- International Monetary Fund. Research Dept.
- Published Date:
- January 1992
World economic activity showed signs of revival in the first half of 1992 as some major economies slowly began to emerge from the cyclical downturns of 1990–91. During the next 12 months, world growth is expected to continue to recover at a moderate pace: following stagnation in 1991, world output is projected to expand by 1 percent in 1992 and by 3 percent in 1993, close to the average growth rate during the past two decades but somewhat less than experienced after the two previous—and more pronounced—recessions in 1974–75 and 1981–82 (Chart 1). Recent progress in reducing inflation is likely to continue in most countries. The growth of world trade is forecast to rise from 2¼ percent in 1991 to 6¾ percent in 1993.
Chart 1.World Indicators1
1Shaded areas indicate IMF staff projections.
2Excluding trade among states of the former U.S.S.R.
Notwithstanding signs of recovery in the industrial countries, the expansion continues to be slow and uneven, and the balance of risks remains on the downside. An important impediment to a stronger performance is the continued need in several countries for balance sheet adjustments to unwind the effects of earlier speculative excesses in real estate and other asset markets. In addition, the persistence of large budgetary imbalances in a number of countries is adversely affecting business and consumer confidence. As experienced recently, large divergences in economic policies among countries are also contributing to tensions in financial and foreign exchange markets, with the U.S. dollar having fallen to historic lows against other major currencies. In most countries, the need to control inflation remains a constraint on economic policy, and there is little scope for further actions to support activity in the short run beyond the steps that have already been taken to reduce short-term interest rates in some countries and the adoption of an economic package in Japan. Major efforts to reduce fiscal imbalances, however, are urgently required in many countries to improve confidence and strengthen prospects for sustained growth over the medium term.
In many of the developing countries, growth has remained relatively strong, despite the weak international environment, as an increasing number of countries have made substantial progress toward stabilization and economic reform. However, inadequate policy efforts remain an obstacle to sustained growth in many other countries. In some Eastern European economies, there are indications that the sharp contraction of output may be coming to an end and that economic reforms are beginning to bear fruit, but the situation remains fragile. In the countries of the former Soviet Union, where the transformation process has only just begun, further output losses are expected.
Since the early 1980s, most of the industrial countries have sought to conduct their economic policies in the context of a medium-term growth strategy. The basic elements of this strategy include the pursuit of price stability; the promotion of higher rates of investment and saving, especially through reductions in government deficits; and the elimination of obstacles to efficient resource allocation and job creation through structural reforms. Despite progress in some areas, the record in achieving these objectives has been disappointing.
The greatest progress has been made in reducing inflation, which has slowed markedly during the past decade, in some cases to levels not seen since the 1960s. In many countries, however, inflation needs to be reduced further.
Although budget deficits have declined substantially in some countries during the 1980s, in others budgetary imbalances have remained very large or have recently widened following earlier consolidation. This has contributed to the persistence of historically high real long-term interest rates, despite the recent weakness of activity. The peace dividend has enhanced the scope for trimming budgetary outlays, but it is increasingly clear that pressures on expenditures will intensify in coming years as a result of aging populations, the rising cost of health care, the demand for investment in infrastructure, and concerns over the environment.
Much remains to be done to dismantle barriers to trade, to reduce industrial and agricultural subsidies, and to improve the functioning of labor markets, particularly in those countries where unemployment has remained high. The delay in concluding the Uruguay Round of trade negotiations is particularly worrying, and a failure to conclude the Round would be a major setback.
There has been greater progress in liberalizing financial markets, but to reduce the risk of excessive leveraging and unsustainable increases in asset prices as experienced in the 1980s in many countries—and thereby reap the full benefits of financial liberalization—the authorities will need to strengthen oversight and pay greater attention to developments in asset markets in formulating the appropriate policy stance.
The failure to implement fully the medium-term strategy has contributed significantly to the difficulties currently facing many industrial countries. These began in the late 1980s, when inflation was rekindled in several countries following a steady decline in the 1982–86 period. The rise in inflation in 1988–90 was partly attributable to pressures on capacity, which could have been alleviated by more determined efforts to curb budget deficits and to eliminate structural rigidities, particularly in labor markets. Moreover, in many countries monetary policy inadvertently accommodated speculative increases in asset prices, while the monetary easing that occurred in part in response to the stock market crisis in late 1987 was not reversed sufficiently quickly.
The subsequent tightening of monetary policies was eventually successful in reducing inflationary pressures, but at the expense of an inevitable weakening of economic activity. The slowdowns were particularly protracted in those industrial countries that allowed the greatest acceleration of inflation during the late 1980s, while countries that maintained generally good control over inflation typically suffered only moderate slowdowns in economic growth. Thus, even though other factors also played a role, improved adherence to the objective of seeking price stability was generally rewarded—not only by lower inflation, but also by smaller fluctuations in output and employment.
