Chapter

II The World Economy in 1995–96

Author(s):
International Monetary Fund. Research Dept.
Published Date:
October 1995
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Developments in financial markets during the past eighteen months and signs of a softening of growth in the industrial countries since the beginning of 1995 have highlighted the sensitivity of financial markets to economic imbalances and the downside risks to the outlook. However, although economic performance has been adversely affected in some countries, there are many reasons to expect that the global economic expansion will proceed at a satisfactory pace. Fears of a pickup in inflation in the industrial countries have largely abated, long-term interest rates have again fallen substantially in most countries following the sharp increases in bond yields during 1994, coordinated foreign exchange market intervention by leading central banks and supportive policy developments have helped to correct the misalignment of key currencies that had emerged earlier in the year, contagion effects from the financial crisis in Mexico have been contained, and growth in most of the emerging market countries in the developing world and among the transition countries has remained robust. While the short-term projections for the industrial countries have been marked down somewhat, the forecasts for many developing countries are now even stronger than expected in the May 1995 World Economic Outlook (see Table 1).

Notwithstanding the staff’s relatively optimistic baseline projections, which are based on a number of positive policy developments, there are still downside risks to both the near-term and medium-term outlook. These risks derive partly from policy weaknesses in many industrial countries that may provoke renewed turbulence in financial markets. Among the developing countries, rapid growth and difficulties in managing capital inflows pose risks of overheating in many economies. And the prospects for sustained economic growth in many transition countries are tempered by possible setbacks in stabilization efforts related partly to the fragility of their financial systems. The policy requirements to address these risks are discussed in the following chapters.

Economic Activity

A broad range of indicators seem to indicate a slowing of demand and activity in the industrial countries since the beginning of 1995. With the important exception of Japan, however, there are few signs of recession, suggesting that the slowdown represents a midcycle pause. Such a pause will help to prevent overheating in those countries that are most advanced in the economic cycle, and hence should help to prolong the expansion. But there also seems to be some softening of activity in continental Europe, where the expansion began more recently, even though the underlying growth momentum still appears to be quite strong.

The moderation of growth in the industrial countries has been reflected in a stagnant industrial output in the major industrial countries as a group during the first half of 1995. A marked decline in real commodity prices also indicates a slowdown in demand. And various leading or coincident indicators, including consumer confidence, business expectations, and real money growth (which has been slightly negative in most of the major industrial countries since the beginning of the year), suggest that the growth pause extended into the second, and possibly even into the third, quarter of 1995 (Charts 2 and 3). Quarterly GDP statistics confirm that growth was particularly weak in Japan and Canada in the first half of the year and that the other major countries also experienced a slowdown.

Chart 2.Selected Industrial Countries: Output Growth and Leading Economic Indicators1

(Percent change from previous year)

In early 1995, leading indicators were signaling declines in output growth in the United Suites and continental Europe.

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

1 The leading economic indicators are composite indices of variables that lead cyclical activity in the economy. 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.

Chart 3.Industrial Countries: Indicators of Consumer Confidence1

Consumer confidence has weakened but remains relatively high.

Sources: For the United States and Canada, the Conference Board; for Japan, Economic Planning Agency; and the European Commission.

1 Indicators are not comparable across countries.

2Quarterly observations.

3Values above 50 indicate that respondents, on average, expect an improvement in their economic situation; values below 50 indicate an expected deterioration.

4Percent of respondents expecting an improvement in their situation minus percent expecting a deterioration.

The reasons for the apparent slowdown include both common and country-specific factors. The run-up in long-term interest rates worldwide during 1994, which reinforced the effects of pre-emptive monetary tightenings in a number of countries that had reached high levels of capacity utilization, has probably been a key factor in affecting consumer confidence and restraining both consumption and residential investment. Generally low real wage growth and tax increases in some countries have also acted to restrain private consumption. Other factors include the spillover effects of the Mexican crisis on major trading partners, especially the United States, and the adverse effects of exchange rate appreciations on export prospects in Germany. Switzerland, and especially Japan. In Japan, the excessive strength of the yen in the first half of the year and the Kobe earthquake have compounded the difficulties that began with the collapse of the asset price bubble in the early 1990s.

Looking ahead to 1996, private consumption growth is expected to remain relatively moderate in most countries. Moreover, public consumption is likely to expand only marginally in the industrial countries overall, as efforts continue to control the growth of public expenditure. In contrast, the strength of investment intention surveys is extremely encouraging, suggesting that business investment should generally remain by far the most buoyant component of overall demand. High rates of capacity utilization in some countries, generally solid profits in recent years (Chart 4), continued restructuring under the pressure of global competition, and high levels of foreign direct investment should all contribute to raise overall investment levels and to stimulate rapid growth of trade in capital goods. Japan is the only country where private domestic investment is expected to be relatively weak, whereas outward foreign direct investment is likely to continue at a high level as Japanese producers adjust to the strong yen by shifting production to other countries, especially in Asia.

Chart 4.Industrial Countries: Indicators of Business Sector Profitability

Profit shares and rates of return in the industrial countries in 1994 were the highest in twenty years.

Source: OECD, Economic Outlook data base.

Note: The data underlying these indicators are adjusted for the imputation of wage component of the self-employed.

Turning to the outlook for individual countries, in the United States, following unsustainably rapid growth during 1994, the economy reached very high levels of resource use by early 1995. Although price increases remained moderate, the strains on labor markets and on capacity were threatening to boost inflation, which would ultimately have required a serious slowdown or even a recession to unwind the inflationary pressures. To prevent this, the Federal Reserve gradually tightened monetary conditions during 1994, setting the stage for a “soft landing” (Chart 5). This strategy clearly proved successful, even though activity appears to have slowed somewhat more than expected in the May 1995 World Economic Outlook, partly due to the decline in exports to Mexico and the rise in long-term interest rates during 1994, But the reversal of the rise in long-term interest rates since early 1995 should provide stimulus to activity during the period ahead. The risk of a rise in inflation has diminished, but it has not gone away completely and overall resource use remains close to, if not above, the level consistent with noninflationary growth. It seems unlikely that a further easing of monetary policy—beyond the small cut in the federal funds rate on July 6—will be warranted.

Chart 5.Three Major Industrial Countries: Policy-Related Interest Rates and Ten-Year Government Bond Rates1

(In percent a year)

Contrasting movements in policy-related interest rates reflect different cyclical positions.

1 The 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 the United Kingdom, Canada, and Australia, the business cycles remain closely synchronized with that of the United States (Table 2). All three countries have experienced a slowdown in key indicators since the start of the year, partly under the influence of significant increases in interest rates during 1994. Relatively weak exchange rates and buoyant export growth have helped to support activity in the United Kingdom and Canada, but rising import prices and producer prices have been threatening to spill over into broader indicators of inflation. Some moderation of growth in these countries was desirable following the rapid pace of expansion in 1994. However, should activity weaken more than expected, monetary policy would be faced with a dilemma, notably in Canada where the exchange rate has been weak and further depreciation would add to inflationary pressures. In both Canada and Australia, large external deficits underscore the need to raise domestic saving, especially through a lightening of fiscal policy. In the United Kingdom, unemployment has fallen to the lowest level since 1991, but wage increases have remained moderate and there still appears to be some margin of slack in the economy. Continued implementation of the authorities’ commitments to reduce budget deficits and keep inflation low should reduce premiums on interest rates and the exchange rate and permit sustained growth over the medium term. In New Zealand, economic activity began to slow to a more sustainable rate in late 1994; however, the economy is still operating close to capacity. The fiscal position has strengthened markedly and the structural budget balance is now in sizable surplus, but financial policies need to remain sufficiently tight to forestall the buildup of inflationary and balance of payments pressures.

