- International Monetary Fund. Research Dept.
- Published Date:
- May 1993
The recovery of global economic activity after the 1991 downturn remains hesitant and uneven. Although some industrial countries have emerged from recession, growth has declined sharply in many other countries because of extensive balance sheet restructuring, persistently high short-term real interest rates, considerable financial tensions, and depressed levels of consumer and business confidence. As a result, the growth of world output picked up only modestly, from ½ of 1 percent in 1991 to 1¾ percent in 1992, which was the third consecutive year of below-trend performance (Chart 1). World output is projected to grow by 2¼ percent in 1993 and then to strengthen by 2½ percent in 1994, but the outlook remains unusually uncertain. On the positive side, inflation has continued to abate in most industrial and developing countries.
Chart 1.World Indicators1
1Blue shaded areas indicate IMF staff projections.
2Excluding trade among states of the former U.S.S.R.
Encouraging signs of stronger growth in North America contrast with the recent marked deterioration in economic performance in Japan and especially in Europe, where recessionary tendencies are expected to persist through much of 1993. For Japan, growth in 1993 has been revised down to 1¼ percent, from 2½ percent in the January 1993 Interim Assessment and 3¾ percent in the October 1992 World Economic Outlook. These revisions are due partly to the effects of balance sheet adjustments by households, corporations, and financial institutions after the recent correction of inflated asset prices. The sharp slowing of growth in Europe—to a revised projection that suggests stagnation in 1993 compared with 1 percent growth in the Interim Assessment and 2¼ percent in the October World Economic Outlook— reflects a range of adverse factors, including tight monetary conditions, inadequate progress toward inflation convergence and budgetary consolidation in many countries, and the attendant weakness of consumer and business confidence. More generally, the turbulence in foreign exchange markets since the middle of 1992 and an escalation of tensions over trade have contributed to increased uncertainty in many countries.
Many developing countries have continued to show resilience to the weakness of activity in industrial countries. Low interest rates on dollar-denominated external liabilities, and considerable capital inflows in some cases, have helped to offset the effects of declining terms of trade for commodity exporters and of generally weak demand in the industrial countries. But the most important reason for the comparatively strong performance of a growing number of developing countries has been the beneficial effects of sustained stabilization and reform efforts in the context of outward-oriented economic strategies. For many other developing countries, however, economic performance has remained unsatisfactory, and living standards are continuing to decline in many of the poorest countries.
The economic situation also remains difficult for the countries in transition from central planning, following what has already been a sizable decline in output. The contraction now appears to be bottoming out in parts of central Europe, where some countries are projected to register positive growth in 1993 and 1994. But key aspects of the reform and stabilization efforts have not yet been fully implemented, and there remain risks of policy slippages. In the Russian Federation and most other countries of the former Soviet Union, economic conditions are of particular concern because of inadequate attention to macroeconomic stabilization and because of political unrest and armed conflicts in many regions.
Notwithstanding the continued economic difficulties in many countries, recent positive developments offer hope for a cooperative growth strategy in the near term, which could also permit a strengthening of global economic performance over the medium term (see the IMF Interim Committee’s declaration, facing the opening of this chapter). Many developing countries are reaping the fruits of sustained reform and stabilization efforts. There are now early signs of recovery in some of the economies in transition. Efforts to enhance assistance to countries affected by the transition to market-based trading systems occurring in central Europe and the former Soviet Union, and to low-income countries to support strengthened stabilization and restructuring efforts, are moving forward. In Europe, exchange market tensions have eased, and interest rates have been falling and should continue to do so as evidence accumulates of the waning of inflationary pressures. The near-term fiscal stimulus announced by the Japanese government should help to restore confidence and promote economic recovery. Other industrial countries have announced programs of budget deficit reduction that have been favorably received in financial markets. Implementation and further strengthening of these deficit-reduction plans would lay the foundation for sustainable increases in growth and living standards over the medium term. To be successful, it is vital that these efforts are supported by an immediate conclusion of the Uruguay Round: a failure to complete the Round would deprive the world of the benefits of further liberalization and would risk aggravating protectionist pressures, which would seriously harm all countries.
