Economic Interactions and Policy Issues
- International Monetary Fund. Research Dept.
- Published Date:
- January 1986
The following section represents a preliminary response to the suggestions made in the Interim Committee communiqué of April 1986 that the world economic outlook exercise might be “further adapted to improve the scope for discussing external imbalances, exchange rate developments, and policy interactions among members.” In the context of the medium-term prospects presented in the previous section, this section reviews certain potential sources of tension in the interaction of economic developments and considers their implications for the current stance of policies.
The broad policy stance being pursued by industrial countries raises issues for the individual countries concerned, for the interactions between them, and for the global outlook over the medium term. For the individual countries, the central questions are whether the orientation of policies will be sufficient to deal with the economic imbalances faced by each country, and how the transition to a more sustainable budgetary and balance of payments position can be achieved while minimizing adverse short-term effects on output growth. From a broader perspective, the questions are whether the large current account imbalances that now prevail will diminish significantly as a result of these policies, and whether key economic variables such as growth, inflation, and interest rates will foster a favorable environment for a recovery in developing countries. In assessing the scope for policies that might affect the medium-term outcome, it is of interest to consider the implications of different assumptions with respect to key variables, such as the pattern of exchange rates among major countries and relative rates of domestic demand growth.
Sources of Tension in the Projections
An important issue inherent in the scenario described in the previous section is how the assumed substantial reductions in fiscal deficits and projected shifts in payments balances are to be achieved while avoiding or minimizing any short-term adverse effects on the growth of output,7 For a single country, a sustained reduction in its fiscal deficit will normally be associated over the medium term with a rise in private domestic investment, perhaps a small decline in private saving, and a strengthening of the external current account position. For the world as a whole, the external position cannot change, and so a global fiscal strengthening will have to be associated with an equivalent decline in net private saving, either through a rise in investment or through a fall in private saving. The challenge therefore is to ensure that the stimulus to net investment, both in the industrial countries and in the rest of the world, is large enough to avoid any significant deflationary consequences.
|Current account balance||–0.1||–0.9||–0.7||—||–0.2||–0.4|
|Germany, Fed. Rep. of||0.3||1.1||2.1||3.4||2.5||…|
|General government financial balance||–3.0||–3.5||–3.6||–3.4||–2.5||–1.2|
|Germany, Fed. Rep. of||–3.1||–1.9||–1.1||–0.8||–0.7||…|
|Net private domestic saving1||2.9||2.6||2.9||3.4||2.4||0.8|
|Germany, Fed. Rep. of||3.4||3.0||3.2||4.2||3.2||…|
As shown in Table 4, the combined fiscal deficit of the large industrial countries is expected to decline by about 1 percent of GNP from 1985 to 1987, while the combined current account balance strengthens by about ½ of 1 percent of GNP. The difference—½ of 1 percent of GNP—is reflected in a decline in net private saving. From 1987 to 1991, fiscal deficits and net private saving are both projected to decline further, by somewhat over 1 percent of GNP, with relatively little change in the combined current account of the group. The overall medium-term picture is one in which the relative stability of the combined current account balance of these countries is associated with significant changes both in the aggregate private investment/saving balance of the group and in the distribution of current account balances among countries. The question that arises in this context is whether the existing settings of policies and pattern of exchange rates are such as to facilitate the implied shifts in investment and saving.
On the likelihood of a medium-term rise in private investment, there are three general factors that make for a favorable outlook. First, real interest rates have already declined quite markedly since mid-1984, and they are assumed to remain at their new, lower levels over the next few years. Consequently, the financial incentives to delay major outlays that were present in the early 1980s are now greatly reduced. Second, with higher profits and moderate increases in real wages, the incentives for capital broadening should have improved. Third, competition in capital markets from public sector borrowers is expected lo diminish.
In addition to these general considerations, there are a number of factors that are relevant to individual countries. In the United States, for example, the current account is expected to strengthen, thus helping to sustain the growth of output. The large federal government deficits of recent years were associated with relatively high interest rates and an appreciating exchange rate and have led to large capital inflows from other countries. The reversal of these factors should arrest the earlier trend of deterioration in the current account and contribute to an improvement over the medium term.