In contrast to the results in the area of inflation, the failure of many countries to implement the medium-term strategies for fiscal consolidation and structural reform has continued to impede economic performance—as illustrated by the sluggish recovery from the recessions or slowdowns of 1990–91. In Europe, the high level of interest rates stemming from German unification and from the persistence of large fiscal imbalances in several other countries, together with inadequate progress in correcting structural problems in labor markets, has contributed to the sluggishness of activity. In North America, short-term interest rates have been reduced considerably and appropriately in light of the weakness of activity and the progress achieved in reducing inflation. However, the effectiveness of these actions in supporting recovery has been limited by the high level of real long-term interest rates and by generally depressed levels of consumer and business confidence. These problems, in turn, reflect the lack of adequate progress in reducing the structural budget deficit in the United States, the heritage of high inflation for most of the past two decades, and the need to correct the financial imbalances that resulted from the heavy private sector borrowing and asset price inflation of the 1980s.
Looking forward, it is again clear that deficiencies in achieving medium-term policy objectives constitute critical barriers to additional policy measures to support more robust recovery. As discussed below, this is particularly the case in the fiscal area. With respect to monetary policy, efforts to stimulate activity by reducing short-term interest rates are counterproductive when such efforts erode the credibility of the commitment to contain future inflation and, therefore, are reflected in high long-term interest rates. In countries where short-term interest rates have been substantially reduced, additional interest rate reductions would not now appear to be warranted. Moreover, the monetary authorities in these countries will need to remain alert to signals of increasing inflation and to be prepared to undertake prompt upward adjustments to short-term interest rates. In Germany, the same principle implies that an easing of monetary conditions must await clear evidence that inflationary pressures are receding, particularly in the absence of greater progress in reducing the budget deficit.
Turning to developments in specific countries, growth in the United States picked up in the first quarter of 1992, supported by a recovery of consumption and residential construction and by continued strong export growth. Consumers and investors have remained hesitant, however, and the pace of recovery slowed again in the second quarter, prompting a further lowering of short-term interest rates. Nevertheless, on the basis of stronger balance sheets, the marked decline in short-term interest rates, and the improved international competitiveness of U.S. producers, real GDP is projected to increase by 2 percent in 1992 and by 3 percent in 1993.
For close to a decade, the chief economic policy problem in the United States has been the large federal budget deficit, estimated at 6¼ percent of GDP in FY 1992 (excluding net outlays for deposit insurance and net social security receipts). Lack of progress in reducing the deficit in 1990–91 was due in part to the weakness of the economy, but the medium-term fiscal prospects have also deteriorated further. By affecting inflation expectations and by diverting scarce resources away from private sector investment through its effects on long-term interest rates, the persistently large structural deficit constitutes an impediment to growth both domestically and globally. It has been a major reason for the accumulation of large external deficits in the United States during the past decade, and it remains a potential source of tension in financial and foreign exchange markets.
A determined new effort to reduce the federal budget deficit in the United States is urgently required as a necessary condition for a more satisfactory economic performance over the medium term. A comprehensive program to reduce expenditures (and to control their future growth) and to increase revenues would help to improve confidence and would foster a decline in real long-term interest rates. Such measures would also reduce the risk of a pickup in inflation as activity strengthens. Some deficit-reduction measures, including the elimination of distortionary tax expenditures and a reduction of support to agriculture, would also help to address long-standing structural problems.
In the European Community (EC), following a slowdown in 1991, growth is expected to recover gradually during 1992–93, with real GDP rising by 1½ percent in 1992 and by 2¼ percent in 1993. As in North America, however, the recovery is less robust than in previous cyclical upturns, with a recent intensification of exchange rate tensions contributing to uncertainty and weak confidence. The United Kingdom has not yet emerged from recession, and growth has remained weak in Italy. There are now signs of recovery in the eastern German Länder, but activity has again slowed in west Germany following a pickup in the first quarter of 1992. In France, activity also slowed in the second quarter following a strong pickup in the first quarter. Although economic activity in the EC is expected to strengthen somewhat during the period ahead, growth in 1993 is unlikely to be strong enough to reverse the recent rise in the rate of unemployment, now standing at close to 10 percent.