The present difficulties in the industrial world owe much to the failure to implement key elements of the medium-term strategy that was adopted in the early 1980s as the appropriate guide for economic policy. In particular, inadequate budgetary consolidation and structural rigidities have left countries in a weak position to cope with the recent—and continuing—sluggishness of global economic activity. Large budget deficits have contributed to high real long-term interest rates and have also been an important factor in the recent turbulence in European currency markets. And labor market policies have been unsuccessful in addressing persistently high unemployment, especially in Europe.
Despite success in reducing inflation in most countries, important challenges still confront monetary policy. The speculative excesses in asset markets in the late 1980s were at least partly a result of excessive credit expansion and risk taking by financial institutions. The eventual tightening of monetary policy did succeed in puncturing the speculative bubbles, but the tightening occurred too late to prevent the unwarranted run-up and subsequent abrupt correction of asset prices. Although important lessons have been learned about the need to strengthen prudential oversight and to pay greater attention to asset markets in the conduct of monetary policy, many countries continue to suffer the consequences of asset deflation.
In the United States, monetary conditions were eased substantially between 1990 and the end of 1992 in response to the recession and to the weakness of the recovery (Chart 2). This has helped to stimulate demand and has also promoted balance sheet adjustment by lowering debt-service costs. Monetary conditions have also been eased significantly over the past two years in Japan as evidence of financial strain and slowing activity has accumulated. The cuts in the official discount rate together with recent fiscal measures should help to support activity, but the experience of other countries that are going through similar balance sheet difficulties suggests that the weakness of private demand may persist for some time. In Europe, by comparison, the level of real short-term interest rates has remained very high, which has delayed balance sheet adjustment and weakened activity.
Chart 2.Three Major Industrial Countries: Policy-Related Interest Rates and Ten-Year Government Bond Rates1
1End of month except for the federal funds rate, which is the average of daily observations, and the repurchase rate, which is the average of weekly data.
Looking ahead, the industrial countries now need to take effective action to strengthen growth and to diminish exchange and financial market tensions while preserving progress in reducing inflation. In the United States, the first steps toward meaningful medium-term fiscal consolidation are being taken. Japan has recently announced a new package of stimulatory measures. At the same time, conditions are improving for significant reductions of official interest rates in Europe, which should help to contain recessionary forces and ensure that recovery takes hold by 1994. There is also an urgent need for positive steps to resist protectionist pressures, especially by bringing the multilateral trade negotiations under the Uruguay Round of the General Agreement on Trade and Tariffs (GATT) to a successful conclusion. Determined action to alleviate short-term difficulties and to achieve key medium-term objectives would unquestionably strengthen consumer and business confidence.
For the United States, as recognized by the administration, the most pressing priority of economic policy is the need to reduce the large federal budget deficit and to strengthen saving and investment. The economic plan presented in mid-February represents a considerable effort, but its full enactment and implementation could still leave the structural federal fiscal deficit in FY 1998 at about 3 percent of GDP (more than 4 percent if the social security surplus is excluded)—that is, at the same level as in the late 1980s. Thus, further action is needed to ensure an adequate degree of fiscal consolidation over the medium term. Recent economic developments suggest that the natural forces of recovery, aided by earlier monetary stimulus, are taking hold and that significant short-term fiscal stimulus is now less necessary than might have appeared earlier. As the recovery gathers momentum and economic slack is reduced, the authorities may need to allow monetary conditions to tighten in order to avoid any resurgence of inflationary pressures.
In Canada, where recovery is not yet as firmly established as in the United States, interest rates have been coming down after a sharp rise associated with exchange market developments in the fall of 1992. In light of the cyclical situation, there should be room for a further easing of interest rates without jeopardizing the progress made toward price stability. Continued perseverance in reducing the structural budget deficit also is required.
In Japan, the authorities announced a large package of stimulative fiscal measures in August 1992, and the official discount rate was reduced further in the face of a sharp weakening of activity. While there are recent signs of a bottoming out of the recession, uncertainties remain with respect to the timing and strength of the upswing. To give recovery the desired momentum, substantial additional measures, supplementing the FY 1993 budget, have recently been announced. Given Japan’s efforts at fiscal consolidation in the past, these measures do not jeopardize the credibility of the authorities’ medium-term budgetary objectives. The low inflation rate and the recent strength of the yen suggest that there also remains some room for interest rate reduction should economic weakness persist.
