6 Adjustment Becomes More Complex, 1973–76
- Margaret De Vries
- Published Date:
- March 1987
In 1973, such dramatic changes took place in the international monetary system and in the world economy that it was as if a trapdoor opened and everything from the system of the previous three decades suddenly disappeared. The changes produced a world economy and an international monetary system that were entirely different for the rest of the 1970s and into the 1980s, at least through 1986. In brief, in March 1973, the par value system ultimately collapsed and floating rates for the main currencies were introduced. In midyear, inflation in most industrial members accelerated to historically high levels and double-digit inflation began. In the last quarter of the year, partly induced by the accelerating inflation in industrial members, steep, sudden increases in prices for crude oil were announced, bringing on massive balance of payments imbalances.1 The nature and dimension of balance of payments adjustment for all Fund members, industrial and developing, became altogether different.
Emphasis on Financing Oil-Related Deficits
The Managing Director, H. Johannes Witteveen, was among the first financial officials in January 1974 to address the problem of how to deal with the new massive international balance of payments disequilibria following the sudden leap in oil prices at the end of 1973. His concern was that oil importing members, industrial as well as developing, might decide to deal with their unprecedented balance of payments deficits by means of deflation, exchange depreciation, or intensification of trade and payments restrictions—the usual ways to cope with external payments deficits. His concern about these measures was all the more pronounced since floating rates now prevailed and no new agreed international rules existed to govern actions in the international monetary field. Such measures could bring about a world depression of a magnitude not seen since the 1930s. Higher prices for oil could be thought of as a tax that oil importing countries would have to transfer to oil exporting countries. To pay this tax, oil importing countries might have to cut back severely, not only on imports of oil but also on other products. Since oil exporting countries were not expected to increase their own demand for imports sufficiently to compensate for the cutback by other countries, there could be a substantial drop in world demand for goods and services.
Monetary officials shared Mr. Witteveen’s concern and concurred with his emphasis on financing the oil-related deficits rather than adjusting to them. The Committee of Twenty thus agreed that in managing their international payments “countries must not adopt policies which would merely aggravate the problems of other countries,” and approved Mr. Witteveen’s proposal for a temporary oil facility in the Fund.2
The oil facility was designed to meet unexpected higher costs for imported oil in much the same way as the compensatory financing facility assisted members in dealing with temporary export shortfalls. Eventually there were two oil facilities; the 1974 facility was succeeded by another for 1975. The conditionality of the 1974 oil facility was only slightly greater than that applied to the compensatory financing facility at the time. The main condition was that the member avoid recourse to restrictions on imports or payments. The 1975 oil facility had somewhat stricter conditionality: the member making a drawing was to describe to the Fund its policies to achieve a medium-term solution to its balance of payments problems and to have the Fund assess the adequacy of these policies. The Fund was also to judge the extent to which reserves could be used to meet the member’s balance of payments deficit. The member was to describe the measures it had taken or proposed to take to conserve oil or to develop alternative sources of energy, although these measures were not subject to the Fund’s assessment. As in the 1974 facility, access to the 1975 facility was also to depend on a member’s avoidance of the introduction or intensification of restrictions on trade and capital. For the 1975 facility, the Managing Director and staff had favored stricter conditions in the form of quantitative targets for monetary and fiscal policies, as was done when the Fund approved stand-by arrangements. Most Executive Directors did not want to go so far, however, and the Executive Directors elected by developing members opposed even the conditionality that was worked out.3
In essence, the conditionality attached to both the 1974 and 1975 oil facilities can be described as moderate or even low. Some observers regard it as having been zero. It is true that the principle was clearly enunciated that members that financed their oil-related deficits by drawing on the Fund’s oil facilities should at the same time correct their non-oil related balance of payments deficits. But this principle was not easy to apply and the Fund did little to enforce it. A far more stringent conditionality for drawings would have been necessary to make this principle stick.
The oil facilities thus reflected the common view of the great majority of Governors of the Fund and Executive Directors, as well as of the Fund management as of 1974 and 1975, that primary emphasis should be on the maintenance of demand in oil importing members with major reliance on the financing of the large current account deficits, and that adjustment to reduce substantially these deficits should play a secondary role. Unique circumstances explain why this view was so pervasive.
The size of the expected balance of payments deficits was startling. Moreover, the deficits were being imposed on a situation already characterized by sizable payments imbalances among the industrial members. The imbalances of 1970 to 1973 had not yet been corrected following the currency revaluations of 1971 and 1973. In 1973 the United States had achieved a $3.3 billion surplus on current account in contrast to its record current account deficit of $7.1 billion in 1972, and the current account surplus of Japan, $7.2 billion in 1972, had virtually disappeared. Disequilibria among the Western European members had increased, however; the current account surplus of the Federal Republic of Germany had soared to $6.6 billion in 1973 from $2.8 billion in 1972, while the current account surpluses achieved by Italy and the United Kingdom in 1972 turned into deficits in 1973.
