II World Economic Situation and Short-Term Prospects

International Monetary Fund. Research Dept.
Published Date:
May 1996
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In 1995, world economic growth weakened slightly to 3½ percent, which is marginally below both its long-term trend rate and the projection published in the October 1995 World Economic Outlook (see Table 1). This slight change in overall growth performance, however, masks a significant slowing of growth in the industrial countries and among the developing countries of the Western Hemisphere, and improved performance in Africa (especially the CFA countries), the Middle East, and the countries in transition.5 Among the industrial countries, the slowdown in activity during 1995 was particularly marked in Germany, France, and a number of other countries in western Europe, while the poorer performance in the developing countries of the Western Hemisphere is essentially accounted for by output declines in Mexico. Argentina, and Uruguay. In the Asian developing countries, growth remained rapid although it moderated slightly, allaying concerns about overheating in some countries. Inflation remained low in industrial countries and declined significantly in developing countries and countries in transition. World trade again grew at more than double the rate of world output.

Although, as discussed in Chapter I, prospects are favorable for continuing world growth of around 4 percent this year and next, there are a number of potential threats to the global expansion. In Europe, growth performance and short-term prospects have deteriorated considerably since early last year, owing partly to (and contributing to) flagging consumer and business confidence. In the United Stales, failure to make expected progress toward balancing the budget risks unsettling financial markets. Elsewhere, shifts in investor sentiment, for instance in response to changed assessments of economic policies, may pose particular risks for those transition and developing countries with weak banking systems and limited capacities to intermediate large capital flows. While such concerns indicate downside risks to the near-term outlook, the tensions and imbalances that typically presage a downturn in activity are generally absent.

Economic Activity and Policy Stances in Industrial Countries

Average growth in the industrial countries of 2 percent in 1995 was somewhat below earlier projections. Moreover, the distribution across countries was markedly different from that expected in October, especially when considering developments within the year. Thus growth in North America, having weakened sharply in the first half of last year, rebounded in the third quarter but subsequently waned. In Japan, economic activity remained sluggish for most of 1995, but by the end of the year there were increasing signs that activity was beginning to pick up. In Europe, by contrast, growth generally weakened from early last year, although there were significant variations across countries.

In fact, in all the major industrial countries other than Japan, economic growth slowed during 1995 (Chart 3). The nascent recovery in Japan reflects the substantial easing of monetary and fiscal policies last summer and early fall, the reversal since last spring of the earlier sharp appreciation of the yen, and the authorities’ announcement in late December of a strategy for resolving problems in the financial sector. For some countries where expansion has weakened, such as the United States, the United Kingdom, and Australia, the slowdown was from growth rates considerably above potential to rates more consistent with sustained non inflationary growth, and reflected the effects of monetary tightening and rising bond yields during 1994. But for countries where the recovery has made less headway and where there are still significant margins of slack, notably Germany, France, and several other European countries, the weakening of growth is of much greater concern.

Chart 3.Selected Industrial Countries: Output Growth and Leading Economic Indicators1

(Percent change from four quarters earlier)

Leading indicators signal declines in output growth.

Sources: Bureau of Economic Analysis, Department of Commerce (United States); Statistics Canada (Canada); OECD, Main Economic Indicators (Germany, France, and Italy); and Central Statistics Office, Economic Trends (United Kingdom).

1The leading economic indicators are composite indices of variables that lead activity in the economic cycle. The indices differ by country, but typically include variables such as new orders, construction starts, hours worked, unfilled orders, producers’ shipments, stock prices, money supply, and other variables. Japan is omitted because there is not a close relationship between output growth and the index of leading indicators.

2Data through 1991 apply to west Germany only.

The slowdown in Europe seems to reflect a number of adverse forces important to varying degrees in different countries, together with the high degree of integration and interdependence among the European economies. As discussed in Chapter I, there is a striking difference in recent growth performance between the strong currency countries and those countries whose currencies depreciated during and following the 1992/93 crisis in the European Monetary System. As partly mirrored in exchange rates, the difference appears to reflect differences in the stance and mix of fiscal and monetary policies between the two groups of countries. In addition, confidence factors may have played a role, particularly in France and Germany.

For Europe as a whole, relatively high real interest rates—especially given the generally considerable margins of slack—appear to have been a restraining factor. Both short-term and long-term real interest rates in Europe have remained significantly higher than in the United Stales during the comparable phase of its economic upswing and also much higher than in Japan (Chart 4). Real bond yields, in particular, have been consistently higher in Europe than in the United States and Japan. It is likely that Europe’s fiscal deficits provide part of the explanation. In addition, the recurrent pressures within the exchange rate mechanism (ERM) of the European Monetary System and the fact that monetary policies in most countries have been constrained by the need to ensure exchange rate stability have meant that any additional policy support for economic activity would have to come from fiscal policy, thus adversely affecting the credibility of fiscal consolidation plans. This may have induced investors to demand higher interest rates on long-term bonds than they otherwise would have done.

Chart 4.Industrial Countries: Real Interest Rates1

(In percent a year)

Real interest rates in Europe have remained considerably above those in the United Stales and Japan.

Sources: WEFA, Inc.; and Bloomberg Financial Markets.

1Real rates are nominal rates minus percent change of consumer prices from a year ago. Price data for January and February 1996 are partly estimated.

2Data prior to January 1990 exclude Luxembourg.

3Excludes Greece, and data prior to June 1993 exclude Finland.

Real interest rates do not explain the distribution of weakness within Europe, however. Short-term interest rates, in nominal and real terms, have been reduced significantly in most European countries since 1992, but in Germany, in some of the countries whose currencies have been closely tied to the deutsche mark, and in Switzerland, the stimulative effect on activity has been largely offset by rises in real effective exchange rates. And it is in these countries that export growth and business fixed investment have been weakest and the slowing of growth most marked. Meanwhile, exchange rate changes have provided added support for activity in the past few years in countries such as Italy, the United Kingdom, Spain, and Sweden. These contrasts are illustrated by movements in indices of monetary conditions that combine changes in short-term real interest rates and real effective exchange rates, weighted very approximately by their relative influences on aggregate demand.6 Broadly measured in this way, it would appear that over the past three years the combined effects of changes in short-term interest rates and real effective exchange rates in Germany and France have been more of a restraining factor than in Italy and the United Kingdom (Chart 5).

Chart 5.Selected Major Industrial Countries: Monetary Conditions Index1

Broadly defined, monetary conditions in the United Kingdom and Italy have eased significantly more than in Germany and France, reflecting the real depreciation of sterling and lira.

1For each country, the index is defined as a weighted average of the percentage point change in the real short-term interest rate and the percentage change in the real effective exchange rate from a base period (January 1990). Relative weights of 3 to 1 are used for France, Italy, and the United Kingdom, and of 2.5 to 1 for Germany. The weights are intended to represent the relative impacts of interest rates and exchange rates on aggregate demand: they should be regarded as indicative rather than precise estimates. For instance, a 3-to-1 ratio indicates that a 1 percentage point change in the real short-term interest rate has about the same effect on aggregate demand over time as a 3 percent change in the real effective exchange rate. Movements in the index are thus equivalent to percentage point changes in the real interest rate. The lag with which a change in the index may be expected to affect aggregate demand depends on the extent to which the change stems from a change in the interest rate or the exchange rate, and varies depending on the cyclical position: the lag also differs across countries No meaning is to be attached to the absolute value of the index; rather, the index is intended to show the degree of tightening or easing in monetary conditions from the (arbitrarily chosen) base period. Changes in the relative weights used alter the value of the index but not the qualitative picture.

Some role in the slowdown may have also been played by the short-term negative effects on domestic demand of fiscal consolidation, especially in those countries where fiscal actions have not been sufficiently bold to induce marked and sustained declines in long-term interest rates or favorable expectations effects on private sector consumption and investment. There has also been a fairly general weakening of consumer and, especially, business confidence. Consumer confidence has seemingly been sapped by job insecurity and poor prospects for wage growth; and, in some countries, concerns about the implications for disposable incomes of proposals for reform of pension and social security systems and other measures related to budgetary consolidation efforts may have contributed as welt. Business confidence may have been affected by uncertainties about countries’ capacity to carry out necessary fiscal adjustments, and by concerns about high cost levels and the persistence of structural rigidities that impede the ability of firms to compete in international markets.

The easing of short-term interest rates in Europe during the past year—which may well continue in coming months given the weakness of inflationary pressures—together with further progress in the reduction of structural fiscal deficits should bring about both a more appropriate mix of policies and greater convergence of policies across Europe. Together with the significant decline in long-term interest rates since early 1995, the conditions would seem to be in place for growth to pick up again in the second half of 1996. The moderate pace of expansion that is projected, however, implies that little of the slack in labor markets will be absorbed over the next couple of years.

Growth in other industrial countries also will be supported in the period ahead by the declines in real interest rates over the past year. Real bond yields fell considerably during 1995, reversing much or all of the rise in the previous year, and despite the upturn in yields in early 1996, they remain relatively low by the standards of recent years. Real short-term interest rates have also come down, as subdued inflation and mounting evidence of weakening economic activity have led to monetary easing (Chart 6). Inflation in the industrial countries is expected to remain at around the lowest level in thirty years, permitting monetary policies to accommodate continuing expansion.

Chart 6.Three Major Industrial Countries: Policy-Related Interest Rates and Ten-Year Government Bond Yields1

(In percent a year)

Recent declines in policy-related interest rates should support economic activity.

1The U.S. federal funds rate, Japanese overnight call rate, German repurchase rate, and all ten-year government rates are monthly averages. All other series are end of month.

In most industrial countries, even in those cases where activity has recently weakened, fiscal policy can contribute most effectively to sustained recovery through the implementation of consolidation programs that address long-standing deficit and debt problems. Japan alone is implementing a substantially stimulative policy; and its fiscal consolidation will need to resume when recovery is firmly established. Most other countries seem likely to implement budgetary measures that reduce structural deficits this year and next (Table 2). In Europe, irrespective of the Maastricht convergence process, most countries need to pursue fiscal consolidation not only to help lower real long-term interest rates and to alleviate the burden on monetary policy, hut also to address the prospective budgetary costs of aging populations.

