Chapter

I Overview

Author(s):
International Monetary Fund. Research Dept.
Published Date:
October 1993
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This year marks the fourth consecutive year of sub-par growth performance for the world economy, and indications of a resumption of stronger growth in 1994 are still tentative (Chart 1). The uncertainty characterizing the short-term prospects is underscored by a further markdown of the output projections for most industrial countries since the May 1993 World Economic Outlook. In Japan, recent indicators suggest that the recovery stalled in the spring; recovery in continental western Europe appears unlikely to begin until late this year or early in 1994; and in North America the expansions are somewhat weaker than expected. Several central European countries appear to have started the process of recovery, but high inflation and excessive budget deficits threaten to prolong the crisis in most countries of the former Soviet Union. Strong growth in many developing countries remains the most positive feature of the global situation, but excess demand pressures in several countries are of concern, as is the continued plight of many of the poorest countries, especially in Africa.

Chart 1.World Indicators1

(In percent)

1 Blue shaded areas indicate IMF staff projections.

2 Excluding trade among states of the former U.S.S.R.

Relatively slow growth of world activity during the period ahead implies that margins of slack are likely to remain large in many countries and that rates of unemployment may increase further, especially in Europe, through much of 1994. Slow growth and weak labor market conditions, in turn, could lead to increased demands for protection and could delay critically needed efforts to reduce large structural budget deficits in many industrial countries; these risks create additional uncertainty. In the countries participating in the European exchange rate mechanism (ERM), slow progress in reducing interest rates to levels appropriate to the weak economic conditions and low or declining inflationary pressures has delayed recovery and could provoke further slippages in fiscal policy, thereby aggravating an already unbalanced policy mix. To break these vicious circles, and as emphasized by the Interim Committee in April, the difficult economic conditions continue to call for a global cooperative effort to bolster confidence and strengthen prospects for a durable, noninflationary world expansion.1

Notwithstanding the near-term uncertainties, developments consistent with the cooperative strategy give some reason for cautious optimism that global economic performance will strengthen gradually. There is growing recognition that the recent large fiscal imbalances in North America and Europe are unsustainable and need to be substantially reduced over the medium term. As measures to strengthen fiscal positions are implemented, continued success in containing inflation in most industrial countries provides scope for monetary policy to provide temporary support to activity. The adoption of significant deficit-reduction measures in the United States already has been favorably received by financial markets. In Europe, commitments to medium-term fiscal consolidation also have been strengthened in several countries, including importantly in Germany. This has contributed to a decline in longterm interest rates and to a new round of reductions in official interest rates, and should facilitate a significant further easing of short-term interest rates in the months to come, without jeopardizing the outlook for inflation. In Japan, implementation of the three fiscal stimulus packages adopted in December 1992 and June 1993, and announced in September 1993, should help to support activity in the second half of this year and in 1994. However, there continues to be scope for flexibility in both the monetary and fiscal areas if economic activity remains weak or weakens further. Finally, new efforts to assist the economies in transition and the poorest developing countries are moving forward.

In the area of trade, unfortunately, progress has been slow. With the Tokyo agreement on market access, chances have improved that the longoverdue conclusion of the Uruguay Round of multilateral trade negotiations may be reached in 1993, but many difficult areas are still to be resolved. Moreover, protectionist pressures remain strong, and there has been little progress in dismantling the managed trade arrangements and other nontariff barriers established in industrial countries over the past decade. A failure to conclude the Round would provide even greater impetus to unilateral solutions to trade disputes, and would undermine the multilateral trading system and prospects for sustained economic recovery.

Industrial Countries

The need for balance sheet adjustments by households, enterprises, and financial institutions following the correction of inflated real estate and other asset prices in the late 1980s has been the distinguishing factor underlying the recessions that began during the 1990-92 period in North America, the United Kingdom, Australia, and several of the Nordic countries, and the subsequent hesitant recoveries in most of these economies. More recently, asset price deflation and ensuing balance sheet adjustments have triggered a downturn in Japan. The experience to date shows that a decisive factor influencing the duration of the adjustment process and its impact on economic activity has been the ability to ease monetary conditions and, thereby, to lower debt-service costs and limit nonperforming assets in the financial system. This, in turn, has depended on inflation remaining subdued and on credible commitments to reduce fiscal deficits. In Europe, exchange rate policies have also constrained the ability of some countries to ease monetary conditions, at least until recently.