In Europe, although conditions differ among countries, an essential contribution to stronger growth would come from a further reduction of interest rates in Germany as the inflationary consequences of unification fade. Recent small reductions in official German interest rates have helped to reduce the tensions in the European Monetary System (EMS), but monetary conditions remain unduly tight in most countries. Substantial interest rate differentials relative to Germany, associated with the recent exchange market turbulence, have exacerbated this situation. Large budget deficits in most of Europe generally preclude short-term fiscal stimulus, since this would only delay the critically needed decline in both short- and long-term interest rates, further complicate the achievement of medium-term fiscal objectives, and jeopardize policy credibility.
Conditions for a further reduction of short-term interest rates in Germany are improving, however. Although increases in prices have remained high in recent months, the pronounced weakening of the economy, early indications of a slowdown in money growth, and favorable developments on the wage front suggest that inflation should soon begin to moderate. Progress toward fiscal consolidation, which would need to go beyond the recent solidarity pact, would also contribute to the reduction of macroeconomic imbalances. These developments should ensure a durable reduction of inflation in Germany and would allow a marked easing of monetary conditions that would be fully consistent with both domestic objectives and the broader interests of the world economy.
For France, persistent pressure on the exchange rate since September 1992 had necessitated the maintenance of a very large short-term interest rate differential relative to Germany, despite lower inflation than in Germany, but these pressures seem now largely to have subsided. The differential has recently narrowed substantially, following the new government’s reaffirmation of the strong commitment to the current exchange rate mechanism (ERM) parity and the announcement of plans to give more autonomy to the Banque de France. The reduction of exchange market tensions should permit a further narrowing of the interest differential. While fiscal policy is allowing the automatic stabilizers to cushion activity during 1993, it will be important to reduce the budget deficit as activity recovers in 1994 and beyond.
For the United Kingdom, the lowering of interest rates and the sharp depreciation of the exchange rate following the suspension of the pound sterling from the ERM have improved prospects for recovery. The sustainability of the recovery, however, will depend on the authorities’ ability to safeguard the credibility of their anti-inflationary commitment, especially in light of the potential inflationary consequences of sterling’s decline. This, in turn, depends critically on the adoption of further measures, in the 1994 budget or even before, to secure a faster reduction of the large budget deficit. A general decline of interest rates throughout Europe would help to alleviate the downward pressure on the exchange rate, but any further easing of monetary policy in the United Kingdom should be resisted unless there is good reason to believe that a further cut in interest rates would not endanger the goal of containing inflation.
The need for a substantial reduction of the fiscal deficit is particularly critical in Italy. The large depreciation of the lira has improved the competitive position considerably, but a sizable interest rate premium relative to Germany persists, particularly on long-term interest rates. Important measures have been taken to contain the budget deficit, but, as the government recognizes, further action is required to strengthen the credibility of the fiscal consolidation efforts and permit a decline in interest rates. Additional measures will be needed both to achieve the 1993 budget objective and to meet the government’s medium-term target of bringing the overall deficit below 5 percent of GDP by 1995. Substantial financial assistance has been granted by the European Community (EC) to help to establish the conditions under which the lira could rejoin the ERM. An adequate degree of fiscal consolidation will be crucial to permit such a move.
The recent crisis in the EMS witnessed the suspension from the ERM of two major currencies, four realignments imposed by market pressures in just five months, and the floating of three Nordic currencies that had been pegged to the European currency unit (ECU). In all cases, the direction of the exchange rate adjustments that have taken place appears to have been in accordance with the fundamentals, including differences in policies associated with divergent cyclical positions. For some currencies, however, the large depreciations appear to have overshot, which is adding to strains in economic relations within Europe. Although the pressures on the system have abated since early February, economic policy cooperation within the EMS will need to be strengthened to reduce the risk of a recurrence of turbulence and to promote further progress toward economic and monetary union (EMU). A key requirement remains the need to ensure greater economic convergence. Because some countries may achieve a sufficient degree of convergence only in the medium term, small adjustments of parities within the ERM band on a timely basis could help to avoid new tensions without undermining the character of the system.
