Chapter

II World Economic Situation and Short-Term Prospects

Author(s):
International Monetary Fund. Research Dept.
Published Date:
February 1995
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World output is projected to expand by 3 percent in 1994 and by 3¾ percent in 1995 as the global economy continues its gradual recovery (Table 1). The expansions that are now clearly under way in North America and the United Kingdom contrast with continued sluggishness in continental Europe and Japan. Developing country growth is expected to remain robust on average, although disparities remain large and the short-term outlook for the poorest countries has not improved substantially. Overall output in the countries in transition is expected to decline substantially again in 1994, although growth is beginning to pick up in most of central Europe and the Baltic countries. In all regions except the former Soviet Union, significant progress in reducing inflation has already been achieved or is anticipated in the near term. The successful conclusion of the Uruguay Round of trade negotiations in December 1993 stands out as a major policy achievement. This has removed a substantial downside risk to the prospects for world growth and is expected to support recovery in the short term by bolstering confidence and increasing incentives for investment.

Table 1.Overview of the World Economic Outlook Projections(Annual percent change unless otherwise noted)
Current ProjectionsDifferences from October 1993 Projections
199219931994199519931994
World output1.82.33.03.70.1-0.2
Industrial countries1.61.22.42.60.10.2
United States2.63.03.92.60.31.3
Japan1.10.10.72.30.1-1.3
Germany2.1-1.20.92.10.4-0.3
France1.4-0.71.22.60.20.1
Italy0.7-0.71.12.5-1.0-0.5
United Kingdom-0.61.92.52.80.1-0.3
Canada0.72.43.54.1-0.2-0.4
Seven countries above1.71.42.52.50.20.3
Other industrial countries0.91.62.8-0.1
Memorandum
European Union1.0-0.31.32.5-0.1-0.3
Developing countries5.96.15.55.8-0.1
Africa0.41.13.44.5-0.60.9
Asia8.18.47.57.4-0.30.4
Middle East and Europe7.54.73.03.71.1-1.4
Western Hemisphere2.53.42.83.4-0.7
Countries in transition-15.5-8.8-6.11.41.3-4.8
Central Europe-8.3-1.41.83.5-0.2
Former Soviet Union and-9.8
Baltic countries-18.2-11.90.41.9-6.8
World trade volume4.52.45.86.3-0.50.7
Industrial country import volume14.5-0.25.45.2-1.52.0
Developing country import volume10.28.77.29.2-0.6-1.9
Commodity prices
Oil2-0.5-11.5-14.75.9-3.0-18.1
In U.S. dollars a barrel18.2216.1313.7614.57-0.55-3.48
Nonfuel3-0.1-3.86.02.1-1.32.1
Consumer prices
Industrial countries3.32.92.52.6-0.1-0.2
Developing countries38.845.940.912.01.35.2
Countries in transition766.9687.2290.273.2115.5154.6
Central Europe145.1128.078.653.7-0.37.6
Former Soviet Union and Baltic countries1,292.41,226.3457.483.2269.1284.7
Six-month LIBOR (in percent)4
On U.S. dollar deposits3.93.44.25.10.1
On Japanese yen deposits4.33.02.22.9-0.3-1.2
On deutsche mark deposits9.46.95.24.1-0.2
Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during March 1-24, 1994, except for the bilateral rates among ERM currencies, which are assumed to remain constant in nominal terms.

Information on 1993 trade may understate trade volume because of reduced data coverage associated with the abandonment of customs clearance of trade within the European Union.

Simple average of the U.S. dollar spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil; assumptions for 1994 and 1995.

Average, based on world commodity export weights, of U.S. dollar prices.

London interbank offered rate.

Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during March 1-24, 1994, except for the bilateral rates among ERM currencies, which are assumed to remain constant in nominal terms.

Information on 1993 trade may understate trade volume because of reduced data coverage associated with the abandonment of customs clearance of trade within the European Union.

Simple average of the U.S. dollar spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil; assumptions for 1994 and 1995.

Average, based on world commodity export weights, of U.S. dollar prices.

London interbank offered rate.

Activity and Employment

Among industrial countries, the cyclical disparities evident for some time became even more pronounced toward the end of 1993, but divergences in growth are expected to diminish during 1994-95 (Chart 4). Recoveries in the large economies that first went into recession—the United States, Canada, and the United Kingdom—have gained strength; the estimated output gap in the United States had been substantially closed by end-1993, and in Canada and the United Kingdom it is expected to begin to narrow in 1994 (see Chart 2 in Chapter I). In continental Europe and Japan, economic activity remained subdued through 1993. While signs have now emerged that the downturns have bottomed out, recoveries in these economies may not be firmly established until next year, and margins of slack are expected to increase throughout 1994.

Chart 4.Major Industrial Countries: Real GDP1

(Percent change from four quarters earlier)

1 Blue shaded areas indicate IMF staff projections; data for Italy for the fourth quarter of 1993 are also projected.

2 Through west Germany only; thereafter, IMP staff estimates for unified Germany.

The nonsynchronous nature of the cyclical movements in these economies has been one of several distinguishing characteristics of the recent period. A second has been the tow levels of short-term real interest rates required to support even the modest recoveries in some economies. Moreover, employment gains have been slower than usual over the course of the expansion in the United States and Canada, although this may be attributed in part to efficiency-enhancing restructuring undertaken in recent years. The principal downside risk for the economies now recovering—particularly for the Nordic countries—stems from the possibility of prolonged slumps in major continental European countries and Japan.

Although the recession in Japan coincided with the downturns in continental Europe, its origins have much more in common with the earlier down-turns in North America, the United Kingdom, and the Nordic countries. Experience in these countries suggests that an important risk in the outlook for Japan is that banking sector problems and balance sheet adjustments will be resolved only slowly. An important difference, however, is that Japan’s fiscal position has permitted the adoption of several fiscal stimulus packages—the largest of which was announced in February of this year. These packages, along with the reduction of official interest rates, have helped to moderate the downturn and should spur the recovery of domestic demand. In most of continental Europe, the expected persistence of high unemployment remains a major obstacle to an early strengthening of confidence and a rebound of activity. An additional source of uncertainty in the outlook concerns the timing, and impact, of needed fiscal consolidation efforts, although experiences in the United States and the United Kingdom in 1993 have shown that the gains from improved confidence and lower long-term interest rates can be significant.

The recovery in the United States, which was initially very sluggish, has been firmly established for some time, and the economy is now in an expansionary phase. Growth in the fourth quarter of 1993 was strong, at a 7 percent annual rate. The earthquake in California and the extreme weather in early 1994 probably reduced first-quarter growth somewhat, but the underlying momentum for recovery appears to be sustained. Output is projected to expand by 4 percent in 1994, and then by a more sustainable 2½ percent in 1995 (Table 2). Nonresidential fixed investment, which increased by almost 12 percent in 1993, is expected to continue to lead demand growth. Monetary policy contributed to the recovery by allowing short-term interest rates to remain at low levels, thereby permitting significant reductions in debt burdens and facilitating balance sheet adjustment (Chart 5). The stance of fiscal policy was mildly contractionary in 1993, in part owing to the continued constraints on discretionary spending. The U.S. Administration’s budget for FY 1995 was presented in February 1994 and is expected to have a mildly contractionary effect in 1994-95, The budget proposal includes net expenditure cuts needed to meet the medium-term spending ceilings set out in the August 1993 budget legislation (Box 1). Nevertheless, continued improvements in economic confidence and robust growth of private investment and consumption provide a strong basis for the expansion (Chart 6). Capacity utilization rose above 83 percent in early 1994, the average workweek has been at postwar highs since November 1993, employment in manufacturing has begun to increase more consistently, and unemployment has declined significantly.4 The forecast for growth in 1994-95 is predicated on an assumed adjustment in monetary stance in keeping with the absorption of slack in the economy. The small increases in the federal funds rate in February and again in March were first steps in this direction.