The reasons for the Community’s lackluster growth and high unemployment are complex. Notwithstanding the push to liberalize and deregulate that has been generated by the Single Market program, many structural impediments remain to be tackled, particularly in the areas of labor markets and government subsidies. Moreover, the tightening of monetary conditions in Germany necessary to contain inflationary pressures associated with unification has spilled over to the rest of the EC, where domestic considerations do not in all cases warrant high interest rates. In addition, in those EC member states where progress in reducing inflation and budget deficits has been inadequate, such as Italy, interest rates are particularly high and have recently been pushed up further as a result of exchange market tensions.
The necessary efforts to reduce macroeconomic imbalances in the EC have been given new impetus by the Maastricht agreement to move to full economic and monetary union (EMU) by the end of the decade. The implementation of measures to meet the agreed convergence criteria for participation in the final stage of EMU is essential to reduce exchange market tensions and to permit a lowering of real interest rates and an improvement in the Community’s growth performance over the medium to longer run. Indeed, it is highly unlikely that growth could be maintained at a satisfactory pace in the absence of efforts to reduce excessive fiscal deficits and bring down inflation to sustainable levels. Early measures to bring the German budget deficit well below the Maastricht ceiling of 3 percent of GDP, in accordance with the authorities’ objectives, would facilitate budget consolidation and achievement of convergence by other EC countries through the beneficial effects such measures would have on monetary conditions throughout the Community. Labor market and other structural reforms will also be crucial to foster stronger growth. It is encouraging, in this context, that the basic principles of a fundamental reform of the Common Agricultural Policy have now been agreed.
Activity slowed markedly in Japan during 1991 following several years of rapid expansion and signs of overheating. Real GDP increased significantly in the first quarter of 1992, but the most recent months have seen a weakening of some indicators, including private consumption. The present slowdown reflects the unwinding of earlier inflationary pressures and a desirable, but painful, correction of real estate and stock prices. To ease the adjustment process, a number of policy measures have already been taken, including substantial reductions in short-term interest rates and a front-loading of public investment spending, and an additional large economic package was announced at the end of August. These measures should help to support confidence and stimulate the growth of real GDP, which is expected to recover to 3¾ percent in 1993 following a slowdown to 2 percent in 1992. In light of Japan’s earlier efforts to consolidate the fiscal position, the recent action should not jeopardize the credibility of the country’s medium-term budgetary objectives.
Despite the near-term risks, Japan’s medium-term outlook remains strong, with potential growth of about 3½ percent. The country has prepared well for the pressure on public finances associated with the aging of the population in the coming two to three decades, through the determined pursuit of fiscal consolidation and the accumulation of a surplus in the social security sector. The success in the fiscal area should permit the authorities to focus greater attention on structural reforms, particularly in the areas of financial markets, competition policy, agriculture, and land management. Such structural reforms would benefit domestic consumers directly and would also help to defuse tensions over trade.
The developing countries are projected to grow by 6¼ percent in 1992 and 1993, the strongest growth in more than a decade. The only regions where the outlook has deteriorated are southern and eastern Africa, where a number of countries are suffering from the effects of a severe drought and civil disturbances. For other developing countries, the sluggishness of world demand and the weakness of commodity prices have been mitigated by the favorable impact on debt-servicing costs of the decline in short-term interest rates in the United States and Japan and by debt-restructuring agreements. In the Middle East, reconstruction after the recent conflict is contributing to a marked recovery of activity.
Beyond these special factors, there is also encouraging evidence that stabilization and economic reform efforts are beginning to bear fruit in an increasing number of countries. Overall, as many as 35 countries—accounting for over 50 percent of output in the developing world—can now be characterized as successful adjusters, even though the reforms have not yet been completed in all cases. A core group of these countries, predominantly located in Asia, began the reform process more than a decade ago. During the past three to four years, however, a growing number of countries in all regions have begun to overcome their earlier adjustment difficulties. The experience of these countries suggests important lessons for other countries undertaking adjustment and reform.
During the recent period of sluggish global growth, the successful reformers have registered sustained and relatively rapid increases in output. The key to their performance has been determined efforts to reduce fiscal deficits and to control inflation. Equally significant has been their recognition of the importance of market forces: most of these countries have acted to liberalize foreign trade, to cut subsidies, and to privatize state enterprises. In many cases, financial market reforms have also been adopted to mobilize financial resources and to ensure that resources are allocated efficiently.
For a growing number of developing countries, recent improvements in economic performance have been accompanied by a reversal of capital flight and substantial capital inflows in the form of both direct and portfolio investments. This is a welcome indication that confidence in the outlook for these countries is improving. At the same time, the authorities need to recognize that the capital inflows can easily be reversed and that appropriate policy adjustments are required to prevent overheating. In several countries, a tightening of fiscal policy would help to make room for higher investment and would permit a reduction of high interest rates, often a major reason for the capital inflows. Allowing a real appreciation of the currency may be appropriate in some cases. It may also be possible to speed up privatization, which would help to retire both domestic and external government debt.