The payments imbalances of 1972 and 1973 were dwarfed, however, by those expected for 1974. The Fund staff was estimating that the combined current account surplus of the nine major oil exporting members would increase in 1974 to perhaps $65 billion, more than 13 times the surplus of 1973, with a deterioration of similar magnitudes for all other members combined. Two thirds of this deterioration was expected to be incurred by industrial members, shifting them from their aggregate Current account surplus of $10 billion in 1973 to a deficit of $22 billion in 1974, and one third by “non-oil primary producing countries.” Unusually severe balance of payments problems were foreseen for the non-oil developing members, which were expected to have enlarged current account deficits totaling possibly more than $20 billion in 1974, compared with $9 billion in 1973.
As Mr. Witteveen pointed out at the time, these marked shifts in the pattern of world payments radically altered the traditional concept of what constituted a sustainable international balance of payments structure. In the past, a satisfactory position for most industrial members involved a modest surplus on current account sufficient to cover outflows of aid and capital to the developing world. The counterpart of this surplus was a current account deficit in the developing world. In the new situation, the overwhelming majority of members, industrial as well as developing, would have big current account deficits, while oil exporting members would have unprecedented surpluses. Deficits were expected to be almost universal, including large deficits by most, if not all, industrial members. The oil facility was intended for use by both industrial and developing members, and, in fact, was used by both.
Another reason for preferring financing to adjustment was that the current account surpluses of the oil exporting members were considered structural rather than financial. Their genesis did not lie in inappropriate macroeconomic policies or in unrealistic exchange rates. They could not be eliminated by the usual changes in monetary or fiscal policy or in exchange rates, either by members in surplus or by members in deficit. Instead, elimination of the balance of payments surpluses of oil exporting members required basic changes in the patterns of consumption and production of both oil exporting and oil importing members, that is, in the structure of their economies. These changes would take several years, possibly a decade or two, to accomplish. Meanwhile, the oil exporting members would in all likelihood not import nearly enough to help reduce the payments deficits of oil importing members. Hence oil exporting members would be piling up foreign exchange reserves. It seemed logical to tap these reserves, readily available in the system, by recycling them to oil importing members needing financing.
Because Of the higher cost of fuel, the oil price increases were expected also to cause further inflation; a prospect that was considered alarming since inflation, which had been accelerating since the mid-1960s, had become the dominant problem of economic policy for most members. Inflation could also severely damage the world economy, it would be better to help accommodate the oil price rises rather than to increase considerably the costs of production in virtually all members.
Finally, the new balance of payments problem and the recycling to deal with it were considered temporary. The common view was that the big rise in oil prices in 1973 was a once-and-for-all phenomenon, a correction for the low prices of the past, and that if this crisis could be adequately weathered, the world economy could again proceed satisfactorily.
As matters turned out, despite expectations of inflation as of mid-1974, an unexpectedly severe worldwide recession, characterized by exceptionally high rates of unemployment, developed in 1974–75. Real gross national product in industrial members as a group, which had risen steadily by at least 6–7 percent in 1972–73, actually fell by an average of 4–4.5 percent in the second half of 1974 and the first half of 1975. Unemployment and slack use of productive capacity in the large industrial members reached levels not experienced since the 1930s. Lower imports helped alleviate the balance of payments positions of industrial members, and a large swing in the combined current account balance of the industrial members took place, from a sizable deficit in 1974 to a surplus of $19 billion in 1975.
The impact of the recession also radiated to nonindustrial members, primarily through changes in trade and in associated financial flows, but also through worsening terms of trade. The current account deficit of the non-oil developing members, in particular, was sharply enlarged, rising from the already unprecedented $28 billion in 1974 to $38 billion in 1975. The sheer size of the aggregate deficit initially cast doubts on the ability and willingness of the non-oil developing members concerned to find adequate financing.
Financing the Deficits The oil facility notwithstanding, only a small proportion of the total financing of the 1974 and 1975 balance of payments deficits came from the Fund. Drawings on the oil facility from September 1974 until the last of the drawings in May 1976 totaled SDR 6.9 billion. Members, including non-oil developing members, greatly reduced their foreign exchange reserves to help pay for the deficits. Most important, a very large part of financing came from a substantial expansion of lending by private commercial banks, which, for the first time, began to lend directly to the governments of many developing members. Readily available credit from private commercial banks, at low or even negative real rates of interest (i.e., nominal rates of interest below the current and expected rates of inflation in the prices of the borrowing country’s export goods, measured in dollars or the currency in which it borrowed), helped induce members to borrow. And steadily rising deposits, particularly as oil exporting members banked their vastly enlarged oil revenues, induced creditors to lend. In these circumstances, non-oil developing members in particular opted to accumulate large external debts rather than to take measures to reduce their current account deficits since such measures would in all likelihood have reduced their rates of growth, at least in the short run.