Table 2.Industrial Countries: Real GDP, Consumer Prices, and Unemployment(In percent)
Real GDP1Consumer Prices1Unemployment
199119921993199419911992199319941991199219931994
All industrial countries0.61.61.22.44.53.32.92.57.07.88.28.3
Major industrial countries0.51.71.42.54.43.12.82.46.67.37.37.4
United States2-0.72.63.03.94.23.03.02.86.77.46.86.2
Japan4.31.10.10.73.31.71.30.92.12.22.53.0
Germany1.02.1-1.20.94.54.94.73.06.77.78.910.0
France0.71.4-0.71.23.22.42.11.99.410.111.712.4
Italy31.20.7-0.71.16.35.24.33.810.911.510.411.3
United Kingdom4-2.2-0.61.92.56.84.73.03.28.19.810.310.0
Canada-1.70.72.43.55.61.51.90.510.311.311.210.8
Other industrial countries0.90.91.65.54.23.73.29.110.412.312.9
Belgium1.90.6-1.31.03.22.42.82.77.58.29.410.2
Denmark1.01.20.32.42.42.11.32.210.611.412.312.1
Greece1.80.90.519.515.814.411.27.79.29.810.0
Ireland2.64.92.54.03.23.11.52.514.715.515.815.3
Netherlands2.11.40.30.83.93.72.12.37.26.97.88.9
Portugal2.31.5-0.81.111.48.96.55.54.14.15.56.8
Spain2.20.8-1.01.05.95.94.64.316.318.422.724.0
Austria2.71.6-0.51.43.34.13.62.75.85.97.37.5
Finland-7.1-3.8-2.61.64.22.92.22.87.613.117.919.8
Norway1.63.31.83.13.22.32.31.85.55.96.16.0
Sweden-1.1-1.9-1.72.29.32.34.72.72.95.38.38.4
Switzerland-0.1-0.71.25.84.03.31.51.12.65.15.3
Australia-0.82.03.02.63.21.01.92.39.610.810.810.4
New Zealand-2.72.13.73.62.61.01.41.210.610.39.49.0
Memorandum
European Union0.71.0-0.31.35.34.63.73.29.110.111.211.9
West Germany4.51.6-1.90.53.54.04.12.75.55.87.38.6

Annual percent change.

To maintain comparability with the historical data, the projections are not adjusted to the higher unemployment level implied by the new survey techniques adopted by the U.S. Bureau of Labor Statistics in January 1994.

The unemployment rate presents a new series starting in 1993, reflecting revisions in the labor force surveys and the definition of unemployment to bring data in line with those of other industrial countries.

Data for consumer prices based on the retail price index excluding mortgage interest.

Annual percent change.

To maintain comparability with the historical data, the projections are not adjusted to the higher unemployment level implied by the new survey techniques adopted by the U.S. Bureau of Labor Statistics in January 1994.

The unemployment rate presents a new series starting in 1993, reflecting revisions in the labor force surveys and the definition of unemployment to bring data in line with those of other industrial countries.

Data for consumer prices based on the retail price index excluding mortgage interest.

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

(In percent a year)

1 The U.S. federal funds rate, Japanese overnight call rate. German repurchase rate. Italian treasury bill rate, and all ten-year government bond rates are monthly averages; the Canadian bank rate and overnight money market financing rate are those of the last Wednesday of each month. All other series show end-of-month data. For April 1994, the observations reflect data available as of April 11.

Chart 6.Six Major Industrial Countries: Indicators of Consumer Confidence

Sources: For the United States, the Conference Board: for Canada, the Conference Board of Canada; and for the lower panel. European Union.

1 Quarterly observations.

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

The Canadian recovery is expected to gain momentum in 1994-95. This improvement is attributable in part to spillovers from the United States, but it also reflects a broadening of the expansion beyond the export sector. Domestic demand growth is projected to accelerate from 1¾ percent in 1993 to 2¾ percent in 1994, and to 3½ percent in 1995. An important factor restraining confidence is the high rate of unemployment, which is expected to decline only slowly from its current level of about 11 percent. Fiscal consolidation efforts initiated with the recent budget represent a step toward deficit-reduction goals; the stance of fiscal policy is expected to remain contractionary as government spending cuts continue in 1994. The projections reflect a continuation of relatively easy monetary conditions, given the very low rate of inflation, continuing declines in unit labor costs, and low levels of capacity utilization.

The United Kingdom is the third bright spot in the short-term outlook for the major industrial countries. Growth strengthened further in the final quarter of 1993, and unemployment declined below 10 percent in December—for the first time since August 1992. Much of the improvement in the competitiveness of manufacturing exports that occurred when sterling left the ERM has been maintained, although weak demand in key export markets limits this sector’s contribution to growth. The economic turnaround in 1993 has mainly reflected rising consumer demand: house-hold debt-income ratios have declined from earlier peaks, and the sharp reductions in short-term interest rates have reduced mortgage payments and have raised disposable income. In addition, progress with both inflation and fiscal consolidation contributed to a moderate decline in long-term interest rates in 1993. A significant factor in the short-term outlook is the fiscal tightening arising from restrained government spending and from tax increases that take effect in April 1994. Nevertheless, the momentum of recovery should be sufficiently strong to permit output to rise by 2½ percent in 1994 and—with an anticipated recovery in key export markets—-by slightly more in 1995.

Box 1.U.S. Budget Proposal for Fiscal Year 1995

On February 7, 1994, the U.S. Administration presented its budget for FY 1995 (beginning on October 1, 1994), The Administration’s proposals were constrained by the Omnibus Budget Reconciliation Act of 1993 (OBRA93), a multiyear fiscal program that established a freeze on total discretionary spending and maintained a “pay-as-you-go” feature, adopted in November 1990, requiring that deficit-increasing legislated changes in revenues or mandatory spending programs be financed by offsetting measures.1

The Administration projects that the budget would reduce the unified deficit to $176 billion (2½ percent of GDP) in FY 1995, followed by a gradual increase in the deficit, to $200 billion by FY 1999, with the deficit remaining close to 2¼ percent of GDP during that time (see table).2 The Administration estimates that the cyclically adjusted deficit would decline by ¾ of 1 percentage point, to 2 percent of GDP, in FY 1995 and would show no further improvement in the medium term. Excluding the surpluses of the social security trust funds, these deficit projections would be higher by roughly 1 percentage point of GDP in FY 1995-99.

The IMF staff projects a slightly higher deficit, primarily owing to the Administration’s assumption of a slower and more modest rise in short-term interest rates. In the absence of health care reform, both the unified deficit and total federal debt are expected to rise in relation to GDP after 1999, in part because of projected increases in Medicare and Medicaid outlays.

To meet the OBRA93 caps, the Administration proposes to cut FY 1995 discretionary outlays by 1½ percent in nominal terms relative to their FY 1994 levels, or about 4 percent in real terms, by scaling back or in some cases terminating a broad range of programs. Roughly half of the proposed cuts are in defense, and the balance from reduced outlays in areas such as low-income energy assistance programs, agriculture, and mass transit subsidies. Savings are also expected from measures to reduce administrative costs, including previously issued executive orders requiring federal personnel reductions of 100,000 by FY 1995 and cuts in administrative expenses, as well as implementation of the National Performance Review.

These measures are expected to make room for the Administration’s proposed $14.9 billion increase in spending in FY 1995 (¼ of 1 percent of GDP) for social welfare programs (such as health, housing subsidies, education and training programs, and the National Service Initiative), crime prevention programs, research and development, and environmental programs. Although the budget contains no tax measures (other than those specifically related to the health care reform), a number of increases in user fees were proposed that would help to offset the effects of spending increases classified as mandatory outlays. These revenue measures would yield $1.5 billion in FY 1995 and a cumulative $7 billion in the subsequent four years.

The budget also refers to initiatives that the Administration hopes to address during 1994, including health care and welfare reform, a program to enhance job search and training, and measures that would strengthen budget discipline and planning, including enhanced presidential rescission authority, biennial budgeting, and a capital budget.3

United States: Estimates of the Federal Budget Balance(In billions of dollars unless otherwise noted; fiscal years)
1993199419951996199719981999
U.S. Administration estimates
Unified budget basis-255-235-176-173-181-187-201
In percent of GDP-4.0-3.5-2.5-2.3-2.3-2.3-2.3
Excluding social security-302-292-239-240-259-275-297
In percent of GDP-4.8-4.4-3.4-3.2-3.3-3.3-3.4
Structural balance1-231-196-146-160-177-188-180
In percent of GDP-3.7-2.9-2.1-2.2-2.3-2.3-2.1
IMF estimates
Unified budget basis-255-233-173-179-193-209-233
In percent of GDP-4.0-3.5-2.5-2.4-2.5-2.5-2.7
Excluding social security-302-290-236-246-272-296-329
In percent of GDP-4.8-43-3.4-3.3-3.5-3.6-3.8
Sources: The Budget of the United States Government: Fiscal Year 1995 (Washington: Government Printing Office, February 7, 1994); and IMF staff estimates.

Administration estimates of the structural balance exclude net outlays for deposit insurance but are not on a national accounts basis and so are not directly comparable to the IMF staff estimates reported elsewhere. The dollar amounts are expressed as a share of the Administration’s projection of actual rather than potential GDP, since estimates for the latter were not available.

