- International Monetary Fund. Research Dept.
- Published Date:
- January 1986
This section describes the Fund staffs medium-term scenario for the period to 1991. An underlying assumption in this scenario is that there will be no major economic or financial disruption, such as a sharp break in the pattern of exchange rates, intensified difficulties in servicing external debt, or a slide into recession. The absence of such features does not mean, of course, that the danger of such developments is absent. Potential sources of economic tension, and the means by which such tensions might be alleviated, are the subject of the next section.
Medium-Term Trends in Industrial Countries
Financial policies in the large industrial countries are now directed more firmly toward medium-term fiscal consolidation than they have been in the past. Over the next few years, the three large countries that have serious budgetary imbalances—the United States, Canada, and Italy—are all planning significant reductions in their fiscal deficits relative to GNP. The deficits of the other large industrial countries, which are generally more moderate at the general government level (although not always at the central government level), are also expected either to decline or to remain near current levels in relation to GNP. For the seven large countries as a group, these trends are estimated by the Fund staff to imply that the combined general government deficit would decline from about 3½ percent of GNP in 1986 to 2½ percent in 1987. Based on announced policy intentions in some countries and general trends in others, the aggregate deficit could be reduced to a level of between 1 percent and 1½ percent of GNP by 1991. As for monetary policy, the lower growth rates of monetary aggregates that are projected for most countries in 1987 are expected to continue in the medium term.
Because of the inherent difficulty of forecasting exchange rates, the staff has employed the working assumption that they will remain essentially unchanged in real terms. In some cases, this assumption may create a potential inconsistency with other aspects of the scenario. Identifying such inconsistencies, and analyzing ways in which they could be resolved, is a central purpose of the next section.
The medium-term trend of GNP growth is strongly influenced by the growth of productive potential. Estimates of the growth of productive potential are derived from projections of increases in the labor force and the stock of capital, and the extrapolation of productivity trends. The staff has assumed that output over the medium term will grow at approximately its estimated potential rate in the United States and Japan, and slightly faster than potential in most of the other major industrial countries. This latter assumption reflects an expectation that the high unemployment rates in European countries will decline somewhat over the period to 1991, in part through the alleviation of structural rigidities.
Inflation over the medium term will be strongly influenced by monetary growth rates. The staff has assumed that monetary growth will be such as to stabilize inflation in 1988–91 at rates close to the underlying level projected for 1987. This assumption recognizes that central banks will be attempting to maintain downward pressure on inflation, but also takes into account the practical difficulties of further lowering price increases when primary commodity prices are no longer declining and public preoccupation with inflationary dangers has diminished.
Balance of payments positions have been projected on the basis of a continuation of the average real exchange rates prevailing in the two-week period to September 5, 1986, together with the GNP growth rates described above. This means that rates of growth of domestic demand have been adjusted to secure consistency between the balance of payments projection and the GNP growth assumption. In some cases, this may give rise to tensions in the projections. For example, if the assumed strengthening of the fiscal position is much greater than the projected balance of payments improvement at current exchange rates, this could imply an implausibly large decline in private sector saving (or rise in investment). If net private investment were not to respond in the implied manner, domestic interest rates would tend to decline and the exchange rate to depreciate relative to the scenario assumptions, thus stimulating net exports. If, for some reason, the exchange rate did not depreciate, then the weakness of domestic demand would be reflected in lower output growth.
The current pattern of exchange rates, together with the projected evolution of rates of growth of domestic demand, would, under the staffs assumptions, result in some significant shifts in current account positions over the medium term (Table 2). The current account deficit of the United States, which is projected at almost 3 percent of GNP in 1986, would fall to around 2 percent of GNP by 1991. The surpluses of Japan and especially the Federal Republic of Germany, which are estimated at 4 percent and 3½ percent of GNP for 1986, would be reduced by larger amounts in relation to GNP. Among the other large industrial countries, a small deficit is projected for Canada, while the position of the United Kingdom is projected to shift from a small surplus in 1986 to a sizable deficit.
|(Annual growth rates, in percent)|
|Germany, Fed. Rep. of.||1.9||3.3||2.5||3.0||3.0||…|
|Real domestic demand||2.5||5.1||3.0||3.6||3.4||3.1|
|Germany, Fed. Rep. of||1.8||2.2||1.5||4.2||3.7||…|
|Germany, Fed. Rep. of||4.0||1.6||2.2||2.8||1.6||…|
|(As percent of GNP/GDP)|
|Current account balance||–0.3||–0.8||–0.6||—||–0.1||–0.31|
|Germany. Fed. Rep. of||0.3||1.0||2.1||3.4||2.5||…|
A major factor contributing to future shifts in payments flows is the very sizable exchange rate movements that have occurred during the past year and a half. In particular, the appreciation of the Japanese yen and the major European currencies against the U.S. and Canadian dollars since early 1985 has reversed—in a relatively short period—a substantial part of the depreciation that had occurred during the previous four years. The lagged effects of these recent movements on payments balances are expected to be quite substantial. Had they not occurred, the deficit of the United States, and the surpluses of Japan and Germany, would have tended to increase even further from the levels reached in 1985–86.