Outside North America, the direct effects of recent exchange rate changes will generally be to reduce the contribution to demand from the external sector. Thus, although the further withdrawal of stimulus as a result of budgetary consolidation is not expected to be large, an issue arises of how the desired faster pace of private domestic demand is to be sustained. This is an important question in an international as well as a domestic context, since the projected growth in net exports by deficit countries is predicated on the assumption that growth in Europe and Japan will henceforth be led by domestic demand. A beneficial factor in this connection will be the boost to real incomes in Europe and Japan from exchange rate appreciation and lower raw material prices. A further assumption is that structural improvements in European economies will gradually improve the outlook for private economic activity, while the focus of demand growth in Japan will shift toward infrastructural investment and consumption.
Nevertheless, the fiscal objectives of governments, together with expected trends in payments positions, imply substantial shifts in the financial balances of the private sector. In virtually all countries, net saving by the private sector would be significantly lower in 1991 than in recent years. If this cannot be achieved through an increase in investment (or a reduction in saving propensities), then it would tend to come about in other ways. For an individual country, this could be through an exchange rate depreciation leading to a strengthening in external demand. For all countries together, however, an ex ante excess of saving over desired investment would lead to reduced income levels.
Even if net private investment in the industrial countries as a group rises sufficiently to maintain the projected rate of growth of GNP, achievement of the assumed output path in individual countries might still have implications for the pattern of exchange rates. In the United States, for example, the reduction in the fiscal balance, expressed as a share of GNP. is considerably larger than the improvement in the current account balance that is projected at current exchange rates. Thus, investment relative to private saving is assumed to rise quite sharply. Given the fact that private saving is already quite low and that the recent boom in business investment may be tapering off, the projected shift in the private sector’s financial balance might not occur. In such a case, there would be downward pressure on interest rates and exchange rates, which would tend to “crowd in” expenditure on investment and net exports.
A further potential source of tension lies in the implications of prospective payments positions for the growth of international indebtedness over time. Whether the net debtor and creditor positions for the three largest industrial countries can be considered sustainable is not an easy question to answer. Developments in debt and asset ratios of the size mentioned do not seem excessive by historical standards. (Indeed, relative to GNP, the United Kingdom is currently a larger net creditor and Canada a larger net debtor than any of the three major countries are expected to be by 1991.) On the other hand, it needs to be remembered (1) that the absolute magnitudes of the international claims outstanding by the end of the decade will be unprecedented, and (2) that the prospective pattern of current account balances in 1991 will tend to add to existing disparities in debt-asset ratios. Moreover, Canada and the United Kingdom may not be appropriate comparators, since Canada has traditionally financed economic development from imported capital while the accumulation of external assets by the United Kingdom can be seen as the counterpart of natural resource depletion.
Policy Issues in a Medium-Term Context
The two most important issues facing industrial countries in a medium-term context are, first, how to ensure that aggregate demand grows at an adequate pace as government deficits (or external surpluses) are reduced; and second, how to foster a pattern of exchange rates that results in stable and sustainable current account balances.
Demand Growth in the Medium Term
Macroeconomic policies in industrial countries have for some time been based on the belief that improved economic performance requires an environment of financial stability and increased flexibility in the functioning of markets. As part of this strategy, governments have sought to reduce the share of real and financial resources absorbed by the public sector, to bring down inflation and inflationary expectations through steady deceleration in rates of monetary growth, and to improve the working of markets by reducing structural rigidities.
While this general approach has been widely accepted, it has been unevenly implemented. The greatest success has been with respect to inflation; inflation rates have dropped sharply in virtually all industrial countries and inflation differentials have narrowed. Performance in this area is now better than at any time in almost twenty years. Much less progress, however, has been made in curbing government expenditure and deficits, although some countries, Japan and the Federal Republic of Germany for example, have done reasonably well. Other countries, notably the United States, Canada, and Italy, have had significant increases in government expenditure and have seen a sharp widening in their fiscal deficits.