Another important force in this business cycle has been the broader economic and financial consequences of German unification and of the policy choices made by European governments to cope with them. Beginning in 1990, large budgetary transfers to the new Lander resulted in a substantial loosening of fiscal policy in Germany and contributed to a severe overheating of the western German economy. The subsequent tightening of monetary conditions needed to reduce inflationary pressures was, not surprisingly, followed by a cyclical downturn. For the rest of Europe, the initial spillover effects of the fiscal expansion in Germany were positive, as witnessed by sharp increases in exports to Germany, and helped to prolong the economic upswing. During the course of 1992, however, the combination of tight monetary conditions in the anchor country and strong commitments to defend exchange rate parities in the ERM began to contribute importantly to the spreading of recessionary tendencies. In some countries, there were already serious underlying problems arising from balance sheet adjustments and unsustainable levels of public debt. The pressure on interest rates added to the difficult economic situation in these countries. Labor market rigidities and a loss of confidence also played a role in the deterioration of economic conditions across Europe.

The growing conflict between the policy mix in Germany, where inflationary pressures remained of concern despite the economic slowdown, and the weak economic conditions in other European countries whose currencies were pegged to the deutsche mark eventually spilled over to foreign exchange markets. By September 1992, the economic and financial tensions, together with uncertainties about ratification of the Maastricht Treaty on economic and monetary union (EMU) and a perception in markets that some currencies were overvalued due to a loss of competitiveness, triggered the first in what became a long series of crises in the European Monetary System (EMS). For some countries, the policy dilemmas posed by the differences in domestic policy requirements diminished somewhat after they decided to float their currencies. However, for the remaining members of the ERM, including those that were forced to realign their currencies, intense pressures against their currencies continued to re-emerge and it became increasingly apparent that the responses to the recurrent episodes of exchange market turmoil were interfering with the ability of economic policy to re-establish conditions compatible with the requirements for economic recovery.

These events culminated in the decision, with effect from August 2, 1993, to widen to 15 percent (from the central parities) the permissible band of exchange rate fluctuations for ERM currencies.2 The wide band should provide greater scope for countries to proceed cautiously with interest rate moves that are warranted by domestic economic conditions, although monetary policies will continue to be constrained by the risk of excessive exchange rate depreciations, which might in some instances undermine price stability. There is also a danger that the wide band might entail a loss of policy credibility that could lead to higher risk premiums for some countries. So far, however, the reaction of markets to the widening of the fluctuation band suggests a perception that monetary conditions outside Germany now are likely to ease somewhat faster and that prospects for recovery have improved. At the same time, the recent behavior of long-term interest rates would seem to indicate little perceived risk of higher inflation.

The widening of the band is seen by the participating countries as a temporary solution. However, in view of the heightened sensitivity of financial markets to perceived tensions or conflicts of interest, a return to a narrow band will require a high degree of convergence of economic performance and of the perceived domestic requirements for monetary policy—conditions that are unlikely to develop until a broad European economic recovery is well established. In the light of recent experience, it would also require greater policy cooperation in both the monetary and fiscal areas than has been feasible so far.

Large fiscal imbalances have severely limited the scope for countercyclical fiscal measures in the recent recessions in Europe and North America and have led to growing concerns in most countries about the sustainability of their fiscal situations. The overall budget shortfall in the industrial countries is expected to reach 4½ percent of GDP in 1993—about the same as the previous record in 1982, when the need to reduce large fiscal imbalances led to the formulation of the medium-term strategy. During 1983-89, some progress was made in reducing fiscal imbalances, but the early 1990s have witnessed a sharp reversal of earlier efforts. The recent deteriorations in fiscal positions have been related in part to the recession, which has reduced tax revenues and raised unemployment compensation and other outlays. Such cyclical effects are normal and constitute an appropriate stabilizing influence, provided that the underlying fiscal situation is sound. Adjustment for cyclical factors, however, shows that structural fiscal imbalances are now at record levels in many countries (Table 1).

