Presentation of the Thirty-Fourth Annual Report1. By the Chairman of the Executive Board and Managing Director of the International Monetary Fund

International Monetary Fund. Secretary's Department
Published Date:
November 1979
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J. de Larosière

Mr. Chairman, I should like to associate myself with your words of appreciation and thanks to President Tito for his cordial welcome, and to all those in Yugoslavia who have been responsible for the excellent arrangements that have been made for our meetings. It is a great honor for the Annual Meetings to have received this greeting from President Tito, one of the greatest figures of the Second World War—a statesman who thinks constructively about international affairs, always striving to secure peace, solidarity, and the prosperity of mankind. I sincerely wish that his courage, the breadth of his vision, and his capacity to guide his people through the most difficult of circumstances may inspire us as we address the daunting problems of the world economy today. This country offers an example of imagination and tenacity in pursuing original solutions to economic problems, and we must be impressed by the rapid progress that has been achieved in recent decades.

Yugoslavia is rightly famous for its beauty and for its tradition of hospitality, and it is gratifying that our deliberations will take place in such pleasant surroundings. May I extend a welcome here to the Governors of Cape Verde, Djibouti, and Dominica, which have become members of the Fund since last we met.

The present world economic situation is gloomy. But it contains fewer uncertainties than the situation in 1974, which in many respects was similar. Today, the world can at least benefit from the lessons of experience. The difficulties are better seen for what they are, and the broad course of events seems less unpredictable.

But if the policies that should be adopted are more obvious than five years ago, the obstacles in their path are more deeply entrenched. Some essential adjustments have been delayed, and this makes the measures which must now be taken more severe. Behind the illusory defense of protective devices and complex regulations, the industrial economies have become less flexible. They are now less able to make changes that have, nonetheless, become indispensable. Economic policies have too often been focused on the short run, and structural reform has been negelected. As to the longer-term problems of the international monetary system, these have been put aside even though their solution is one element—necessary, if not sufficient—of a satisfactory world order.

On the basis of the experience gained by the International Monetary Fund in the last few years, I shall attempt today to set out the three lines of action that seem to me essential if we wish to see the world economy escape from the straits into which it has entered.

The first theme concerns the fight against inflation. The second deals with problems of developing countries. The third touches on the role which the Fund can play in the current state of the international payments situation, as well as in the longer-term evolution of the system.

I. The struggle against inflation, wherever it emerges, is the most urgent requirement for healthy and sustainable growth

1. Inflation is a deep-rooted and widespread evil

Inflation is rampant practically throughout the world. Only a very few countries—those which took the necessary measures early enough—have been able to contain it. Even in these countries, however, it is always latent and threatening to become more serious. Inflation, it must be recognized, is a destructive and deep-rooted disease. Experience shows that it cannot be viewed as a “fact of life” that one must accept. Some countries are able to develop for a while in an inflationary climate, but observation suggests that their economies, which are usually heavily protected, become increasingly vulnerable over time. The measures adopted in inflationary economies are often as harmful as the disease: price controls eventually bring in their wake an erosion of profit margins, and other distortions, while indexation blunts the thrust of adjustment policies.

But when countries throughout the world have the disease of inflation, the entire system of production and trade is jeopardized. The pace of inflation inevitably varies from one country to another, and the exchange rate movements which result introduce uncertainty into the working of markets. As this process affects major currencies, it threatens both investment and world trade.

The domestic consequences of inflation are too well-known to rehearse in any detail. Inflation is socially unjust because it attacks those with the least means to defend themselves against the destruction of their savings. It leads inevitably to disenchantment with money and securities, and to a preference for what are termed “real” assets. These are generally property or forms of unproductive hoarding which are all the more subject to speculation in that the markets in them are narrow and their prices reflect a magnified image of the general inflation. The gold market today offers a striking example of the disorders to which monetary instability can lead. It is impossible to overemphasize the economic losses that the whole world has suffered as a result of inflation.

Today this phenomenon has become generalized. Inflation has won ground almost everywhere during 1979. In the industrial countries, it is moving up at a pace reminiscent of that judged unacceptable in 1975. Especially disturbing in view of its international repercussions is the recent intensification of inflationary pressures in the United States. In that country consumer prices so far this year have been rising at an annual rate of 13 per cent.

As far as developing countries are concerned, their already precarious position has become even more serious where it has not proved possible to contain the inflationary pressures of recent years. During 1979, there has been retrogression in certain areas that previously had achieved striking success in containing inflation. As in the industrial countries, the full force of inflationary pressures is clearly manifest in the economies of the Third World.