The major countries are now attempting to correct the imbalances that were allowed to develop in the early stages of recovery. The United States, in particular, is planning a major fiscal strengthening. If these plans are implemented as intended, the direct effect of government spending on total demand is likely to be negative over the next several years, after a period in which it has been strongly stimulative. In Japan and most European countries, fiscal policy will generally be more neutral, but the lagged effects of recent exchange rate changes will tend to reduce net external demand. With economic activity having been disappointingly weak in early 1986, the question arises whether these withdrawals of stimulus will perpetuate slow demand growth.
While it is true that activity has been weaker than expected, and that government spending, in itself, will exert a negative impact on growth, this does not, in the staff’s view, constitute a case for making any significant change in the basic economic strategy of the individual countries. There are at least three reasons for this conclusion. First, the “pause” in economic growth in the early part of the year, although not generally forecast, is not out of line with normal experience in cyclical upswings. (In 1985, growth in the five largest industrial countries was initially thought to have ceased in the first quarter of the year, but was later revised to 2 percent, at an annual rate, and averaged over 3 percent in the remaining three quarters of the year.) Second, as noted earlier, it appears that some of the adverse effects of the recent decline in oil prices—those in energy-producing regions for instance—were felt more rapidly than the positive effects. On this view, final demand can be expected to strengthen in the second half of 1986 and in 1987. Third, while the direct effect of cutbacks in government spending are contractionary, there are indirect consequences that work in the other direction. Specifically, the fiscal deficit of the United States has grown to such a size that it constitutes an important element of uncertainty in its own right. Convincing action to reassure market participants that this fiscal imbalance is being brought under control could well have beneficial consequences in the short as well as in the medium term. The behavior of financial markets since late 1985 seems to lend support to this view. More generally, when fiscal deficits are being curbed as part of an announced and credible medium-term strategy to limit the role of the public sector in the economy, positive responses on the part of the private sector may perhaps be expected with less of a lag than when changes in the government’s financial position are unforeseen.
Nevertheless, if the basic policy stance of the industrial countries can be said to remain appropriate, this need not mean that there is no scope for modifications in the manner in which policies are put into effect. In this connection, it is appropriate to recall that the magnitude of the planned fiscal consolidation in the major industrial countries, taken together, is larger than any that has occurred in at least the past fifteen years. Moreover, even in countries where the budgetary position is expected to remain fairly neutral, a significant withdrawal of stimulus is likely to occur via the foreign trade sector.
A case can, therefore, be made for considering policies that would help ensure that the desired “crowding-in” of other sources of expenditure actually occurs. Monetary policy assumes an important role in this regard. A principal mechanism for “crowding-in” private sector expenditure is through the reductions in real interest rates that occur when public sector demands on financial markets (both actual and prospective) are reduced. Central banks have generally recognized the desirability of permitting such a decline in interest rates to occur when it can be seen to be a legitimate consequence of fiscal strengthening and so long as it does not require excessive monetary growth. A continuation of a flexible approach to monetary policy seems desirable in present circumstances, especially given the considerable uncertainties that surround the behavior of velocity. It has to be recognized, however, that inflation has not been removed as a danger. Price pressures will inevitably tend to revive when the beneficial effects of the cut in energy prices have been absorbed, and it is important that monetary authorities preserve the credibility of their basic anti-inflationary approach.