For its part, the Fund also made record amounts of financing available. In addition to the oil facility, the Fund substantially liberalized the compensatory financing facility at the end of 1975, and the liberalization was followed by a large upsurge in drawings. Drawings in the gold tranche (called reserve tranche after April 1978) also went up and so did drawings under stand-by arrangements, especially after the Fund temporarily widened each credit tranche by one half so that each tranche was equivalent to 37.5 percent of quota instead of the customary 25 percent. Hence, in the Fund’s two financial years from May 1, 1974 to April 30, 1976, total drawings amounted to a record SDR 11.7 billion.4
The second oil facility that came into effect in mid-1975, the substantial liberalization of the compensatory financing facility in December 1975, and the temporary enlargement of credit tranches in January 1976, taken together, amounted to countercyclical financing policies on the part of the Fund to help members with balance of payments deficits aggravated by the 1974–75 recession. The actions did not reflect a deliberate countercyclical policy but rather were taken independently. Nonetheless, their combination was tantamount to a countercyclical financing policy.
Several reasons explain why the monetary authorities of the industrial members went along with, or even proposed, these actions to enlarge use of the Fund’s resources. They agreed to the second oil facility only after they cut back the amount sought by Mr. Witteveen. They were concerned about the massive balance of payments deficits of several members, especially of the non-oil developing members that did not have easy access to private financing. Hence they were responsive to pressures from the authorities of developing members to make more Fund money available after the oil facility expired. The compensatory financing facility seemed the logical way to do so, especially since commodity prices had been falling. Even so, some industrial members, notably the United States, wanted to restrict use of the facility to members most in need of financing from official sources. Monetary authorities from industrial members also wanted to retain the goodwill of their counterparts from non-oil developing members. At the time the industrial members were contemplating a special “safety net” for themselves to help with their own oil-related payments deficits and they did not want to appear unmindful of the problems of developing members. Monetary authorities of industrial members were also concerned that non-oil developing members might, in the absence of sufficient financing, have to adjust their balance of payments positions by intensifying their restrictions, thereby reducing their imports from industrial members. In addition, the Second Amendment to the Fund’s Articles of Agreement was nearly completed and its acceptance by developing members was essential for it to enter into force. Monetary authorities from industrial members were also somewhat embarrassed that, for a second time, they had rejected establishment of a link between SDR allocations and development finance, an idea long cherished by developing members. These last-cited circumstances also helped induce monetary authorities from industrial members to agree to the establishment of the extended facility in the Fund, described later in the chapter, and to propose the establishment of a Trust Fund in the International Monetary Fund.5
All of these circumstances helped persuade the monetary authorities of the industrial members to provide more financing for non-oil developing members through the Fund. In addition to providing larger amounts of official financing, monetary authorities of industrial members especially welcomed the greatly increased lending to non-oil developing members by private banks. They strongly preferred recycling of surplus funds to be handled through private markets. The bulk of the surpluses of oil exporting members to finance the deficits of oil importing members was thus recycled through the private commercial banks of the industrial members. The recycling of surplus funds was not to be done directly, as would be the case if oil exporting members that had surplus funds themselves assumed claims on the oil importing members that had deficits. It was done indirectly: commercial banks of industrial members provided the oil exporting members that had surplus funds with the assets or claims these members preferred, namely, deposits in commercial banks, and, for a fee, the banks took on the liabilities of the oil importing members.
Measuring the Size of the Adjustment Needed
Although Fund officials centered most of their attention in 1974 and 1975 on finding ways to help members finance oil-related deficits, they also paid attention to the problem of adjustment. The staff benefited from its experience of the previous four years. In 1971 the staff had felt sure enough of its ground to propose a new set of exchange rates for the major currencies, rates that did not differ substantially from those agreed at the Smithsonian Institution in December of that year. Eventually the rates proposed proved wrong: the changes were too small and did not produce enough adjustment. There was, however, a rather comforting explanation: it was not that the Fund’s MERM model was wrong but that the size of the 1971 disequilibrium had been seriously underestimated.