Table 2.Industrial Countries: General Government Fiscal Balances and Debt1(In percent of GDP)
Major industrial countries
Actual balance-3.0-2.1-2.7-3.8-4.3-3.5-3.3-3.1-2.5-1.3
Output gap-
Structural balance-2.7-3.3-3.0-3.5-3.3-2.7-2.5-2.1-1.6-1.3
United States
Actual balance-2.6-2.7-3.3-4.4-3.6-2.3-2.0-1.7-1.6-1.0
Output gap-0.72.8-0.8-0.5-
Structural balance-2.3-3.8-3.1-4.1-3.4-2.5-2.2-1.7-1.6-1.0
Net debt34.744.848.352.054.455.356.456.656.453.4
Gross debt48.057.561.364.
Actual balance-
Output gap-
Structural balance-
Net debt22.
Gross debt66.269.166.669.975.180.487.092.294.7103.3
Actual balance excluding social security-4.3-0.6-0.8-2.0-4.8-5.2-6.2-7.0-5.2-5.4
Structural balance excluding social security-4.3-1.6-1.8-2.2-4.2-4.1-4.5-5.5-3.9-5.4
Actual balance-2.1-2.0-3.3-2.9-3.5-2.6-3.5-3.9-3.4-1.3
Output gap-
Structural balance-1.3-3.2-5.6-4.0-2.4-1.3-2.1-1.6-1.4-1.3
Net debt20.821.621.427.735.040.348.751.352.751.9
Gross debt39.843.441.143.747.850.157.760.161.158.8
Actual balance-2.0-1.4-2.0-3.9-6.0-5.8-5.0-4.2-3.6-2.0
Output gap-
Structural balance-1.9-2.6-2.3-3.5-3.4-3.6-3.1-1.8-1.7-2.0
Net debt321.525.
Gross debt29.035.435.839.745.448.452.355.056.457.1
Actual balance-10.9-10.9-10.2-9.5-9.6-9.0-7.2-7.3-5.9-1.5
Output gap2.12.91.8-3.4-3.3-2.3-2.1-1.60.1
Structural balance-11.7-12.3-11.1-9.6-7.9-7.3-6.0-6.2-5.1-1.5
Net debt71.292.896.2103.0112.0117.2114.4112.0109.594.5
Gross debt77.197.8101.3108.4119.4125.4122.9121.4119.5103.8
United Kingdom
Actual balance-2.0-1.2-2.5-6.3-7.8-6.8-5.1-3.8-2.5-0.3
Output gap-0.92.0-2.3-4.5-4.5-2.9-2.4-2.0-1.2
Structural balance-1.0-3.7-2.7-3.8-4.4-4.1-3.2-2.3-1.4-0.2
Net debt41.627.226.728.132.537.740.843.243.038.5
Gross debt49.334.433.634.940.446.048.849.749.545.0
Actual balance-4.5-4.1-6.6-7.4-7.3-5.3-4.2-2.4-1.30.4
Output gap-0.11.2-2.6-3.7-4.0-2.1-2.2-2.5-2.0-0.2
Structural balance-4.4-4.9-4.9-4.8-4.6-3.8-2.9-0.9-0.20.5
Net debt28.744.049.756.961.964.466.768.066.557.3
Gross debt59.573.180.488.093.895.698.399.797.383.4
Other industrial countries5
Actual balance-4.1-2.4-3.8-4.8-6.1-5.1-4.1-3.0-2.2-1.4
Output gap-
Structural balance-4.0-4.2-4.6-4.6-4.3-3.6-3.1-2.1-1.5-1.4

Turning to developments and prospects for individual countries, the United Stares saw a marked slowdown of growth in the first half of 1995, accounted for by a sharp inventory correction and a decline in real net exports that reflected the effects of the recession in Mexico (Table 3). Growth then rebounded strongly in the third quarter on the continued strength of investment demand and a pause in inventory adjustment, but slowed back to ½ of 1 percent at an annual rate in the fourth quarter. There seems to have been some renewed pickup in the early months of this year; in any event, growth is not expected to remain significantly below the growth of capacity for long. Thus, real GDP growth is expected to be 1¾ percent in 1996 as a whole and to rise to 2¼ percent in 1997, in line with the growth of potential output.7 Several developments support this favorable assessment. Moderate wage increases and continuing productivity gains have contained cost pressures and resulted in a better-than-expected inflation performance. In turn, interest rates have fallen considerably. The Federal Reserve cut its target rate for the federal funds rate by a total of 75 basis points between July and January as the expansion weakened and inflation remained subdued. Bond yields also declined up to late January, seemingly helped by more optimistic market expectations of budget deficit reduction; they have subsequently risen back to the levels of mid-1995, but remain lower than in the preceding twelve months. And equity markets rose steeply up to early March, helped by strong corporate profits as well as interest rate developments; at the end of March they were more than 40 percent higher than at the beginning of 1995. High capacity utilization rates in manufacturing are another factor that should continue to support business fixed investment.

Table 3.Industrial Countries: Real GDP, Consumer Prices, and Unemployment Rates(Annual percent change and percent of labor force)
Real GDPConsumer PricesUnemployment Rates
Industrial countries2.
Major industrial countries2.
United States13.
United Kingdom23.
Other industrial countries3.
New Zealand33.
European Union2.

A significant risk to sustained expansion would seem to be posed by the vulnerability of financial markets to a possible failure to make significant early progress toward meeting announced fiscal goals. Although there is agreement between the Congress and the administration on the goal of a balanced federal budget by FY 2002, notable differences remain on measures needed to attain that objective. Moreover, under both of their proposals, much of the adjustment is delayed until the later years and depends on substantial further declines in interest rates.

In Canada, real GDP growth slowed from 4½ percent in 1994 to 2¼ percent in 1995. Domestic demand weakened sharply on higher interest rates, slow employment growth, falling real disposable incomes, high levels of consumer debt, and cutbacks in government consumption. The export sector, which had contributed substantially to the recovery, also weakened as the U.S. economy slowed, but net exports nevertheless continued to make a positive contribution to GDP growth. On several occasions last year, political uncertainties and concern about fiscal consolidation created tension in financial markets, pushing up interest rates and exerting downward pressure on the Canadian dollar. Following the Quebec referendum on October 30, interest rates declined substantially. Renewed market confidence in continued significant progress with budgetary consolidation was also a factor helping to lower interest rates. Both the federal and the provincial governments’ fiscal deficits have narrowed appreciably in recent years. In early December, the federal government reaffirmed its commitment to the longer-term goal of a balanced budget and set a deficit target of 2 percent of GDP for FY 1997/98. The outlook is for continuing expansion, as lower interest rates and strong corporate profits support business fixed investment. Real GDP is expected to grow by 2 percent in 1996 and 3 percent in 1997.

In Japan, output expanded by only 1 percent in 1995, and despite weak labor force growth, the unemployment rate rose to 3.4 percent at year-end, a historical high. Although still low relative to other industrial countries, this unemployment rate understates the degree of slack in the labor market, given the nature of employment contracts in Japan and the tendency toward labor hoarding in periods of weak growth, as indicated by the decline in labor productivity in manufacturing in 1992–93. In the final quarter of 1995, growth picked up to 3½ percent at an annual rate, and conditions are in place for a convincing recovery to emerge in 1996 and to continue in 1997. The yen has depreciated by over 20 percent in real effective terms since its peak in April 1995 to a level that appears to be more consistent with economic fundamentals. Reflecting actions by the Bank of Japan, short-term interest rates declined from about 2¼ percent in early 1995 to below ½ of 1 percent in September, while growth in narrow money has picked up notably since about the middle of 1995. Furthermore, the implementation of the September 1995 supplementary budget and the extension into 1996 of the 1995 temporary tax cuts are expected to impart substantial fiscal stimulus during the year. These supportive policy measures and the steps taken to address the problems in the financial sector (Box 3) have improved consumer and business confidence and sparked a recovery in equity prices. On the strength of private consumption and capital investment, real GDP is expected to grow by 2¾ percent this year and over 3 percent in 1997. The decline in consumer prices experienced in 1995 will gradually be reversed, but with the large output gap and the modest pace of recovery, inflation is expected to be negligible in the next couple of years.

The pace of economic expansion in Germany slowed sharply, to a virtual halt, in the second half of 1995, and output growth is expected to remain well below its potential rate until the second half of this year. Output in 1996 as a whole is projected to be only 1 percent higher than last year. The slowdown stemmed from widespread weakness in demand. Private consumption and fixed investment have been sluggish, reflecting depressed consumer and business confidence; and export growth dwindled during 1995 partly because of the continued strength of the deutsche mark, relatively high unit labor costs, and the slowdown of growth elsewhere in Europe and in North America. Short-term interest rates were lowered substantially in late 1995 and early 1996 in response to weak monetary growth, low inflation, and the strong deutsche mark. The pickup in growth expected in the latter part of this year should be supported by lower interest rates and a strengthening of consumer spending as tax cuts raise real disposable income. However, the strong deutsche mark and relatively high unit labor costs could remain restraining factors, dampening business confidence. Moreover, rising unemployment may continue to depress consumer confidence.

Following the sharp deterioration in the fiscal position of the early 1990s, reflecting the costs of unification, impressive progress toward fiscal consolidation was achieved in 1992–94. However, beginning in 1995, the debt and debt-service obligations of the Treuhandanstalt (and of various other agencies) were taken over by the general government This debt is equivalent to 8 percent of GDP, and the associated debt service amounts to between ½ percent and 1 percent of GDP. Although revenue shortfalls contributed to a larger-than-expected general government deficit of 3½ percent of GDP in 1995, another source of the worsened fiscal outturn was the larger deficits of the state and local governments and the pension funds. The structural deficit rose from 1¼ percent of GDP in 1994 to 2 percent of GDP in 1995. While some accommodation of weaker revenues may be warranted in 1996, there seems to be no scope for relaxing discipline on discretionary expenditures. In late January, the government unveiled a package of supply-side measures aimed at raising economic efficiency and job creation over the medium to long term. They are not expected, however, to have any marked impact on employment in the near term.

The deterioration in consumer confidence during 1995 was especially marked in France. Consumption declined steeply in the second half of the year, especially in the fourth quarter because of public sector strikes. Although private consumption expenditure is expected to strengthen during this year, it will be restrained by relatively weak disposable income growth, while public consumption will be affected by budget cuts. Domestic demand should nonetheless be sustained by increases in business investment and other interest-sensitive expenditures. Owing to weak external demand, net exports are expected to make a negative contribution to real GDP growth in 1996, and overall growth is expected to decline to only 1¼ percent from 2½ percent in 1995. As private consumption and exports recover in the second half of the year and through 1997, real GDP growth is expected to pick up to some 2½–3 percent next year. With the household saving ratio particularly high, growth prospects in France, as in a number of other European countries, depend importantly on an upturn in consumer confidence. The interest rate reductions on national savings instruments and other measures announced at the end of January are intended to boost consumer spending and the housing market.

In October, the French government announced a major reform of the social security system, intended to eliminate two thirds of the social security deficit in 1996 and achieve a small surplus in 1997. It also presented measures aimed at holding the 1995 central government deficit to its initial target. Despite a wave of strikes in response to the announced measures, and some concessions to public sector employees, the government adhered to the substance of its planned reforms. Financial markets responded positively with a strengthening of the franc, permitting an easing of monetary conditions and a narrowing of short-term interest differentials over Germany.