More fundamentally, recent experience has demonstrated the crucial importance of strengthening monetary policy cooperation across Europe. It is necessary to recognize that economic and financial integration is rapidly eroding the distinction between resident and nonresident enterprises and financial institutions and appears to be blurring the distinction between national monetary indicators. To ensure that monetary conditions are compatible with sustained noninflationary growth in Europe as a whole, it will therefore be necessary to consider whether—and how—national indicators of monetary conditions, activity, and inflation might be complemented with ERM-wide indicators. While the scope for independent monetary policies has largely disappeared with the close economic and financial integration of the European economies and the commitment to stable exchange rates, monetary policy continues to have a comparative advantage in ensuring price stability across the ERM countries as a group. Increasingly, however, the task of dealing with the consequences of economic disturbances that affect inflation and economic activity in specific countries or regions now falls primarily on fiscal and structural policies rather than on monetary policy.
Especially in the present period of economic difficulty, the ongoing policy responses of the industrial countries need to be complementary if more satisfactory growth is to be achieved during 1993 and beyond. The confidence of markets in the longer-run orientation of U.S. monetary policy toward the objective of low inflation facilitated a significant monetary policy response to the recession of 1990–91 and to the subsequent sluggish recovery, without raising concerns about longer-term inflation that would have been adversely reflected in long-term interest rates. The responsiveness of monetary policy also helped to avoid fiscal stimulus that would have enlarged an already excessive federal deficit. The fruits of this policy can be seen in the relatively rapid pace of economic expansion now under way in the United States, the benefits of which will gradually spread to other countries. Conversely, economic recovery in Europe and Japan, provided that it begins this year and gains momentum by 1994, should help to offset any short-term dampening effect of deficit-reduction measures that the U.S. administration plans to implement during 1994.
More generally, sustained expansion in each of the major industrial countries benefits from, and to an important extent requires, sustained expansion in its partner countries. Within Europe, where economic linkages are particularly strong and getting stronger, economic recovery in one country cannot get very far unless the whole of the continent is also recovering. Mutually reinforcing growth for Europe as a whole would, in turn, help to support economic expansion beyond Europe. Similarly, the monetary and fiscal policy measures already undertaken in Japan, and the additional measures recently announced for FY 1993, will be important in spurring recovery of the Japanese economy and will also contribute to strengthening activity worldwide.
A broadly based recovery would provide better opportunity for governments to pursue determined medium-term programs of fiscal consolidation. Favorable effects on confidence, and on longer-term interest rates, from the announcement of credible programs of consolidation would help to offset any short-term dampening effects from reductions in public expenditure or from tax increases. Moreover, it would be highly desirable if any tendency for overheating during the coming expansion were offset by a tightening of fiscal policy, which in any case is required in most countries to achieve adequate medium-term fiscal consolidation. This would not relieve monetary policy of its primary responsibility for assuring reasonable price stability, but it would make the fulfillment of this goal consistent with a lower path for interest rates. An appropriate fiscal and monetary policy mix would also promote greater calm in foreign exchange and other financial markets, thereby facilitating a general recovery of consumer and business confidence. In addition, improving saving-investment balances through fiscal consolidation in key deficit countries would help to address the most important cause of large, persistent international payments imbalances and thereby reduce the associated tensions over trade and permit increased resource transfers to developing countries and to economies in transition.
The implications of complementary and mutually consistent macroeconomic measures for trade policies deserve particular emphasis. As the experience of the 1930s so dramatically demonstrated, the apparent loss of jobs to foreign competition can easily give rise to calls for protectionist policies during a period of pervasive economic weakness and rising unemployment. Firm adherence to the established rules of the open international trading system—and the reconfirmation of countries’ commitments to these rules through early completion of the Uruguay Round—are obviously the first line of defense against self-defeating protectionist policies. But pressures for protection must not be allowed to become too great. Properly attuned and cooperative macroeconomic policies must guard against persistent economic weakness and high unemployment and must seek to limit the extent and duration of cyclical divergences among countries, their impact on international payments imbalances, and the repercussions on financial and foreign exchange markets.