Table 2.Industrial Countries: Real GDP, Consumer Prices, and Unemployment Rates(Animal percent change and percent of labor force)
Real GDPConsumer PricesUnemployment Rates
199319941995199619931994199519961993199419951996
Industrial countries1.13.12.52.42.92.32.52.58.18.17.67.5
Major industrial countries1.33.12.42.32.82.22.42.47.37.26.86.8
United States13.14.12.92.03.02.63.03.26.86.15.75.9
Japan-0.20.50.52.21.30.7-0.20.12.52.93.13.2
Germany2-1.22.92.62.94.52.71.81.78.89.69.18.7
France-1.52.92.92.72.11.72.12.311.612.411.711.0
Italy-1.22.23.02.84.54.05.44.010.411.311.210.5
United Kingdom12.23.82.72.93.02.42.93.010.39.38.38.1
Canada2.24.62.22.71.80.22.12.011.210.49.79.4
Other industrial countries0.22.93.23.03.73.23.53.012.212.511.811.2
Spain-1.22.03.23.24.64.74.83.722.724.223.122.0
Netherlands0.42.53.32.42.62.72.32.27.78.78.68.5
Belgium-1.72.42.52.52.82.41.72.09.510.39.89.4
Sweden-2.62.22.52.64.62.23.23.48.28.07.36.9
Austria-0.12.72.82.53.63.02.72.54.24.44.24.2
Denmark1.54.43.32.51.22.02.33.012.312.110.09.7
Finland-1.63.95.24.62.21.11.42.517.918.416.814.7
Greece-0.51.51.92.314.510.99.37.49.79.69.59.3
Portugal-1.21.02.83.26.55.24.23.75.56.87.06.6
Ireland4.05.26.24.91.42.52.52.515.714.813.813.5
Luxembourg2.8283.03.33.62.32.22.32.12.83.02.6
Switzerland-0.91.21.52.03.30.91.91.74.64.84.34.0
Norway2.35.15.03.52.31.42.52.26.05.45.04.5
Iceland1.12.83.02.64.11.62.52.54.44.84.54.3
Australia3.95.43.83.61.81.94.53.410.99.78.47.6
New Zealand35.04.32.23.21.71.82.31.39.27.46.56.3
Memorandum
European Union-0.62.82.92.83.83.03.12.811.111.611.010.4

In Germany, the appreciation of the deutsche mark in the first half of the year has led to some downward revision of near-term growth expectations following stronger-than-expected growth in 1994. Investment intentions are still buoyant, however, in both the eastern and western Lander, and continued rapid productivity growth in manufacturing should help to offset the adverse effects of exchange rate appreciation on export growth. Although good progress toward fiscal consolidation will again dampen private consumption in 1995, planned tax reductions will contribute to raise real disposable incomes in 1996. Official interest rates were eased in March and again in August 1995 in response to the weakness of monetary indicators and the strength of the currency; low inflation and continued weak growth of M3 provide room for a further easing in support of the recovery should this prove warranted.

France has also felt the impact of exchange market tensions and again raised short-term money market rates substantially in the spring of 1995 to counter speculative pressures on the franc. More recently, these pressures have abated, the franc has strengthened against the deutsche mark to near its central parity, and interest rates have fallen significantly. With export demand remaining strong, the economy is not expected to be seriously affected by the earlier tensions. While some economic indicators weakened in early 1995, consumer confidence strengthened significantly in the second quarter. Unemployment is expected to decline only slowly, however, and wage increases are assumed to remain moderate. Inflation is projected to remain among the lowest in the industrial countries, which should provide scope for a further easing of monetary conditions should conditions in exchange markets allow. This will partly depend on the prospects for fiscal consolidation.

In Italy and Sweden, growth seems to have been well sustained, at least into the early part of 1995. Although domestic demand is being restrained by very high real interest sates, the competitive positions of both countries have improved sharply with the large depreciations of their currencies since 1992, which continued into the spring of 1995. The resulting boom in exports is providing welcome support for activity, but inflationary pressures have increased as rising import prices and producer prices are affecting consumer prices and inflation expectations. Both countries have therefore had to tighten monetary conditions quite early in the expansion. This should help to contain inflationary pressures although it puts at risk the prospects for a more balanced economic expansion, Progressive cuts in fiscal deficits, under way in both countries, are necessary to improve confidence in financial markets and to alleviate risks to their economic recoveries.

In Austria, Belgium. Denmark, and the Netherlands, growth is expected to remain relatively strong in 1995, although exports will be adversely affected by the effective appreciation of their currencies in the early part of the year. The strength of their currencies will also act as a brake on inflation, but inflationary pressures are nevertheless expected to increase somewhat in Denmark as the output gap narrows. Denmark’s fiscal balance is expected to improve in 1995 and 1996 as the government reverses fiscal stimulus introduced to support the economy in 1994. In Switzerland, the franc appreciated against the U.S. dollar even more sharply than the deutsche mark in the first half of the year. The appreciation will restrain exports and dampen growth somewhat in 1995–96. Official and market interest rates have eased in recent months, which should help sustain activity without undermining inflation objectives. In Spain and Portugal, the economic recovery is also expected to continue at a moderate pace. Domestic demand has begun to supplement exports in supporting the upswing. Unemployment remains exceptionally high in Spain but should gradually decline this year and next as labor market reforms contribute to employment growth. The genera) government budget deficit declined in 1994 and is expected to decline further in 1995 to 5.9 percent of GDP. The 1996 budget will need to include substantive measures to reduce the deficit to 4.4 percent of GDP in 1996, which is the objective set in the government’s Maastricht convergence plan.

Growth has been particularly buoyant in Ireland and, more recently, in Finland, and is expected to remain vigorous in both countries in 1995 and 1996. In Ireland, inflation has been well contained following the depreciation of the Irish pound in 1992, and the external position has strengthened considerably: the fiscal deficit has been kept below the Maastricht ceiling and progress has also been good in reducing the high level of public debt relative to GDP Finland’s fiscal consolidation plans have been well received by financial markets. This has allowed the markka to appreciate, relieving pressure on monetary policy and helping to contain inflation.

The Japanese economy has yet to show convincing signs of recovery from the deep and protracted downturn that began in late 1991. The estimated gap between potential and actual output has now widened to almost 6 percent (Chart 6). Open unemployment, although still low by the standards of other countries, is at a record high and threatens to rise further in the absence of a strong recovery. The persistent weakness of activity is due to the combined effects of sluggish domestic demand, which is affected by the balance sheet difficulties that arose after the bursting of the asset price bubble, the overhang of excess capital stocks, and the strength of the exchange rate. The sharp appreciation of the yen during the first half of 1995 threatened to set back further the prospects for recovery. However, the subsequent depreciation of the yen to levels closer to those implied by economic fundamentals and the rise in equity prices have strengthened the prospects for a pickup in growth in 1996. Both fiscal and monetary policies have been eased substantially to support activity, and the authorities have recently taken additional action that increases the chances of recovery.

Chart 6.Major Industrial Countries: Output Gaps1

(Actual less potential, as a percent of potential)

Output gaps continue to narrow in the major industrial countries except in Japan, where the gap is expected to widen further.

1 Blue shaded areas indicate IMF staff projections. The gap estimates are subject to a significant margin of uncertainly. For a discussion of the approach to calculating potential output, see the October 1993 World Economic Outlook, p. 101.

2Data through 1990 apply to west Germany only.