In Italy, real GDP growth of 3¼ percent in 1995 was stronger than projected in October and a full percentage point higher than in 1994. The expansion slowed through last year, however; and unemployment in early 1996 was unchanged from a year earlier. Export growth has been a key driving force behind the recovery, with the lira’s depreciation during 1992–95 bringing further gains in market shares last year and boosting the current account surplus to 2½ percent of GDP. Fixed investment responded strongly to the export surge and robust profits. Private consumption was unusually sluggish, however, owing in part to the slow expansion of household income, while public consumption contracted. After declining to a 25-year low of less than 4 percent in mid-1994, inflation rose to 5½ percent in 1995, fueled by the depreciation of the lira and indirect tax increases. Underlying inflation, however, has been contained by a cautious monetary policy and moderate wage growth.

Italy’s generally favorable aggregate performance masks an unbalanced recovery: export volumes have grown at an average annual rate of over 11 percent in the past three years, while domestic demand has recovered only sluggishly from its steep decline of 1992–93. The short-term prospects are for more balanced, albeit more moderate, expansion. The relative contribution of domestic demand is expected to rise, and its composition is expected to shift toward consumption, in line with a pickup in the growth of real disposable income. After four successive years of decline, employment is expected to pick up and unemployment should gradually fall.

Italy’s 1995 fiscal outturn was somewhat better than originally budgeted, owing to higher-than-expected inflation and stronger-than-expected growth. Fiscal adjustment has made appreciable progress in recent years: the general government fiscal deficit narrowed to 7¼ percent of GDP in 1995 from 9 percent in 1994; the primary surplus widened to 3¾ percent; and the rise of the public debt-to-GDP ratio was halted. Also important, the improvement in recent years has stemmed from reductions in primary spending. The 1996 budget was passed by Parliament in late December, with favorable effects on bond yields and the lira, and the subsequent monetary easing across Europe should assist the fiscal situation, given the high cost of debt servicing in the Italian budget.

In the United Kingdom, economic expansion slowed to the more sustainable pace of 2½ percent in 1995, with unemployment continuing to fall at a moderate pace. Growth appears to have been below potential through most of last year, but underlying prospects remain favorable. Domestic cost pressures have remained subdued, household and corporate financial positions are strong, and income tax cuts will shortly take effect. The decline in long-term interest rates and the competitiveness of sterling should also support activity. Consumer confidence has improved, though it remains below the level seen in the late 1980s. In the wake of further signs of softening of demand, official interest rates were cut in three steps of 25 basis points each in December, January, and early March. The tax and spending measures announced in the November budget were neutral, but in view of the accommodation of the revenue shortfall in 1995, the downward path of the public sector borrowing requirement (PSBR) has been shifted back by one year.

Elsewhere in Europe, growth has also slowed in Belgium, Austria, Denmark, and Switzerland. In Belgium, a smaller contribution from net exports in 1995 more than offset a pickup in business investment. This year, consumer demand is expected to remain weak, partly because of uncertain employment prospects, and growth is expected to slow further. In Austria, much of the slowdown has been concentrated in the service sector, with tourism suffering from the appreciation of the schilling. A substantial tightening of fiscal policy is needed to meet deficit-reduction targets. In Denmark, investment is expected to grow less briskly, which, combined with slowdowns in consumption and exports, will reduce GDP growth in 1996 below potential. In Switzerland, projected growth has been revised downward quite substantially, reflecting the effect on exports of the large appreciation of the Swiss franc. The recent easing of monetary conditions should contribute to a gradual recovery in consumer spending and residential investment.

Growth of non-oil output in Norway slowed to 3¼ percent in 1995, still above its potential rate. All demand components are expected to contribute to a further slowing of the mainland economy in the next couple of years. With the output gap now closed, however, there is a risk of overheating if the pace of expansion remains significantly above its potential rate. In the Netherlands, the pace of economic expansion, which had been supported by a boom in business fixed investment, also slowed during 1995. The outlook is for continuing moderate growth, reflecting weak external demand, with continued low inflation and a declining fiscal deficit as a ratio to GDP. In Ireland, growth of around 5 percent is expected through 1996–97, owing to resurgent investment and continued buoyant export growth. In view of strong labor force growth and other demographic factors, however, declines in unemployment are likely to be limited without substantial labor market and tax reforms.

Moderate growth is projected for 1996 in Spain, Sweden, and Finland. In Spain, investment and exports are the driving forces of the recovery. Although labor market reforms introduced in the past couple of years have increased labor market flexibility somewhat, most of Spain’s very high unemployment rate still appears to be structural. Continuing wage moderation should support further declines in inflation. Sweden and Finland have benefited from improved market confidence because of their successes in reducing fiscal deficits in 1995. In both countries, unemployment rates have remained very high, but the inflation outlook has improved, interest differentials with respect to Germany have narrowed, and currencies have strengthened.

Both Greece and Portugal are likely to see further improvements in growth performance in 1996. Further fiscal consolidation in Greece during 1995 bolstered market confidence and led to reduced interest rates, which, together with improved profitability, are expected to boost private investment in the coming year. The recovery in Portugal, which began in mid-1994, is projected to continue in 1996 as private consumption and investment strengthen. Reflecting a better-than-budgeted fiscal outcome in 1995, a 1996 budget that aims at further consolidation, and an ambitious privatization program, the escudo has remained stable and interest rate premiums have fallen appreciably.

In 1995, economic growth in both Australia and New Zealand slowed somewhat from 1994 reflecting the tightening of monetary conditions in both countries. In Australia, strong private consumption and business investment spending have continued to spur the economic expansion, which has been accompanied by a moderate increase in inflation. New Zealand’s expansion, now in its fourth year, remains broadly based across production sectors and expenditure components. Unemployment declined further in 1995, reflecting this sustained growth and also significant progress with labor market reforms.

Economic Situation and Prospects in Developing Countries

In the developing countries, output increased by close to 6 percent in 1995 for the fourth consecutive year, and growth of 6–6½ percent is projected for 1996 (Table 4) and 1997. Particularly positive aspects of the outlook for developing countries include the recoveries that have begun in Mexico and Argentina following the adjustment undertaken in 1995; stronger stabilization and reform efforts in many countries, particularly in Africa; and continued robust growth in Asia, despite the recent tightening of monetary policy in a number of countries to reduce excessive demand pressures.

Table 4.Selected Developing Countries: Real GDP and Consumer Prices(Annual percent change)
Real GDPConsumer Prices
Developing countries6.45.96.348.019.912.6
Côte d’Ivoire1.86.56.526.014.26.8
South Africa2.
SAF/ESAF countries13.
CFA countries1.14.65.327.814.84.8
Hong Kong5.
Taiwan Province of China6.
Middle East and Europe0.
Iran, Islamic Republic of1.83.03.535.248.823.0
Saudi Arabia-0.1-0.8-
Western Hemisphere4.70.93.1223.737.919.0
Dominican Republic4.

Box 3.Resolving Financial System Problems in Japan

Japanese financial institutions face considerable asset-quality problems, arising both from the bursting of the bubble in land and equity prices since 1990 and the prolonged downturn in economic activity. The failure of several financial institutions during 1995, together with the lack of full disclosure of nonperforming loans and the absence of a transparent framework for disposing of failed institutions, contributed to market participants’ sense of increasing risk of systemic crisis. This was reflected in the emergence, in late summer 1995, of a “Japan premium”—the amount of extra interest Japanese banks had to pay to borrow funds in the international interbank market. The premium widened considerably following the delayed revelation of large trading losses at the New York branch of Daiwa Bank. These developments strengthened the authorities’ determination to tackle the difficulties in the financial sector: comprehensive plans have been announced for liquidating the jusen (housing loan corporations), improving bank supervision, and resolving the problem of failed institutions.

In November 1995, the Ministry of Finance released detailed estimates of problem loans in the financial sector based on a survey of individual institutions (see table below).1 These estimates, revised slightly in December, place total problem loans at ¥38.1 trillion (about 8 percent of GDP), of which ¥18.6 trillion is considered to be unrecoverable. While total problem loans are probably somewhat larger than the Ministry’s figures suggest,2 the latest estimates appear to have reduced uncertainly as to the magnitude of the problem.

A plan to liquidate the seven insolvent jusen was approved by the Cabinet in December 1995. following intense negotiation among the principal creditors.3 While the agreement is yet to be ratified by the Diet, it represents a significant step forward in resolving the problems in the Japanese financial sector. The immediate losses associated with an estimated ¥6.4 trillion of unrecoverable assets are to be distributed among founding banks, other financial institutions, and agricultural cooperatives as shown in the table opposite.

In addition, ¥685 billion have been earmarked in the FY 1996 budget to cover the balance of the losses. The remaining jusen assets, amounting to about ¥6.8 trillion, are to be transferred to a loan-collecting firm, the Jusen Resolution Corporation (JRC). The founding banks. lender banks, and agricultural cooperatives are to extend low-interest loans to the JRC to finance the cost of assets purchased. Public money will be used to cover half of the possible losses incurred by the JRC; the commercial banks are expected to cover the remainder. The commercial banks are also to provide funds for the Deposit Insurance Corporation (DIC), amounting to around ¥1 trillion, and the investment income generated from these funds is to be used to make up part of the loss to be borne by the commercial banks.

Estimated Problem Loans, as of the End of September 1995
Twenty-One Major BanksRegional BanksCooperative InstitutionsTotal
(In trillions of yen)
Problem loans23.87.86.538.1
(In percent of GDP)
(In percent of assets)
Unrecoverable loans18.6
Loan-loss reserves4.
Net operating profit
(April-September 1995)
Distribution of Immediate Losses of Insolvent Jusen
(In trillions of yen)(In percent of loans)
Founding banks3.53.5100
Other financial institutions3.81.745
Agricultural cooperatives5.50.510

The Financial System Stabilization Committee—set up in July 1995 to formulate a strategy for resolving the non-performing loan problem—issued its final report at the end of December. The report recommended that deposit insurance premiums—currently 0.012 percent of insured deposits—be raised fourfold to recapitalize the DIC, whose funds are essentially exhausted. Moreover, financial institutions are to pay a special levy over the next five years, equal to three times the existing insurance premium, to establish “special funds” for financing the disposal of failed institutions beyond the payoff costs. To facilitate the disposal of failed credit cooperatives, the Committee recommended the establishment of the Resolution and Collection Bank—an institution similar to the Resolution Trust Corporation set up in the United States to restructure insolvent savings and loans in the late 1980s—(I) to take over failed institutions and handle their liquidation after deposit repayment and loan collection. in cases where other institutions cannot be found to take over the failed institutions; (2) to serve as a bridging bank until a takeover institution can be found; and (3) to collect those non performing loans that are not transferred to takeover institutions.