Benefiting from this experience, the staff of the Research Department in mid-1975 undertook to calculate “the underlying balance of payments disequilibria of industrial members that would materialize over the medium term,” assuming existing exchange rates and reasonably high levels of economic activity in all industrial members, and to have the Executive Board discuss the methods and procedures used. There were several reasons for this exercise. The methods and procedures that the staff were using in calculating underlying balance of payments disequilibria for the “World Economic Outlook” exercise were still in the process of being developed.6 Also since early 1972, after the Smithsonian agreement, the Fund had devoted considerable attention to how the adjustment process, especially among the major industrial members, was working. By 1975 the staff was trying to find a way to assist the Fund in its efforts to guide the adjustment process in the radically changed circumstances. The staff regarded the study of the evolution of the underlying payments imbalances in industrial members over the next few years as necessary for any discussion in the Fund of balance of payments adjustment and of the policy measures suitable for its achievement. Adjustment policies, especially those involving changes in relative prices, such as exchange rates, affected the balance of payments slowly and with considerable delay. To ascertain the adjustment policies needed, it was therefore essential to eliminate the influence of temporary factors, particularly the effect of the prevailing recession on output and employment. In addition, the staff was seeking ways to help predict developments in the exchange rates for the main currencies.
The staff defined the concept of the underlying balance of payments position of an industrial member as the balance of payments surplus or deficit that would exist in the absence of temporary influences, the main temporary influence of concern at the time being the 1974–75 recession. The staff then projected how that surplus or deficit would evolve over the medium term. At the time, economists usually measured the impact of recession on output and employment for an industrial member by measuring the shortfall of gross national output from some high-employment norm; that is, the output obtained in the past, such as in the mid-1960s, when little unemployment existed. However, because of the severity of the 1974–75 recession, the Fund staff regarded high-employment norms based on a historical period to be of limited relevance. They therefore preferred using estimates for members’ balance of payments positions in 1975 based on projections for members’ cyclical positions in 1978, making some allowance also for other temporary disturbances, such as poor harvests, dock strikes, and changes in the terms of trade caused by short-run movements in commodity prices, that affect the balance of payments. In more technical terms, the staff calculated underlying current account balances for 1975 on the basis of two alternative definitions of the “cyclically neutral” level of economic activity, as measured by capacity utilization in manufacturing, unemployment, or the gross national product gap.7 The first definition was that customarily used by economists at the time; however, the Fund staff used the period 1967 through the first half of 1974. In this period unemployment was relatively high in most industrial members so that the period could be considered in line with reasonably realistic targets for employment levels of various members in the future. The second definition was a level of employment likely to be attainable in the medium term, say, by 1978. The staff believed that the size and persistence of the 1974/75 recession made it necessary to introduce the second definition. It was clear that the employment levels experienced in the 1960s and early 1970s would not be attainable by many members in the next two or three years. It was therefore useful to calculate the cyclical adjustment that was implied by an expansion not to the relatively high employment levels of the past but to a level of activity considered attainable in the next few years. In the staffs view, the first definition could be viewed as a reference point for the longer term, while the second definition might be used for studying medium-term policy alternatives related to the adjustment process.
To obtain a more complete picture of underlying balance of payments disequilibria in industrial members, the staff supplemented its analysis of the current account positions by an assessment of likely capital flows. Projecting capital movements was more hazardous than forecasting the flows of trade and service items, both because of the greater volatility of capital movements and because the factors on which capital flows depend were more difficult to forecast than those determining trade flows. For this reason, the Staff did not estimate underlying net capital flows in the same way as they projected underlying current account balances. Instead of first forecasting actual flows in 1975 and then removing the influence of cyclical and other temporary factors, as was done for the projections of balance on current account, the underlying capital flows for 1975 were estimated directly. There were, in principle, two methods by which this estimation could be done. The first, and perhaps intellectually more respectable method, was to forecast developments in the main immediate determinants of capital flows, such as interest rates and yields on various types of investments, or in the more ultimate determinants of capital flows, such as propensity to save and incentives to invest. The staff rejected this method because it was difficult to assess the underlying tendencies in these determinants of capital flows, some of which were strongly influenced by fiscal and monetary policies, and because economists’ knowledge of the quantitative effects of these determinants on capital flows was scant. The second method, the one the staff used, relied on the persistence of the prevailing structure of international financial capital flows by extrapolating existing trends, modifying these trends where necessary to allow for structural or policy changes, including changes in exchange rates and in the oil price, that had occurred in the past two years or so. Official transfers, long-term governmental capital movements, direct investments, and a remaining category of all other capital flows and errors and omissions called “financial capital movements,” were examined separately.
The staff wanted to ascertain the views of the Executive Directors on the methodology and concepts, especially since some estimation of the balance of payments positions of the industrial members was a prerequisite for any discussions in the Fund of the policies followed by members and assessment of the appropriateness of those policies. At the Executive Board’s discussion, while a few Directors argued that the Executive Board was not the best forum for fruitful discussions of such complex methodological matters, most of them commended the staff for seeking to arrive at a balance of payments concept that was free of the impact of cyclical influences. Several Executive Directors noted that their authorities were also working to determine the most appropriate balance of payments strategy for the medium term, taking the needs of economic recovery and employment into account. They agreed that the underlying balance of payments situation had to be assessed over a series of years in the future before conclusions could be formed about the correct policies for balance of payments adjustment. Some Executive Directors took the view that such assessment was necessary particularly in order to enable the Fund to form policies for floating exchange rates. The Executive Board concluded that it would be useful to convene a group of technical experts with whom the staff could examine the methodological questions involved.