Sources: The Budget of the United States Government: Fiscal Year 1995 (Washington: Government Printing Office, February 7, 1994); and IMF staff estimates.

Administration estimates of the structural balance exclude net outlays for deposit insurance but are not on a national accounts basis and so are not directly comparable to the IMF staff estimates reported elsewhere. The dollar amounts are expressed as a share of the Administration’s projection of actual rather than potential GDP, since estimates for the latter were not available.

1 Discretionary outlays are subject to the annual appropriation process. OBRA93 froze total nominal discretionary outlays at their estimated FY 1993 level for the following five years; adjustments to the caps were permitted only to the extent that inflation exceeded projected levels.2 These projections exclude the budgetary effects of health care reform. Note that the unified budget concept differs from the general budget concept discussed elsewhere in the World Economic Outlook, since the latter includes the fiscal activities of the state and local governments and treats government receipts and outlays on a national accounts basis.3 At present, the President has no authority to veto individual items (a “line item veto”) in the budget passed by the Congress. Enhanced rescission authority would require a prompt congressional vote on a presidential recommendation to rescind specific spending proposals from the budget.

Box 2.February 1994 Economic Stimulus Package in Japan

The Japanese government announced a new economic stimulus package on February 8, the fourth stimulus measure since 1992 (see table below). The new package includes a temporary tax cut of ¥5.9 trillion for the current year, mainly in the form of reductions in central and local government personal income taxes.1 On the spending side, the main element is an increase in public investment (excluding land purchases) of ¥4 trillion.

The remaining expenditures comprise allocations for land purchases, and loans for housing, small and medium-sized enterprises, and equipment investment in new business activities. The package also provides for subsidies for employment development and adjustment and contains a number of measures to strengthen the financial sector and the securities market.

To assess the macroeconomic impact of this package, it is useful to divide its provisions into two categories: measures such as lax cuts and increases in public spending that are likely to raise spending on goods and services directly; and the other measures, which are expected to provide indirect support to the recovery of private demand. The IMF staff estimates that the direct measures will raise the level of output by about ¾ of 1 percent in both 1994 and 1995.2 Because of the transitory nature of the stimulus, output returns to its base-line level in 1996. These estimates are based on simulations using the IMF’s MULTIMOD econometric model, which incorporates a multiplier for government expenditure of about 1.0 and a multiplier for tax measures of roughly 0.5.3 It is assumed that monetary policy keeps market interest rates unchanged, and consequently that there is no change in the exchange value of the yen. There is essentially no impact on inflation because of the large output gap.

Japan: Summary of Recent Economic Stimulus Packages(In trillions of yen unless otherwise noted)
Date Proposed
August 1992April 1993September 1993February 1994
Total package10.713.26.215.3
In percent of GDP2.32.81.33.2
Tax reductions0.25.9
In percent of GDP1.2
Public investment15.87.62.04.0
In percent of GDP1.31.60.40.8
Land purchases1.61.20.32.82
In percent of GDP0.30.30.10.6
Increased lending by Housing Loan Corporation0.81.82.91.2
In percent of GDP0.20.40.60.3
Increased lending by government-affiliated financial institutions2.12.41.01.5
In percent of GDP0.50.50.20.3
Sources: Japanese authorities; and IMF staff estimates.

Includes disaster relief, unidentified land component of public investment, and Fiscal Investment and Loan Program lending to public corporations for public works.

Including ¥0.5 trillion for land purchases to be conducted over a five-year period.

Sources: Japanese authorities; and IMF staff estimates.

Includes disaster relief, unidentified land component of public investment, and Fiscal Investment and Loan Program lending to public corporations for public works.

Including ¥0.5 trillion for land purchases to be conducted over a five-year period.

Japan: Macroeconomic Effects of the February 1994 Stimulus Package(In percent unless otherwise noted)
19931994199519961997
Real GDP growth
Without package0.12.34.24.6
With package0.10.72.33.64.6
In nation rate
Without package1.30.90.81.21.2
With package1.30.90.91.21.2
Current account (in billions of U.S. dollars)
Without package131.4135.5127.2128.0131.2
With package131.4133.4125.7128.9131.6
Source: IMF staff estimates.
Source: IMF staff estimates.

Real GDP growth in 1994 is estimated to be ¾ of 1 percent—compared with essentially no growth in the absence of the package—while in 1995 estimated real growth is about unchanged at 2¼ percent (see table above).4 Consumer price inflation is projected to ease from 1¼ percent in 1993 to slightly less than 1 percent in 1994 and 1995. Relative to developments in the absence of the package, the current account surplus is projected to be roughly $2 billion lower in 1994 and 1995, reflecting the response of imports to aggregate demand. The current account surplus is thus expected to rise slightly in 1994 before declining in 1995.

Several considerations need to be borne in mind in interpreting these results. First, in addition to these direct effects, private sector confidence could well be boosted by the package. Second, the indirect measures have not been included in these estimates, and they would tend to have a positive effect. For these two reasons, the estimated output effect of the package given above may be underestimated.

1 This tax cut is expected to be implemented on a temporary basis in the form of a 20 percent reduction in income tax with-holding in June and December 1994, The tax cut is viewed as an interim measure to be implemented in advance of full-fledged tax reform, including a permanent reduction in income taxes, which is to be agreed on by the government by the end of the year.2 This assumes that about two-thirds of the effect of the tax cut on private spending will be felt in 1994, with the remainder falling into 1995. The increase in government spending on goods and services is assumed to be somewhat larger in 1995 than in 1994, given a normal implementation pattern. The Japanese authorities estimate that the entire package will have a cumulative impact on nominal GNP of 2.2 percent.3 For a description of the structure and properties of MULTIMOD, see Paul Masson, Steven Symansky, and Guy Meredith, MULTIMOD Mark II: A Revised and Extended Model, IMF Occasional Paper 71 (July 1990).4 The fiscal package put the level of output above the base-line projection in 1994 and 1995. With the withdrawal of the fiscal stimulus in 1996, simulated growth is lower than without the package in that year, and the level of output returns to its baseline.

The largest downward revision to earlier projections for 1994 is for Japan, where the economy has been weighed down by the contractionary aftereffects of asset price declines (including loan losses in the banking sector), continued weakness in investment following the exceptional activity of the late 1980s, the persistent strength of the yen, and depressed levels of business and consumer confidence. Industrial production fell at a 14 percent annual rate in the fourth quarter of 1993; although there were signs of a rebound in early 1994, the durability of this pickup remains uncertain. The fiscal stimulus package announced in February included a tax cut for one year equivalent to 1¼ percent of GDP, additional expenditure for public works, and increases in loan programs focusing on the residential sector and business investment (Box 2). The positive effects of this package, and the continuing stimulative effect of earlier measures, are expected to support a turnaround during the course of 1994, but output is projected to expand by only 2¼ percent in 1995, following growth of less than 1 percent in 1994.

The downward revisions to 1994 growth in continental Europe can mainly be attributed to the continued depressed levels of business and consumer confidence. In general, economic developments and policies in continental Europe have been subject to an array of conflicting pressures: the contradictory requirements of domestic recovery and exchange rate objectives; the rival needs for fiscal consolidation and economic stimulus; and tension between the desire for rapid reductions in unemployment and the need for fundamental—but slower-acting—structural labor market reforms. Substantial reductions of short- and long-term interest rates since early 1993 have attenuated a major depressive force on activity. However, the stance of monetary policy in most of Europe remains mildly restrictive in view of the weakness of economic conditions, with real short-term interest rates at relatively high levels and the yield curve in many countries still inverted in early 1994, Monetary policy in Germany is expected to continue the cautious easing initiated in September 1992, which brought short-term interest rates in line with long-term interest rates in early 1994. This should facilitate further interest rate cuts in France and other ERM countries and should permit an important rebalancing of macroeconomic policies throughout Europe. Fiscal policy in Germany has shifted progressively toward a more restrictive stance following the unification-related increase in the structural budget deficit in 1990-91. In France, despite selective stimulus measures intended to help reverse the deteriorating employment situation, overall fiscal policy has aimed to gradually reduce the general government deficit.