2. The present inflation problem must be tackled in a generally difficult economic setting

Unfortunately, the fight against inflation must be conducted in an international economic environment that is in many respects unfavorable.

There have, of course, been significant improvements in the relative positions of the major industrial economies in the year since our last meeting. Policy changes have led to a better balance in rates of growth in real domestic demand. In addition, important adjustments in real exchange rates have taken place. These developments have brought about a significant corrective shift in the distribution of current account balances among the industrial countries, especially among the three largest, and have improved fundamental factors in the outlook for behavior of the exchange markets. Naturally, many industrial countries feel concern about the cost pressures resulting from the recent 60 per cent increase in oil prices. But the current account deterioration now in prospect for industrial countries as a group (projected at some $30 billion in 1979) does not generally imply serious problems of financing.

Nevertheless, the present outlook for real growth in the industrial countries is very restrained. In most of these countries, rates of economic advance have been sluggish for several years and current levels of unemployment are high. Moreover, a marked slowdown in the industrial world may now be expected, in large part because of the emerging recession in the United States. Against this background, it is all the harder to take the necessary firm stand against inflation.

This economic slowdown in the industrial world is in turn a cause for concern among the non-oil developing countries. It is one of the factors, together with the rise in oil prices, that accounts for the sharp resurgence of their combined deficit on current account, bringing problems that I shall touch on shortly.

These unfavorable aspects of the international setting must not be allowed to discourage remedial actions on the inflation front. On the contrary, they give all the more reason to press on with basic policies that offer promise of curing the underlying inflationary disease.

3. The battle against inflation must be pursued through several complementary lines of policy

The current wave of inflation is rooted in various structural factors, as well as in failures on the side of demand management. Correspondingly, any anti-inflation strategy must include two essential lines of attack.

(a) The pursuit of decisive demand policies requires greater emphasis

It is now very clear that the strategy of “gradualism,” widely agreed on by the industrial countries a few years ago, has not in fact been successfully implemented. This is primarily, in my view, because of the failure to bring about any abatement of inflationary expectations. In retrospect, one must conclude that gradualism as an approach to the reduction of inflation and inflationary expectations has been overly gradual. The main source of difficulty in this regard has been unduly high rates of monetary expansion, often caused by excessive budgetary deficits. Monetary policy has allowed interest rates to remain generally too low for too long periods in relation to rates of inflation. Greater decisiveness and firmness will need to be exercised in the conduct of monetary policy, and this change will have to be supported by fiscal policy. The fundamental aim must be to achieve credibility of fiscal and monetary policies so as to roll back inflationary expectations and restore confidence. Such a change in the stance of general demand policies is called for not only in industrial countries, but also in most other countries.

Of course, the current acceleration of inflation can be explained to some extent by the recent increase in the price of oil, as well as by the rise in prices of food and certain other primary commodities. One essential task at present is to prevent this wave of commodity price increases from being translated into an escalation in the “underlying” rate of inflation. The increases now under way must not be allowed to add a new dimension to inflationary expectations, which would give a further impetus to the wage-price spiral. Another task for economic policy is to determine what should be the appropriate reaction to the deflationary impact of the increase in oil prices. This reaction is bound to vary among countries. But all countries whose inflation rates are relatively high, or whose external positions are weak, would be well advised to accept this deflationary impact rather than to offset it.

(b) But the control of demand is not sufficient: it must be underpinned by a range of measures that address the productive base itself

Although a change in the thrust of general demand policies is crucially important, it is not by itself sufficient to deal with the present accumulation of longer-term problems of a structural nature. For that purpose, the traditional use of fiscal and monetary policies must be accompanied by greater emphasis on various other instruments of policy. In the prevailing situation of “stagflation,” an effective incomes policy—where feasible—should help to limit cost pressures and moderate price increases without incurring greater slack and unemployment. More generally, there is clearly a need for greater focus on measures to improve supply conditions and to achieve higher levels of saving and investment. In many countries, performance of the domestic economy in recent years has been affected by structural impediments, often stemming from public regulation itself. These include a severe drop in productivity growth, scarcity of energy, impairment of profits, and rigidities arising from attitudes to work and from the widespread quasi-automatic adjustment of wages and social benefits to rising prices. Such problems now loom more important in the overall economic picture than expected earlier, and they must be dealt with in order to improve economic efficiency. I would lay emphasis on two areas where constructive actions are fundamental not only for the success of the struggle against inflation, but also for the maintenance of a stable international order. I refer to energy policy and the freedom of international trade.