Two Conferences Held The staff held a conference at the Fund’s Paris Office on February 23–25, 1976, in which 27 officials from all 13 industrial members of the Fund participated, plus two representatives from the Organization for Economic Cooperation and Development (OECD) and one each from the Bank for International Settlements (BIS) and the European Community (EC). The conference was organized around five topics—the Fund staffs ways of assessing underlying balance of payments disequilibria; techniques for eliminating cyclical influences on estimates of current account balances; assessment of members’ relative cyclical positions; ways to estimate lagged price and exchange rate effects and special nonrecurrent events; and ways to estimate underlying capital account balances. The conference participants generally liked the Fund staffs innovations, the historical series of underlying current account positions, the estimates of underlying current account imbalances based on assumed 1978 employment levels, and the methodology used for estimating balances on capital account.
About two years later, in an Executive Board seminar on exchange rates held in January 1978, a number of Executive Directors suggested that it would be useful to convene a second conference of experts on the methodology used by the staff, particularly in the World Economic Outlook exercise, to forecast underlying balance of payments positions. In the two years since the first conference, many of the recommendations made by the experts had been reflected in the staff’s work, and the staff’s techniques of analyzing current account developments had been improved. The staff had also dropped preparing estimations of underlying balances on capital account, at least temporarily, since estimating these balances proved to involve severe difficulties. In addition, the staff had shifted from measuring underlying current account payments disequilibria to an analysis based on medium-term “scenarios” of coordinated growth and balance of payments adjustment, which is described in Chapter 7.
The second conference, held on October 23–25, 1978, in the Fund’s Paris Office, again brought together experts from the governments of the 13 industrial members of the Fund and Switzerland, plus representatives from the OECD, the BIS, and the EC. Discussions were organized around six topics: the Fund’s approach to assessing industrial members’ external positions; cyclical adjustments of trade balances, involving both assessing the degree of capacity utilization in a member and the effects of variations in income and economic activity on trade flows; the delayed effects of past changes in domestic prices and exchange rates on trade flows; adjustment of invisible items for cyclical and other temporary influences; the concept of measurement of underlying capital movements; and the main conclusions to be drawn.
These staff exercises and technical conferences show how difficult it was after 1973 for monetary officials and economists, including those in the Fund, to determine what balance of payments adjustment was needed by industrial members or even the size of the imbalances that needed adjusting. Yet such assessment was essential before officials and economists could focus on the policies needed for balance of payments adjustment by industrial members.
Switch in Emphasis to Adjustment in 1976
In mid-1976 Fund officials, especially Mr. Witteveen, switched emphasis from financing oil-related balance of payments deficits to adjusting these deficits to more manageable levels. In April 1976 in a speech to the international banking community, Mr. Witteveen made remarks that, in view of the debt crisis of the 1980s, are worth spelling out here at some length. Commenting on the roles being played by commercial banks and the Fund in the financing of national balance of payments positions, he pointed out that temporary balance of payments financing has always been an important means by which the Fund can achieve its general purposes, while for private commercial banks, balance of payments financing lies outside the mainstream of traditional banking operations. He noted that commercial bankers themselves were raising questions about the trend toward an increased role for private banks in balance of payments financing and were calling for a return to more traditional forms of international banking, that is, trade and project financing, which assure the generation of foreign exchange from which the loan may be repaid. He stressed that in contrast to the traditional banking activities of trade and project financing, balance of payments loans inevitably involve judgments that go beyond strictly commercial considerations into the field of national financial and economic policies. Concerned about the inflationary effects of the increasing international operations of commercial banks, the delay of members in adopting needed adjustment policies, and the potentially hazardous mounting debt burden, Mr. Witteveen stated explicitly that competitive enlargement of the balance of payments financing role of private banks “might well foster a climate of all-too-easy borrowing by deficit countries.” He warned, too, that should debt-servicing problems arise in the future, the banks “would have to accept some share of responsibility for, in retrospect, there is little doubt that credits were sometimes granted in a market climate that was not very conducive to the maintenance of adequate standards.” In conclusion he emphasized that balance of payments financing generally had to be accompanied by the appropriate degree of adjustment in domestic economic policies and that it was the task of the Fund “to promote sound general financial policies and to help create a climate that is conducive to steady development and the productive use of available external resources.”8
Against this background, in July 1976 Mr. Witteveen added the topic of balance of payments adjustment to the agenda of the meeting of the Interim Committee scheduled to be held in Manila on October 2. In his opening speech at the Annual Meeting in Manila, on October 4, 1976, he stated that “the time has come to lay more stress on the adjustment of external positions and less on the mere financing of deficits.”9
A combination of circumstances explain his shift. Following the deep and prolonged recession of 1974/75, economic expansion had at last resumed throughout the industrial world. In the first half of 1976, annual rates of increase in output in industrial members ranged as high as 6–9 percent lot the three largest economics (those of the United States, the Federal Republic of Germany, and Japan) as well as for the Canadian and French economies, and averaged about 6.5 percent for the industrial members as a group. In addition, as economic activity in the major industrial members expanded, upward momentum was being restored to world trade. Following a decline in world trade of 4.5 percent in 1975—the first year since 1958 in which world trade had experienced an actual decline—a marked rebound of import demand took place in early 1976 in the industrial members, while strong increases in import demand by the major oil exporting members continued. Moreover, after an 18 percent drop in 1975, prices for many primary products were beginning to rise, and as a result the export earnings of all primary producing members, including the non-oil developing members, were again rising. These favorable developments in the world economy, in world trade, and in primary product prices all underlay Mr. Witteveen’s conviction that the time was right to emphasize adjustment.