Economic activity in Germany remains subdued, and a recovery is not expected to take hold until mid-1994. Unemployment, which continued to rise throughout 1993, is unlikely to begin to decline until 1995. Weakness in domestic demand in particular is expected to persist, in part because of low consumer confidence in the face of uncertain job prospects, but also because of increases in fuel and social security taxes and reductions in public spending in 1994. The announcement of these fiscal measures may have contributed to a decline in long-term interest rates in the second half of 1993. However, the benefits of lower long-term financing costs—and, in general, of the gradual easing of monetary conditions since September 1992—are expected to feed through only slowly into investment and business activity this year. High unemployment and the associated pressure on the wage bargaining process are expected to stabilize wage costs in 1994-95. This should help to arrest the decline in competitiveness experienced in recent years and, together with the projected expansions in North America and in many developing countries, to facilitate a modest pickup in exports. On balance, output is projected to expand by 1 percent in 1994, with growth in the eastern Länder at 6 percent and activity in the western Lander remaining weak. Strengthening export markets and the beneficial effects of the continuing rebalancing of the policy mix are expected to raise growth to 2 percent in 1995.

After a very sharp decline in the first quarter of 1993, economic activity in France increased moderately in the remainder of the year, limiting the decline in output for 1993 to ¾ of 1 percent. For 1994, growth is forecast at l¼ percent, strengthening to 2½ percent in 1995. Investment, which declined for three consecutive years through 1993, is projected to increase slightly in 1994. The large margin of slack in the French economy has been reflected in a marked increase in unemployment, to over 12 percent of the labor force at the end of 1993. Government decisions to increase public works spending and to unblock household savings held in profit-sharing plans should contribute some positive stimulus in 1994. Monetary conditions seem likely to ease further over the course of 1994, bringing real interest rates and the yield curve closer to positions more consistent with the weakness of economic conditions.

A strong boost from exports has helped to cushion the downturn in Italy, although, as in other continental European countries, a turnaround has not yet materialized. Growth in 1993 fell short of earlier projections, largely because domestic demand declined more sharply than expected—by some 5 percent over-all, with investment down by 11 percent. Consumption was restrained by lower wage increases, higher taxes included in fiscal reform measures, and continued labor shedding. Both consumption and investment were adversely affected by a sharp decline in confidence—following the 1992 financial crisis—as well as by continued high real interest rates that reflect, in part, uncertainty regarding political developments and the future course of fiscal policy. In addition, bank lending has become more cautious in the wake of rising loan losses. Although some recovery is projected for 1994, unemployment is expected to remain at about 11 percent. Against this background of relatively weak economic conditions, the recent reduction in the fiscal deficit is particularly noteworthy. However, the debt and deficit remain very high, and additional measures are likely to be needed to ensure the achievement of the government’s budget targets for 1994 and beyond. Further progress in fiscal consolidation will be the key to facilitating continuing declines in interest rates.

Growth in the smaller industrial countries is projected to average 1½ percent in 1994 (see Table 2). Differences in the outlook for individual countries follow a pattern similar to that among the major industrial economies. The Nordic countries—which went into recession earlier, following the asset market overheating and subsequent sharp corrections in the late 1980s (especially in Sweden) and, in Finland, following the collapse of trade with the former Soviet Union—are now showing clearer signs of recovery. Lower interest rates, improved competitiveness and export sector performances, and increased business confidence have been the main positive factors. Economic growth remained relatively strong in Ireland in 1993, supported in part by large reductions in interest rates, and the outlook for 1994-95 is very favorable. Elsewhere in Europe, prospects are more closely linked to the outlook for Germany and France; growth is projected to remain modest until 1995, when the expansions are expected to become mutually reinforcing, notwithstanding increased fiscal consolidation efforts in several countries. Growth projections for Australia and New Zealand are encouraging—the adverse effects of the recession in Japan have been more than offset by positive domestic developments, in particular a recovery of investment, and by demand from elsewhere in Asia and from North America.

Aggregate performance in developing countries is projected to remain strong in 1994 and 1995 (see Table 1 and Chart 7). The sustained growth in the group of developing countries as a whole is indicative not only of improved conditions in many individual countries, but also of growing interdependence among developing countries. Exports to other developing countries have increased steadily as a proportion of developing country exports (Chart 8), Moreover, economic expansion in many developing countries has helped to offset some of the weakness in demand growth among industrial countries: since 1990, exports to developing countries have risen significantly as a proportion of total industrial country exports.

Chart 7.Developing Countries: Real GDP1

(Annual percent change)

1 Blue shaded area indicates IMF staff projections.

Chart 8.Developing Countries: Contribution to Regional Export Flows

1 As a percent of total dollar value of developing country exports.

2 As a percent of total dollar value of industrial country exports.

Box 3.The Impact of Lower Oil Prices

The average spot price for oil has declined considerably since mid-1992, falling to the $12-$13 range following the November 1993 decision by the Organization of Petroleum Exporting Countries (OPEC) not to reduce production quotas (see chart). Futures market prices suggest that oil prices will recover somewhat during 1994 from their end-1993 level, reflecting the expectations of stronger growth in the industrial countries and continued high growth in the developing countries. Global demand for oil in 1994 is expected to be about 1 percent higher than in 1993. Oil prices are assumed to average $13.76 during 1994, 20 percent lower than was assumed in the October 1993 World Economic Outlook.

The slide in oil prices reflects changing conditions on both sides of the market. Global demand for oil fell about ¼ of 1 percent in 1993, the first drop since 1985, because of weak demand in Europe, Japan, and the former Soviet Union. Low demand, in conjunction with abundant supply resulting from buoyant OPEC production, higher North Sea output at the end of 1993, and relatively resilient net exports from the former Soviet Union, led to a large buildup of crude oil inventories in Europe and the Caribbean toward the end of 1993. The relatively unrestrained production by OPEC reflected attempts to compensate for the fall in oil revenues, the absence of a strategy to deal with Iraq’s eventual market re-entry, and lack of cooperation by non-OPEC producers, particularly the North Sea producers, to reduce supply. It also reflected OPEC’s recent emphasis on regaining market share, which has depressed prices in the short run but may put OPEC in a better position to influence prices in the medium term. OPEC’s share in world supply has increased in recent years, and almost all of the rise in world demand since the oil price collapse of 1985 has been met by increased OPEC production (see chart).

The beneficial effect of a 20 percent fall in oil prices on some individual countries could be significant, but the net impact on world activity is unlikely to be large because some countries would experience an income loss. Oil importing countries would benefit: aggregate supply would rise, since oil is used in production; and aggregate demand would be stimulated by the decline in overall prices, by the rise in real wealth, and, assuming an unchanged monetary policy, by lower interest rates. In addition, the improvement in the terms of trade would help to alleviate balance of payments constraints, especially in finance-constrained developing countries, thus permitting a rise in oil and other imports and strengthening domestic activity. In general, however, the positive effects on demand are likely to be relatively small. In most industrial countries, interest rates and inflation are already relatively low, and oil intensity—oil consumption as a ratio to GDP—is lower than in the 1970s. In addition, exports to major oil exporting countries are important for many oil importers, and falling oil prices would have an adverse effect on such exports.

Simulations with the IMF’s MULTIMOD econometric model, which takes into account the above supply and demand effects, indicate that a permanent fall in nominal oil prices of 20 percent would raise GDP in industrial countries by about 0.1 percent after two years.1 Interest rates would fall by about 10 basis points, and the price level would decline by ¼ of 1 percent. Using the IMF’s developing country model, the effect on activity in non-oil developing countries is estimated to be roughly 0.1 percent after two years, and the aggregate current account balance of these countries as a ratio of their exports would improve by around ¾ of 1 percentage point.2 The beneficial effects on the balance of payments in oil importing developing countries could have a positive impact on their credit-worthiness, depending on the extent to which the wind-fall gains are to be saved.

For major oil exporters, the fall in oil prices would have sizable negative effects on national incomes and GDP, and on fiscal balances because government revenues are largely dependent on oil royalties. GDP in the major oil exporters could fall by around 1½ percent after two years, and real incomes could fall even more.3 The aggregate current account as a ratio to exports could worsen by around 8 percentage points, and government budget balances as a percent of GDP could fall by around ½ of 1 percentage point. Falling oil prices underscore the urgency in oil exporting countries of taking decisive steps to deal with already excessive fiscal and current account imbalances. The situation has been exacerbated by the near depletion of the financial surpluses of the 1970s and early 1980s, and by the significant increase in domestic and international borrowing.

World Oil Prices and Supply

Sources: Petroleum Market Intelligence (New York); other oil industry sources; and International Energy Agency.

1 Simple none average of daily U.S. dollar spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil, equally weighted.

2 Oil supply is in millions of barrels a day. The price of oil is deflated by consumer prices in industrial countries and is in constant 1980 U.S. dollars.

In the former Soviet Union, over two-thirds of Russia’s exports are energy related, and a fall in hard currency earnings would further increase demand for external financing and would put pressure on the reform process. Because Russia’s oil production faces supply constraints, the fall in revenue could not easily be countered by raising output, and policies to improve domestic energy efficiency might be required. Elsewhere in the region, net oil exporters (Kazakhstan, Azerbaijan, and Turkmenistan) would also suffer income losses, while net oil importers would benefit.