Energy policy—There is a vital need for better policies in the field of energy. To conserve energy and to develop additional sources of supply, realistic pricing policies for energy are essential, especially in those countries whose domestic energy production has been declining in relation to imports. Energy has become, and clearly will remain, an expensive resource. Achievement of an increased output of energy will depend on new investment in oil exploration and in the development of alternative sources of energy. Such investment will require appropriate financing, as well as large increases in saving to support it. An important contribution in this field could be made by enhancing the role of international institutions in promoting energy production in developing countries.

As to the pricing of energy, realistic policies would require the 1979 increase in oil prices to be passed on in full to consumers. Despite the reduction in real incomes and living standards that is implied, governments should at the same time endeavor to limit the indirect effects of the oil price increase on the general price level. Here, there is a clear, though difficult, role for incomes policy, by excluding oil prices from the mechanism of wage indexation and thus limiting self-defeating wage-price spirals.

The fight against protectionism—Let me voice again my grave concern about protectionism. Resort to protectionism under any guise is harmful. It is conducive to higher inflation, greater structural rigidities, and lower productivity. I am particularly troubled by the adverse effects that protectionism is having on the efforts of developing countries to promote economic growth through outward-looking policies. Clearly, measures are required in many countries—developed and developing alike—to foster the reallocation of resources required for an expanding volume of world trade. I must stress the importance for countries to adapt to structural changes in export capacity and to maintain an open trading system.

* * * * *

The world economy may be entering a very difficult phase for at least the next few years. But I firmly believe that policies along the complementary lines I have indicated could serve to turn the situation around and get things moving in the right direction. I do not underestimate the economic and social difficulties of pursuing such a course, nor the political courage it will take; but I see no alternative.

II. It is essential to take into account the needs and problems of the developing countries

1. The position of the developing countries is becoming more serious

Developments in the industrial world, in conjunction with the new rise in oil prices, pose major problems for the non-oil developing countries. The general worsening of the external position of these countries which is now under way is occurring against a domestic economic background that is quite disappointing.

Economic growth rates of the non-oil developing countries in recent years have been modest in relation to population growth and developmental needs. This generalization is particularly applicable to a subgroup of countries having the lowest per capita incomes 1—countries that together account for nearly two fifths of the population of all Fund members but less than 3 per cent of their total GDP.

At the same time, inflation remains a serious problem in many of the non-oil LDCs. The estimated rise in consumer prices for these countries in 1979—amounting to some 30 per cent, on average—is three times as high as the average for the late 1960s and early 1970s.

The worsening of the external position for non-oil developing countries as a group is evident in a steep buildup in their combined current account deficit. After rising from $21 billion in 1977 to $32 billion in 1978, the deficit is projected to reach $45 billion in 1979 and to move well above the $50 billion mark in 1980. This projected increase in the combined deficit means that strained external positions are likely to become more numerous.

As a group, the non-oil developing countries have borrowed abroad on a greatly expanded scale in recent years, not only covering their current account deficit but also making substantial additions to their international reserves. The growth of external debt thus generated will continue to increase the burden of debt service charges on these countries. Much of the new debt reflects borrowing in international financial markets on terms less favorable than those associated with traditional development financing. Thus, debt service charges are rising even faster than the debt itself.

But what is even more worrying is that the large rise in the current account deficit of the non-oil LDCs from 1977 to 1979 can be wholly attributed to two factors: deterioration in the terms of trade and larger interest charges. These factors have been absorbing borrowed funds without increasing the real flow of external resources for development.

I am deeply concerned about the external position of the low-income subgroup of developing countries. Although they account for a declining share of the combined current account deficit of the non-oil LDCs, this is probably because of an inability to finance sharper growth of their deficits. In real terms (that is, in import purchasing power), the net inflow of capital and aid received by the low-income developing countries is estimated to be no larger in 1978 and 1979 than it was in 1973. This is a very disturbing situation—one that clearly underlines the crucial importance of increasing the flow of official development assistance.

2. Forceful action in favor of these countries is indispensable

It is vital that the industrial countries should do as much as they are able to assist developing countries in their external financing. Those industrial countries in a relatively strong position on current account should take all feasible steps to promote additional flows of private capital for development. Such flows, let me stress, would be facilitated by policies on the part of the developing countries themselves to maintain creditworthiness. Also, there is a strong case for all industrial countries—surplus and deficit alike—to increase their official development financing. Further efforts by the major oil exporting countries to increase their already large flows of developmental finance to non-oil LDCs likewise would be helpful. Expanded flows of capital and aid to the developing countries—along with measures to improve market access for their exports—are essential for economic development. They are also needed for the proper functioning of the international monetary system. In this connection, I want to warn against resort to monetary mechanisms in the illusion that they could provide a costless way of financing aid flows.