Among the developing countries, the repercussions of the financial crisis in Mexico have been successfully contained in all but a few cases. In the Western Hemisphere, although growth is expected to slow in 1995 (Table 3) before picking up to 4 percent in 1996, the projections have been revised up for several countries compared with the May 1995 World Economic Outlook. In Mexico, however, output is estimated to fall by 5 percent this year as a result of necessary economic adjustments; but growth is expected to resume in 1996 as the bulk of the adjustment is completed and macroeconomic stability is achieved. In Argentina, which has been most affected by the Mexican crisis, growth is expected to slow in 1995–96 following a sharp decline in capital inflows and a tightening of fiscal policy that was necessary to restore confidence. In Brazil, by contrast, output growth so far in 1995 has been stronger than expected as a result of the positive effects on real incomes of the successful stabilization program. The authorities, however, face the challenge of avoiding overheating and containing the balance of payments deficit at a sustainable level. Chile and Colombia have been less affected by the Mexican financial crisis and are expected to experience robust output growth in 1995 and 1996. In Venezuela, output is expected to begin to turn around in 1995 after three consecutive years of contraction associated with a severe domestic financial crisis and inappropriate policies.

Table 3.Selected Developing Countries: Real GDP and Consumer Prices(Annual percent change)
Real GDPConsumer Prices
199319941995199319941995
Developing countries6.16.26.043.148.119.5
Median3.43.54.48.511.58.0
Africa0.82.63.027.932.920.8
Algeria-2.2-0.23.029.022.56.4
Cameroon-2.2-3.83.3-3.712.726.7
Côte d’Ivoire-0.81.76.42.126.08.0
Ghana5.03.85.025.024.928.9
Kenya-0.63.24.946.028.83.2
Morocco-1.111.5-5.15.25.17.0
Nigeria2.31.33.357.257.058.3
South Africa1.12.33.09.79.09.9
Sudan7.65.57.2111.5102.058.5
Tanzania3.73.14.526.129.022.0
Tunisia2.33.44.24.04.75.5
Uganda5.510.06.56.56.15.0
SAF/ESAF countries10.73:4.916.324.310.6
Asia8.78.58.79.413.512.0
Bangladesh4.94.44.91.63.24.2
China13.711.511.413.021.718.0
Hong Kong5.85.75.78.58.08.5
India3.74.95.58.110.29.5
Indonesia6.57.37.59.78.59.6
Korea5.38.49.74.86.35.0
Malaysia8.38.78.53.63.74.6
Pakistan2.53.95.110.512.813.5
Philippines2.14.35.37.69.17.1
Taiwan Province of China6.16.56.92.94.13.9
Thailand8.28.58.43.35.06.0
Vietnam8.18.59.05.214.514.5
Middle East and Europe3.60.32.424.532.325.3
Egypt1.51.31.512.08.17.5
Iran, Islamic Republic of2.31.63.022.935.230.0
Israel3.56.55.010.912.310.2
Jordan5.85.76.13.33.64.5
Kuwait29.31.1-0.3-1.24.76.1
Saudi Arabia-0.5-0.10.50.80.62.2
Turkey7.5-5.53.266.1106.372.5
Western Hemisphere3.34.61.8212.2226.738.2
Argentina6.07.40.510.64.33.6
Brazil24.35.75.12,103.32,407.6
Chile6.34.27.012.711.48.0
Colombia5.35.75.322.422.620.0
Dominican Republic3.04.34.05.28.310.5
Ecuador2.04.02.045.027.318.8
Guatemala3.94.03.013.412.58.2
Mexico0.63.5-5.09.87.031.0
Peru6.512.96.548.623.710.8
Uruguay2.55.11.154.144.740.2
Venezuela-0.4-3.30.538.160.860.0

Average growth in the developing countries in Asia is expected to exceed 8 percent in 1995 for the fourth year in a row. This is providing a welcome offset to the weakness in Japan, but there are concerns that continued growth at unsustainable rates would heighten inflationary pressures. In China, growth in industrial production slowed to an annual rate of around 17 percent in the first quarter of 1995 after increases in excess of 20 percent in the second half of 1994. But export growth and foreign direct investment remain stronger than expected, and overheating is still a cause for concern. Real GDP growth is expected to moderate to single-digit levels only in 1996, The recovery in India is now firmly established, partly reflecting the supply response to structural reforms as well as the stimulus from capital inflows. Output is expected to increase by 5½ percent in 1995, as export volumes continue to grow at double-digit rates and as private investment remains robust. Further fiscal consolidation will be necessary to ensure adequate resources for private investment and thus allow faster growth to be sustained. Economic growth in Korea is expected to pick up to 9¾ percent in 1995 driven by strong export growth and investment, with the export sector benefiting from gains in competitiveness against the yen. The strength of activity in Indonesia is supported by buoyant domestic demand, whereas the contribution from net exports is expected to remain negative. The boom in private investment is likely to be sustained by recent deregulation measures, lit Malaysia and Thailand, the strong expansion of domestic demand and large capital inflows have also led to widening current account deficits despite impressive export growth: inflationary pressures appear to be intensifying in both countries. The Philippine economy performed better than expected in 1994 and appears to be on the way to recovery following the implementation of a successful stabilization program.

Growth in the Middle East and Europe region is expected to strengthen somewhat in 1995 and 1996. mainly because of improved prospects in several countries that have experienced significant difficulties recently. The recent weakening of oil prices, however, is likely to have adverse effects on the oil exporting countries in the region. Although demand for oil has increased in line with world economic growth since the beginning of the year, most of the increase in demand has been met by non-OPEC (Organization of Petroleum Exporting Countries) producers. In Egypt, despite progress in reducing the budget deficit and inflation, there has been some slippage in macroeconomic policies. The objective of maintaining a de facto peg to the U.S. dollar has resulted in a loss of competitiveness that is hampering growth. Real GDP is expected to rise by only 1½ percent in 1995 but could expand more in 1996 subject to progress with reforms. In the Islamic Republic of Iran, the economic situation remains difficult, but growth is expected to pick up somewhat in 1995. In Saudi Arabia, the government is planning to cut the fiscal deficit to between 2 percent and 3 percent of GDP and little growth is expected during 1995–96. Turkey is gradually emerging from a protracted crisis caused by overheating and an abrupt loss of confidence. Output declined by 5½ percent last year, but the current account went into surplus as imports fell sharply and competitiveness improved. Growth is expected to begin to recover during 1995–96. although high inflation continues to cloud the outlook.

Africa’s economic prospects have improved in recent years as a strengthening of economic policies in a number of countries has fostered greater macroeconomic stability. The projected increase in growth in 1995–96, however, remains subject to risks of policy slippages. In South Africa, economic activity is expected to pick up during the period ahead, reflecting increased private investment and strengthening consumer and business confidence. Nevertheless, unemployment is expected to remain very high in the foreseeable future. In Nigeria, political uncertainties contributed to a deterioration of the economic and financial situation in 1994. A recovery of oil production, and continued light fiscal policy, underlies the envisaged recovery during 1995–96. In Morocco, a return of drought conditions is expected to adversely affect agricultural production and economic activity. In Algeria, economic activity is expected to strengthen as the reform process continues. Growth in Kenya has been boosted by favorable weather and an expansion of exports and tourism receipts. In Uganda, economic activity has been stronger than anticipated, in part due to prudent financial policies. Growth is expected to be sustained at a relatively rapid pace, although the economy remains fragile and vulnerable to negative shocks.

In many countries of the CFA franc zone, the positive effects of the currency adjustment in early 1994 and the associated macroeconomic and structural policies are now beginning to be visible. Economic activity has picked up and growth in the CFA franc zone is expected to average 5 percent in 1995–96, supported by healthy growth of both investment and exports. In Côte d’lvoire, for example, output growth is expected to reach 6½ percent in 1995, An export-led recovery in Cameroon is also under way. For the African countries that had arrangements at the end of 1994 under the IMF’s structural adjustment facility (SAF) or enhanced structural adjustment facility (ESAF), growth is expected to be sustained at a relatively robust pace of about 5 percent in 1995–96.