The fall in oil prices over the past decade has in part resulted from increased energy efficiency in consuming countries, and the downward trend is generally expected to continue (see Box 5 in the May 1993 World Economic Outlook, pp. 56-57). There are, however, several factors that might tend to slow, or even reverse, this downward trend. The current weakness of prices conceals the fact that the market (excluding Iraq) is operating at over 90 percent capacity and thus is vulnerable to short-run fluctuations in demand or supply. Moreover, the over-hang in the market during December 1993, which was estimated to be in the range of 55-65 million barrels, was almost eliminated by the end of January 1994, in part because of unusually cold weather in North America. In addition, the sustained low level of oil prices has weakened conservation efforts somewhat in recent years, and the rate of decline in oil intensity has slowed in most industrial countries. Low oil prices and weak demand have also made exploration, investment, and extraction in high-cost fields unprofitable and have slowed the expansion of capacity in low-cost fields. Unless oil prices recover, capacity in OPEC countries may not increase significantly. If high growth continues in the developing countries and if activity in the industrial countries recovers to more normal levels, even with stagnating demand in the former Soviet Union, demand for oil may pick up over the medium term. With production in the North Sea likely to peak during the 1990s, and with some oil exporters (including China and Indonesia) expected to become net importers by the end of the decade, the downward trend in oil prices may be attenuated or even reversed.

1 See Paul Masson, Steven Symansky, and Guy Meredith, MULTIMOD Mark II: A Revised and Extended Model, IMF Occasional Paper 71 (July 1990). These simulations do not take account of the possible increase in energy taxes.2 These estimates take into account higher output and lower interest rates in the industrial countries; see Manmohan S. Kumar, Hossein Samiei, and Sheila Bassett, “An Extended Scenario and Forecast Adjustment Model for Developing Countries,” in Staff Studies for the World Economic Outlook (IMF, December 1993), pp. 47-75.3 Major oil exporters are defined to include Algeria, Indonesia, Islamic Republic of Iran, Kuwait, Libya, Mexico, Nigeria, Oman, Qatar, Saudi Arabia, United Arab Emirates, and Venezuela.

Among the developing countries in Asia, activity in China slowed in the second half of 1993 as efforts to contain unsustainably rapid growth began to take hold. Growth for the year was nevertheless strong, at 13 percent, but is expected to moderate somewhat in 1994-95 (Table 3). Economic activity in India in 1993 was slightly weaker than earlier projected, largely because of the slower-than-anticipated recovery in the industrial sector. An expected revival in investment and the prospect of sustained export growth support the stronger growth forecast for 1994. Domestic demand strengthened decisively in Korea during 1993, and the outlook for 1994 is for robust growth, supported by both consumption and investment. Economic performance in Indonesia, Malaysia, Pakistan, and Taiwan Province of China remains buoyant, with growth in 1994-95 projected at 6 to 8 percent. In Thailand, consumption growth and increases in infrastructure investment, as well as strong exports related to recoveries in industrial countries, will continue to support the expansion. The outlook for the Philippines has improved somewhat, due in large part to increased power-generating capacity and expanding investment.

Table 3.Selected Developing Countries and Countries in Transition: Real GDP and Consumer Prices(Annual percent change)
Real GDPConsumer Prices
199219931994199219931994
Developing countries5.96.15.538.845.940.9
Median3.53.74.09.37.18.0
Africa0.41.13.440.631.730.6
Algeria1.1-1.83.031.820.237.8
Cameroon-5.2-4.9-5.92.0-3.912.8
Côte d’Ivoire0.2-1.10.84.22.035.4
Kenya0.40.23.027.346.17.5
Morocco-2.91.07.14.94.54.0
Nigeria3.82.92.244.660.451.2
South Africa-2.11.03.313.99.58.0
Sudan8.96.03.0117.695.060.0
Tunisia8.04.16.45.56.05.5
SAF/ESAF countries1-0.83.64.824.219.111.9
Asia8.18.47.57.49.57.9
China13.013.110.05.313.010.0
India3.74.14.810.79.98.5
Indonesia6.36.56.27.69.76.0
Korea4.85.36.36.24.84.7
Pakistan5.15.17.09.58.77.2
Philippines0.31.83.58.97.610.0
Taiwan Province of China0.55.75.84.52.93.0
Thailand7.67.88.24.13.35.0
Middle East and Europe7.54.73.024.224.420.9
Egypt11.41.32.615.710.37.8
Iran, Islamic Republic of4.63.03.021.627.510.0
Israel6.63.55.312.010.98.0
Saudi Arabia3.01.0-3.1-0.42.01.0
Turkey5.36.85.170.165.065.0
Western Hemisphere2.53.42.8165.8236.5213.9
Argentina8.76.04.524.910.64.0
Brazil-0.95.02.0991.12.103.31.888.0
Chile10.36.04.515.412.710.0
Mexico2.60.43.015.59.86.0
Venezuela6.8-1.0-2.531.438.749.1
Countries in transition-15.5-8.8-6.1766.9687.2290.2
Central Europe-8.3-1.41.8145.1128.078.6
Czech Republic0.52.520.810.0
Former Czechoslovakia-8.511.0
Poland1.54.04.543.035.327.3
Slovak Republic-3.623.214.0
Former Soviet Union and Baltic countries-18.2-11.9-9.81.292.41.226.3457.4
Sources: The World Bank; and Fund staff estimates.

African countries that had arrangements, as of end-1993, under the IMF’s structural adjustment facility (SAF) or enhanced structural adjustment facility (ESAF)

Sources: The World Bank; and Fund staff estimates.

African countries that had arrangements, as of end-1993, under the IMF’s structural adjustment facility (SAF) or enhanced structural adjustment facility (ESAF)

In the Western Hemisphere, overall growth is projected to be somewhat slower in 1994 than in 1993, but to return to a stronger pace thereafter. Political uncertainty and a drop in investment in Venezuela in 1993 contributed to a decline in output of 1 percent; the need for monetary tightening in the period ahead points to a likely further contraction in 1994. Economic activity in Mexico slowed sharply in 1993, reflecting restructuring efforts in manufacturing and the need to reduce inflation. Growth is projected to rebound in 1994-95 as private investment and economic confidence benefit from the ratification of the North American Free Trade Agreement (NAFTA). A stabilization plan anticipated for mid-1994 in Brazil should reduce domestic imbalances and strengthen the medium-term outlook, but it may cause a temporary decline in growth in the near term. In Chile a modest slowdown, associated with continued weakness in key export markets, is projected to bring the rate of expansion down somewhat further in 1994, albeit to a still satisfactory range. In Argentina as well, growth is expected to decline slightly as demand growth returns to more sustainable levels.

The short-term outlook for Africa shows significant improvement, relative to the experience of the past several years. The projected increases in activity in Morocco and Tunisia reflect the end of the drought that severely curtailed output in 1993. In addition to the drought, the decline in oil prices, a shortage of foreign exchange, and problems in obtaining imported inputs contributed significantly to the contraction in Algeria in 1993; reversal of some of these factors should strengthen growth in 1994-95. More generally, the anticipated improvement in world commodity prices and the prospect of stronger demand from industrial countries are significant positive factors in the regional outlook. An exception is Nigeria, where macroeconomic policy imbalances have hampered economic activity. Growth in the African countries of the franc zone is expected to be boosted considerably by their improved international competitiveness following the devaluation of the CFA franc by 50 percent, and of the Comorian franc by 33 percent, in January 1994 (see Box 8 in Chapter IV).5 With the maintenance of prudent financial policies in these countries, and with supportive financial flows on a bilateral basis from several countries and from multilateral institutions, the almost 2 percent decline in output in 1993 is expected to be reversed in 1994, and output is expected to increase by 4½-5 percent in 1995, African countries that had arrangements, as of end-1993, under the IMF’s structural adjustment facility (SAF) or enhanced structural adjustment facility (ESAF) are projected to sustain average growth of 5 percent in 1994-95.

The sharp drop in oil prices in late 1993 has had a considerable impact on the oil exporting countries of the Middle East and Europe (Box 3). Declining oil revenues have weakened the short-term outlook for the Islamic Republic of Iran and have exacerbated problems with its short-term external debt. Lower oil prices have also been a factor in Saudi Arabia, compounding pressures resulting from fiscal and external imbalances. In the economies less dependent on oil production, growth prospects have generally improved. Economic activity in Egypt is projected to strengthen because of sustained economic reform. In Israel, growth is expected to improve in 1994 because of higher private investment and stronger export markets. In Turkey, however, problems associated with large fiscal deficits and external imbalances present a significant risk in the period ahead.