Table 1.Major Industrial Countries: Actual and Structural Budget Positions for General Government(In percent of GDP)
ActualStructural
1982-8319891993199519981982-831989199319951998
United States-3.8-1.5-4.1-2.4-2.2-2.6-2.8-3.9-2.3-2.2
Japan1-3.62.50.4-0.5-3.42.21.72.5
[-6.3][-0.7][-3.8][-2.9][-2.4][-6.1][-1.1][-2.2][-1.0][-2.0]
Germany2-3.00.1-4.8-3.0-2.3-1.00.2-3.1-0.9-1.4
France-3.0-1.3-6.0-4.7-2.7-2.9-2.2-3.8-2.5-1.8
Italy-11.0-10.5-10.3-8.0-5.6-9.8-10.6-8.2-5.8-4.1
United Kingdom-2.90.9-8.6-5.8-3.9-1.3-1.5-5.7-4.0-3.2
Canada-6.4-2.9-7.0-4.6-2.1-3.9-5.6-3.5-2.6-1.9
Major industrial countries-4.2-1.2-4.5-2.8-2.3-3.1-2.3-3.3-1.7-1.9
Note: The structural budget position is defined as the actual budget deficit (or surplus) less the effects of cyclical deviations of output from potential output. Because of the margin of uncertainty that attaches to estimates of cyclical gaps and to tax and expenditure elasticities with respect to national income, indicators of structural budget positions should be interpreted as broad orders of magnitude. Moreover, it is important to note that changes in structural budget balances are not necessarily attributable to policy changes but may reflect the built-in momentum of existing expenditure programs.

It is encouraging that governments everywhere acknowledge that the re-emergence or persistence of large budget deficits needs to be addressed as a matter of considerable urgency. A failure to reduce substantially these imbalances over the medium term would likely renew upward pressure on longterm interest rates, reduce capital formation and the scope for new job creation in the private sector, lower the rate of growth of potential output and income, and continue to impede the flexibility of fiscal policy in the event of adverse cyclical developments. Persistence of large deficits also would raise debt-servicing costs, and would add to the difficulties associated with the rising need to support aging populations. Finally, growing doubts about the sustainability of budgetary imbalances could eventually lead to a rise in inflationary expectations and to instability in financial and foreign exchange markets.

As recent experience in several countries shows, early announcement and legislation of credible medium-term deficit-reduction measures have immediate beneficial effects on long-term interest rates and on economic confidence, even when recessionary conditions make it difficult to undertake significant deficit cuts in the short run. As growth begins to recover, implementation of the necessary measures would permit short-term interest rates to follow a lower trajectory than otherwise, which should also help to support activity. As illustrated by policy scenarios in previous issues of the World Economic Outlook, deficit reductions will normally have temporary adverse effects on activity, but such effects are likely to be small and of relatively short duration. By contrast, postponing action to deal with the fiscal imbalances would continue to impede a recovery of confidence.

Several countries already have announced medium-term budget consolidation plans, but in most cases the implied targets are insufficient to permit a significant reduction of outstanding government debt relative to national income, which would be an appropriate objective in view of the sharp increase in public debt during the past ten to fifteen years in most countries. Current deficitreduction plans are also generally inadequate to meet broader economic objectives, in particular to achieve an adequate level of national saving and investment with reasonable external balance, and to meet future demands on budgets associated with aging populations, including considerable unfunded pension liabilities in most countries. To meet these objectives, the structural deficits will need to be substantially reduced, and in some cases it would be appropriate to bring the underlying budget positions into surplus—in sharp contrast to the persistently large structural deficits projected for most countries on the basis of current policies.

In the United States, the adoption of the budget for FY 1994 represented a significant effort to slow the rise in public debt and to reverse the declining trend in national saving and investment. There continue to be mixed signals about the strength of the recovery, but the favorable reception by financial markets of the deficit reduction package, and the associated decline in long-term interest rates (Chart 2), should help to achieve growth of 2½ percent during 1994, which is an acceptable performance in view of the relatively small margin of spare capacity. Recent wage and price data suggest that underlying inflation is likely to remain at or slightly below 3 percent. Although interest rates should be allowed to firm as slack is gradually absorbed in order to avoid any resurgence of inflation, the implementation of measures to reduce the fiscal deficit should permit interest rates to follow a lower path than would otherwise be required.

Chart 2.Major Industrial Countries: Policy-Related Interest Rates and Ten-Year Government Bond Rates

(In percent a year)

Note: End of month, with the following exceptions: the U.S. federal funds rate, Japanese overnight call rate, German repurchase rate, Italian treasury bill rate, and all ten-year government bond rates are monthly averages; and the Canadian bank rate and overnight money market financing rate are for the last Wednesday of each month.