Measures to improve banking inspection and supervision have also been announced. To strengthen internal management controls, financial institutions will be expected to follow guidelines on in-house inspections and risk management, and will be inspected by external auditors and the Ministry of Finance to verify compliance with these criteria. Overseas branches also will be subject to greater scrutiny by the Ministry and the Bank of Japan. In addition, the authorities plan to strengthen the exchange of information with foreign supervisory authorities, in accordance with the Basle Concordat, Finally, there is to be greater coordination between the local and national supervisory authorities to strengthen the supervision of credit cooperatives.4

Banks’ profitability improved in the first half of FY 1995. Net business profits rose to a record high, increasing by 66 percent over the same period in FY 1994, reflecting the decline in short-term interest rates and associated steepening of the yield curve.5 In addition, the rise in overall equity prices boosted the banks’ hidden reserves by close to 40 percent in the first half of FY 1995. Taking into consideration this increase in hidden reserves, the IMF staff estimates that the capital ratios as defined by the Bank for International Settlements (BIS) for the 21 major banks rose from 8.9 percent at the end of March 1995 to 9.3 percent at the end of September. The ratio is expected to decline, however, as loans to jusen will be written off in March 1996. Total operating profits of these banks have been around ¥3 trillion in recent years. Assuming that this level of profitability is maintained, that there is no further accumulation of problem loans, and that all profits are used to write down problem loans, the difficulties of the major banks can probably be resolved in about three years. However, given the uneven distribution of problem loans among smaller financial institutions, deposit insurance assistance or public money, or both, will likely be needed to wind up several failed institutions.

1Problem loans include nonperforming loans (loans to borrowers that have legally been declared bankrupt and loans on which interest has not been paid for 180 days) and restructured loans (loans on which interest rates have been reduced to below the official discount rate prevailing at the time).2For instance, the official figure excludes an additional ¥3.1 trillion of problem loans of three institutions that collapsed during the summer, and the ¥5.5 trillion exposure of the agricultural cooperatives to the jusen. In addition, recapitalized loans and loans that have been restructured at above the official discount rate are excluded.3There are eight jusen, of which seven are believed to be insolvent. The jusen, partially owned by banks (founding banks), insurance companies, and securities firms, were originally established to finance housing loans. During the second half of the 1980s, however, these institutions increased their borrowing from their shareholders, other financial institutions (lender banks), and the agricultural cooperatives to finance their rapidly expanding lending to real estate developers.4Disclosure requirements for all classes of financial institutions are to be made more rigorous to promote market discipline, including sound management and depositor responsibility. These disclosure requirements will, however, not be made uniform across institutions.5Bank equity prices rose sharply relative to the Nikkei 225 average in late 1995, reflecting strong profits in the first half of FY 1995 and expectations of a quick resolution of the difficulties in the banking sector. In early 1996, bank share prices retraced some of their previous gains, owing to uncertainties as to the pace at which problem loans are likely to be resolved—particularly in view of public opposition to the use of public funds to resolve the jusen—and the disproportionate burden to be borne by the major banks.

Among the developing countries of the Western Hemisphere, aggregate output is expected to expand by 3 percent in 1996. substantially higher than the 1 percent growth seen in 1995. The improved outlook reflects successful adjustment efforts by countries affected by the Mexican crisis.

In Mexico, tight fiscal and monetary policies, brought about a major adjustment of the economy in 1995, promoted the recovery of investor and consumer confidence, and helped to stabilize financial markets. The external current account deficit was virtually eliminated as real GDP contracted by about 7 percent. Economic activity recovered somewhat in the latter part of the year, and with financial policies remaining tight, the restoration of confidence should lead to stronger growth in 1996. In Argentina, a significant adjustment of the fiscal stance, together with a restructuring of the banking system, particularly the provincial banks, helped contain the spillover effects of the crisis in Mexico. Real GDP fell by 4½ percent in 1995 but is expected to recover gradually this year. In Brazil, output increased by 4 percent in 1995 and inflation slowed sharply, reflecting the continued success of the currency stabilization plan. In contrast, economic conditions in Venezuela worsened over the past year, as confidence in government policies waned and investment stagnated. Prospects for an improvement in the economic situation in 1996 depend on the adoption of a credible exchange rate policy, the removal of controls, and measures to strengthen the fiscal position and deal with the problems of the banking sector. Countries with strong economic fundamentals, such as Chile and Peru, are continuing to see robust growth.

Economic growth in Africa is expected to improve further in 1996, reflecting continuing advances in macroeconomic and structural policies. Apart from the need to avoid policy slippages, weak commodity prices pose a downside risk for many countries in the period ahead. The South African economy grew by about 3½ percent in 1995, despite declines in the agricultural sector owing to a drought and in the gold mining sector because of labor disputes. In manufacturing, meanwhile, output expanded vigorously and is expected to continue to do so in 1996. In Uganda, continuing gains in the credibility of policies, as well as higher coffee prices, boosted real GDP by 6½ percent last year; weaker coffee prices are expected to moderate growth in 1996. In Kenya, with the implementation of prudent polices, the deepening of structural reforms, and the resumption of normalized relations with the donor community, the expansion is projected to continue in 1996. Tight financial discipline in Algeria, supported by rescheduling agreements with official and commercial creditors, has promoted macroeconomic stability; the 5½–6 percent growth rate projected for 1996 is subject to downside risks, however. In Nigeria, growth picked up during 1995 but remains low compared with other major African countries, because of ongoing political uncertainties. Recently, however, oil production rose and foreign exchange market liberalization has been boosting non-oil exports.

In most countries in the CFA franc zone, buoyant commodity prices in 1994 and early 1995, and improved external competitiveness following the devaluation in 1994, supported the continued recovery in 1995. Real GDP grew by 4½ percent, the strongest growth in ten years. Restrained fiscal and wage policies have been essential to the recovery process. In Côte d’Ivoire, coffee and cocoa production increased, while in Senegal groundnut production registered strong growth. With continued liberalization and prudent financial policies, growth is expected to continue to strengthen in 1996 despite a downward revision in projected commodity export prices.

Despite a tightening of financial policies in a number of countries in the region, growth in Asia is expected to slow only slightly in 1996, to about 8 percent. After a prolonged period of overheating, a restrictive credit policy in China should help to hold economic growth to a more sustainable rate of 10 percent in 1996. Economic expansion in India remained strong during 1995 but is projected to moderate during 1996, partly because of higher interest rates that are restraining domestic demand. Further progress is expected in the area of structural reform after the elections, and this should help to boost investor confidence. Growth in Korea is expected to moderate to 7½ percent this year from 9 percent in 1995. In Malaysia, overheating should ease in 1996 as a result of the recent lightening of monetary policy, but the economy is still likely to grow by about 9 percent. In Thailand, tighter monetary policies helped to reduce demand pressures in the second half of 1995, and growth should slow marginally in 1996. Growth is also expected to slow somewhat in 1996 in Taiwan Province of China. Economic activity in the Philippines is continuing to recover following the implementation of a successful stabilization program. In Indonesia, rapid growth of bank lending and surging foreign investment continue to support economic activity. Strong industrial expansion sustained economic growth above 9 percent in Vietnam in 1995; a similar growth rate is expected in 1996.

Improved regional stability in the Middle East and Europe is expected to stimulate confidence and activity in a number of countries in 1996, but large government deficits and weakening oil prices continue to cloud the outlook for several oil producers. In Saudi Arabia, continued tight fiscal policies are expected to restrain growth again in 1996. In Turkey, following a severe recession and the initiation of substantial adjustment policies during 1994, output increased by 7½ percent in 1995, owing to strong exports, consumption, and investment. The economic outlook for 1996 is quite uncertain, however, and rests on the strengthening of public finances. In Egypt, growth in 1995 was sustained by increases in industrial production and construction that offset a decline in cotton production. In the Islamic Republic of Iran, growth and investment remain weak owing to tight credit and import controls, and a slowdown in non-oil exports. In Jordan, economic recovery is expected to continue, supported by substantial stabilization efforts.

Developments and Prospects in Transition Countries

Most of the countries in transition made substantial further progress toward low inflation and market-based economic structures in 1995, and most also saw improved growth performance or smaller output declines than in the preceding years (Table 5). Output growth has remained most robust in countries that began earliest and that have persevered longest with macroeconomic stabilization and structural reforms. In Poland, output expanded by about 6½ percent in 1995, fueled by strong export performance and a recovery in investment spending. With somewhat less strong growth projected for 1996. real GDP is poised to reach its pretransition peak. Economic recovery continued during 1995 in the Czech and Slovak Republics, Estonia, and Lithuania. In Latvia and Lithuania, the authorities have acted to contain the effects of serious banking sector problems that emerged during 1995. In Hungary, the need to restrain domestic demand to correct large maeroeconomic imbalances slowed output growth in 1995 to 2 percent. In Mongolia, despite policy slippages earlier in the year, output expanded by about 6 percent in 1995 and, provided that appropriate policies are kept in place, robust growth is expected to continue.

Table 5.Countries in Transition: Real GDP and Consumer Prices(Annual percent change)
Real GDPConsumer Prices
Countries in transition-8.8-1.32.526512838
Central and eastern Europe-
Excluding Belarus and Ukraine3.45.24.5462617
Czech Republic2.65.05.01099
Macedonia, Former Yugoslav Rep. of-8.2-3.03.0123167
Slovak Republic4.97.45.513107
Transcaucasus and central Asia-14.2-5.70.41,61126352
Kyrgyz Republic-

Among the countries in transition that have implemented stabilization and reform policies more slowly or less consistently, growth performance and prospects are mixed. Even though output rose in 1995 in Armenia, Bulgaria, and Romania, future growth prospects for these countries are somewhat uncertain. Future economic growth in Armenia critically depends on the lifting of the blockade along the west and east trade routes and also on the timely resolution of tax arrears and banking sector problems. In Bulgaria, serious delays in implementing structural reforms threaten the sustainability of maeroeconomic stabilization and therefore the outlook for growth. In Romania, the further quickening of growth in 1995 was accompanied by rapidly expanding bank credit, falling external reserves, and a deteriorating current account. Corrective maeroeconomic policy measures have been implemented, but any further policy slippages could jeopardize sustained growth.

Progress with stabilization during 1995 arrested the steep declines in output in a number of other countries, creating the conditions for the resumption of growth in 1996. In Russia, output, which declined by 4 percent in 1995 as compared with 15 percent in 1994, has shown signs of an emerging recovery since early last year. One of the essential preconditions for growth began to be put more securely in place last year with the significant progress made in reducing inflation. In the Kyrgyz Republic, noteworthy progress with macroeconomic stabilization and structural reforms laid the foundation for the modest growth seen in 1995, and stronger expansion is projected for the medium term. Economic prospects have also become more favorable in Georgia and Uzbekistan; both countries have made considerable progress with stabilization over the last year, and should begin to see clearer results of their efforts in the period ahead.

In other transition countries, progress in achieving macroeconomic stability has been insufficient to prevent further sleep declines in output. Although tight financial policies have been implemented in Azerbaijan and Kazakstan, they have not been in place long enough to translate into growth. Meanwhile, in Belarus, Ukraine, and Tajikistan policy slippages in 1995 have undermined any prospect for recovery in the year ahead.