The International Monetary Fund, for its part, has continually adapted its policies in ways that have proved beneficial to developing countries among its membership. For example, 59 developing countries are now eligible to receive low-interest loans from the Trust Fund during the period ending on June 30, 1980. Since 1976 the Trust Fund has disbursed SDR 1.2 billion in loans to 47 countries. Also, I might mention, the recent liberalization of the compensatory financing facility and the adoption of a new set of guidelines on conditionality, while applicable to all members, should prove helpful particularly to developing countries. With respect to the latest changes in provisions of the compensatory financing facility, it is especially significant that the Fund is now prepared to authorize drawings of up to 100 per cent of quota.

III. The role of the International Monetary Fund and the longer-term evolution of the system

1. Current role of the Fund in financing and adjustment

The large payments imbalances that must be expected to characterize the world economy over the next few years will require financial intermediation on a substantial scale. International private capital markets will naturally play the main role in recycling funds from surplus to deficit countries, as they did so successfully after 1974, in the wake of the first round of major increases in oil prices. I believe that we can be confident that the international banking system will again meet the demands placed upon it, and in this connection I am greatly encouraged by the attention currently being given to supervision of international banks for prudential purposes. It is not, of course, a function of private banking institutions operating in international capital markets to look after the working of the international adjustment mechanism. In this area, therefore, it is the Fund’s role to provide conditional liquidity to members under terms and conditions designed to strengthen balance of payments adjustment.

The Fund is ready to play an active role in the provision of assistance to countries in formulating programs of adjustment and in the financing of balance of payments deficits. An examination of the payments outlook through the end of 1980 has confirmed the impression that problems have worsened considerably for many members that might need to have access to the Fund’s conditional resources. It has also disclosed that in most cases the problems are rooted in policies of domestic economic management over a period of years. Moreover, analysis has indicated that, although the present accentuation of problems is mainly of external origin, most of the difficulties faced are not of a short-term nature. Hence, adjustment is needed and undue delay in adapting to the new developments would be virtually certain to force even harsher—and more abrupt—adjustment later.

In these circumstances, I do not feel that it would be appropriate now to suggest the creation of a special facility on the lines of the 1974 and 1975 oil facilities. The important thing, in the light of the increased needs, is for the Fund to be fully responsive in assisting members with difficult adjustment problems. The Fund must be responsive by means of both its resources and its policies.

As regards resources, a substantial source of assistance is provided by the supplementary financing facility arranged with great foresight by my predecessor. This facility, with loan commitments of nearly SDR 8 billion, augments the resources available to meet the needs of members requiring assistance in larger amounts and for a longer period than would be available under the Fund’s regular tranche policy. It allows the Fund to lend flexibly in relation to members’ quotas. Countries facing “special circumstances” can draw larger-than-normal amounts provided they have programs which give adequate assurance that the necessary adjustments will be carried through.

Given this situation, it is essential that, in discussing adjustment programs, the Fund pay due regard to the causes of the imbalances and also to the domestic social and political objectives, the economic priorities, and the individual circumstances of members. As regards Fund policies, the Executive Board has adopted a new set of guidelines for the use of Fund resources that, in my view, deals with the question of conditionality in a much more flexible way. In order better to adapt the Fund’s conditional lending to present circumstances and needs, it is important that, here in Belgrade, the Development Committee and the Interim Committee have agreed on my proposals to make two requests of the Fund’s Executive Board:

—to give further consideration to increasing the maximum repurchase period in respect of purchase under the extended facility from eight to ten years. This facility is particularly useful in the case of structural adjustments where the use of Fund and Bank resources can often go hand in hand.

—to give attention to developing ways and means of lowering the interest costs of the supplementary financing facility.

Finally, in the light of the obvious need to enhance the Fund’s role in intermediation, I should like to urge members that have not yet accepted quota increases under the Seventh General Review of Quotas to do so as soon as possible. The 50 per cent increase in quotas is needed to place the Fund in a better position to meet potential needs for use of its resources in the current environment of uncertainty.

2. The longer-term evolution of the international monetary system

Our concern with the severe problems of today should not induce us to ignore the more basic problems of the system, as we have tended to do for a number of years. Unless the monetary system develops in parallel, we shall continue to encounter severe disturbances from time to time and will never reach a fully satisfactory situation. Hence, the Fund’s concern with problems of its members and of the world economy needs to be seen in the broader framework of the development of the international monetary system. The entry into force, in April 1978, of the amended Articles of Agreement was a step—but only a step—in the process of reform. We must now address the possibilities of further developing and improving the system.