Among the former centrally planned economies, recorded output is now expanding in those countries that achieved financial stabilization early on in their transition. During 1995. growth in Albania. Croatia, the Czech Republic, Estonia, Lithuania, Poland, the Slovak Republic, and Slovenia is expected to reach or exceed 4 percent (Table 4). In some of these countries, strong growth has reversed the sharp increase in open unemployment characteristic of the earlier stages of the transition. Despite their slow start in achieving financial stabilization, measured output is also expected to increase during 1995 in Armenia, Bulgaria, the Kyrgyz Republic, Moldova (subject to harvest conditions), and Romania. In Russia, signs of a recovery in output are now visible with recent increases in industrial production; however, output is expected to decline overall for 1995, by about 4 percent. Continued declines in activity are expected in countries where progress toward stabilization remains fragile, including Belarus, Ukraine, and most countries of central Asia and the Transcaucasus. The reasons for the differences in economic performance among the transition countries are discussed in detail in Chapter V.

Table 4.Countries in Transition: Real GDP and Consumer Prices(Annual percent change)
Real GDPConsumer Prices
199319941995199319941995
Countries in transition-9.1-9.5-2.1675301148
Median-10.3-1.01.768620753
Central and eastern Europe-6.1-3.80.2459203116
Excluding Belarus and Ukraine-1.92.84.01398764
Albania9.69.47.885239
Belarus-10.6-20.2-13.81.1882.220737
Bulgaria-2.41.42.3739662
Croatia-3.70.85.01.516972
Czech Republic-0.92.64.021109
Estonia-6.66.06.0894326
Hungary-0.82.01.2221929
Latvia-14.81.90.41093625
Lithuania-24.21.75.34107236
Macedonia, former Yugoslav Rep. of-15.5-7.20.82485518
Moldova-8.7-22.11.583711130
Poland3.86.05.5353229
Romania1.33.54.525613734
Slovak Republic-4.14.85.0231310
Slovenia1.35.04.5322013
Ukraine-16.8-23.7-10.34,735891329
Russia-12.0-15.0-4.3896302181
Transcaucasus and central Asia-11.2-16.2-5.91.2411.583214
Armenia-14.15.35.13,7325,273185
Azerbaijan-23.1-22.0-8.71.1301.664464
Georgia-39.2-35.0-5.03,4217,380163
Kazakhstan-12.0-25.0-11.01,6621,880165
Kyrgyz Republic-16.0-26.52.01.20927844
Mongolia-3.02.13.52688828
Tajikistan-11.1-21.4-19.52,195350389
Turkmenistan-10.0-20.0-1.03,1022.611226
Uzbekistan-2.4-3.4-4.05341,433273

Inflation and Commodity Prices

The aggregate inflation projections for the industrial countries have been revised down slightly, which is consistent with the revisions to demand and activity, and inflation is generally expected to remain well under control in 1995 and 1996. Nevertheless, there are some indications of an increase in inflationary pressures, especially at the producer level (Chart 7). Countries that have experienced significant exchange rate depreciations in recent years are encountering the greatest difficulties in preserving the momentum of disinflation and in meeting stated inflation objectives.3

Chart 7.Selected Industrial Countries: Producer Prices1

(Percent change from previous year)

Producer prices indicate an increase in inflationary pressures. especially in countries with depreciating currencies.

1 Manufacturing output price (United Kingdom); wholesale prices (Japan, Germany, and Spain); finished goods (United States).

Several factors, however, suggest that inflation in most industrial countries is unlikely to pick up much during the current expansion. Most important, the tightenings of monetary policy in countries where slack was being rapidly absorbed during 1994 have pre-empted potential inflationary pressures. This has demonstrated the strong commitment of monetary authorities to reasonable price stability, thereby helping to strengthen the credibility of monetary policy and reducing inflation expectations. Low inflation expectations are reflected both in the fall in long-term interest rates since early 1995 and in continued moderate wage cost pressures in most countries. More flexible labor markets may be contributing to wage moderation in some countries. The continued rapid growth of international trade and increased global competition should also help to alleviate inflationary pressures. And relatively comfortable profit margins should provide some buffer for unforeseen cost increases. While there is no place for complacency about inflation, the maintenance of reasonable price stability in most industrial countries is particularly encouraging and bodes well for the future.

In the United States, intermediate and raw materials price inflation picked up somewhat during 1994: however, moderate wage increases and the slow growth of employee benefits have helped to contain the rise in overall inflation. While consumer prices are projected to increase by 3 percent in 1995, the continued high level of resource use is expected to raise the inflation rate slightly to 3¼ A percent in 1996. In Europe, partly under the influence of exchange rate appreciations, inflation is likely to remain close to or below 2 percent in Germany, France, Belgium, Finland, the Netherlands, and Switzerland; and below 3 percent in the United Kingdom, Austria, Denmark, Ireland, and Norway. In Italy and Spain, the effects of significant exchange rate depreciations are complicating the task of disinflation. Inflation has also picked up under the influence of exchange rate depreciations in Canada, Australia, and Sweden, and to a lesser extent in the United Kingdom. Disinflation in Greece has been hampered by insufficient fiscal consolidation. In New Zealand, “headline” inflation has increased so far in 1995 owing to the effect of higher interest rates on the consumer price index, but underlying inflation is expected to rise only temporarily above the 2 percent upper target band. Japan is faced with the unusual challenge of preventing consumer price deflation: producer prices have been declining since 1991.

Among the developing countries, average inflation remained high in 1994 because of continued high inflation in a few countries, but price increases are generally expected to slow in 1995 (see Table 3). Median inflation is forecast at 8 percent in 1995, down from 11½ percent in 1994. Although inflation rates are expected to remain higher in Africa than in other regions, it is for this region that the greatest progress is expected. This partly reflects projected declines in inflation in the CFA countries—contingent on tight financial policies to contain the price effects of the 1994 devaluation, and the expected successful control of hyperinflation in Zaire. However, inflation is also expected to decline in other countries, in part owing to increased supplies of agricultural products associated with favorable weather. In Kenya, for example, inflation is expected to fall into single digits for the first time since 1989.

Inflationary pressures are a matter of concern in many Asian countries. High levels of capacity utilization exerted considerable pressure on prices in 1994. The impact of large capital inflows on liquidity and demand has aggravated the problem. Despite measures of restraint in several countries, inflation is expected to moderate only slightly in 1995 and may well rise again in 1996 given the continued rapid pace of growth in the region. Price increases in China fell below 20 percent in the first half of 1995 as a result of strengthened stabilization efforts, and there are recent signs that the growth of demand and activity is moderating, but resource pressures remain strong. In India, monetary policy became progressively tighter in the early months of 1995, and the inflation rate has come down to single-digit levels. Many of the successful emerging market countries in southeast Asia will also need to tighten financial policies to contain inflationary pressures.

Inflation in the Middle East and Europe region is projected to fall from over 30 percent in 1994 to about 25 percent in 1995. Inflation was over 100 percent in Turkey during 1994, boosted by a sharp exchange rate depreciation and lax financial policies, but is expected to fall to 50 percent during 1995–96 as stabilization policies take hold. In the Islamic Republic of Iran, inflation was over 30 percent in the first half of 1995, in part a result of strongly negative real interest rates, exchange rate depreciation, and supply bottlenecks, but is expected to decline in 1996. Elsewhere in the region, inflation is expected to moderate during 1995–96 in Egypt and in Israel, and remain subdued in Saudi Arabia.