Even with the latest efforts to reduce the deficit, the U.S. budget would still remain in substantial imbalance in the future, with a structural deficit in 1998 of 2 percent of GDP for general government and almost 4 percent of GDP on a unified budget basis excluding social security. Furthermore, in the absence of new measures to contain the growth of mandatory expenditures, there would be a tendency for the deficit to widen further in future years. Additional deficit-reduction efforts, particularly in the context of the prospective reform of the health care system, will therefore be required over the medium term.

The recovery in Canada is expected to gain momentum gradually during 1993 and 1994. With a relatively large margin of slack in the economy and an increasingly credible policy of promoting price stability, output and employment seem poised to grow faster than in other industrial countries during the next few years. Low inflation permitted shortterm interest rates to fall significantly during the recession, but long-term interest rates remain high in real terms, which underlines the need for further efforts to reduce fiscal imbalances. In addition to the cyclical improvement in the budget position as the economy recovers, announced fiscal plans will permit a further reduction of the federal government structural budget deficit to about 1 percent of GDP, and of the general government structural budget deficit to about 2 percent of GDP, by 1998.

In Japan, the principal short-term objective of economic policy is to provide adequate support to domestic demand to permit a sustainable recovery of economic activity. Stronger domestic demand would also help to contain the external surplus. Japan’s past efforts to consolidate its public finances have allowed fiscal policy to be used with some degree of flexibility without jeopardizing credibility. However, the economy has remained weak because of balance sheet problems and the substantial appreciation of the yen during the past year; and more recent indicators suggest that the recovery stalled in the spring. Even with the fiscal stimulus package announced in September 1993, preliminary evaluation by the staff suggests that further actions may well be necessary. Low inflation, the strength of the yen, and the weakness of activity all suggest room for further reduction in the official discount rate. Additional market-opening efforts and other structural reforms—such as further deregulation, efforts to increase the passthrough of yen appreciation to consumers and producers, and changes to land-use policies that would promote residential construction—would help to enhance living standards.

In Europe, where activity is now expected to contract slightly in 1993, it has been apparent for some time that prospects for recovery depend closely on coordinated efforts to establish a more balanced mix between fiscal and monetary policies. Although interest rates have fallen gradually over the past year, further actions to ease monetary conditions across Europe, supported by adequate steps to rein in excessive budget deficits in the medium term and by other confidence-building measures, are clearly necessary to stem recessionary forces and to ensure recovery during 1994. A moderate depreciation of European currencies as a result of a narrowing of interest differentials vis-à-vis North America and Japan should not be resisted.

In Germany, rising economic slack has led to a marked reduction of underlying inflationary pressures, and conditions are now in place for continuing the policy of a gradual, but cumulatively significant, decline in short-term interest rates. The restraining effects of tight monetary conditions have been particularly visible in the export sector because of the spillover effects on demand in Germany’s principal partner countries and because of a loss of competitiveness. Growing slack in the tradable goods sector has helped to reduce wage pressures and points to the likelihood of a significant decline in consumer price inflation in the second half of 1993. In eastern Germany, however, the rapid closing of the wage gap relative to western Germany remains a major concern for employment in the new Lander. Recent budgetary decisions, including the Solidarity Pact, have contributed to a considerable improvement in the fiscal outlook, although vigilance continues to be required to keep expenditure under control and reverse the upward trend in the tax burden. The long-standing need for significant cuts in Germany’s high levels of subsidies provides an opportunity to limit the recourse to tax increases in the process of budget consolidation.

For France, as for other ERM countries, the abatement of tensions in European currency markets during the first half of 1993 permitted a rapid elimination of the large interest differential relative to Germany that had prevailed since the fall of 1992 and that contributed to the recent sharp weakening of activity. For a period, French short-term interest rates fell below those in Germany as low inflation helped to restore confidence in the franc. A reversal of sentiment concerning the franc occurred in July, however, in part because of indications of further weakness of activity in France and in part because of doubts about the speed of interest rate reductions in Germany. The scope for further easing of monetary conditions has improved significantly with the widening of the ERM band, but the need to safeguard progress toward price stability suggests that the authorities should proceed cautiously in order to avoid an excessive depreciation. Efforts to secure a marked reduction of the large budget deficit over the medium term are also essential for the credibility of economic policies. The government’s current deficit-reduction plans would come close to meeting the convergence criterion stipulated in the Maastricht Treaty but will need to be complemented by additional measures in order to further improve the underlying budgetary position.