Many aspects of the system, such as the working of the adjustment process, the structure of reserve assets, and the exchange rate mechanism, are being actively studied by the Fund. Since the 1978 Annual Meeting, the Executive Board has given renewed attention to one possible development in the area of reserve assets that could substantially enhance the role of the SDR, namely, a substitution account, administered by the Fund, that would accept deposits of U.S. dollars from official holders in exchange for an equivalent amount of SDR-denominated claims. The positive response that the idea of a substitution account has received reflects the renewed interest in aspects of reform that found expression, over a decade ago, in the introduction of the SDR. It also reflects the widely felt need for more stable conditions in the functioning of the system.

I strongly welcome the active support that the Interim Committee has just given to this approach and its request to the Executive Board to continue to direct priority attention to designing a substitution account plan and to report progress to the next meeting of the Interim Committee. The Committee has expressed the view that

In order for the account to achieve widespread participation on a voluntary basis and on a large scale, among other things, it should satisfy the needs of depositing members, both developed and developing, its costs and benefits should be fairly shared among all parties concerned, and it should contain satisfactory provisions with respect to the liquidity of the claims, their rate of interest, and the preservation of their capital value.

I believe that a substitution account with these features would constitute a significant step forward in the evolution of the international monetary system. It would diminish the inherent instability of a system too centered on one currency—the dollar—or on a multicurrency reserve system with which many member countries are uneasy. A third route has to be explored, and the Fund would be neglecting its responsibilities if it did not actively pursue its thinking in this direction. The substitution account would contribute to the development of the SDR—as foreseen in the Articles of Agreement—into the principal reserve asset of the system. This, in turn, should bring about conditions more conducive to international influence over the growth of international liquidity.

It is obvious that the introduction of a substitution account with the features that I have specified does not constitute an answer to all short-comings of the system. It should not be considered as a panacea, still less as a way to avoid discipline. In due course, further steps toward reform will no doubt be necessary. But, above all, no arrangements will produce satisfactory results unless they are supported by prudent economic policies in member countries—most importantly, those member countries that play an essential role in the functioning of the system.

* * * * *

Mr. Chairman, in the field of economic policy, a substantial role can, and should, be played by international cooperation. Such a role, indeed, is required for maximum effectiveness of the broad policy prescriptions that I have set forth earlier in these remarks. In a world of increasing interdependence, no country can afford to ignore international influences in the management of its domestic economy.

All countries must contribute to the working of the international adjustment process, following principles that have been established in the Fund. The industrial countries, on which the performance of the world economy depends so greatly, have a particular responsibility in this area. Achievement of a better working of the adjustment process could, in my judgment, lead to a significant improvement of economic conditions around the world.

On a more specific plane, there has been great improvement in the day-to-day management of exchange markets since the introduction in November 1978 of a package of measures by the authorities of the United States and other countries. I believe that the larger industrial countries should continue efforts to coordinate their actions regarding exchange market intervention. Coordinated intervention is all the more necessary in the light of the general tendency for countries to “take a view” of the market, evidently because of some disenchantment with the operation of market forces that may push exchange rates too fast or too far. I also believe that the larger industrial countries should try to move further in the direction of coordinating their monetary and interest rate policies. In our open world of free capital movements, experience indicates that, without more cooperation in the monetary field, actions by partner countries may not only complicate domestic economic management in individual countries, but may also lead to capital flows having disturbing effects on the exchange rates for major currencies.

All these matters relate closely to the interest and work of the Fund. I would therefore emphasize, as another aspect of international cooperation, the importance of members’ collaboration in strengthening the capacity of the Fund to exercise its wide-ranging functions. The effectiveness of these functions—particularly those relating to surveillance over exchange rate policies and to the conduct of a worldwide forum on economic and financial problems—implies strong collaboration on the part of member countries. In this connection, collaboration means discussion of problems and possible courses of action in an open and cooperative spirit, with a willingness to listen to the voice of the international community just as carefully as to that of any important domestic interest group. The Fund has the unique characteristic of having a permanent body—the Executive Board—which is the expression of our membership and which can deal with these matters in a responsible and efficient way. In the difficult and challenging tasks that lie ahead, I am confident that the support and collaboration of member countries will be forthcoming.

October 2, 1979.

Consisting of the 39 Fund members with a per capita GDP equivalent to US$300 or less in 1977.

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