Among the developing countries of the Western Hemisphere, inflation is also projected to decline in 1995. In Brazil, where progress has been most significant, monthly inflation rates have fallen from about 40 percent before the real was introduced in July 1994 to an average monthly rate of about 1½ percent during the first half of 1995. For the second half of the year, monthly inflation is expected to increase somewhat as a result of adjustments in certain administered and market prices that were kept constant for a year after the introduction of the real, a more flexible exchange rate policy, and continued strong demand. Other countries in the region—such as Chile and Ecuador—have also experienced substantial reductions in inflation. And in Mexico, following large price increases in the first half of the year in the wake of the depreciation of the peso, inflation is expected to abate as a result of the country’s stabilization efforts. Inflation in Venezuela is expected to remain high owing to lax financial policies in recent years.

Many economies in transition have achieved considerable progress in bringing down inflation from the high rates prevailing in the initial years of the transition. Inflation in Albania, Croatia, the Czech Republic, and the Slovak Republic has approached rates typically observed in western economies but remain higher than in major trading partner countries. Strict monetary and credit policies recently brought monthly inflation down to low single-digit levels in Belarus, Bulgaria, Kazakhstan, the Kyrgyz Republic, Moldova, Romania, and Ukraine. Despite these accomplishments, inflation still remains relatively high in most of these countries, reflecting persistent fiscal imbalances that are typically financed through money creation, the widespread use of indexation mechanisms, and continued relative price adjustments. Further progress in reducing inflation hinges on steadfast adherence to tight money and credit policies. Inflation has recently picked up in Poland and Hungary, as large increases in net international reserves resulted in rapid monetary expansion that fueled inflation in Poland, while large increases in energy prices in January 1995 and a devaluation in March contributed to higher inflation in Hungary. Struggles to gain control over inflation continue in a number of other countries. In Russia, a decline in effective reserve requirements and high growth in base money have contributed to the disappointing inflation performance.

Oil prices strengthened in the early months of 1995 as market conditions firmed. However, prices began to decline in May, owing to a marginal increase in OPEC production and easing political tensions, and fell further in late June and in July as it became apparent that OPEC quotas would not be reduced. Prices firmed somewhat in August, mainly on a seasonal upturn in demand. For 1995 as a whole, oil prices are assumed to average $16.67 a barrel, an increase of 7¾ percent over the previous year; in SDR terms, oil prices are expected to increase by only 1 percent in 1995 and to decline by 6 percent in 1996.

The prices of many nonfuel primary commodities measured in terms of SDRs fell steeply in the first half of 1995, after rising sharply in 1994 (Chart 8). Much of the upward pressure on commodity prices in 1994 stemmed from increased demand in the industrial countries and buoyant demand in the fast-growing Asian economies. Demand factors, in particular the slowdown in economic activity in the industrial countries, also appear to have contributed to the weakening of commodity prices in the first half of 1995.

Chart 8.Commodity Prices

(1990 = 100)

Primary commodity prices began to decline in early 1995 as economic activity in industrial countries slackened.

Note: The values for the third quarter of 1995 are averages for July and August.

Some special factors have also played an important role, however. Coffee prices in 1994 rose to their highest levels since 1986 in the wake of midyear frosts and subsequent drought in Brazil’s coffee growing regions and prospects of tight supply in 1995. Large price changes have also been recorded by metals and a number of agricultural raw materials. For metals, improved market fundamentals and speculative purchases by commodity investment funds raised prices throughout 1994. The boom in metal prices ended in the first quarter of 1995, when investor sentiment changed amid signs that the U.S. economy was slowing. Uncertainty regarding prospects for exports of metals from some transition countries also contributed to the volatility of metal prices. Strong demand, and production problems in major producing countries, led to sleep increases in the prices of agricultural raw materials, especially for natural rubber, wool, and cotton. Speculative activity drove the price of natural rubber at the end of 1994 to its highest level since 1980. Subsequently, rubber prices declined but remained above average prices in 1994. The downward trend in the prices of most commodities that began in the second quarter of 1995 is expected to continue in subsequent quarters as new supplies come on the market and the growth in demand slows somewhat. In 1996. commodity prices are expected to weaken somewhat further in a context of moderate demand and favorable supply conditions. The IMF’s indices of prices of non-oil primary commodities have recently been revised using 1987–89 export weights (Box 2).

Foreign Exchange and Financial Markets

The pressures that developed in foreign exchange markets in the spring of 1995 have abated, and exchange rate developments since midyear generally have been in the direction implied by economic fundamentals. After falling sharply to record lows against the Japanese and German currencies in April, the U.S. dollar mostly traded in a narrow range of DM 1.38-1.41 and ¥84-85 in June. It continued in this range in July and early August against the deutsche mark; against the yen. it moved up to around ¥91 per dollar in early August. The dollar subsequently appreciated sharply against the yen, reaching ¥104 in mid-September, a level last seen in May 1994. Against the deutsche mark, the dollar had appreciated to DM 1.48 by mid-September, a level only slightly lower than at the beginning of 1995.4

Box 2.Nonfuel Primary Commodity Prices

The IMF’s index of nonfuel primary commodity prices has been revised to reflect more recent information on the composition of world trade in commodities and to incorporate more representative price series for some items. The weights used to calculate the commodity price index are now based on average world exports of commodities during 1987–89. Compared with the previous weights based on 1979–81 exports, the weight of food has been reduced to 33 percent from 43 percent and the weight of tropical beverages to 6¾ percent from 11¾ percent, while the weight of agricultural raw materials has increased to 32¼ percent from 23¼ percent and the weight of metals has increased to 26¾ percent from 22 percent. Other changes include a more comprehensive price index for timber, a separate index for fertilizers, and new price series for rice and tobacco.1

Until the early 1990s, movements in the revised world index of nonfuel commodity prices were similar to those in the old index (see chart). The most important differences are that the most recent trough in commodity prices occurred earlier and was less deep in the revised index, and the recovery in prices since late 1992 is significantly stronger in the revised index than in the old index. These differences mainly reflect the larger weight assigned to timber and some metals, such as copper, whose prices have risen sharply since 1992.

Nonfuel Primary Commodity Prices

(In SDRs: 1990 = 100)

The commodity price indices are calculated by the Research Department and published monthly in International Financial Statistics, which contains additional information on the specifications and weights for the commodities included in the revised indices. See also Table A26 in the Statistical Appendix for more detail and projections. Because of data limitations, the weights do not incorporate information on commodity exports of the Baltic countries. Russia, and the other countries of the former Soviet Union.

Several factors may have contributed at various times to the weakness of the dollar in the first half of the year, including the effects of the Mexican crisis, diminished expectations of further U.S. interest rate increases—which were related to signs of a slowdown in U.S. economic growth—the persistence of the U.S. current account deficit, and a shift in currency preferences of Japanese investors away from U.S. dollar-denominated assets in the context of the general strength of the Japanese yen.5

Whatever the precise reasons for the earlier weakness of the dollar, especially against the yen, it appears that policy actions played an important role in the significant correction of key exchange rates that subsequently occurred. In mid-July and early August, the dollar began to strengthen against the yen as the Bank of Japan eased monetary conditions—-following the 25 basis point cut in the federal funds rate by the Federal Reserve—and the monetary authorities of both Japan and the United Stales intervened jointly, surprising the market by purchasing dollars even as the currency was rising. In addition, on August 2, Japan announced measures to promote increased outflows of capital. The more recent strengthening of the U.S. dollar occurred in the wake of coordinated intervention in the foreign exchange market by leading central banks in mid-August and in the context of a further easing of monetary conditions in Japan and Germany. The effect of the intervention was to reinforce the modest appreciation of the dollar that was under way and to persuade market participants that a further strengthening of the U.S. dollar was warranted. Two factors contributed to the success of the official intervention. First, it was increasingly evident that markets had taken the value of the dollar below levels that were justified by economic fundamentals, especially against the Japanese yen. Second, incoming data and evidence about policies were supportive of official efforts to promote a stronger dollar.