Output in the developing countries is projected to expand by 5 percent in 1993 and 1994, only slightly less than in 1992, which had the highest growth in more than a decade. Even excluding special factors such as the reconstruction in the Middle East, which boosted growth in that region to 10 percent in 1992, this is an impressive result, especially given the weakness of activity in the industrial countries. Divergences in growth among developing countries have tended to widen in recent years, however, as many countries have failed to register any meaningful improvement in economic conditions. In some of these countries, per capita real incomes remain below the levels experienced ten or even twenty years ago.
The stronger performers among the developing countries share a number of essential characteristics. Compared with the slow-growing countries, the successful countries have markedly higher saving rates; higher investment rates (also in human capital); and higher efficiency of investment and higher overall productivity growth. They also typically finance a larger proportion of investment from domestic saving, and when they have recourse to external saving, it is often in the form of foreign direct investment and equity capital rather than debt-creating capital inflows. Finally, these countries are generally more outward-oriented than the low-growth countries, both with respect to trade links with the industrial countries and in terms of their economic ties with other developing countries. Many developing country exporters have weathered the current sluggishness of growth in the industrial world by expanding their trade with other developing countries.
Government policies explain an important part of the divergences in economic structure and performance across the developing countries. The stronger performers have maintained or restored sustainable fiscal balances, low and predictable inflation, positive but low real interest rates, viable external positions, and competitive and stable exchange rates. In addition to macroeconomic stability, the successful countries have relied on market forces to allocate resources efficiently, through reduced government intervention, through trade liberalization and currency convertibility, and through financial market reform. The impressive growth record of many Asian countries illustrates the longer-term benefits from sustained stabilization and reform efforts, and the recent experience of many Latin American countries demonstrates that economic growth can recover when the necessary policies are put in place.
In some of the successful developing countries, the recent strength of economic performance has been accompanied by substantial capital inflows in the form of both direct and portfolio investment. This has contributed to excess demand pressures and, in several cases, to growing signs of overheating. There is also a risk of speculative excesses in asset markets like those experienced in many industrial countries in the 1980s. In countries where demand pressures are strong, a tightening of fiscal policy may be necessary to make room for higher investment. Allowing some appreciation of the currency may also be appropriate. It may finally be possible to speed up privatization, which would help to retire both domestic and external debt. In China, strong demand pressures generated an increase in output in 1992 of close to 13 percent in the context of accelerated reform efforts; to sustain the momentum of the reforms and to avoid overheating, a cautious stance of stabilization policies will be essential during the period ahead.
In most African countries, major reform efforts are quite recent, and the resulting higher growth rates are only beginning to show up. However, at their relatively early stage of development these countries remain highly vulnerable to adverse terms of trade and other shocks, such as drought, which held back growth in 1992 in most of southern Africa. An important issue is the difficulty of coherent implementation of economic policies during the (often lengthy) transition to democracy. For many countries, it is clear that decisive progress will not materialize in the absence of considerable improvements in governance supported by adequate levels of financial and technical development assistance. Where the required policy changes are implemented, the international community must stand ready to provide strong support—for example, through appropriate debt relief and through the IMF’s concessional enhanced structural adjustment facility (ESAF), a successor to which is currently under consideration. As the economic outlook improves in other parts of the world, there should be scope for increased efforts to assist the poorest countries.
Countries in Transition
The early experience of the former centrally planned economies has already demonstrated the crucially important link between structural reforms, macroeconomic stabilization, and successful economic transformation. Among the central European countries, the Czech Republic, Hungary, and Poland have made the greatest progress in structural reform; inflationary pressures there have abated following price liberalization, and output has begun to recover. These achievements will be difficult to sustain, however, in the absence of strong efforts to contain the large fiscal deficits that have accompanied the considerable losses of output and tax revenue since the start of the reform process.