In the United Kingdom, the lowering of interest rates and the improvement in competitiveness that followed the decision to float the exchange rate last September have helped to turn an incipient recovery into a moderate expansion, while inflation has continued to decline. However, the large fiscal deficit and the weak international environment pose significant risks to the outlook. Although part of the budgetary deterioration since 1989 reflects the large margin of slack in the economy, the structural shortfall has increased sharply—to about 5 percent of GDP in 1993—as public expenditures relative to GDP have risen from 38 percent to 44 percent over the past four years. The structural deficit is projected to decline significantly in 1994-95 because of planned tax increases and expenditure restraint. However, further efforts to reduce the deficit over the medium term will be essential for growth to be sustained at an acceptable pace and for inflationary expectations to continue to moderate.

In Italy, although exports have responded strongly to the improvement in competitiveness following the exit of the lira from the ERM in September 1992, investment has dropped sharply, and overall GDP growth is expected to be only slightly positive in 1993. However, the outlook for inflation and prospects for economic recovery have improved with the new agreement on wage bargaining by the social partners. Despite some success in containing the underlying budget deficit in recent years, there is an urgent need for further corrective action to reduce the deficit in 1994-96. This should go beyond what is needed to meet the government’s newly revised medium-term plan, which would leave the overall deficit close to 6 percent of GDP in 1996. Concrete measures to reduce the deficit, backed up by early legislative action, are needed to further reduce the large risk premium in Italian interest rates.

Among the smaller industrial countries in Europe, Finland and Sweden have experienced particularly large contractions of output, mainly because of balance sheet difficulties that have severely weakened the financial sector; Finland has also been seriously affected by the collapse in trade with the former Soviet Union. The floating of the Swedish krona and the Finnish markka in 1992 has resulted in significant improvements in external competitiveness, which have helped to improve conditions for recovery, but the ability to alleviate the crisis by easing interest rates has been constrained by substantial fiscal imbalances and the risk of rising inflation. In several other European countries, including Belgium, Denmark, and Spain, in particular, EMS-related strains have contributed to their economic slowdowns. Because of the close interdependence of the European countries, activity has also weakened in countries such as Austria, the Netherlands, and Switzerland, whose currencies have not been subject to downward pressure. In contrast to the weakness in Europe, economic recovery has continued in Australia and New Zealand. New Zealand, in particular, has experienced relatively strong growth, following a long period of sluggish activity, as the economy has adjusted to the wide-ranging structural reforms introduced over the past decade.

The weak growth performance in recent years has led to a dramatic worsening of labor market conditions, especially in Europe, where the unemployment rate is projected to exceed 12 percent by the end of 1994. Although the sharp rise in unemployment since 1990 has been largely a result of cyclical developments, slow adjustment and persistence mechanisms may make it difficult to absorb the newly unemployed as growth recovers. Structural unemployment rates, therefore, could increase further from the high levels observed in the 1980s. To improve labor market conditions, an immediate priority must be to ensure that existing imbalances in Europe’s policy mix are corrected; this would help to promote economic recovery and to limit the cyclical component of unemployment. At the same time, it will be necessary to reform eligibility for social insurance schemes and other labor market regulations that hamper job search, wage flexibility, and employment creation. More generally, further efforts are required to reorient government expenditure programs from passive income support to more active labor market policies that emphasize education and training.

The urgency of improving the job outlook is underscored by the pervasive increase in protectionist sentiment in many industrial countries that has accompanied the rise in unemployment since the late 1980s. There is a growing and dangerous perception that protection (including subsidies) may be necessary to insulate the industrial countries from increased international competition—from lowwage countries in the developing world, and among the economies in transition—which is being blamed for job losses and pressures on living standards and social conditions. Such concerns reflect a very short-term view of the effects of competition and overlook the essential role of trade and competitive forces in the growth process of all countries. Protection might help to preserve a few existing jobs in exposed sectors for a while, but experience shows that this would be at the expense of growth and living standards in the economy as a whole in the longer term. It would also substantially reduce growth prospects in the newly liberalizing economies, and hence their demand for industrial country exports. By contrast, remaining open to the competitive pressures from these countries would stimulate productivity and growth in the industrial countries and would permit capital and labor resources in industries with declining market shares to be put to better use in sectors with higher value added. Rather than protection or subsidies, the appropriate response to globalization is to promote the adjustment of industries that face increased competition and to encourage job search, training, and mobility.