In assessing recent movements in the three major currencies, it is also important to consider the exchange rates of other currencies, including those of developing countries. This is especially the case when considering movements in the U.S. and Japanese currencies, but less so for the German currency. Chart 9 shows the real effective exchange rates of the U.S. dollar, Japanese yen, and deutsche mark that take account of the developing countries and use competitiveness weights.6

Chart 9.Three Major Industrial Countries: Real Effective Exchange Rates1

(Based on CPI: January 1990 = 100)

Recent fluctuations in the value of the yen have been Tar greater than movements in the dollar or the deutsche mark.

1 Price data for July and August are partly estimated.

2The index for “industrial countries” is indistinguishable from that for “all countries.”

For Germany, developing countries have a comparatively small weight, and it is the European industrial countries that are really key. Although there has been considerable variation in the movement of the deutsche mark in real terms against the various European currencies, the German currency overall has moved within a fairly narrow range, appreciating in the 1990s by roughly 10 percent. From a nearer-term perspective, exchange rate tensions within Europe have subsided compared with the earlier pressures in the spring of 1995: several currencies, including the French franc and the Spanish peseta, have reversed most of their earlier declines against the deutsche mark this year, while the Italian lira and the Swedish krona have reversed some, but not all, of their earlier depreciations. By mid-September, the lira, the krona, and the peseta had appreciated by around 14 percent, 11 percent, and 7½ percent, respectively, against the deutsche mark from their lows in early-to-mid April. Still, the most recent exchange rate changes have offset the earlier appreciation of the deutsche mark to only a small extent.

For the U.S. dollar, the real effective exchange rate across the widest array of trading partners has declined by about 8 percent since 1990. While the U.S. dollar moved substantially downward against some currencies in the first half of 1995, notably the German and Japanese currencies, the movement was offset to a degree by the weakness of the Canadian dollar and the Mexican peso against the U.S. currency. For the United States, Mexico has a particularly large weight and this is reflected in the steep slope of the line labeled “other developing countries” beginning near the end of 1994. Chart 9 shows that the dollar overall reached new lows in spring 1995, especially when the developing countries are excluded, but has since retraced some of the earlier losses. Even abstracting from Mexico, in August the dollar was only about 4 percent below the average for the decade.

Changes in the Japanese yen have been considerably larger than those for the other two major currencies. Taking the period from the autumn of 1991 through 1992 as a base, the yen has appreciated by about 25 percent in overall effective terms and has shown a broadly similar real appreciation against all the country groupings in Chart 9, including other Asian currencies. The weakening of the Asian currencies against the Japanese yen during the first half of 1995 mirrored the fact that a number of these countries are closely-linked to the dollar. The most recent exchange rate developments have brought the effective value of the yen back to levels broadly corresponding to those prevailing at the end of 1994.

Among other industrial countries, Canada, Italy, the United Kingdom, Australia, and Sweden have experienced significant real effective exchange rate depreciations in recent years (Chart 10). Since the early 1990s, the Canadian dollar and the Italian lira have depreciated by some 25 percent to 30 percent, while the United Kingdom. Australia, and Sweden have seen their currencies fall by between 10 and 20 percent. In contrast, the Swiss franc has appreciated by around 15 percent, while the French franc has been broadly stable. The appreciation of the Swiss franc reflects its strength not only against the U.S. dollar, but also against other European currencies, including the deutsche mark. Like other currencies, however, the Swiss franc has depreciated significantly against the yen in recent years, albeit less steeply. These exchange rate trends were generally being accentuated during the early months of 1995, with the lira, the krona, and the pound sterling all depreciating significantly, the Australian dollar reversing the appreciation during 1994, and the Swiss franc appreciating quite sharply. Since April, however, the Canadian dollar, the lira, and the krona have all appreciated significantly, while the Swiss franc has retraced some of the earlier gains. The French franc and the pound sterling have remained broadly stable, while the Australian dollar has appreciated since June.

Chart 10.Selected Industrial Countries: Real Effective Exchange Rates

(Based on CPI: January 1990 = 100)

A number of currencies have depreciated sharply in recent years.

Note: Price data for July and August are partly estimated.

In government bond markets, despite upticks in June and July, long-term interest rates in mid-September had dropped from their peaks last autumn by about 2 percentage points in the United States and Japan and by about 1 percentage point in France, Germany, and the United Kingdom. (For trends in long-term interest rates, see Table A18 in the Statistical Appendix.) These declines, which have substantially reversed the rise in interest rates in 1994, have occurred under circumstances of more moderate growth expectations, reduced fears of an upsurge in inflationary pressures, and increased commitments to fiscal consolidation in some countries. In Italy, Spain, and Sweden, long-term interest rates in mid-September were between 1 and 1¼ percentage points below their end-1994 levels; however, sizable premiums relative to German interest rates remained, reflecting the weak fiscal fundamentals and other policy concerns of these countries. Some of the possible reasons for the large movements in bond yields in recent years are discussed in Chapter III.

In equity markets, prices in many European countries fell in the second half of 1994 and remained at comparatively low levels into early 1995. With the strength of the deutsche mark adversely affecting share prices. As exchange market tensions subsided, and as inflation fears and interest rates eased, equity prices rebounded strongly. Between early April and mid-September, they rose by 16 percent in Germany, 12 percent in the United Kingdom, and 8 percent in Italy. Equity prices in France were essentially unchanged. Meanwhile, equity prices in the United States and Canada have tested new highs. By comparison, equity prices in Japan are still down by over 5 percent this year, notwithstanding gains of some 20 percent since early July.

The movements in the foreign exchange values of the major currencies, in particular the earlier appreciation of the yen, had significant potential repercussions for a number of developing countries. For many southeast Asian economies, the rise in the value of the yen, coupled with the relative stability of their currencies against the dollar, although strengthening their international competitiveness in the short term, threatened to heighten inflationary pressures. Moreover, for countries that have substantial liabilities denominated in Japanese yen and export earnings that are tied mainly to the dollar—for instance, Indonesia—the strength of the yen was cause for concern. These concerns have subsequently abated with the depreciation of the yen. Elsewhere in Asia, the Chinese yuan has appreciated by about 5 percent against the U.S. dollar since the unification of yuan exchange markets in January 1994. In the Western Hemisphere region, the Mexican new peso, which depreciated sharply during the financial crisis early in 1995, fell to almost MexN$8 to the U.S. dollar in April. By June, however, it had recovered to around MexN$6 to the dollar, on evident progress under the adjustment program and increased confidence in the economy, and it has remained around that level. In Brazil, following its introduction in July 1994, the real appreciated substantially until the early part of this year. Subsequently it has depreciated somewhat and in June the band around the real was changed from R$0.88-0.93 to the U.S. dollar to R$0.91-0.99. In contrast, the Argentinean peso depreciated somewhat in real terms during 1994 and in early 1995, in part owing to the decline in the inflation rate, thus offsetting some of the peso’s real appreciation since it was pegged to the dollar in 1991.

In the Middle East and Europe region, the pressure on the Turkish currency has eased somewhat in recent months, owing in part to the introduction of a ceiling on the rate of depreciation. In Egypt, the objective of preserving a de facto peg against the U.S. dollar was supported by a high interest rate policy. In Africa, the South African rand was unified in March by abolishing the financial rand system that applied to nonresident capita) transactions. In Nigeria, the large spread between the official exchange rate and the market-determined rate persisted as high inflation and macro-economic imbalances continued. In Uganda, the authorities imposed a coffee stabilization tax to prevent the boom in coffee prices leading to an appreciation of the currency and a loss of competitiveness. The real effective exchange rates of the CFA franc countries have appreciated modestly over the past year, but a large part of the gains in competitiveness stemming from the January 1994 devaluation have been preserved.