Inflation and Commodity Prices

Generally subdued inflation in much of the world economy is a particularly encouraging aspect of the current global expansion. At the root of this success seems to be a greater understanding among voters that inflation is harmful to growth and economic welfare. As a result, there appears to have been a general strengthening of policymakers’ mandates and determination to address macroeconomic imbalances and especially of monetary authorities’ resolve to resist inflationary pressures. The fact that progress toward price stability is shared by so many countries testifies to the important role of peer pressure in countries’ common fight against inflation. Moreover, rapid trade integration and enhanced global competition are helping to transmit efficiency gains across countries and to diminish the scope for excessive increases in wages and other costs to be shifted to consumers. Although there is no room for complacency, there would seem to be grounds for optimism with respect to the chances of safeguarding the progress that has been achieved on the inflation front.

Among the industrial countries, earlier fears of an increase in inflationary pressures in the countries most advanced in the expansion have largely subsided. The strong anti-inflationary commitment and pre-emptive actions of monetary authorities in these countries have played a key role. In the United States, modest wage increases and slower growth in nonwage labor costs—in particular, employer-provided health insurance costs—have helped to keep inflation in check despite the high level of resource utilization (Chart 7). In Canada, inflation rose to the top half of the authorities’ official target range of 1–3 percent in the first half of 1995. owing in part to the earlier depreciation of the Canadian dollar, but it has since subsided to below 2 percent. In the United Kingdom, inflation firmed as a result of input price increases following the depreciation of sterling, but domestic cost pressures have remained moderate, and headline inflation should edge down slowly in 1996 from its present level close to 3 percent. In New Zealand, underlying inflation has mostly been maintained within the 0–2 percent target band, while in Australia, underlying inflation has edged up to just over 3 percent, reflecting continued wage pressures and indirect tax increases.

Chart 7.Major Industrial Countries: Output Gaps1

(Actual less potential, as a percent of potential)

Output gaps in most major industrial countries remain negative.

1Blue shaded areas indicate IMF staff projections. The gap estimates are subject to a significant margin of uncertainty. For a discussion of the approach to calculating potential output, see the October 1493 World Economic Outlook, p. 101.

2Data through 1991 apply to west Germany only.

In most of continental Europe, inflationary pressures have continued to diminish partly due to currency appreciations and continuing sizable margins of slack. High unemployment has contributed to the containment of wage pressures in many countries, including France, although its influence was less apparent in the 4½ to 5 percent increase in hourly earnings in Germany’s manufacturing industry in 1995. Wage pressures in Germany are likely to have been a significant factor behind recent increases in unemployment, particularly given the strength of the deutsche mark during 1995. Unit labor costs, however, have been contained by rapid productivity growth and labor shedding. Rigidities in labor markets suggest some potential for inflation rates in Europe to rise if activity were to pick up strongly. However, with the recent downscaling of growth prospects for Europe, many countries may well continue to experience weaker-than-projected inflation during the next couple of years.

Even some of the countries with weak currencies have been quite successful in containing inflation at relatively moderate levels. These include Finland and Sweden, in particular, while Spain and Portugal registered significant declines in inflation during 1995. Italy has had greater difficulty in controlling the inflationary impulses associated with the depreciation of the lira during 1992–95, and consumer price inflation rose to 5½ percent last year. However, provided recent progress in the fiscal area continues at an adequate pace, Italy’s inflation rate should again begin to converge toward the moderate inflation performance of its main trading partner countries.

Japan has been facing the unusual problem of a declining price level as a result of a period of protracted economic weakness and the sharp appreciation of the yen in the first half of 1995. Price declines have exacerbated the weakness of demand and added to difficulties in the financial sector. However, the prospect of moderate recovery in 1996 supported by stimulatory fiscal and monetary policies should help prevent further reductions in the price level. While the prospect of stagnating wages in 1996 should help the recovery of industrial profitability after recent years’ deterioration in external competitiveness, it also carries adverse implications for consumer confidence and private consumption.

In the developing world, although inflation remains generally higher than in the industrial countries, the large majority of countries have also experienced a moderation of price increases in recent years. This is the case in several countries that had earlier experienced very high inflation rates. Among the countries in the Western Hemisphere, for example, Argentina, following hyperinflation in the late 1980s, has successfully kept inflation in low single-digit rates since 1993.8 Brazil has also seen a sharp decline in inflation since the introduction of the real in 1994, and the maintenance of strong stabilization efforts should hold inflation at 15 percent in 1996, the lowest rate since 1973. In Mexico, the steep decline in the value of the peso contributed to a sharp rise in inflation during 1995 in spite of the tightening of financial policies, but inflation is expected to decline substantially during 1996. In Venezuela, on the other hand, strong stabilization policies will need to be implemented to prevent further acceleration of prices.

Inflation in most African countries is expected to decline further in 1996, as these economies reap the benefits of the recent strengthening of stabilization efforts. Inflation in Algeria declined in 1995 despite the depreciation of the dinar and reductions of subsidies on cereals. In Uganda, inflationary pressures last year were subdued, as the monetary impact of the coffee price boom was successfully contained. In South Africa, although drought reduced domestic corn production, inflation was stable at 9 percent. Inflation in countries of the CFA franc zone is also expected to ease in 1996. Nigeria is one of the relatively few African countries to have seen a rise in inflation, to above 70 percent, in 1995; but there has been a substantial tightening of fiscal and monetary policies since the latter part of last year, and provided that these are kept in place, inflation is expected to decline in 1996.

Inflation in Asia is also expected to moderate in 1996, owing to monetary tightening in many countries. A tightening of financial policies in China contributed to a reduction of inflation to 15 percent in 1995, and a further decline is expected in 1996. In Southeast Asia, several countries, including Malaysia and Thailand, experienced problems of overheating in 1995, which were reflected mainly in widening current account deficits while inflation increased only moderately. With recent measures of restraint, these problems, linked to rapid capital inflows, should abate somewhat in 1996. In Pakistan, inflation is likely to ease in 1996, but to remain above 9 percent owing mainly to the depreciation of the rupee.

In the Middle East and Europe region, inflation is expected to remain relatively moderate during 1996 in most countries. In Israel, strong growth in recent years has led to concerns about overheating, but a nonaccommodating monetary stance should help to ease inflationary pressures. In contrast, inflation in Turkey is expected to remain high at about 80 percent owing to loose financial polices and continued currency depreciation.

Hard-earned progress in bringing down inflation has been sustained in most of the countries in transition. For the countries more advanced in the transition process, strong growth does not pose an immediate threat of overheating in most cases because of continuing large output gaps and the opportunities for improved productivity, particularly through enterprise restructuring (Chart 8). Although the Czech and Slovak Republics, as well as Albania and Croatia, have contained inflation to under 10 percent, other countries such as Poland, Hungary and the Baltic countries have had greater difficulty in reducing inflation below the 20–40 percent range. The persistence of inflation in these countries may be attributable in varying degrees to continued large relative price adjustments, the use of indexation mechanisms (particularly in Poland), and in some cases to capital inflows that have led to marked increases in official reserves and rapid monetary growth.

Chart 8.Selected Countries More Advanced in Transition: Inflation

(Twelve-month percent change in the consumer price index)

Inflation has come down but remains high generally.

Progress in 1995 in reducing inflation is also noteworthy in many countries less advanced in the transition process (Chart 9). Russia made substantial headway, reducing monthly inflation from 18 percent in January 1995 to 3¼ percent by year-end, through lighter financial policies. Inflation in January 1996 edged up to about 4 percent, partly as a result of adjustments to administered prices for public transportation and utilities; in addition, however, there was considerable pressure in late 1995 and early 1996 to ease financial policies, and this pressure will need to be resisted effectively for the projected further progress in lowering inflation to be secured. In Armenia, Azerbaijan. Bulgaria, Kazakstan, the Kyrgyz Republic, Moldova, and Uzbekistan, monthly inflation has been maintained in the low single-digit range, but more progress is needed in strengthening monetary and credit policies. After some progress earlier in the year, inflation worsened in Turkmenistan and Ukraine, and most notably in Tajikistan, owing to slippages in financial policies.

Prices for all major categories of primary commodities rose between 1994 and 1995 in U.S. dollar terms although most of the increase reflected the weakness of the U.S. currency. In real terms, commodity prices fell slightly, continuing their long-term trend.9 In 1996–97, average commodity prices are expected to continue to decline in real terms.

Economic Outlook have in a number of respects been conducive to improved economic growth performance. In most countries, reflecting the actions of monetary authorities, short-term interest rates have declined substantially. Long-term interest rates generally continued to decline up to late January, and although they have risen more recently they have remained below the levels seen in most of 1994 and 1995. Exchange rate movements have generally been moderate and have brought the currencies of the three major countries into better alignment, relative to fundamentals. There has also been an appropriate appreciation of the Italian lira, and tensions in the exchange rate mechanism of the European Monetary System have eased. In addition, most equity markets have remained buoyant.

Since the end of September, monetary authorities in most industrial countries, faced with continuing low inflation and weakening growth, have allowed short-term interest rates to decline (Chart 10). In Japan—the only notable exception—short-term market rates have remained stable at very low levels since the official discount rate was reduced to its historic low of ½ of 1 percent in early September.

Chart 10.Major Industrial Countries: Nominal Interest Rates

(In percent a year)

Interest rates have declined in most industrial countries.

Sources: WEFA, Inc.; and Bloomberg Financial Markets.

1Yields on government bonds with residual maturities of ten years or nearest.

2Three-month maturities.

Among the seven major industrial countries, short-term rates have declined most since September in France (by about 2 percentage points) and Canada (by about 1½ percentage points), partly reflecting the easing of currency pressures related to political and fiscal policy concerns.12 Downward pressure on the Canadian dollar receded in the period immediately following the Quebec referendum at the end of October. Pressures on the French franc were also relieved from late October, following renewed commitment to fiscal discipline in France and the easing of tensions over prospects for EMU. Pressure on the franc and in French financial markets re-emerged in early December amid strikes in protest against the authorities’ reform proposals, but subsequently receded. In Italy, short-term rates declined substantially between October and January as confidence strengthened with the enactment of the 1996 budget. Subsequently, renewed political uncertainties led to an upturn in rates, but at the end of March they were still about 1 percentage point lower than in September.

In many other industrial countries, short-term rates have declined by 50–80 basis points since September. In mid-December, key official interest rates were lowered by 50 basis points in Germany and by 25 basis points in the United Stales and the United Kingdom, amid increasing evidence of weakening growth in these countries. Further reductions of 25 basis points followed in January in the United Kingdom and the United Stales, and again in early March in the United Kingdom, while Germany also eased monetary conditions further. The decline in short-term rates in Germany helped further to relieve tensions in the ERM and contributed to a general lowering of short-term interest rales in participating countries.

The general decline in long-term interest rates that began in late 1994 continued in most countries other than Japan up to the latter part of January 1996. By that time, the increases in long-term rates that had occurred in 1993–94 had been almost fully reversed in a number of countries, including the United Slates. The declines between September and January may be attributed to the downgrading of projections for growth and inflation, the reductions in short-term interest rates permitted by monetary authorities, and also improved prospects for fiscal consolidation in the United States and a number of other countries. Among the major industrial countries, only in Japan, where prospects of economic recovery improved and projected fiscal deficits widened, did long-term rates rise in this period. Between mid-January and mid-March, however, bond yields moved upward in the other industrial countries as well. This reversal appears to have stemmed partly from revised market expectations about near-term monetary policy adjustments in the light of some relatively buoyant economic and monetary indicators in key countries, but less optimistic assessments of fiscal prospects may also have played a role. In Europe, concerns that slow growth might place medium-term fiscal targets in jeopardy, and related uncertainties about EMU, may have contributed to upward movements in long-term rates.