Most important in the new emphasis on adjustment was that the developments in the world economy and world trade and in primary product prices were also generating significant shifts in the global pattern of balance of payments surpluses and deficits on current account. The $67 billion current account surplus of major oil exporting members of 1974 was in the process of being lowered to $41 billion in 1976. After a huge current account deficit in 1974, when oil prices went up, followed by a substantial surplus in 1975, when their import demand was depressed, the industrial members as a group were achieving virtual equilibrium on current account. The aggregate current account deficit of industrial members in 1976 did, in fact, amount to only $1 billion, and by early 1977 the Fund staff was projecting a continued aggregate current account deficit for industrial members of only $1 billion. The situation among industrial members was uneven, however, indicating the need for adjustment by individual members. The United States, the Federal Republic of Germany, Japan, and the Netherlands had current account surpluses, with the German surplus especially large. Austria, Canada, Denmark, France, Italy, Norway, Sweden, and the United Kingdom had deficits, with the deficit of Italy and the United Kingdom in excess of amounts considered acceptable by the authorities.
While the more developed primary producing members were still generally in the backwash of the international recession of 1974/75—they continued in 1976 to have an aggregate current account deficit of $14 billion—the situation of the less developed primary producing members was improving. The aggregate current account deficit of the non-oil developing members, which had risen to unprecedented size in 1974 and 1975, showed a substantial reduction in 1976—from $38.2 billion in 1975 to $25.8 billion in 1976. By early 1977, the staff was projecting a continued aggregate current account deficit for non-oil developing members of about $25 billion.
A further pivotal element in the Fund’s decision to emphasize adjustment in 1976 was that in evaluating the magnitude of the projected $25 billion aggregate current account deficit of non-oil developing members, the analyses of the Fund staff suggested that a deficit of this size was no longer of serious concern. While a deficit of $25 billion remained three times as large in nominal terms as it was during the late 1960s and early 1970s, staff calculations showed that this nominal difference was chiefly a reflection of growth of output and inflation in the world economy over the intervening years. A current account deficit of non-oil developing members of $25 billion in 1977 was roughly comparable to the annual average deficit of these members in 1967–72, reseated to 1977 prices and levels of world output. The staff concluded that the financing of this deficit would not require total capital flows on an extraordinary scale compared with relevant flows of income, savings, and investment in either the lending or borrowing countries. This did not imply, however, that individual members did not need to adjust their balance of payments positions further or that adequate financing for all members would be available. The distribution of current account deficits within the non-oil developing members was extremely uneven, and in a number of cases, it was not well matched with the distribution of access to external financing on a readily sustainable basis, nor with debt-servicing capabilities. The sharp downward adjustment of the aggregate current account deficit of the non-oil developing members from 1975 to 1976 was concentrated mainly in Asia and in the Latin American and Caribbean area. African members and the few non-oil exporting members of the Middle East had not experienced much, if any, reduction in their current account deficits.10
The considerable balance of payments adjustment attained by several Latin American and Caribbean members, particularly by Brazil, Chile, Colombia, and some Central American members, by 1976 was studied intensively by the Fund staff.11 The study explained that adjustment of the large payments deficits of 1974 of these members had been facilitated by high world market prices for coffee but, in addition, several of these members had introduced more flexible exchange rates, more careful demand-management policies, and more realistic pricing policies for basic foods that had previously received subsidies, and had adjusted upward their domestic prices for oil.
Additional Reasons for the Switch Another crucial element in the Fund’s decision of 1976 to begin to emphasize adjustment to the new higher oil price was growing concern with the mounting external indebtedness of the non-oil developing members. Debt service ratios had risen to historically high levels in a number of members and the national authorities of several members had themselves begun to take into account the need to restrain the growth of debt service charges as they took measures to reduce balance of payments deficits. Yet, despite the reduction in their current account deficits, several developing members, particularly in Latin America, did not cut back their borrowing.