For most of the transition countries that have brought inflation under relative control, nominal exchange rates have stabilized. However, since domestic inflation rates are still quite high, real exchange rates have tended to appreciate. In the Czech Republic, appreciation of the currency has begun to threaten external competitiveness. In Hungary, similar concerns prompted the government to devalue the forint by ¼ percent in March 1995. In contrast, in Russia—where inflation remains very high—the nominal exchange rate was allowed to appreciate substantially in recent months albeit from very low levels. As a result, the real exchange of the ruble against the U.S. dollar rose by about 33 percent during the second quarter of 1995. To stabilize the ruble, the Russian authorities in July announced their intention to maintain the nominal exchange rate against the U.S. dollar within a band of Rub 4,300 to Rub 4.900 during the third quarter of 1995. Many countries in transition have made further efforts to remove foreign exchange restrictions, underscoring their commitment to an open and transparent exchange system for current transactions.

Net capital flows to developing countries declined substantially in the immediate aftermath of the Mexican financial crisis, but have subsequently returned to a relatively high level. The aggregate picture, however, masks considerable variations both in the composition of capital flows and across different countries and regions. Foreign direct investment flows, which remained stable through 1994, have declined only marginally this year. By contrast, portfolio flows, which had already slowed significantly in the second half of 1994 as interest rates in the industrial countries rose, fell sharply further in the first half of 1995. In the recent episode of declining capital flows, financial markets appear to have become considerably more selective, depending on countries” saving performance and degree of macroeconomic stability. Latin American countries, with the exception of Chile, have experienced the largest declines in capital inflows. Among the large recipient countries in Asia, the decline in portfolio capital inflows has been less pronounced. Indeed, capital flows to many of these countries have rebounded in recent months, increasing the risk of overheating.

On the assumption that policies in the emerging market economies continue to strengthen, capital inflows are expected to increase gradually over the medium term, but aggregate flows are assumed to remain below the high levels experienced during the early 1990s (Chart 11). Developing countries in Asia and the Western Hemisphere will continue to account for the major share of private capital flows. Economic prospects of some African countries such as Côte d’Ivoire and Uganda have significantly improved and have to some extent been reflected in moderate increases of private capital flows. Most African countries, however, are still primarily dependent on official flows, especially development assistance from bilateral donors. With recent trends in aggregate official development assistance indicating a continuing slowdown, external financing constraints for many of these countries are likely to tighten further; thus, improvements in macroeconomic policies and reform efforts will be crucial to sustain growth.

Chart 11.Developing Countries: Net Capital Flows1

(In billions of U.S. dollars)

Net capital flows to developing countries are expected to remain only slightly lower than in 1991–93.

1 Net capital flows comprise net direct investment, net portfolio investment. and other long- and short-term net investment flows, including official and private borrowing. Blue shaded areas indicate IMF staff projections.

Among the countries in transition. Poland and Romania recently joined the Czech Republic, Hungary, and the Slovak Republic in regaining access to private international capital markets, marking a shift from exceptional to normal financing. Following Poland’s first Eurobond issue in late June, Russia is considering doing the same later in 1995. Large capital inflows have occurred in many transition countries including the Czech Republic, Russia, and the Slovak Republic and reflect in varying degrees external borrowing by enterprises, the return of flight capital, and foreign portfolio and direct investment.

The initial effects of the Mexican financial crisis were felt strongly in emerging equity markets, with sharp declines in equity prices in January and February of this year. Most Latin American and Asian markets proved to be remarkably resilient, however, and rebounded during the second quarter of 1995 (Chart 12). In Latin America, growing confidence among investors that economic adjustment programs were broadly on track, and declining bond yields in the industrial countries, contributed to a recovery of stock markets, especially in Argentina, Brazil, and Mexico. However, except in Chile, where the repercussions were smallest, and in Peru, prices remain below their mid-December 1994 levels. Equity prices staged even stronger recoveries in Asian countries, in part boosted by gains in competitiveness against the Japanese yen. More recently, some of the gains were reversed, but by mid-September stock prices in Indonesia, Malaysia, the Philippines, and Thailand were above their pre-Mexieo crisis levels. In contrast, in India, equity prices were about 25 percent lower in mid-September compared with mid-December 1994, reflecting the significant tightening of monetary policy and rise in interest rates over this period, and as uncertainties regarding the pace of reforms contributed to a rather lackluster performance of the equity market.

Chart 12.Emerging Markets: Equity Prices

(In U.S. dollars; 1993 = 100)

Equity markets have recovered in the wake of the Mexican crisis.

Note: The values for the third quarter of 1995 are averages for July and August.

Notwithstanding the rebound in equity prices, price-earnings ratios in the major developing country equity markets have been declining since mid-1994 and are now close to their 1992 levels. Rising interest rates in the industrial countries during 1994. and more recently a more cautious attitude toward emerging markets among international investors, are likely to be important contributory factors, but the growth and deepening of these markets may also have led to greater convergence in the valuation of developing and industrial country equity markets.

Trade, External Payments, and Debt

Following the sharp cyclical rebound in 1994. When the volume of world trade in goods and services rose by 8¾ percent, the expansion of trade is expected to continue at a rapid pace of 8 percent in 1995 and about 6½ percent in 1996. Outsourcing from industrial countries with strong exchange rates, increased trade among the developing countries, and the continued recovery of trade in the transition countries are among the factors that will contribute to rapid trade growth. Prices of internationally traded goods (measured in SDRs) are expected to change only marginally over the short term, as productivity increases, trade is further liberalized, and competitive forces (including in commodity markets) contribute to keep global inflationary pressures at bay. Despite the significant correction of the exchange rate changes that occurred in the first half of the year, trade flows will be heavily influenced by past changes in exchange rates. In particular, Japan is expected to continue to lose export market shares (between 1991 and 1996, the projections suggest that Japanese merchandise export volumes will have risen by only 6 percent compared with a rise in world trade by 34 percent over the same period); at the same time, import penetration is rising rapidly, albeit from relatively low levels. Many of the Asian emerging market countries are expected to continue to gain market shares (Table 5).

Table 5.Selected Countries: World Export Market Shares(In percent of world exports of goods and services)
Projections
1970–791980–89199119921993199419951996
United Stales12.112.113.012.913.513.312.813.0
Japan6.37.88.08.08.58.48.37.8
Germany10.29.410.510.49.39.29.49.1
France7.06.77.07.36.66.56.76.6
Italy4.54.65.45.65.45.35.15.1
United Kingdom6.05.65.35.25.05.05.15.2
Canada4.03.73.23.13.43.53.33.3
Belgium2.92.93.23.33.03.03.13.1
Netherlands5.93.74.03.93.83.63.73.7
Sweden1.91.61.51.41.31.41.41.4
Switzerland2.22.22.52.42.32.32.12.1
China0.81.21.61.51.92.42.52.7
Hong Kong1.01.62.73.03.43.53.43.6
Korea0.71.51.91.92.02.22.42.6
Malaysia0.50.70.90.91.11.21.31.4
Singapore0.71.21.71.71.91.91.81.9
Taiwan Province of China0.71.41.91.92.02.02.02.0
Thailand0.30.40.80.91.01.11.11.2
Argentina0.50.40.30.30.30.40.40.4
Brazil0.91.00.80.80.90.90.80.8
Mexico0.61.01.00.91.01.01.11.1

The large shifts in external competitiveness in recent years, together with changes in relative rates of capacity utilization, will have a significant bearing on the global pattern of current account positions (Table 6). However, while some payments imbalances are diminishing, others are widening, in many cases increasing the urgency of policy actions to contain domestic demand or improve external competitiveness. In several cases, already significant external surpluses are expected to grow further, possibly indicating the scope for currency appreciation.

