. As I said earlier, there is now a need for all countries in external disequilibrium to intensify their adjustment effort, and to give the correction of disequilibrium a higher priority than it presently enjoys. The Fund has the essential task of assisting members in the formulation of adjustment programs and of providing financial assistance to deal with payments problems while the program is taking hold.

Experience shows that, for the Fund to be effective in promoting adequate adjustment, the amounts it can make available in support of a satisfactory program should be substantial. This applies particularly when payments disequilibria are large, as at present. It is therefore gratifying to note that the Sixth General Review of Quotas will increase the access of members to the Fund’s resources by about one third on average. Pending the entry into effect of the new quotas, access to the Fund’s resources in the credit tranches has been temporarily enlarged by 45 per cent. Looking beyond these two steps and bearing in mind the crucial importance of having a Fund that is adequate in size to perform its adjustment role effectively, I attach particular importance to the fact that the Seventh General Review of Quotas will be accelerated and is to be concluded by February 1978, two years ahead of the usual schedule.

An important milestone for the Fund will be the second amendment of the Fund’s Articles of Agreement. This comprehensive amendment, when accepted by the necessary majorities of members, will go a long way toward adapting the Fund and its operations to present-day conditions. It is therefore important that it should go into effect as soon as possible; this will also permit the enlarged quotas under the Sixth General Review of Quotas to become effective.

The new Articles will give members both new rights and new obligations. Since Governors are familiar with the many and important changes to be introduced into the Articles, I do not propose to go into detail on these matters here. I wish simply to stress that the Fund is meant to play an increasingly important role through consultations with members and surveillance over the international adjustment process and international liquidity.

Mr. Chairman, I have indicated a number of fields in which the Fund and its members will face crucial tests. A transition must be made to sustainable rates of economic growth and to lower rates of inflation. At the same time, the industrial countries should take specific measures to support the economic growth of developing countries. Balance of payments adjustment must be pursued vigorously. And we have the new task of establishing surveillance over exchange rate policies and international liquidity. These are all vitally important tasks, and I trust that we will be able to measure up to them.

October 4, 1976.

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