At the end of March, long-term rates were higher than six months earlier in the United Slates (by about 15 basis points) as well as Japan (by about 40 basis points), and they were virtually unchanged in the United Kingdom. But they were still about 90 basis points lower than at the end of September in France and Italy, partly reflecting improved budget prospects in these countries. In Germany and Canada, long-term rates declined by around 15 basis points over the six months. In all the major industrial countries, long-term rates at the end of March remained lower than in most of 1994 and 1995. The likelihood of further declines in long-term rates would be improved by the implementation of strong fiscal consolidation plans and by the reduction of risks of slippages in fiscal policies arising from weak growth and rising unemployment.

In foreign exchange markets, the U.S. dollar’s recovery from the historic lows reached in spring 1995 against the Japanese yen and the deutsche mark, and also in effective terms, continued up to late January, but the dollar weakened slightly in February and stabilized in March. Since the end of September, the U.S. dollar has risen by a further 8½ percent against the yen, by around 3 percent against the mark, the French franc, and the pound sterling, by 1 percent against the Canadian dollar, and by 3 percent in nominal effective terms. The yen has declined further against all other major currencies, depreciating by 6½ percent in nominal effective terms in this period. The nominal effective value of the yen is now more than 20 percent below its peak of April 1995, and estimates of Japan’s real effective exchange rate indicate that its international cost competitiveness has improved to early 1993 levels (Chart 11). Only a few currencies have strengthened against the dollar since September. They include the Italian lira and Swedish krona, both of which have benefited from increased confidence in progress with fiscal consolidation in their respective countries.

Chart 11.Major Industrial Countries: Effective Exchange Rates

(1990 = 100; logarithmic scale)

The main counterpart to the continued recovery of the U.S. dollar in recent months has been the depreciation of the Japanese yen.

1Defined in terms of relative normalized unit labor costs in manufacturing, as estimated by the IMF’s Competitiveness Indicators System, using 1989–91 trade weights.

2Constructed using 1989–91 trade weights.

Equity markers have risen further since the end of September in most industrial countries, reflecting declines in interest rates and, in a number of cases, strong profit growth (Chart 12, top panel). Since the beginning of 1995, equity prices have risen particularly strongly in the United States, recording gains of about 40 percent. In contrast to the situation in 1987, when a sharp rise in the U.S. stock market opened up a large premium of bond yields over equity yields prior to the October crash, the growth of corporate profits and the decline in U.S. bond yields since 1994 have been such that the premium has actually fallen to relatively low levels (Chart 13). In Japan, the corresponding yield gap has remained low in recent months, by historical standards, in spite of the sharp recovery in equity prices from their low of July 1995. Equity markets generally remain vulnerable both to reversals in bond markets—and thus to disappointments about progress with fiscal consolidation—and also to any significant weakening of profit performance.

Chart 12.Equity Prices

(In U.S. dollars; logarithmic scale; January 1990 = 100)

Equity prices have risen in most industrial countries but have been more volatile in many developing countries.

Sources: WEFA, Inc.; and International Finance Corporation, Emerging Markets data base.

Chart 13.United States and Japan: Equity Yield Gap and Stock Market Prices

Despite strong gains in equity prices, bond yields have declined in relation to equity yields in both the United States and Japan.

Sources: WEFA, Inc.; and Morgan Stanley, Capital International Perspective.

1The equity yield gap is defined as the difference between the yield On ten-year government bonds and the inverse of the price-earnings ratio of stocks.

In the developing world, movements in currency and financial markets since September 1995 reflect a wide range of country-specific economic and political factors. However, for a number of countries, a common underlying element has been the continuation of large capital inflows, which gathered momentum in the closing months of last year and January of this year. This led to pressures on exchange rates, large accumulations of foreign exchange reserves, and increases in domestic liquidity.

Capital flows to developing economies recovered strongly in 1995, topping levels seen in earlier years (Table 6). To alleviate upward pressures on exchange rates resulting from these inflows, authorities in several countries responded by intervening in currency markets that boosted foreign exchange reserves and domestic liquidity. In Latin America, Brazil’s reserves increased by over $l5 billion in the second half of the year, with broad money increasing concomitantly, and there has been significant downward pressure on interest rates. In Argentina, a significant inflow of capital during December returned international reserves and monetary aggregates to their pre-crisis levels before the Mexican crisis, while annual yields on benchmark bonds dropped by about 5 percentage points in the last few weeks of the year. In the first three months of the year, deposit and loan rates began to follow long-term rates down.

Table 6.Developing Countries: Capital Flows1(Annual average, in billions of U.S. dollars)
Developing countries
Net private capital Flows210.226.011.6114.3149.0166.4
Net direct investment3.69.012.639.861.371.7
Net portfolio investment0.21.74.341.550.437.0
Other net investments6.415.3-
Net official flows11.025.529.511.72.627.3
Change in reserves3-20.2-21.7-9.6-56.8-57.9-75.7
Net private capital flows24.
Net direct investment1.
Net portfolio investment0.1-0.3-0.4-
Other net investments3.44.3-
Net official flows2.
Change in reserves3-1.40.4-0.4-2.1-5.1-1.4
Net private capital flows24.313.911.245.775.198.2
Net direct investment1.43.05.624.441.952.4
Net portfolio investment0.10.20.910.116.018.5
Other net investments2.810.74.711.217.127.3
Net official flows4.
Change in reserves3-6.9-7.0-18.0-38.9-61.6-50.0
Middle East and Europe
Net private capital flows2-10.3-21.11.929.711.419.0
Net direct investment-1.3-
Net portfolio investment0.0-
Other net investments-9.1-20.8-4.315.2-4.110.5
Net official flows2.36.66.6-2.6-1.4-3.8
Change in reserves3-14.2-17.69.5-4.4-0.2-2.6
Western Hemisphere
Net private capital flows211.728.9-
Net direct investment2.55.84.712.417.717.1
Net portfolio investment0.02.0-
Other net investments9.221.1-5.63.615.612.3
Net official flows2.
Change in reserves32.22.5-0.7-1.49.0-21.7
Sources: IMF, Balance of Payments Statistics data base; and IMF staff estimates.

Several financial markets in Latin America experienced considerable volatility in October and November following market turbulence in Mexico. Beginning at the end of September private sector concerns about prospects for an early recovery in Mexico and the health of its banking system exerted downward pressure on the peso (Chart 14). By mid-November, the Mexican peso had depreciated by 27 percent against the U.S. dollar, and short-term interest rates had more than doubled. A mildly favorable response to the 1996 budget, the announcement of stepped-up efforts to support troubled commercial banks, occasional intervention by the Bank of Mexico in the foreign exchange market, and successful international bond placements contributed to improving market sentiment at year-end. However, the peso came under renewed pressure in early February on concerns about inflation. Nevertheless, the peso was still stronger in real and nominal terms than it was last autumn; and peso interest rates, although still high, are well down from their peaks in September and October. Venezuela lowered the official value of its currency by 41 percent relative to the dollar in mid-December, in the face of dwindling reserves. The devaluation unified all administered exchange rates and eliminated a two-tier system in place since October. In Brazil, at the end of January the trading band for the real against the U.S. dollar was lowered by 7 percent because of concerns about deteriorating trade competitiveness, but the actual exchange rate only depreciated by 1½ percent over the three months to the end of March 1996. Also, in response to a surge in capital inflows and strong growth of reserves, the authorities announced a number of restrictions on shot-term capital flows. In Ecuador, the currency has depreciated against the dollar by over 10 percent since September because of uncertainty about inflation and stabilization policies.

Chart 14.Selected Developing Countries: Bilateral Exchange Rates Against the U.S. Dollar and Real Effective Exchange Rates1

(January 1992 = 100; logarithmic scale)

The Mexican peso experienced considerable volatility in 1995 and early 1996.

1Bilateral exchange rates are in domestic currency units per U.S. dollar, so that a rise indicates depreciation of the domestic currency. The real effective exchange rate indices show changes in the real value of the domestic currency in terms of a basket of currencies of trading partners, with consumer price indices used as deflators; here a rise indicates appreciation (in real effective terms) of the domestic currency.

In Asia, the desire to enhance the effectiveness of monetary policy prompted the Indonesian central bank in January to widen (to 3 percent) the intervention band within which the currency may fluctuate in response to market forces. In Thailand, to prevent currency appreciation in the face of large inflows, the central bank intervened substantially in the foreign exchange market; despite measures to sterilize the resulting increase in liquidity, downward pressure on interest rates emerged in early 1996. Following a two-year period in which the exchange rate of the Indian rupee had been held stable in the face of heavy capital inflows, it depreciated by over 15 percent against the U.S. dollar between September and January, reflecting rapid import growth, a widening of the trade deficit, and political uncertainties. After falling to a record low of nearly 38 rupees to the dollar in early February, the currency stabilized after the Indian authorities announced measures aimed at reversing the lags in repatriation of export receipts, which have affected flows in the thin foreign exchange market. It has traded in a narrow range of around Rs 34 to the U.S. dollar since then. At the end of October, the Pakistan rupee was devalued by 7 percent, following concerns over external competitiveness and a sharp fall in the country’s foreign exchange reserves. Since then the currency has been relatively stable.

In Turkey, the lira came under significant pressure amid uncertainties in the run-up to the general election in December, leading to considerable exchange market intervention and reserve losses. The currency stabilized in January, but continued to fall in February and March as the central banks allowed the Turkish lira to depreciate in line with inflation expectations. At the end of March, the lira had depreciated against the dollar by about 18 percent since December. Finally, the South African rand fell sharply against the U.S. dollar in mid-February amidst concerns that government plans to relax foreign exchange controls would trigger flows of capital out of the country. The currency remained under pressure on uncertainties about economic policies and by the end of March was trading around R 4 to the U.S. dollar compared with a six-month average up to mid-February of around R 3.65.