Another way of ensuring that domestic spending grows at an adequate pace in the face of cuts in government spending or net exports is through a flexible implementation of fiscal policy. Where tax reductions are already planned, there may be scope to bring their implementation forward, particularly in countries where good progress has already been made in reducing the fiscal deficit and the pressure of demand does not seem to threaten a renewal of cost-price pressures. There may also be scope for flexibility in the implementation of increases in public expenditures and related measures, as, for instance, with the package of measures to support stronger domestic demand growth announced by the Japanese authorities on September 19, 1986.8
Changes in the structure of government revenues and expenditure can play a role in ensuring that total private spending is adequately maintained and distributed across countries in a manner that is efficient and sustainable. In this connection, better harmonization of incentives to save and invest across countries through the gradual reduction of tax provisions that provide abnormal inducement to household saving, or that tend to inhibit spending for capital formation would be helpful. Actions of this kind would not only help to support final demand, but would foster more efficient resource allocation and would facilitate the restoration of a more sustainable pattern of external balances.
An important mechanism for helping smooth the transition from public to private spending as the main source of demand growth is through improving market processes. Financial market deregulation can be instrumental in ensuring that financial resources no longer absorbed by the public sector are made available speedily and efficiently for private investment. Much has already been achieved in the area of financial market deregulation, but it may nevertheless be possible to speed up the implementation of measures already planned for future adoption.
An area in which inflexibilities have impaired growth is that of labor markets. Dealing with rigidities while preserving social goals that continue to be valid will require sustained policy efforts. The prices of factors of production have to become more flexible in the face of changes in supply and demand. The purpose of greater wage flexibility, of course, is to facilitate the return to high employment. Declining relative wages in particular industries or sectors serve both to limit employment losses in the industries concerned and to provide an incentive for factors of production to transfer to other industries. An important additional requirement in this connection is the provision of facilities that help displaced workers retrain and relocate. In general the goal should be to assist the workers whose jobs have become uneconomic to find new employment, rather than to preserve the existence of jobs that can no longer be justified in economic terms.
Although rigidities are most evident in labor markets and policy efforts need to concentrate in these markets, it is also important to improve the functioning of other markets. Some of the fields in which structural policies have a role to play include curtailing subsidies that are being used to perpetuate uneconomic activities; re-examining the scope for deregulation when existing regulations cannot meet an appropriate cost-benefit criterion; using antimonopoly legislation to encourage increased competition; selling publicly-owned enterprise to achieve a similar result; and, as mentioned above, reforming the tax structure with a view to improving resource allocation.
Achieving Sustainability in Current Account Positions
An important area of potential incompatibility in the present situation of industrial countries is the persistence of large imbalances in current accounts among the three largest countries. As already discussed, these imbalances could lead to very large shifts in net creditor and debtor positions over the next several years that would become increasingly difficult to reverse. Such imbalances would tend to perpetuate trade tensions and would hinder the promotion of a stable flow of resources to developing countries.
There are a number of ways through which the pattern of current account balances could be altered. These include changes in terms of trade; movements in exchange rates; differential relative growth rates (either among the industrial countries or between them and the developing countries); and shifts in productivity growth. Of these, the factors that are the most readily amenable to change by policies adopted by the industrial countries themselves are exchange rates and GNP growth rates. These factors have played a prominent role in the public debate on these issues, and it is important to determine the extent to which they can in fact influence current account balances.
Perhaps the most important point that emerges from the examination of the empirical evidence on the relationship between exchange rate changes and current account positions is that exchange rate changes are not a substitute for the required policy changes. Rather, they are an integral part of the process by which policy actions—fiscal policies in particular—affect current accounts. A depreciation of the exchange rate provides the necessary incentive for a shift of resources toward net exports; but a reduction of the fiscal deficit may be needed to underpin the sustainability of an exchange rate movement and to ensure that resources are available to be redirected to the external sector.
Fiscal policy shifts also affect current account balances through their effects on relative growth rates. If it is deemed desirable to try to change current account balances without a further change in exchange rates, it might be possible for surplus countries to attempt to stimulate demand and to offset the exchange rate effects through an accommodating monetary policy. Specifically, a rise in domestic demand outside the United States would tend to raise demand for U.S. exports and contribute to a strengthening of the U.S. current account balance.