Economic conditions improved substantially in most of the transition countries of central Europe and the Baltic states during 1993 (for more detailed discussion, see Chapter V). Output expanded in Poland, Albania, and Slovenia at a strong pace, and activity in the economies of the Czech Republic, Hungary, and Romania reached a turning point in the second half of 1993, with these countries experiencing output increases since then. Output continued to decline in Bulgaria and in the Slovak Republic—in the former, because of financing constraints and the adverse impact of the embargo on the Federal Republic of Yugoslavia (Serbia/ Montenegro); in the latter, in the aftermath of the dissolution of Czechoslovakia. Unemployment in Poland, Hungary, and other central European transition countries remained in the 10-16 percent range, but unemployment in the Czech Republic stabilized below 5 percent.

Continued adverse developments in the countries of the former Soviet Union present a somber picture for the period ahead. Measured unemployment remains fairly low, but underemployment—in the form of shortened hours or obligatory leaves—is considerable, and open unemployment is expected to increase sharply in most states of the former Soviet Union in 1994 and beyond. The economies of Ukraine, Belarus, and most other countries of the former Soviet Union, with the notable exception of Turkmenistan, experienced further substantial drops in output in 1993 and early 1994 as a result of ongoing disruptions to interstate trade, failures to implement stabilization policies, and, in several countries, armed conflicts. In Russia, GDP is estimated to have fallen an additional 12½ percent in 1993, despite efforts to contain the decline by extending the provision of credit and subsidies to state enterprises and by permitting the re-emergence of sizable interenterprise arrears. Prospects for 1994-95 are extremely uncertain.

Inflation and Commodity Prices

The weakness of economic activity in the industrial countries since 1990 has helped to reduce inflation to very low levels (see Table 2). The drop of almost 20 percent in oil prices since mid-1993 has also helped to bring inflation down, although there have been partially or fully offsetting increases in fuel taxes in several countries.6 Output gaps in the major industrial countries still in recession have widened to unprecedented postwar levels, contributing in Japan to further reductions in inflation below already very low rates of price increase. In continental Europe, tight monetary conditions and smaller wage increases in several countries have also helped to ease price pressures.

Average inflation in continental Europe is projected to continue to slow steadily during 1994-95. Rates of price increase in France, Italy, and Spain are expected to be at the lowest levels since the late 1960s. In Italy, moderate wage growth following the July 1993 labor agreement has contributed to inflation performance in 1993 that was much better than expected and holds promise for continued inflation convergence during the recovery. Broad measures of inflation in Germany have declined more slowly than might have been expected, given the large degree of economic slack and the stance of monetary policy, but increases in administered prices and indirect taxes have masked a steady decline in underlying inflation, especially in the tradable goods sectors. Inflation is expected to continue to decline throughout 1994-95.

In the United States, measured consumer price inflation remained unchanged on a year-on-year basis in 1993, although broader measures such as the GDP deflator showed continued declines. The strength of the U.S. recovery in the latter part of 1993 has largely absorbed the economic slack from the 1990-91 recession, but the oil price decline should contribute to some price reductions, and inflation is expected to remain broadly stable. In contrast, domestic slack remains substantial in Canada and the United Kingdom, despite the recoveries. Inflation is therefore projected to remain very low in Canada and is expected to fall slightly further in the United Kingdom. In Australia and New Zealand, inflation remains very low: New Zealand’s combined outlook of strong growth and price stability is particularly impressive; in Australia, indirect tax increases contribute to slightly higher projected inflation in 1994-95, but underlying inflation remains stable.

Inflation performance in the developing countries also shows notable improvement. Average inflation, which jumped sharply in 1993 because of large price rises in a few countries, is expected to decline substantially in 1994 (see Table 3), Median inflation is forecast at 8 percent in 1994, down from almost 12 percent in 1991. The projected slight decline in average inflation in Africa in 1994 masks a significant increase in the CFA countries as prices adjust to the currency depreciation. With the maintenance of sound financial policies, however, the inflation increase should be temporary. Inflation in Asia is projected to decline in 1994, with continued progress in several countries and on the basis of the assumed implementation of successful stabilization policies in China, Inflationary pressures in the Islamic Republic of Iran intensified in 1993, following the currency depreciation in the wake of exchange rate unification, but more stable financial conditions are expected to bring inflation down in 1994-95. Domestic imbalances in Turkey, including a worsening of the fiscal position, imply that inflation will remain high in 1994. Prices should increase less rapidly in Brazil during the course of 1994 as stabilization efforts take effect, but for the year as a whole inflation is projected at a still very high level, A stabilization program was adopted recently that starts with the introduction of a new index for price adjustment, to be followed by the introduction of a new currency, the “real.” A loosening of financial policies in Venezuela in 1993 contributed to an acceleration in domestic prices in 1993, and inflation is expected to increase further in 1994. Elsewhere in the Western Hemisphere, inflation is generally expected to continue to decline in 1994.

With the exception of the Baltic states, where inflation fell to about 1 percent a month, there was only modest progress in reducing inflation in the countries in transition in 1993. Although inflation rose in the Czech Republic, Romania, and the Slovak Republic, this was due partially to increases in indirect taxes rather than to deterioration in policy stances or underlying conditions. The outlook for central European countries in 1994 and beyond is for further improvements in inflation performance, but prospects are less certain for Russia, where weak credit control led to monthly price increases of over 20 percent during 1993. Very high inflation also characterizes most other states of the former Soviet Union.

Average petroleum prices fell from $17.37 a barrel in the second quarter of 1993 to $14.32 in the fourth quarter, and to $12.65 a barrel in December (Chart 9). Weak demand from industrial countries, and continued supply increases from both within and outside the Organization of Petroleum Exporting Countries (OPEC), exerted substantial downward pressure (see Box 3). Prices recovered somewhat in early 1994 as producers curtailed production. Uncertainty regarding the re-entry of Iraq into oil markets accounts for some continuing downward pressure on prices, although futures markets point to a firming of market conditions during the course of 1994.

Chart 9.Commodity Prices

1 Simple average of the U.S. dollar spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil, equally weighted.

2 Measured in U.S. dollars, with weights based on average world export values in 1979–81

With the exception of metals and minerals, dollar prices of nonfuel commodities generally stabilized and then rose in the second half of 1993, but average 1993 prices were still below 1992 levels, bringing the cumulative decline in the nonfuel commodity price index since 1988 to almost 16 percent (see Chart 9). Prices for metals and minerals continued to fall in 1993 because of subdued activity in many industrial countries together with supply increases, especially from the former Soviet Union, that have brought world stocks to very high levels. The remaining commodity groups saw prices firm despite weak demand in Europe and Japan because of recovery in other large markets, weather-related reductions in the supply of some commodities, and some shift of productive capacity to other uses. Commodity prices are expected to recover somewhat in 1994, reversing some of the recent losses in metals and minerals prices and providing further gains in other prices, as activity gradually picks up in the industrial countries and as supply cutbacks in many areas continue.

Foreign Exchange and Financial Markets

In Europe, tensions have abated significantly within the EMS since the widening of the ERM intervention bands in August 1993. Following initial weakening, the currencies of several of the ERM countries have gradually returned to levels against the deutsche mark that are above their pre-August intervention floors, even as interest rate differentials with Germany have narrowed (Charts 10 and 11). Outside the ERM, the pound sterling has strengthened significantly since early 1993, although the interest rate cut in early February led to some weakening. The Italian lira weakened further during 1993, partly reflecting policy uncertainties; this decline was partially reversed in late March and early April 1994. The Finnish markka has reversed about half of the decline that occurred in the six months following the decision to float the currency, with the improvement in late 1993 reflecting increased confidence, emerging signs of recovery, and prospects for lower inflation. The Swedish krona declined marginally further, in nominal effective terms, during 1993 but strengthened somewhat in early 1994.

Chart 10.Selected European Countries: Bilateral Exchange Rates vis-à-vis the Deutsche Mark1

(Black lines indicate intervention floors; tan lines indicate old intervention floors)

1 Weekly averages of daily data, based on noon quotations in London.

Chart 11.Selected European Countries: Interest Rate Differentials vis-à-vis Germany1

(In percent)

1 Weekly averages of daily data. For long-term interest rates, yields on government bonds with residual maturities often years or nearest. For short-term interest rates; Italy, three-month treasury bill rate; Portugal, three-month domestic deposit rate; and other countries, three-month interbank rate.