A second major factor at work is the lagged effect of the sharp drop in oil prices in early 1986. The initial effect of that decline, of course, is to strengthen the current account balances of oil importing countries.
However, over time that effect is largely offset as the volume of oil imports rises in response to lower oil prices, as other imports rise in response to the gain in real income, and as the oil exporting countries cut back on their imports. Thus the lagged effects will act to weaken the external balances of industrial countries. For the large industrial countries as a group, this effect in 1987–88 is expected to be on the order of $20–25 billion, with the largest impact falling on Japan and the Federal Republic of Germany.
A third influence on underlying payments positions is the further accumulation of indebtedness to the rest of the world by net debtor countries, a group that now includes the United States, and the accumulation of foreign claims by creditor countries, including Japan and the Federal Republic of Germany. At the end of 1985, the net debtor position of the United States is estimated to have been on the order of 3 percent of GNP, or just over $100 billion. The current account deficits that are projected through 1991 would increase that net debt position to perhaps 14 percent of GNP. The cost of servicing this debt will thus become an important and growing element in the U.S. payments position. In contrast to the U.S. pattern, projected current account surpluses would increase the net foreign claims of Japan from about 9 percent of GNP at the end of 1985 to perhaps three times that figure by 1991 and of Germany from 8 percent to over twice that figure.
Medium-Term Growth and Adjustment in Developing Countries
The revised assessment of short-term prospects in developing countries given in the first section clearly represents a setback to the baseline scenario presented in the World Economic Outlook of April 1986. Because of the weakness of export earnings, the debt ratio and the real GDP growth rate of capital importing developing countries are both expected to be significantly less favorable in 1986–87 than projected six months ago. Everything else remaining unchanged, these developments constitute a further delay in the re-establishment of generalized creditworthiness among these countries. This prompts two questions: Are there any reasons for supposing that the ground lost in the short term will be made up in the medium term? And what are the factors that account for the repeated worsening of the base on which the scenarios are premised? With respect to the first question, the answer is for the most part in the negative since the main determinants of the medium-term scenario are relatively little changed.5 As just discussed, growth in the industrial countries remains expected to average about 3 percent per annum in 1988–91. The staffs assessment of the scope for increased financing is also broadly unchanged in real terms. As in the past, there appears to be room for only limited increases in indebtedness of developing countries. Thus their combined current account deficit is expected to remain quite low, in comparison with historical experience, throughout the projection period. It might be thought that part of the hoped-for improvement in the fiscal balance of the United States should be reflected in higher net lending from the industrial countries as a group. While such a prospect cannot be excluded, and is indeed in line with conventional notions of the “normal” pattern of balances among developed and developing countries, it seems inconsistent with the stated intentions of a broad range of creditors, both private and official, as well as with the evident desire of many debtor countries to limit the buildup of their external indebtedness.
Some changes that have been made in the scenario assumptions alleviate (although only partially) the effects of recent adverse developments. In light of current developments in financial markets, and the improved outlook for inflation in the medium term. LIBOR is assumed to average about 6½ percent in nominal terms in 1988–91 (as against 8 percent assumed in April). This change, which also implies a significant reduction in real interest rates from the earlier assumption, would permit a somewhat faster evolution of imports. A similar contribution originates in the assumptions regarding the terms of trade, which, given the abnormally low level to which commodity prices have now fallen, are expected to firm somewhat over the period 1988–91.
The combined effect of these assumptions is a somewhat improved medium-term evolution of the scenario which, however, is insufficient to recoup the “losses” of 1986 and 1987 (Appendix Table A53). Because of lower interest rates and more favorable terms of trade, growth in capital importing developing countries in 1988–91 is expected to be slightly faster than envisaged previously (4.8 percent compared with 4.7 percent) and the decline in debt ratios is somewhat greater (26 percentage points as against 20½ percentage points). However, this more favorable evolution over the scenario period is insufficient to offset the weakening in the starting point. In 1991, the level of real GDP would be ¾ of 1 percent lower than projected previously and the debt ratio would be 7 percentage points higher. Only the interest payments ratio would be improved.