Equity markets in developing countries have been volatile in recent months. In general, prices have risen substantially, especially since December when a cut in U.S. interest rates raised hopes of increasing equity flows to emerging markets (see Chart 12, bottom panel). In Latin America, equity prices fell in both Argentina and Mexico in September and October; the markets rallied from November onward, with a significant surge in January. However, there was a marked correction in February, with a rebound in Mexico in March. By the end of March, equity prices in Argentina were only slightly higher than at the beginning of the year, while in Mexico they were over 10 percent higher. The equity markets in Brazil and Peru, which were adversely affected by the events in Mexico in October, have also rebounded since then, with the market in Colombia increasing sharply in February but then giving up most of the gains in March. The Venezuelan market rose by over 50 percent in local currency terms in the last three months of the year on investor optimism concerning the government’s economic reform and liberalization plans; the market rose another 65 percent in the first three months of this year. The gradual slowing of growth and political uncertainties contributed to a decline in the Korean stock market by over 10 percent in November and December; the decline subsequently slowed and prices increased slightly in March. Tighter financial policies and moderating growth in China contributed to a reduction in equity prices by over 25 percent from September to January. In Indonesia, Malaysia, the Philippines, and Thailand, markets have been buoyant since December, although there was some reversal in Thailand in March. Equity prices in India continued to fall in October and November on concerns about high interest rates and political uncertainty, but a significant pickup has occurred since then; in the first three months of this year, prices increased by over 10 percent. In Pakistan, equity prices bounced back sharply in December after the announcement of the package of measures to stabilize the economy. Prices continued to increase until March, when there was a correction. Equities in South Africa rose substantially during November to January, buoyed by large portfolio inflows and a small upward revision by Standard & Poor’s of the country’s long-term foreign currency rating. The market was. however, adversely affected by political and exchange market uncertainties in February and March. In Turkey, equity prices in local currency terms have risen by over 50 percent since the beginning of the year amidst healthy earnings expectations and receding political uncertainties.

External Payments, Financing, and Debt

As in 1994, world trade in goods and services grew by about 9 percent in 1995, more than twice the rate of growth of world output. Despite the recent economic slowdown in Europe and the softening of domestic demand in the United States, world trade is expected to increase by 6½–7 percent a year in 1996 and 1997. The rapid growth of world trade can be traced to a number of factors, including achievements in trade liberalization, especially the increased openness of many developing countries and countries in transition; increasing international diversification of production, including outsourcing by multinational corporations; and the dynamic growth of trade among developing countries, especially in Asia and Latin America. The implementation of the Uruguay Round agreements under the aegis of the World Trade Organization should ensure further dismantling of trade barriers and promote continued growth.

Recent developments in economic activity, and shifts in external competitiveness, are expected to help reduce current account imbalances significantly in a number of countries over the next couple of years (Table 7). Current account deficits that widened substantially in 1994 and 1995 in a number of rapidly growing Asian economies are expected to narrow or stabilize owing mainly to the implementation of corrective policy measures. In Latin America, however, economic recovery is likely to widen current account deficits in some countries. In the industrial countries, the economic slowdown in Europe is expected to be associated with weaker import and export volumes across countries, resulting in only modest shifts in current account positions in 1996. Japan’s current account surplus, which has narrowed considerably in recent years, is expected to remain at around 1995 levels as a percent of GDP, as the effects of improved competitiveness stemming from exchange rate realignments since mid-1995 are offset by a strengthening of economic activity. For the United States, stronger growth in some important trading partners, particularly Japan and Mexico, together with continuing strong competitiveness, is expected to be countered by relatively strong import growth.

Table 7.Selected Countries: Current Account Positions(In percent of GDP)
United Stales-1.5-2.2-2.1-2.0-2.0
United Kingdom-1.8-0.3-0.8-0.3-0.0
Côte d’Ivoire-8.9-2.1-3.1-3.6-5.0
Saudi Arabia-14.6-7.5-4.0-2.2-4.3
South Africa1.5-0.5-2.3-2.5-2.4
Taiwan Province of China3.
Czech Republic2.2-0.1-3.3-4.9-4.3

Among other industrial countries, Canada is expected to register a further narrowing of its current account deficit, which declined by about 1 percent of GDP in both 1994 and 1995. This projected continued improvement reflects increased competitiveness—resulting from earlier declines in the dollar, gains in productivity, and industrial restructuring—as well as the moderate growth of domestic demand. Within Europe, in Germany and the United Kingdom, export volumes are likely to slow owing to the weakness of growth in other European countries, but declining import volumes will prevent any significant erosion in their external balances. In France, a small decrease in the current account surplus is expected because of a pickup in the growth in import volumes later in 1996 when domestic demand is projected to improve. Current account surpluses are expected to increase during 1996–97 in Italy and Sweden, reflecting strong growth in exports bolstered by earlier depreciations of their currencies, and also in Norway because of a continuing increase in exports of oil and gas. Current account deficits are expected to persist in Austria, partly due to weakness in the tourism balance, and in Greece because of the increase in imports of investment goods, including for publicly funded infrastructure projects.

Among the developing countries of Asia, robust growth during 1995 in Malaysia and Thailand spurred import demand, particularly for machinery and equipment. In Indonesia, supply shocks contributed to sharp growth in food imports. As a result, current account deficits in these countries widened by 1½–2½ percentage points of GDP. Tightened financial policies are expected to cause these imbalances to stabilize or decline slightly in 1996. In China, the current account surplus is expected to narrow because of both strong import growth and moderating export growth.

In a number of countries in the Western Hemisphere, current account deficits narrowed in 1995. Imports declined substantially in response to the adjustment policies implemented in the wake of Mexico’s financial crisis and the resulting slowdown in economic activity. Export earnings increased owing, among other factors, to exchange rate depreciation, and in some cases, favorable terms of trade movements. In Mexico, the current account deficit was virtually eliminated in 1995, after reaching a deficit of about 8 percent of GDP in 1994. The sharp real depreciation of the peso over the last year will continue to spur exports in the coming year. With gains in competitiveness through falling wages and prices in the tradable goods sector, the current account deficit in Argentina also narrowed substantially during 1995. Chile, which was largely unaffected by Mexico’s crisis, also registered a narrowing current account deficit owing to exceptionally high copper prices. Current account deficits in these countries are expected to widen in 1996 as growth continues to recover in most countries of the region and as commodity prices decline somewhat.

For Africa, notwithstanding the recovery-related increase in imports and the projected decline in commodity prices, current account balances are expected to improve somewhat in 1996 as further trade liberalization boosts export volumes. The current account deficit in South Africa widened slightly to over 2 percent of GDP in 1995, despite the expansion of exports, as domestic demand for manufacturing and food imports increased. In Uganda, the doubling of coffee prices in late 1994 and early 1995 boosted export earnings, but this was insufficient to prevent a widening of the current account deficit. With the projected decline in coffee prices the current account deficit is expected to widen somewhat in 1996. In Cameroon, increases in cotton and limber production are expected to improve the current account position this year.

Net capital flows to emerging market countries recovered strongly during the second half of 1995 following the sharp decline in the wake of the Mexican financial crisis. Although some countries have not recovered fully from the fallout of the Mexican crisis—especially countries where weaknesses in domestic financial markets were exposed by the crisis—aggregate net capital flows to developing countries in 1995 were higher than in the previous year. Interest rate declines in the major industrial countries helped capital flows to recover, as did the favorable reaction of financial markets to policy tightening in many emerging market countries. In Latin America, with the two main exceptions of Mexico and Argentina, private inflows exceeded the levels attained in 1994, with particularly sharp increases to Brazil. The Asian countries continued to attract large flows, and flows surged to South Africa and Turkey and central Europe. Official flows to developing and transition countries were unusually high during 1995. In particular, use of IMF resources surged to about $26.8 billion in 1995—more than triple its 1994 level—reflecting in part loans of $13 billion to Mexico and $5 billion to Russia, to support comprehensive adjustment programs.

The rapid recovery in capital flows to developing countries, despite the widespread contagion effects earlier in 1995, suggests that for most of the large recipient countries, these inflows are attracted largely by prudent macroeconomic policies and prospects for strong growth. Provided policymakers in developing countries continue to contain inflationary pressures, aggregate capital flows should be sustained at relatively high levels over the medium term. Capital flows to all developing country regions are expected to increase gradually. The composition of aggregate inflows, however, is expected to vary considerably among the different regions. Asian and Latin American countries will continue to receive most private capital inflows, especially as the pace of privatization activity picks up in a number of the larger countries, such as Brazil and Thailand. By contrast, official flows, which were unusually high in 1995, are expected to decline further in 1996 and 1997. For some African countries, such as the CFA countries and Uganda, the decline in external assistance is expected to be partly offset by a gradual increase in private capital inflows, but for the region as a whole aggregate inflows will only be marginally higher than in 1994 and 1995.

The burden of debt for the developing countries and the countries in transition is projected to ease further during 1996 reflecting the increased share of non-debt-creating flows in net external financing observed since 1994. The external debt burden of developing countries is projected to decline to 30 percent of GDP, and 107 percent of export earnings, the lowest levels since 1982 (Chart 15). In sub-Saharan Africa, however, despite some improvement, debt and debt service are still a cause for concern even though debt-servicing ratios are relatively low, and a large portion of debt is concessional and supported by official transfers. In response to these concerns, the World Bank and the IMF are assisting countries to implement appropriate policies and develop strategies in the event of future financial difficulties. For the countries in transition, the growth of debt in 1996 is projected to slow to about 6 percent and to diminish thereafter.13

Chart 15.Developing Countries and Countries in Transition: External Debt and Debt Service1

(In percent of exports of goods and services)

Debt and debt-service ratios are expected to decline in 1996.

1Debt service refers to actual payments of interest on total debt plus actual amortization payments on long-term debt. The projections (blue shaded areas) incorporate the impact of exceptional financing items.

Since the last World Economic Outlook, a number of countries have completed debt and debt-service agreements with commercial banks, and other countries have made substantial progress toward resolving their commercial bank debt problems. Completed agreements as of February 1996 brought total restructured bank debt for 25 countries to $173 billion. In October 1995, Panama completed a debt and debt-service-reduction agreement with commercial banks covering about $2 billion of principal and $1.5 billion of past due interest, and Algeria concluded an agreement to reschedule $3.2 billion of a total of $4.2 billion commercial bank debt outstanding. Peru made further progress in normalizing relations with commercial banks and announced an agreement in principle, and Vietnam and Côte d’Ivoire continued discussions with their commercial bank creditors. Albania, Ethiopia, Nicaragua, and Sierra Leone completed buybacks of commercial bank debt at steep discounts, with support from the World Bank-IDA Debt Reduction Facility. In November 1995, discussions between Russia and the London Club resulted in an agreement to reschedule $25.5 billion of commercial bank debt inherited from the former Soviet Union, and approximately $7 billion in interest arrears. Slovenia and commercial bank creditors reached agreement on the country’s share of the unallocated portion of the former Socialist Federal Republic of Yugoslavia’s debt. A bond exchange for the debt is likely to take place by the end of May 1996.

Paris Club creditors also made progress with debt restructuring under the Naples terms since the last World Economic Outlook. Agreement was reached with Bolivia on a stock-of-debt operation; with Cameroon, Honduras, and Zambia on now reschedulings; and with Gabon on a nonconcessional flow rescheduling. The international financial institutions are continuing to work on finding ways to alleviate the debt problems of the heavily indebted poor countries.