The U.S. dollar rose in nominal effective terms about 11 percent from its low in August 1992 to March 1994 (Chart 12). Between mid-September 1993 and early April 1994 it recorded gains of 4 to 7 percent against the deutsche mark, French franc, Italian lira, and pound sterling, reflecting relative cyclical positions and changes in interest rate differentials in favor of the U.S. currency. The U.S. dollar also strengthened by 5 percent against the Canadian dollar during this period.

Chart 12.Major Industrial Countries: Nominal and Real Effective Exchange Rates

(Index, 1980=100; logarithmic scale)

Note: An increase represents an appreciation of the currency. Equal vertical distances represent equal percentage changes.

1 Defined in terms of relative normalized unit labor costs in manufacturing, as estimated by the IMF’s Competitiveness Indicators System, using 1980 trade weights.

2 Constructed using 1980 trade weights

Box 4.Emerging Equity Markets

Since the mid-1980s, there have been substantial increases in stock market activity in many developing countries. The combined capitalization of these emerging equity markets—the market value of the equity of quoted firms—has increased from less than $100 billion at the end of 1983 to nearly $1 trillion by end-October 1993.1 This compares with a roughly threefold increase in the combined capitalization of industrial country markets over the same period. The increase in capitalization mainly reflects increases in equity prices (see chart), but there has also been a rise in the listings of new equity shares. Although the markets in the United States, the United Kingdom, and Japan are still significantly larger, market capitalization in some of the emerging markets now approaches that in many industrial countries. Expressed as a ratio to GDP, market capitalization in Chile, Hong Kong, Malaysia, and Singapore exceeds that in the United Kingdom or the United States.

The growth of equity markets has been encouraged by appropriate macroeconomic and structural reform policies implemented by many developing countries in recent years. As a result of these policies, domestic demand, exports, and corporate profits have all increased sharply. Furthermore, declining fiscal deficits and inflation, realistic and stable exchange rates, and improved economic incentives have provided an environment in which the private sector has begun to flourish and confidence in economic prospects has strengthened. The privatization of state enterprises has further promoted stock market activity by expanding the supply of shares, many of them internationally marketable.

Measures to improve the institutional environment have also increased investor confidence and spurred market growth. Countries such as Argentina, Chile, India, Korea, and Mexico have eliminated or reduced restrictions on foreign holdings and have improved settlement and clearance procedures. Reforms to the regulatory environment (for instance, increased disclosure requirements for new listings), as well as reduced taxes on transactions and capital gains, have also encouraged the expansion of equity markets.

During the past four years, the weakness of activity in industrial countries has increased the relative attractiveness of these markets, which has further boosted trading activity and prices. The unusually low interest rates that prevailed in the United States, in particular, attracted investors to the potentially high yields available in emerging markets. Moreover, external inflows appear to have set up a virtuous circle, whereby the efficiency of the domestic market has been enhanced through contacts with foreign financial institutions and sophisticated financial technology, thereby attracting further inflows.

These emerging equity markets have contributed to the mobilization of domestic and foreign saving in developing countries by broadening the set of financial instruments available to savers wishing to diversify their portfolios. In doing so, the markets provide an important source of investment capital at relatively low cost. During the past decade, available data suggest that equity issues financed more than a third of the increase in large firms’ net assets in Chile, Korea, Malaysia, Mexico, Taiwan Province of China, and Thailand. More fundamentally, the limited availability of debt finance in many developing countries, including bank loans (which may be restricted to a select group of companies), can make equity finance highly attractive; it can reduce firms’ vulnerability to interest rate increases and allow them to share risk with equity holders.

At the same time, the continuous valuation of share prices in equity markets and the implied possibility of mergers and takeovers impose discipline on the behavior of firms. Similarly, equity markets can improve the efficiency with which managerial resources are used by enhancing the ability of shareholders to effect changes in management. Although the incentive to monitor firms may be limited, and the takeover mechanism may not be very effective with broadly dispersed shareholdings, equity ownership is sufficiently concentrated in many developing countries to lead to the emergence of share-holders who should find it beneficial to exercise effective scrutiny over managerial actions.

Equity markets also act as a conduit for foreign saving, as the experience of the past four years has shown. External equity finance reduces reliance on external debt, which can render countries vulnerable to increases in international interest rates and the associated increases in debt-service payments. Allowing dividend payments and equity prices to adjust instead also allows for risk sharing with foreign investors. Moreover, inflows of equity finance bring improved accounting and reporting standards in their wake, as well as exposure to advanced supervisory and managerial techniques in the source country. From a global perspective, there is a net gain to the world economy as capital is channeled to areas yielding the highest returns. Investors in industrial countries also benefit from a diversification of their portfolios, since returns in the emerging markets do not appear to be highly correlated with those in industrial country markets.

Equity Prices

(Logarithmic scale; index, December 1988 = 100)

Sources: Emerging Stock Markets Factbook, International Finance Corporation (1993); and Bloomberg, Inc.

Despite these benefits, several concerns have been expressed about the operations of these markets. A common one is that “excessive” volatility in share prices will have negative spillovers for the real economy. It is not surprising, of course, that as markets become more efficient and the liquidity and frequency of trading increase, new information wilt be reflected in prices more quickly, and observed volatility may actually appear to increase. The more important concern is that speculative bubbles lie behind the marked increases in equity prices in developing countries. In this situation, prices can increase for considerable periods over and above the levels warranted by economic fundamentals, only to fall sharply after abrupt changes in market sentiment, with serious economic and financial consequences for the economy.

In practice, it is difficult to distinguish between bubbles and the effects of fundamentals. Although prices have risen sharply, price-earnings ratios have not, until very recently, increased markedly in several countries because there has also been a sharp increase in earnings. This suggests that the likelihood of a bubble may have been limited. Although differences in accounting standards, corporate capital structures, and legal requirements make cross-country comparisons difficult, price-earnings ratios in emerging markets have not, in general, been significantly higher than those in industrial country markets. In the last six months of 1993, however, the price-earnings ratios for some of the emerging markets increased by 50 percent or more. The volatility of these markets and the sharp drop in prices early in 1994 in some countries illustrate the sensitivity to both domestic and external shocks. It also raises concerns about the sustainability of recent stock market buoyancy and the possible adverse effects of a sudden change in market sentiment.

Although equity markets in many developing countries have become considerably more efficient, additional reforms would further increase their liquidity and reduce transaction costs. These include the institution of legal provisions to prohibit insider trading and the means to enforce them, improvements in accounting and reporting standards, and the simplification of procedures for listing new firms. With effective regulation and enforcement, domestic and international investors will have the confidence to commit further resources. Regulation should, of course, be confined to measures needed to correct market failures, so as not to impede the development of the market. The challenge is to provide adequate protection for investors without deterring market growth.

1 The International Finance Cooperation (IFC) identifies 36 emerging equity markets; including Hong Kong and Singapore, which are regarded as emerging markets by many observers, gives the following breakdown: 13 in Asia, 12 in Latin America, 7 in Africa, and 6 in the Middle East and Europe region. Several former centrally planned economies are also in the process of developing equity markets. For an analysis of key issues related to the operation of these markets, as well as data on their performance, and for further elaboration of the discussion in this Box, see Robert A. Feldman and Manmohan S. Kumar, “Emerging Equity Markets: Growth, Benefits, and Policy Concerns,” IMF Papers on Policy Analysis and Assessment, PPAA/94/7 (March 1994).

The Japanese yen strengthened marginally against the U.S. dollar since the October 1993 World Economic Outlook, amid sharp fluctuations that seemed to reflect changing market concerns over external imbalances and trade tensions. From highs approaching 100 yen per dollar in mid-August 1993, the yen fell to around 105 per dollar in mid-September and to 110 per dollar or more in late December 1993 and January 1994—which contributed to a decline in the currency in nominal effective terms—before strengthening again to about 103 yen per dollar in early April. Between mid-September 1993 and early April 1994, the Japanese yen also rose by 6 to 8 percent against the four main European currencies. Reduced interest rate differentials in favor of assets denominated in European currencies contributed to the strength of the yen; trade tensions with the United States also appear to have been a factor in the latest rise against the dollar.

Among the developing countries, the Turkish lira continued to weaken because of high inflation and large fiscal deficits, with further depreciation of the currency at the beginning of 1994 following the downgrading of Turkey’s external debt by international rating agencies. China unified its exchange system in January 1994, with new interbank foreign exchange centers replacing the swap market. Exchange rate unification in India in March 1993 made the rupee convertible for trade transactions, and the 1994-95 budget announced convertibility for the vast majority of current account transactions. In both countries, exchange rates depreciated slightly following exchange reform. The CFA franc was devalued in January 1994 by 50 percent in foreign currency terms, and the Comorian franc by 33 percent (see Box 8 in Chapter IV). Large devaluations occurred in Zaire—despite the introduction of a new, devalued currency in November 1993—against the background of ongoing hyperinflation and a fiscal deficit of over 20 percent of GDP; and in Kenya (through mid-1993) and Sudan, reflecting high inflation, fiscal imbalances, and political uncertainties.