Developing Countries

On the basis of continued rapid economic expansion in many developing countries, particularly in Asia and in much of Latin America, aggregate output in the developing world is expected to increase by 6 percent in 1993 and by5½ percent in 1994. The resulting buoyancy of developing country imports—which are projected to rise by 9 percent in both 1993 and 1994 after 10 percent growth in 1991 and 1992—highlights the crucial contribution of these countries to global economic prosperity, especially in view of the recessionary conditions persisting in many industrial countries. But the success of a growing number of developing countries contrasts sharply with the continued plight of many of the poorest countries, in which per capita real incomes have continued to fall and are now lower than they were one or even two decades ago.

The impressive economic performance of the most successful developing countries illustrates both the longer-term benefits of sustained stabilization and reform efforts and the scope for growth to recover when the necessary reforms and a stable macroeconomic environment are in place. In all cases, market forces have increasingly been allowed to allocate resources efficiently, through price liberalization, financial market reforms, outward-oriented trade policies, exchange market unification, and convertibility. The benefits of improved incentive structures have in turn been reinforced by the maintenance or restoration of a stable macroeconomic environment characterized by low fiscal deficits, moderate rates of inflation, positive but low real interest rates, viable external positions, and competitive and stable exchange rates.

The newly industrializing economies in AsiaKorea, Hong Kong, Taiwan Province of China, and Singapore—stand out as particularly successful examples of outward-oriented development strategies. More recently, Indonesia, Malaysia, and Thailand have undertaken significant structural reforms that have boosted potential growth. The improved flexibility of markets has also enabled them to better withstand external shocks, such as the recent slowdown in global activity. In Latin America, many countries, including Chile and Mexico, and, more recently, Argentina, have achieved a reduction in inflation and more rapid growth in recent years following a sea-change in their economic policies that has increased the role of market forces, opened their economies to foreign competition, and led to the privatization of public sector enterprises. In the Middle Eastern region, several countries, in particular Egypt, have also recently put in place significant structural reforms and sound financial policies, which have improved their growth prospects considerably. Finally, in sub-Saharan Africa, the 16 countries that are pursuing comprehensive adjustment and stabilization policies supported by the enhanced structural adjustment facility (ESAF) have maintained growth at 4½ percent in 1993 and are expected to continue to expand at a similar rate in 1994 despite the difficult international environment.

India is a recent example of how strong adjustment policies and timely international financial support can dramatically improve economic performance. Only two years ago, the country was in the midst of a balance of payments crisis with foreign exchange reserves nearly depleted; inflation—traditionally low—was rising steadily; and output was starting to fall because of a severe import squeeze and sharply declining exports to the former Soviet Union. As in many other countries, the roots of the crisis in India lay in the interaction of longstanding structural rigidities and rising demand pressures stemming from excessive fiscal expansion. As a result of a major stabilization effort centered on fiscal consolidation and a reorientation of economic policies away from four decades of heavy state intervention, together with substantial financial support from bilateral donors and multilateral financial institutions, the economic situation has now been dramatically reversed: inflation has been reduced from a peak of nearly 17 percent in August 1991 to a current rate of less than 6 percent, growth has recovered from about 1 percent in 1991/92 to an estimated 4 to 5 percent in 1992/93 and 1993/94; foreign exchange reserves have been rebuilt; and public confidence and macroeconomic stability have been firmly re-established.

A critical lesson from the experience of the developing countries is the need for high rates of domestic saving—which on average finance 95 percent of investment in the developing world—in combination with policies that ensure an adequate rate of return on domestic investments. When these conditions are not met, there is a substantial risk that reliance on external financing to attempt to accelerate growth will prove unsuccessful—as illustrated by the painful adjustment process in many countries following the unsustainable buildup of foreign debt in the 1970s and early 1980s. For many of these countries, debt restructuring and restoration of external viability have been important factors behind the recent strengthening of their growth performance and their return to external creditworthiness. More recently, some countries have experienced substantial inflows of foreign capital. Such inflows are generally a positive sign of renewed confidence and will provide an important boost to longer-term growth provided that they finance productive investment. Conditions for making good use of the capital inflows have improved substantially in many cases, but in light of earlier experience a cautious attitude is clearly warranted in order to avoid the buildup of undue demand pressures and to ensure a sustained inflow of private capital.