Appendix The Maastricht Convergence Process

On December 16, 1995, at the conclusion of the European Council meeting in Madrid, the member countries of the European Union confirmed that the third and final stage of Economic and Monetary Union will begin on January 1, 1999. They agreed that the Council, meeting at the level of heads of state or government, will decide as early as possible in 1998, on the basis of performance indicators for 1997, which member states fulfill the conditions laid out in the Maastricht Treaty for participation in the monetary union. It was also agreed that the European Central Bank (ECB) will be created early enough (once the decision on stage three is taken) to allow preparations to be completed and full central bank operations to start on January 1, 1999. As stipulated in the Treaty, the primary objective of the European System of Central Banks (ESCB)—the ECB together with national central banks—will be to maintain price stability and, without prejudice to that objective, support the general policy goals of sustainable growth and high levels of employment.

The third stage will start with the irrevocable fixing of exchange rates among the currencies of participating countries and against the Euro—the name chosen for the single currency. For these countries, monetary policy will be formulated and implemented by the ESCB, while the general orientation for foreign exchange policy may be formulated by the Council.14 Monetary and foreign exchange policy decisions will be carried out in Euros and all new tradable public debt will be issued in Euros by the participating member states. Under the changeover scenario to the single currency, it is envisaged that by the start of 2002, at the latest, Euros banknotes and coins will begin to circulate as legal tender alongside national currencies, and that at most six months later (by mid-2002) the national currencies will have been completely replaced by the Euro.

Notwithstanding the strong political commitment to EMU in most member states, it has proven much more difficult than expected to meet the conditions for participation set out in the Treaty. To qualify for the third stage, countries must satisfy convergence criteria for inflation, government budget deficits and debt, long-term interest rates, and exchange rate stability within the ERM. While there has been significant progress in most areas, so far only one country, Luxembourg (which shares a currency with Belgium) is within all the stipulated reference values (Table 8). Others are attempting to comply and most EU countries have at least some chance of qualifying by 1997. However, qualification by a sufficiently large number of countries is by no means assured. Setbacks may result not only from policy slippages but also from adverse economic or financial disturbances beyond the immediate control of governments.

Table 8.European Union: Convergence Indicators for 1995, 1996, and 1997(In percent)
Consumer Price InflationGeneral Government Balance/GDPGross Government Debt/GDP2Long-Term Interest Rates3
19951996199719951996199719971199519961997March 1996
United Kingdom42.82.82.6-5.1-3.8-2.548.849.749.58.1
All EU73.02.62.5-5.1-4.6-3.672.
Maastricht convergence criteria reference range/value2.5-3.33.0-3.33.0-3.4-3.0-3.0-
Sources: National sources; and IMF staff projections.Note: The table shows the convergence indicators mentioned in the Maastricht Treaty, except for the exchange rate criterion. The relevant convergence criteria are (1) consumer price inflation must not exceed that of the three best performing countries by more than 1½ percentage points; (2) interest rates on long-term government securities must not be more than 2 percentage points higher than those in the same three member stales; (3) the financial position must be sustainable. In particular, the general government deficit should be at or below the reference value of 3 percent of GDP. If not, it should have declined substantially and continuously and reached a level close to the reference value, or the excess over the reference value should be temporary and exceptional. The gross debt of general government should be at or below 60 percent of GDP or, if not, the debt ratio should be sufficiently diminishing and approaching the 60 percent reference value at a satisfactory pace. The exchange rate criterion is that the currency must have been held within the normal fluctuation margins of the ERM for two years without a realignment at the initiative of the member state in question.

For the countries whose ability to qualify is in doubt, the most critical obstacle is satisfying the Treaty’s fiscal criterion, which incorporates deficit and debt considerations. Several countries also have difficulties meeting other convergence criteria but tackling the fiscal problems would go a long way toward increasing convergence with respect to inflation and long-term interest rates.15 For countries with fiscal deficits of 3 percent or more of GDP, the Treaty stipulates that the fiscal criterion can still be satisfied if there has been a substantial and continuous decline of the fiscal deficit to a level close to the reference value, or if the excess over the reference value can be considered to be temporary and exceptional. It also stipulates that if the debt-to-GDP ratio is not less than 60 percent, the criterion cart still be satisfied if it is approaching the benchmark at a satisfactory pace. In the annual excessive deficit exercise—which assesses compliance with the Treaty’s fiscal requirements—Ireland’s fiscal imbalance has not been deemed excessive; although the debt ratio is significantly above 60 percent of GDP, it is considered to be falling at a satisfactory pace (the fiscal deficit has been comfortably below 3 percent since 1989).

Over the next two years, the EU member states are expected to intensify their efforts to meet the convergence requirements. Moreover, as reflected in the official targets for fiscal deficits in 1997 shown in Table 8, most member states have declared their intention to go the extra mile to satisfy the fiscal criterion in particular. Given the measures announced so far, further efforts do indeed seem to be required in most cases. In this respect, the recent deterioration in cyclical conditions in much of continental Europe has further complicated the convergence process although by 1997 a number of countries are still projected to be within striking distance of the 3 percent reference value for fiscal deficits.

As discussed earlier in this chapter, there are good reasons to expect growth to pick up in Europe by the second half of 19% and in 1997. On these prospects, the additional effort required to meet the Maastricht criterion in 1997 would seem feasible and worthwhile, especially in certain key cases, given the more general need to strengthen fiscal consolidation in these countries. If activity turns out to be significantly weaker than expected, it would be difficult for many countries to fully meet the fiscal criterion. It would be important in such circumstances that progress in reducing structural budget deficits be sustained even while allowing the automatic stabilizers to cushion activity.

Despite the difficulties in meeting the fiscal deficit criterion, which refers to the actual deficit, the fiscal situation and prospects are somewhat more encouraging on a cyclically adjusted or structural basis (Chart 16). In fact, most of Europe still has not fully recovered from the recessions of 1992–93, and margins of slack—the shortfall of actual from potential output—are likely to remain significant at least through 1996 and possibly longer. Levels of potential output are difficult to measure precisely, partly because of uncertainty regarding the level of unemployment that is consistent with nonaccelerating inflation. Nevertheless, the staff’s assessment is that margins of slack in 1995 may have amounted to roughly 2½ percent of potential GDP in the European Union as a whole. This would imply, on average, a cyclical component in EU countries’ budget deficits of about 1½ percent of GDP, as indicated in the lowest set of bars in the chart. The cyclical components of deficits are likely to widen somewhat in 1996 in those countries that have seen the sharpest slowdowns, especially Germany and France, but should begin to decline in 1997, eventually disappearing with Europe’s assumed recovery in future years.

Chart 16.European Union: General Government Budget Positions1

(In percent of GDP)

Expected progress toward reducing underlying budgetary imbalances is masked to some extent by large cyclical components in fiscal deficits.

Note: The ordering of countries is based on the projected actual budget position in 1997.

1Structural budget positions are not shown for Luxembourg (1995–97) because data are unavailable, and for Finland (1997) because the structural balance is in surplus. Actual budget positions are not shown separately for Ireland (1995–97) because they are about equal to structural deficits, reflecting the high level of resource utilization. The actual budget position for Luxembourg is expected to be in approximate balance in 1996–97.

2Excludes Luxembourg.

The Treaty does not address whether cyclical factors might be considered to justify “exceptional and temporary” excesses from the agreed fiscal reference value. However, although the Treaty seems to allow for some flexibility in interpreting its provisions, the common view is that the 3 percent reference value should be high enough to take account of normal cyclical fluctuations.

The vulnerability of the convergence process to cyclical conditions underscores the need to reduce cyclically adjusted fiscal deficits well below the 3 percent reference value over the medium term. It is therefore encouraging that member states generally have expressed their support, at least in principle, for a Stability Pact along the lines proposed by the German authorities. According to this proposal, the participants in EMU would aim to keep fiscal deficits at no more than 1 percent of GDP in “normal times.”16 To allow automatic stabilizers to operate during cyclical slowdowns, such a rule would imply that government budgets would register moderate surpluses at peaks of the business cycle. The possibility of sanctioning countries with fiscal deficits above 3 percent of GDP through non-interest-bearing deposits and eventually fines is already envisaged in the Maastricht Treaty. A key additional feature of the German proposal is to make such sanctions automatic, unless overridden by a qualified majority of the Council.

The Treaty stipulates that if by the end of 1997 a date has not been set for the start of the third stage, then the third stage will start on January 1, 1999. Some observers, however, have suggested that the starting date for EMU be postponed to give countries more time to meet the fiscal criterion. Even though it seems likely that some of the existing members of the EU would join the monetary union at a later stage, which presumably also would be the case for the potential future member states,17 a postponement is seen by many as likely if only a very small number of countries are considered to qualify by early 1998. Most EU governments, however, have emphasized that there could be serious drawbacks to postponing the starting date since that might lead to a relaxation of convergence efforts and adversely affect financial market confidence.

* * *

From a longer-term perspective—and irrespective of the decision that will be taken in early 1998—achieving a high degree of fiscal discipline is essential for macroeconomic stability, for ensuring reasonable price stability without overburdening monetary policy, and for allowing adequate levels of investment and growth. In addition, fiscal policy in Europe is facing a major challenge because of the potential future pressures on government budgets associated with the aging of Europe’s population (see Chapter III). Fiscal discipline is also necessary to permit a countercyclical role for fiscal policy, at least by allowing automatic stabilizers to operate over the business cycle. In fact, since the exchange rate instrument would no longer be available to help individual member countries adjust in exceptional circumstances, a countercyclical role for fiscal policy may be needed to a greater extent than before. This could be the case particularly in response to adverse disturbances with asymmetric effects across member states, although of course, the incidence of policy-induced asymmetric shocks could well be lower than before. Overall, the success of the monetary union may well hinge on the ability of governments to make binding commitments to appropriate mechanisms for fiscal discipline beyond the test year of 1997.

Both the fiscal outlook and the long-run economic performance of the monetary union will also depend on the success with which countries tackle the many impediments to job creation and job search that characterize European labor markets. Despite some progress in several countries in enhancing labor market flexibility, levels of structural unemployment, particularly among the unskilled and the young, remain much higher in Europe than in most other industrial countries. In response to this problem, many European countries have attempted to lower unemployment through early retirement and work sharing, that is. through reductions in hours worked. However, while there is nothing objectionable in early retirement and reduced working hours freely agreed between employers and employees that exploit the trade-off between income and leisure, there is little evidence to suggest that such measures are likely to reduce unemployment significantly. In fact, because such measures may raise the cost of labor, they are more likely to increase unemployment.

Instead, fundamental reforms are urgently needed in most countries to reduce the gap between wage costs and productivity for the most vulnerable groups, including measures that better achieve social objectives without impeding job creation and job search. As in the case of fiscal discipline, such reforms should not be viewed as policy requirements that are necessary only because of the planned monetary union: they are essential in their own right in order to address the serious problems of unemployment and social exclusion. to enhance the flexibility of wages and prices, to promote greater economic dynamism in the European economies, and to help alleviate fiscal imbalances. Indeed, there are many reasons why economic performance in the monetary union would be much better. and the potential drawbacks associated with the loss of the exchange rate instrument much smaller, if European labor markets were more flexible.

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