These results should, of course, be interpreted with caution. They are quite sensitive to variations in the assumptions with respect to oil prices, interest rates, commodity prices, the foreign exchange value of the U.S. dollar, and the pace of activity in the industrial countries. Moreover, results vary widely across countries. The medium-term outlook is relatively favorable for countries such as Korea that have significant debts at floating rates, devote a sizable fraction of their imports to oil and raw materials, and export manufactured goods. The converse is true for low-income sub-Saharan countries whose terms of trade have tended to deteriorate and whose debt is primarily at fixed rates. Similarly, the fuel exporters face a period of pronounced downward adjustment in real per capita expenditure, an adjustment that is not fully reflected in GDP growth rates.
The downward revisions in the staff’s baseline scenario have, as on several earlier occasions, stemmed largely from revisions in the estimates for the base year (currently 1987) from which medium-term trends are assumed to begin. Given the regularity with which this has occurred, it is of interest to analyze the main sources of these revisions. This is done here by comparing current estimates for 1987 with those, also for 1987, that were part of the first published medium-term scenario (that of May 1984), In line with the staffs classification of countries at that time, the comparison is based on data for the group of “non-oil developing countries.” Analysis of these data (in Table 3) suggests the following:
|Current Estimates||April 1984 Scenario Estimates1|
|Changes, in percent per annum|
|In billions of U.S. dollars|
|Deficit on goods, services, and private transfers||45.3||62.5|
|Exports of goods and services||532.9||644.3|
|External debt—Valued using “current” exchange rate assumptions||892.6||851.8|
|—Valued using April 1984 exchange rate assumptions||820.02||851.8|
|In percent of exports of goods and services|
|Deficit on goods, services, and private transfers||8.5||9.7|
|Of which: interest payments||11.1||10.6|
|Changes, in percent per annum|
|Real GDP in industrial countries||3.0||3.3|
|U.S. GNP deflator||3.2||4.0|
|Effective exchange rate of U.S. dollar||–8.0||—|
|Export unit values for manufactures3||8.1||4.0|
|Prices of non-oil primary commodities3||–5.2||4.0|
|Price of oil3||–18.7||2.6|
|In U.S. dollars or percent|
|Oil prices, per barrel3||15.00||30.40|
The conventional indicators of credit worthiness are indeed significantly off the originally projected track. This is especially true of the debt ratio, which, even if the decline to 167 percent currently projected for 1987 is realized, will still be far above the 132 percent figure originally projected by the staff. Similarly, the interest payments ratio is now expected to average 11 percent in 1987 as against the 10½ percent projected earlier. These deteriorations occur despite an improvement in the projected balance on goods, services, and private transfers, which is now projected to be about 8½ percent of exports of goods and services rather than 10 percent.
The poor performance of the standard indicators of creditworthiness is not due to unexpected developments in the numerators of these ratios. External debt valued at 1984 exchange rates and interest payments in 1987 are expected to be less than expected two and a half years ago.6 The difficulty has rather been with the denominator of these ratios—exports of goods and services. These are now expected to average $533 billion in 1987 as against the $644 billion projected in early 1984. It is this 17 percent shortfall in export earnings that is primarily responsible for the repeated delays in achieving the needed improvement in debt ratios.
The weakness of export earnings can be partly attributed to weaker growth in industrial countries. Growth in these countries, which had been expected to average 3¼ percent per annum in the 1985–87 period, is now estimated at 3 percent. Partly as a result, the estimated real exports of non-oil developing countries are weaker than originally expected over the period (4¼ percent instead of 5½ percent). However, this shortfall seems too large to be entirely attributable to lower growth in industrial countries and it seems likely that other factors also contributed, for example, supply inadequacies in developing countries themselves and, possibly, trade restrictions in industrial countries.
Prices of primary commodities account for the overwhelming bulk of the shortfall in the scenario estimates for export earnings. Primary commodity prices, which had been assumed to remain fairly stable in real terms over the period 1984–87, are now projected to weaken in relation to prices of manufactures: by 33 percent for non-oil commodities and by 57 percent for oil.
On a more positive note, it is worth emphasizing that, despite the weak external environment, the projected growth of real GDP in non-oil developing countries over the period 1985–87 is relatively well sustained. Such growth performance implies a significant reduction in the dependence of growth on rising imports, which in turn illustrates the potential role of domestic policies in fostering an acceleration of growth.
The fact that the staff’s earlier forecasts have erred on the optimistic side underlines the need for caution in assessing the medium-term prospects of developing countries. Undeniably, recent trends have complicated the task these countries face in restoring external creditworthiness while strengthening domestic growth. Nevertheless, the staff’s medium-term scenario continues to suggest that a rate of output growth of 4½–5 percent over the medium term is achievable and would be compatible with a declining trend in the debt-export ratio.
The baseline scenario is presented in Appendix Table A53. Except as modified in this table or in the present text, the assumptions underlying the scenario are the same as those assumed in the World Economic Outlook of April 1986. pp. 92–95.
Valued at current exchange rates, however, debt is significantly higher than originally projected.