Demand pressure, albeit largely because of domestic developments, has become a particular concern in China, where the dynamism of the economy has generated double-digit growth since early 1992 in the wake of the authorities’ decision to accelerate the reform process. Unfortunately, excessive credit expansion has recently contributed to the emergence of macroeconomic imbalances, evidenced by a sharp increase in inflation, growing shortages and bottlenecks in critical areas, and a marked weakening of the external position and of the exchange rate. To reduce demand pressures, the authorities have already implemented some measures, including increases in interest rates. The key policy question is how to bring sufficient restraint to bear on domestic demand in a way that does not compromise the reform process and that thereby sustains the remarkably successful transformation of the Chinese economy.

Although the debt-related difficulties of the 1980s have been substantially reduced for a large number of middle-income countries, the debt problems of many of the poorest countries, particularly in Africa, remain acute. Concessional official lending, successive reschedulings, and forgiveness of part of the debt have helped to alleviate the most acute liquidity constraints. But the magnitude of the external debt of these countries has remained an overwhelming obstacle both to private capital inflows and to increased domestic saving and investment. Many low-income countries have embarked on significant reform efforts, which have begun to show some positive results even though vulnerability to adverse disturbances such as drought, political upheaval, and weak commodity prices has made success elusive in many cases. In addition to improvements in governance and sustained reform and stabilization policies, supported by adequate levels of technical and financial development assistance, the international community must stand ready to increase its efforts to assist the poorest countries through the implementation of substantial official debt relief under existing debt-reduction schemes as well as through new concessional lending. An important element of this assistance is to put in place the successor to the ESAF on a timely basis.

Countries in Transition

In several of the central European countriesincluding Albania, the Czech Republic, Hungary, and Poland—there are promising signs that output is responding to the liberalization of the economic system and to the relatively stable macroeconomic environment. In these countries, most smaller enterprises have now been privatized, and obstacles to the creation of new enterprises have been substantially removed. Transformation and privatization of large enterprises have proved to be more difficult than anticipated, especially in Hungary and Poland, and budgetary pressures remain a threat to the attainment of satisfactory rates of growth over the medium term. Slovakia, Slovenia, and the Baltic countries have also made progress toward stabilization, which is critical for the success of their reform programs.

In Russia and most other states of the former Soviet Union, with the notable exception of the Baltic countries, the lack of financial stability remains a critical obstacle both to sustained growth and to the transformation process. Large budgetary subsidies and excessive credit expansion (much of it directed to specific sectors, regions, or enterprises) have fueled rapid inflation, distorted economic incentives, and delayed the crucial restructuring of the enterprise sector. Privatization of smaller enterprises is well advanced in Russia and some of the other countries, but most large enterprises are still in urgent need of privatization and transformation. The key to successful restructuring will be improvements to the incentive structure through the elimination of remaining price distortions, sharp cuts in all forms of subsidies, restraint on credit expansion, and increased responsiveness of enterprise managers to market forces and new owners. In addition, it will be necessary for governments to take over at least part of the extensive social functions of the larger enterprises.

Efforts by the Russian authorities to strengthen stabilization policies, supported by the IMF’s new systemic transformation facility (STF), led to a strengthening of the ruble in foreign exchange markets and to a substantial accumulation of official foreign exchange reserves in June-July 1993. But much remains to be done to achieve a substantial decline in inflation and reduction of Russia’s large budget deficit during the period ahead. The Kyrgyz Republic had earlier drawn on the STF in conjunction with an IMF stand-by arrangement. Several other transition countries, including Kazakhstan, Belarus, and Moldova (and Slovakia among the central European countries) have also drawn on the STF, and other countries raay do so in the near future.3 By contrast, in Ukraine and some of the other states of the former Soviet Union, conditions for the use of IMF resources have not yet been established.

In addition to the need for strengthened stabilization policies in the reforming countries—and for cooperation among them to resolve common trade, monetary, and payments issues—the international community must continue to provide support for the transformation process. For all of these countries, access to foreign markets is vital. Technical and financial assistance from multilateral institutions and bilateral donors to support the development of the basic institutions of economic management and to promote enterprise reform, including conversion of defense industries, is also a high priority, as underscored by the recent decision by the major industrial countries to establish a privatization fund in Russia. It will be important not to lose sight of the problems of the other countries of the former Soviet Union, which will become increasingly acute as Russia and other energy producers among them move toward world market prices for energy. Developments in these countries also will have a direct impact on the economic and balance of payments prospects of Russia.

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