Table 6.Selected Countries: Current Account Positions(In percent GDP)
Projections
19921993199419951996
United States-1.0-1.6-2.2-2.5-2.3
Japan3.23.12.82.32.0
Germany-1.1-0.8-1.0-0.7-1.1
France0.30.80.71.01.0
Italy-2.31.11.52.12.3
United Kingdom-1.6-1.8-0.3-0.7-0.4
Canada-3.8-4.0-3.0-2.3-1.5
Australia-3.5-3.7-4.8-5.7-5.3
Belgium-Luxembourg3.05.45.66.16.1
Denmark3.03.52.42.12.0
Finland-4.61.01.12.11.0
Netherlands2.43.33.13.32.8
Norway2.62.32.94.48.1
Spain-3.2-0.8-0.8-0.4-0.2
Sweden-3.2-2.20.42.23.2
Switzerland6.37.97.25.95.4
Algeria2.71.6-4.3-7.1-3.9
Argentina-2.8-2.9-3.5-1.3-1.3
Brazil1.6-0.2-0.3-2.4-1.6
Cameroon-3.9-5.6-3.1-3.0-0.6
Chile-1.6-4.6-1.40.8-1.5
China13-2.01.51.70.3
Côte d’Ivoire-12.6-10.0-2.4-2.2-3.0
Egypt8.43.30.20.92.1
India-1.4-0.6-0.4-0.9-1.2
Indonesia-2.4-1.9-2.0-2.7-2.7
Israel0.3-2.1-3.8-5.6-6.1
Korea-1.50.1-1.3-2.0-1.6
Mexico-7.4-6.5-7.8-0.2-1.2
Nigeria-1.9-2.9-2.4-0.9-2.2
Pakistan-3.7-4.9-3.8-3.8-3.1
Philippines-1.9-5.3-4.3-3.5-1.8
Saudi Arabia-14.4-14.6-7.5-3.9-4.7
South Africa1.21.5-0.5-2.0-1.7
Taiwan Province of China3.93.12.51.91.8
Thailand5.5-5.4-5.7-6.6-6.8
Turkey-0.6-3.72.00.80.5
Czech Republic-1.62.2-0.0-3.4-4.0
Hungary0.9-9.0-9.5-7.7-5.7
Poland1.1-0.62.31.9-0.1
Russia1.53.41.2-0.2-1.2

For the two largest economies, the degree of improvement in external positions associated with the cumulative effects of past exchange rate changes is being masked to some extent by the effects of a significant further widening of the output gap differential in favor of the United States. In addition, the persistent widening of net international investment positions will continue to affect net investment income and the balance of payments in the two countries (Chart 13). Thus, for the United States, the forces affecting the external position, including the substantial correction of Mexico’s external deficit, are expected to raise the current account deficit to 2½ percent of GDP in 1995, with a relatively modest improvement expected in 1996. For Japan, although the weakness of the economy plays a major role in masking the underlying degree of adjustment, the net result is a decline in the external surplus to about 2 percent of GDP by 1996. In both cases, adjustments in relative cyclical positions and the lagged effects of current exchange rates point in the direction of a larger reduction of underlying imbalances. For these potential changes in current account positions to materialize, however, domestic absorption will need lo be reduced relative to potential output in the United Stales to allow the economy to lake full advantage of conditions in export markets and external competitiveness. This would be facilitated by stepped-up fiscal consolidation in the United States. In Japan, increased absorption would be encouraged by greater openness, deregulation, and structural reform.

Chart 13.Major Industrial Countries: Net Investment Income

(In billions of U.S. dollars)

U.S. net investment income turned negative in 1994.

Among the other industrial countries, Canada’s external deficit is expected to be more than halved from its level of only a few years ago as a result of improvements in competitiveness and the recovery in the United States; at less than 2 percent of GDP in 1995–96, Canada’s deficit is projected to be at its lowest since 1985. Germany’s relatively small deficit is expected to increase somewhat in 1996 owing to the strength of the deutsche mark. In contrast, strong competitive positions are likely to raise the external surpluses further in Italy and Sweden. A relatively large current account deficit is expected to persist in Australia. Switzerland’s large surplus is expected to decline to a range of from 5 to 6 percent of GDP. While Belgium’s is projected to rise to about 6 percent.

In the emerging market countries, the most dramatic change in external position is for Mexico, where the deficit on current account is projected to decline by about 7 percent of GDP in 1995 owing to the sharp reversal of capital inflows and the resulting adjustment policies, Argentina’s external position is also expected to improve significantly as a result of strengthened stabilization efforts. In Côte d’Ivoire, the depreciation of the CFA franc and accompanying adjustment measures are also expected to continue lo contain the external deficit. Likewise, external deficits are projected to diminish in 1995 in Hungary, the Philippines, Saudi Arabia, and Ukraine, in all cases in the context of strengthened stabilization efforts.

Several emerging market countries are expected to register a worsening of their external positions. Such worsening may reflect a combination of factors, but excess demand pressures—often fueled by cyclical inflows-—are typically the driving force. For some of these countries, which include Brazil, Colombia, Indonesia, Malaysia. South Africa, and Thailand, there may be a need to reappraise the overall stance and mix of policies to address the underlying causes of the worsening trend in external positions. In Algeria, where the external deficit is projected to widen sharply in 1995, an IMF-supported adjustment program is expected to permit a reduction of the deficit in 1996.

With the important exception of Africa, the debt burden of both the developing and the transition countries is expected to continue to ease. With a large share of non-debt-creating flows in total capital inflows, overall indebtedness is growing only modestly.7 Relative to output and export earnings, the external debt burden of the developing countries has declined steadily during the past decade and is expected to reach 29 percent of GDP and 108 percent of export earnings in 1996, the lowest levels since 1982. For the Western Hemisphere, the debt-service ratio in 1994 was 40 percent of export earnings as opposed to a peak debt-servicing burden of 57 percent in 1982. The improving debt situation has been reflected in a considerable strengthening of secondary market prices of developing country debt instruments during the past decade. This trend was temporarily disrupted by the uncertainties that arose in the wake of the Mexican financial crisis, but in most cases secondary market prices have turned around again in recent months (Chart 14).

Chart 14.Selected Developing Countries: Secondary Market Prices for Bank Loans

(In percent of face value)

Secondary market prices for bank loans have begun to recover from their 1994 decline.

Source: Solomon Brothers.

In Africa, only a few countries, including Ghana and Uganda, have managed to reduce substantially their debt burdens in the context of strengthened adjustment efforts, supported in some cases by debt restructuring and debt forgiveness. For most of the region, however, the debt burden remains extremely high and the accumulation of arrears continues to raise overall debt burdens, which in much of sub-Saharan Africa have reached levels that exceed 400 percent of export earnings. Few countries appear to have any realistic scope for servicing debt burdens of such a magnitude. In most countries, however, actual debt service is less than one half of the amount of new inflows from donors. There is a risk that excessive debt burdens may deter foreign direct investment and other private flows to some of these countries.

Paris Club creditors agreed in December 1994 to “Naples terms” for low-income rescheduling countries.8 These offer a 67 percent net present value reduction of eligible debt for most eligible countries and the prospect of an exit from the rescheduling process through stock-of-debt operations. Eleven reschedulings have taken place so far under these terms, including one stock-of-debt operation (for Uganda). Paris Club reschedulings on Naples terms have been complemented for certain countries by bilateral debt forgiveness as well as by debt reduction from commercial banks. The Group of Seven industrial countries at their Halifax summit in June 1995. encouraged the Bretton Woods institutions to develop a comprehensive approach to assist the small number of countries with multilateral debt problems, both through the flexible implementation of existing instruments and, where necessary, through new mechanisms.

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