Equity prices in the major European and North American markets have been quite buoyant, reaching near record highs in many countries in early 1994. From mid-September to mid-February, prices in local currency terms rose by 11 to 14 percent in Italy, Germany, the United Kingdom, and Canada, and by 8 to 9 percent in the United States and France. Declines in European interest rates, and expectations of further declines, as well as expectations of economic recovery in Europe and a stronger expansion in North America thence stronger earnings) contributed to this buoyancy. These factors contributed also to the 12 to 25 percent gains in smaller stock markets in Europe, and to an even stronger 37 percent rise in equity prices in Finland. Since mid-February, equity prices in North America and in several European markets have on balance declined as bond yields increased. Two main exceptions to this recent trend are in Italy, where equity prices reached record highs following the election, and in Germany, where equity markets have made further gains. In Japan, equity prices have fluctuated substantially, falling in late 1993 as prospects for an early recovery weakened, but recovering in early 1994 in anticipation of the stimulus package announced in February. Political uncertainties and trade tensions resulted in considerable short-term price volatility in the first months of 1994.

Emerging stock markets generally continued their advance in the latter part of 1993 (Box 4). Performances were more mixed in the first two months of 1994, with losses reflecting in part the recent developments in financial markets in industrial countries. During the last quarter of 1993, Taiwan Province of China showed the largest gain (73 percent), owing to improving corporate earnings prospects and reduced political tension, followed closely by Thailand—where price rises were supported by a shift in investment portfolios in industrial countries in favor of emerging markets in the region—and the Philippines.7 Profit taking contributed to some reversal of these gains in early 1994. Elsewhere in Asia during the last quarter of 1993, emerging equity markets in Pakistan and Malaysia gained over 40 percent, whereas average equity prices in China declined by 7 percent, in part because of expectations of new taxes on capital gains and stock transactions. In Latin America, equity prices in Mexico rose by more than 40 percent during the fourth quarter, owing to the successful completion of NAFTA. Further increases in January 1994 were offset in February. Elsewhere in the region, equity markets posted broad gains in early 1994.

External Payments, Financing, and Debt

Growth in world trade volumes is estimated to have slowed to 2½ percent in 1993, well below the rate of increase recorded in the previous year (see Table 1). The slowdown mainly reflects low imports in European industrial countries, owing to the continued weakness of economic activity. There also appears to have been a temporary underrecording of trade flows.8 The low growth in trade volumes and a drop in dollar-denominated export prices in 1993 resulted in a decline in trade values measured in dollar terms. This decline follows ten years of uninterrupted growth, during which the dollar value of merchandise trade more than doubled and service trade grew even more rapidly. The volume of world trade is projected to increase by 5¾ percent in 1994 and by 6¼ percent in 1995, reflecting the projected pickup of import demand in industrial countries and a number of countries in transition and the continued strong import demand from the non-fuel-exporting developing countries.

The nonsynchronous nature of cyclical patterns among industrial countries in 1993 was a decisive factor shaping current account developments, driving import demand higher in recovering countries and lower in the economies still in recession. A second critical determinant, and in Canada an offsetting force, has been the course of real effective exchange rates (see Chart 12). Together, these factors contributed to a widening of the current account deficit in the United States, which is expected to continue into 1995 (Chart 13). Japan’s current account surplus is projected to decline only slightly in the period ahead, as the lagged effects of the recent yen appreciation are being partly offset by the projected weak recovery and further terms of trade gains in 1994, Germany’s current account has been in deficit since 1991, but the deficit is projected to shrink gradually through 1995. The sharp fall in oil prices is estimated to reduce the nominal value of oil imports for all industrial countries by about $25 billion in 1994.

Chart 13.Major Industrial Countries: Current Account Positions1

(In percent of GDP)

1 Blue shaded areas indicate IMF staff projections.

2 Before July 1990, the current account balance of west Germany excluding the bilateral balance with east Germany; from July 1990, the current account balance of unified Germany.

Current account deficits in Mexico and Argentina, of roughly $23 billion and $8 billion respectively, are projected for 1994-95, reflecting relatively strong economic activity, including a rebound in investment together with private capital inflows. In Asia, large current account deficits of over $8 billion are projected to persist in 1994 in China and Thailand, as are sizable deficits in Indonesia, the Philippines, and Pakistan. Taiwan Province of China is expected to register a deficit of $1 billion, which is small relative to its large stock of reserves and follows a decade of large surpluses. The deterioration of Taiwan Province’s external balance reflects primarily the high import content of a large-scale investment program included in the current six-year plan. Singapore is the only developing country in Asia that is expected to have a significant surplus in 1994 (about $2 billion). Net direct investment and external borrowing in Asia are expected to remain high at $48 billion—roughly half of the total flow to developing countries (Chart 14)—with China accounting for over one-third of the total for Asia. In Africa, Algeria’s external account is projected to improve, and a deficit of over $1 billion in Sudan and a surplus of nearly $2 billion in South Africa are expected to be largely unchanged in 1994. Africa continues to rely heavily on official transfers as a source of external financing, with roughly half of the total official transfers to the developing countries going to Africa, In the Middle East and Europe region, the current account is projected to move into surplus in Kuwait as the quantity of oil exports recovers, whereas the decline in oil prices is expected to lead to a widening of deficits in other oil exporting countries in the region.

Chart 14.Developing Countries and Countries in Transition: Net External Financing Flows1

1 Data for 1994-95 are IMF staff projections.

2 The sum (with opposite sign) of balance on current account, excluding official transfers, change in reserves, asset transactions, and errors and omissions, net. See the Statistical Appendix, Table A32.

3 The sum of official transfers and direct investment.

The combined current account of the central European countries moved further into deficit in 1993, reflecting domestic recoveries, weak external demand, increased private capital inflows, and in some cases real exchange rate appreciations. In contrast, and despite a significant real appreciation of the ruble, the current account balance in Russia moved from a deficit in 1992 to a surplus in 1993, reflecting depressed domestic demand (for extensive discussion of net external financing flows to transition countries, see Chapter V).

Aggregate measures of developing country indebtedness and debt burdens continue to improve, with a further decline in both debt-to-export and debt-service-to-export ratios projected for 1994-95 (Chart 15). This favorable overall trend is representative of developments in Asia, the Middle East and Europe, and the Western Hemisphere, where both debt and debt-service ratios are well below their peaks in 1986 (see the Statistical Appendix, Table A37). In Africa, however, earlier declines in debt and debt-service ratios have been partially or wholly reversed, leaving the debt ratio only somewhat lower in 1994-95 than it was in 1986, and the debt-service ratio higher than in 1986. In sub-Saharan Africa, the debt ratio increased dramatically through the 1980s and early 1990s. The debt-service ratio (which represents actual debt servicing rather than debt servicing due) declined in the second half of the 1980s, but it has risen substantially since 1991 and is now back above levels reached in the mid-1980s. External assistance has helped many sub-Saharan countries to service this external debt; official transfers in 1993 corresponded to roughly 80 percent of debt-service payments.

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

(In percent of exports of goods and services)

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

In 1991, Paris Club creditors adopted a new approach to debt restructuring that incorporates a 50 percent reduction in net present value terms. Although this approach should offer many countries a strong prospect for resolving debt problems, in some cases further concessions may be needed, conditional on sustained adjustment programs. Since the October 1993 World Economic Outlook, agreements have been concluded with Kenya and with Viet Nam. Negotiations are continuing with Algeria and with Russia. The debt initiatives associated with the devaluation of the CFA franc include a proposal by France to write off the poorest CFA countries’ development aid loans, and to reduce by half the aid loans of the middle-income CFA countries. In addition, in the context of IMF-supported programs, France and other bilateral donors are committed to disbursing fresh financial assistance to CFA states over the next three years to support adjustments in the wake of the CFA franc devaluation.

Commercial bank creditors completed agreements on debt and debt-service reduction with Bulgaria in November 1993 and with Jordan in December 1993 and signed an agreement with the Dominican Republic in February 1994, Negotiations are continuing between Panama, Peru, and Poland and their respective Bank Advisory Committees. Commercial bank creditors concluded a large debt-restructuring agreement with Brazil in April 1994.

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