In the Baltic countries there are encouraging signs that reforms are taking hold and are being supported by strong stabilization efforts. In most other countries of the former Soviet Union, in contrast, inadequate stabilization efforts now threaten to lead to hyperinflation, which could derail the reform process. Inflation, which had abated following the immediate impact of price liberalization in early 1992, surged to extremely high levels in late 1992 and early 1993. The main reason for this development has been excessive credit expansion to the government and to state enterprises. The transformation process is being seriously hampered by the widespread subsidization of inefficient enterprises and the resulting misallocation of resources. The lack of effective economic and monetary cooperation among the countries of the former Soviet Union exacerbates other problems by severely constraining trade flows and impeding inflation control. Partly as a result of these difficulties, some countries have decided that the introduction of separate currencies offers the best scope for avoiding hyperinflation and for improving economic conditions. This development can facilitate the implementation of stronger stabilization programs, but it is not a substitute for fiscal and monetary discipline and vigorous structural reform.
The international community must continue to provide support for strong stabilization policies and reforms in the countries of the former Soviet Union as they struggle to overcome the legacies of the past. To ensure the success of the transformation process, it is vital that the rest of the world open its markets to the exports of the reforming countries. Cooperative efforts on trade and payments issues are also crucial to these countries’ common task of economic restructuring. Considerable emphasis should be placed on technical assistance and on policy advice in all areas. There is also scope for increasing financial support for specific programs of industrial restructuring, including conversion of defense industries. Financial assistance has a critical role to play, and a new IMF facility has been created to help meet the special needs of countries affected by the transition to market-based trading systems. However, the effectiveness of such assistance will be seriously impeded so long as macroeconomic conditions remain highly unstable.
The experience of the past forty years offers strong evidence of close linkage between liberal trade and exchange regimes and economic prosperity. The liberalization of trade in manufactured goods among the industrial countries was one of the principal reasons for the rapid growth of world output in the 1950s and 1960s. Many developing countries also have increasingly moved to make their currencies convertible, to promote competition, and to liberalize foreign trade, and this has helped them to overcome the debt crisis of the 1980s and to sustain growth even in the face of weak activity in the industrial countries since 1990. Most recently, central planning has been abandoned as a viable model for economic progress, giving way to market-based economic reforms that will allow a large number of countries to share in, and contribute to, continued gains in global economic performance.
Yet the significant benefits from free trade now seem threatened. The failure to conclude the Uruguay Round is adding to trade tensions and is depriving the world of potentially large gains from further liberalization of tariff and nontariff barriers; from the extension of multilateral rules to new sectors; from a strengthening of rules and disciplines on antidumping, subsidies, and safeguards; and from a strengthening of the dispute settlement mechanism and of trade policy surveillance. The industrial countries are increasingly seeking recourse to countervailing and antidumping duties and to nontariff barriers. Excessive focus on bilateral or even sectoral trade imbalances has led to a dangerous proliferation of managed trade agreements. And there is a risk that regional trading arrangements could become inward looking, rather than serving primarily to promote regional integration in the context of multilateral free trade.
Efforts to bring the Uruguay Round to an early and successful conclusion and reverse the rise in protectionist barriers must be a central element of any cooperative effort to strengthen growth worldwide. Given constraints on financial resources, market-opening measures by industrial countries are crucial to support the efforts of developing countries and economies in transition to implement outward-oriented reform strategies successfully. Such positive steps are also important in view of the likelihood that current account imbalances among the major industrial countries will widen further as cyclical positions are reversed, which threatens to fuel protectionist sentiment. Not only would trade restrictions do little to affect underlying external positions, they would run the risk of triggering a spiral of retaliation and counterretaliation, severely harming business confidence and prospects for recovery. To reduce the large structural components of the external imbalances, it is necessary to tackle their root cause: the inadequacy of national saving relative to domestic investment opportunities, particularly in the United States, but also in several other countries. In these cases, fiscal consolidation is essential to restore external viability. At the same time, surplus countries have a responsibility to maintain adequate growth of domestic demand and to step up market-opening efforts.
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This issue of the World Economic Outlook introduces a new set of weights for aggregation of output across countries based on estimates of purchasing power parities (PPPs). An important difference compared with the previous weights, which were based on market exchange rates, is that the developing countries’ share of world output increases significantly. Because of this change, world and regional aggregates reported in this World Economic Outlook are not directly comparable with those shown in earlier issues. The rationale for and implications of introducing PPP-based weights are discussed in Annex IV. In addition, in this issue the Statistical Appendix has been extended to include historical data on growth and inflation in individual countries.