Because interest rates were low, or even negative, compared with rates of inflation, borrowing was cheap as well as readily available, and several developing members were using borrowed funds to rebuild their foreign exchange reserves following the large losses in reserves incurred in 1974 and 1975.
In his address at the Annual Meeting, Mr. Witteveen emphasized that there was additional urgency for more stress on adjustment of external positions and less on the financing of deficits because of “the buildup of short-term and medium-term debt resulting from the financing of recent years.” He stated that the debt buildup was “beginning to affect the creditworthiness of some borrowers and to create the possibility of economic and financial difficulties.”12 Even William E. Simon, very much an advocate of recycling through the private sector, after commending the “unprecedented flexibility and resourcefulness” of the international financial system in managing the 1974 deficits, expressed his concern about continued heavy international borrowing. His words in October 1976 should, in retrospect, be especially noted: “And as debt grows to finance the continuing deficits, an increasing number of countries which have delayed adjustment will approach limits beyond which they cannot afford to borrow and beyond which prudent creditors will not lend to them. This is a serious matter and it cannot be ignored by lenders or borrowers.”13
Another important consideration in the Fund’s change to emphasizing adjustment in 1976 was that monetary authorities of several industrial members had begun to feel increasingly uncomfortable with the Fund’s participation in the process of recycling surplus funds from oil exporting members to non-oil members. They were not eager to have the Fund do any more recycling now that the oil facilities were ended; instead, they strongly preferred to let commercial banks handle whatever recycling was to take place. They held that recycling through the Fund was mainly a one-way process, hardly reconcilable with the concept of the Fund as a revolving source of finance. They argued that recycling was incompatible with the Fund’s role in the adjustment process. Already, by early 1976, they had no longer been willing to accept recycling as an important—or perhaps as any—component of the Fund’s financing role. As a consequence, the oil facility had not been renewed after its initial two-year operation and had expired in May 1976. In any event, everyone recognized that not enough monies were available to the Fund for it to be important in the recycling process. Were the Fund to assume the task of intermediating a large proportion of the amounts involved, it would require a number of limes its existing supply of resources. In line with these views, in his speech at the Annual Meeting, Mr. Witteveen explicitly cited the revolving character of the Fund’s resources and the role the Fund should have in helping members adjust their payments positions: “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.”14
Also prompting the new emphasis on adjustment in 1976 was the experience of the United Kingdom and Italy, compared with that of other industrial members. Monetary authorities and Fund officials were in the process of learning a profound lesson—that delay in a member’s taking the necessary policies for adjustment made adjustment at a later date more difficult and more painful. In late 1976 the Fund management and staff were negotiating stand-by arrangements with the authorities of the United Kingdom and Italy. These negotiations were proving to be unusually sensitive and controversial and were becoming prolonged as debates took place over the severe measures required. The programs eventually agreed upon required substantial cuts in consumption and real income, far different from the anti-inflationary programs of the 1950s and 1960s that slowed but did not reverse the rapidly increasing growth of consumption and real income.15 The experiences of Italy and the United Kingdom after the oil price rise of 1973 contrasted with those of some other industrial members. Initially, Italy and the United Kingdom had attempted to offset the deflationary effects of the higher oil prices of 1973 by borrowing heavily to finance their balance of payments deficits, including borrowing from the Fund under the oil facility and in the first credit tranches in 1975. Other industrial members, especially the Federal Republic of Germany, Japan, and the United States had accepted bigger temporary reductions in their economic activity in 1974 and 1975. As a result, the latter were better able to contain a persistent wage-price spiral, to turn their current account positions around, and to provide a sounder basis for their economies after the 1974–75 recession. In contrast, Italy and the United Kingdom had to take very severe measures when they did turn to adjustment.
Agreement on Principles of Adjustment At the 1976 Annual Meeting, Mr. Witteveen stressed pointedly that the adjustment process should be symmetrical as between surplus and deficit countries and that exchange rates should be allowed to play their proper role in this process. Two days before, the Interim Committee had agreed to the principles that were to form the basis of adjustment that the Executive Directors and the Managing Director were recommending. Both deficit and surplus members were to take measures to adjust. Members in deficit were to pursue policies that would restrain domestic demand and permit the shift of resources to the external sector to bring their current account deficits in line with sustainable flows of capital imports and aid. Where necessary, members with deficits might have to depreciate their exchange rates. Industrial members with surpluses had to adjust partly by assuring adequate domestic demand, partly by increasing flows of long-term capital exports and development aid, and partly by appreciating their exchange rates. Adjustment by deficit countries could be promoted by a larger use of the Fund’s credit tranches and the extended Fund facility, described below.16 Although the communiqué did not say so explicitly, it was understood that adjustment was to be “over the medium term.” Medium term was not defined but, with hindsight, it seems to have been thought of as about two to three years.