The considerable decline in the aggregate debt-export ratio of developing countries—from 178 percent in 1986 to 123 percent in 1992—suggests continuing progress in managing the debt problem, particularly in many of the highly indebted middle-income countries. This has been partly the result of effective stabilization policies and economic reforms conducive to higher export growth. In addition to the beneficial effects of lower world interest rates, debt-reduction operations also have contributed significantly in a number of cases.
For the least developed countries, most of which are located in Africa, progress in alleviating the debt burden has been slow, but a number of initiatives by official creditors, the main holders of this debt, have helped to contain the cost of debt servicing. However, further measures are necessary to promote economic reforms and higher growth in the poorest countries, including an early implementation of commitments to raise official financial and technical development assistance and to improve access for developing country exports. In view of the special needs of low-income countries, the IMF has recently extended the commitment period for access to its concessional enhanced structural adjustment facility (ESAF).
Former Centrally Planned Economies
The early phases of the economic transformation process in Eastern Europe were associated with a marked drop in output in 1990 and 1991. Although further substantial output declines are expected in 1992, there are grounds for cautious optimism that the output contraction may be coming to an end in some of these countries. In addition to the inevitable transitional disruptions associated with the dismantling of the command system, the reasons for the huge output losses include the breakdown of trade among the former members of the Council for Mutual Economic Assistance (CMEA); the obsolescence of much of the capital stock; rigidities in capital and labor markets; and financing constraints. The slowness with which supply has responded to market forces and the difficulties in developing new products and finding new markets—notwithstanding a marked increase in exports to the industrial countries—have prolonged the adjustment period.
In Eastern Europe, governments moved relatively quickly in 1990–91 to liberalize prices and to open their economies to external competition. Although progress in these areas has been substantial, the recent experience has highlighted the limits to the pace of structural change and the crucial link between structural reform and financial stability. Much remains to be done to establish the institutions and structures of a market economy. Uncertainties over property rights, the lack of an effective financial system, and an inadequate supply of management and financial skills are major obstacles to improved economic performance. In addition, despite early progress with small enterprises, privatization of medium to large enterprises has generally been delayed. These problems have been compounded by larger-than-expected fiscal imbalances and a lack of adequate monetary control. The prospects for recovery will depend on the success with which these problems are addressed.
The countries of the former Soviet Union are still in the very early stages of the reform process. In the Russian Federation, important structural reforms have been introduced in 1992, including extensive price reform and unification and liberalization of exchange markets. The implementation of other major systemic changes and of effective stabilization policies, however, has yet to be achieved. If the intended strengthening of monetary and fiscal control does not materialize, inflation will remain excessive, which would impede urgently needed improvements in resource allocation. In addition to the measures announced in July, further efforts will be required to reduce the budget deficit, contain credit expansion to loss-making enterprises, and establish effective monetary arrangements within the ruble area. In support of the stabilization effort, and to promote the necessary restructuring in industry, there is also an urgent need to introduce commercial accountability and hard budget constraints for state enterprises, and to accelerate privatization and other structural reforms.
The other countries of the former Soviet Union are experiencing much the same difficulties as Russia. Despite early steps to liberalize prices, output has been slow to respond to market forces, and numerous obstacles continue to hamper trade among the states of the former Soviet Union. A continuing lack of stability in the ruble area reflects excessive credit expansion in a number of countries and the failure to coordinate monetary policy in the ruble area. Several countries are now in the process of introducing separate currencies, in part to achieve a greater degree of monetary independence. In these countries, the need for strong stabilization policies is no less urgent than in the ruble area. Furthermore, countries that leave the ruble area need to ensure the prior establishment of payments arrangements to avoid any unnecessary disruption of trade with countries remaining in the ruble area.
The support of the international community is vital to help to limit the costs of transition and to reduce the risk of setbacks in the reforming countries’ own policy efforts. Three mutually reinforcing types of assistance are essential. The first is policy advice and technical assistance in building market institutions. The second is adequate financial support to permit the buildup of reserves and to help to finance investment projects. Finally, the rest of the world, and especially the industrial countries, will need to open their markets further, on a nondiscriminatory basis, to the exports of the reforming countries so that these countries can benefit from the multilateral trading system that underpins the success of all market-based economies.
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To facilitate analysis of trends in developing countries and in the former centrally planned economies, the Statistical Appendix has been modified to show data separately for the two groups. The former centrally planned economies comprise the countries of the former Soviet Union, Eastern Europe (including the states of the former Yugoslav Federation), and Mongolia.