At the Annual Meeting, Mr. Witteveen also made clear that the Fund would place primary emphasis on adjustment in its consultations with members, in establishing conditions for the use of its resources in the credit tranches, and after the Second Amendment was approved, in its surveillance of exchange rates. Mr. Witteveen’s call for a bold new emphasis on adjustment was supported by several Governors, especially those from industrial members. Governors from several developing members, especially from members in Africa and from some in Asia that had had trouble both in reducing their current account deficits and in financing them, pointed out that adjustment remained primarily a problem for non-oil developing members. They stressed that adjustment would have to be accompanied by larger transfers of real resources to developing members and by an expansion of the resources available to the Fund. The Fund’s policies were about to take a new turn.
An Extended Facility Introduced Meanwhile, quite apart from the oil-related deficits, by the early 1970s it was becoming increasingly clear to Fund staff, particularly of the Exchange and Trade Relations Department, that for a number of developing members the basic assumption of the usual one-year stand-by arrangement was proving to be unrealistic. The assumption was that a member could draw under the arrangement for up to one year while it adopted policies that would enable it to eliminate its balance of payments deficits and generate a surplus sufficient to repay the Fund within a three-to-five year period. In practice, however, payments deficits of many developing members lasted for more than a year and so for many of these members the Fund was frequently approving one stand-by arrangement after another. From 1966 to the early 1970s, for example, the Fund had approved several successive stand-by arrangements for Colombia, Guatemala, Guyana, Haiti, Honduras, Indonesia, Korea, Liberia, Morocco, Panama, the Philippines, Somalia, Tunisia, and Turkey. By having new stand-by arrangements under which further drawings could be made as reputebases due under old stand-by arrangements took place, these members were able to use the Fund’s resources, even in the upper credit tranches, for relatively long periods. Yet use of the Fund’s resources for a long period was not consistent with the idea of the Fund’s stand-by arrangement.
To help meet this problem, in March 1974 the staff of the Exchange and Trade Relations Department proposed to the Executive Board that a new extended Fund facility be created. Six months later the Executive Board approved the facility, which thus became the third facility—the other two being the compensatory financing facility and the buffer stock financing facility—that the Fund introduced to help developing members with their special balance of payments problems. In fact, in the decision establishing the extended facility, a preamble contained a unique sentence: “The facility, in its formulation and administration, is likely to be beneficial for developing countries in particular.” Fund decisions had not previously mentioned developing members. Indeed, the compensatory financing facility was open to all primary producing members, including such members as Australia, Iceland, and New Zealand.
Under an extended arrangement, a member could draw for up to three years. Repurchase was to take place as soon as the member had overcome its balance of payments problems and, in any event, within an outside range of four to eight years after each purchase, normally in 16 equal quarterly installments. In December 1979 the maximum repurchase period under the extended facility was increased from eight to ten years.
Extended arrangements were initially envisaged for, but not necessarily limited to, two kinds of situations in which a developing member might benefit from medium-term financial planning supported by use of the Fund’s resources. One such situation was where distortions in the use of a member’s productive resources had developed. For instance, investment in exports might have been discouraged by an overvalued exchange rate or domestic industries might have become heavily dependent on imported raw material or intermediate goods. In this situation, the member would have to make changes in its financial institutions, such as its system of taxation, its tariff structure, and the techniques and agencies used to encourage domestic savings. These changes went beyond agreeing to targets for domestic and credit expansion or for the budgetary accounts, which were typically involved in the financial stabilization programs associated with stand-by arrangements. More profound changes in financial and economic policy were necessary since the objective was not only to contain inflation and mitigate current pressure on the balance of payments but also to induce a reallocation of real resources. The other situation for which the staff initially intended the extended facility was that of a low-income member in which domestic investment ought to be increased. While such a member might not necessarily be experiencing immediate pressure on its foreign exchange reserves, it could be regarded as having an inherently unstable balance of payments because of a weak productive base. Were the Fund to provide financial support for a medium-term period, the member could take measures to develop its monetary and fiscal institutions so that it could foster more domestic investment.
With the introduction of the extended facility, the Fund for the first time thus undertook financing on a medium-term basis to help developing members put into effect financial programs and policies that would in all likelihood take more than a year to implement so as to help improve their balance of payments positions by structural changes in their economies. Thereby the new facility marked a pivotal change in the Fund’s financing arrangements with its developing members.
The new facility was not used very much at first. It was only after the oil facility had expired and drawings under the liberalized compensatory financing facility had slowed, and especially after 1979 when developing members had newly enlarged balance of payments deficits, as described in Chapter 8, that developing members in any number began to seek extended arrangements with the Fund.17