Unfortunately, the effects on the U.S. current account of shifts in growth rates abroad appear to be relatively small. It is unlikely that a 1 percentage point increase in domestic growth in Japan and the Federal Republic of Germany (maintained over a three-year period and with allowance for induced effects on growth in other countries) would alter the U.S. trade balance by more than $5ȓ10 billion. These effects are small, partly because the U.S. economy is larger than the other two economies, partly because trade between the United States and the Federal Republic of Germany is relatively small, and partly because U.S. exports to Japan are quite limited. Of course, if a large number of countries—not just Japan and Germany—were to stimulate domestic demand, the effects on U.S. trade would be much larger. In summary, demand stimulus outside the United States would have to be very large and widespread in order to have sizable effects on the U.S. position.
Estimation of the effects on current account positions of a given exchange rate change are subject to quite wide margins of error. The relationships involved seem to depend heavily on circumstances and on the way policies are actually implemented. On balance, however, staff estimates suggest that a 10 percent real effective depreciation of the U.S. dollar, if induced by a sustained policy of fiscal consolidation, would be associated over time with a strengthening of the U.S. trade balance in the neighborhood of 1 percent of GNP.9 The magnitude of the reduction of U.S. government expenditure that it would lake to generate that exchange rate change is estimated to be on the order of 2 percent of GNP.
To some extent, the real depreciation of the U.S. dollar during the past year has been supported by the expectation of a sizable reduction in the U.S. fiscal deficit. These estimates indicate that the magnitude of that depreciation—some 20 percent in comparison with the average real value in 1984—would be sufficient to bring about a meaningful reduction in the U.S. external deficit relative to what it otherwise would have been. However, the full potential effects of this exchange rate movement may not materialize until the planned fiscal adjustment actually occurs.
It should be emphasized that trade restrictions do not have a legitimate role to play in dealing with current account imbalances. An intensification of protectionism would not only poison the political climate, reduce the efficiency of resource allocation, and complicate the handling of the debt situation, but it would also be very unlikely to achieve its immediate purpose, which is to strengthen the trade account of the country adopting restrictions. This is partly because such measures almost invariably provoke retaliation from trading partners and partly because a country’s current account is governed by fundamental savings and investment relationships. If specific action is taken to improve the trading position for a given commodity, without corresponding action to alter the aggregate balance between saving and investment, then there will be a tendency for the exchange rate to appreciate and for spending to leak abroad in increased purchases of nonprotected commodities.
International Repercussions of Performance in Developing Countries
In total, developing countries account for about one fifth of the output of the Fund’s member countries and about one fourth of total imports. The ten largest developing countries account for almost half the combined output of the developing world. Clearly, therefore, economic trends in these countries have the potential to exert a significant influence on the global economic environment.
This influence is exerted in three major ways. First, the import demand of these countries is an important component of world trade and output. Thus, import compression in developing countries can exert a substantial negative effect on the overall world trade climate. Over the five years prior to 1981 imports by developing countries increased, on average, by 7¼ percent a year; in the five years since 1981 imports are estimated to have declined by 2 percent a year. This change in trend has had major implications for industrial country exports, which may have grown by some 2½ percent a year less than if the earlier growth of developing country imports had been maintained. With exports of goods and services from industrial countries representing about one fifth of their GNP, the direct effect on industrial country growth of the import slowdown in the developing world could have been as much as ½ of 1 percent per annum. (Of course, to the extent that import cutbacks in developing countries were necessitated by terms of trade losses, domestic demand in industrial countries would have been sustained by the terms of trade gains.) The effect on intra-developing country trade would also have been dramatic. In all regions except Asia, imports by developing countries from other developing countries in the same region dropped even more rapidly than total imports after 1982.
Second, economic performance in developing countries also affects the rest of the world via financial channels. Loans to indebted countries constitute a significant part of the portfolio of international financial institutions. Fluctuations in the creditworthiness of these countries therefore influence the basic stability of the financial system and its capacity to fulfill efficiently its intermediation function. These fluctuations in creditworthiness also stand behind changes in countries’ ability to borrow to finance imports, and thus in the swings in import demand referred to above.
A third interaction arising from policies in developing countries is in the field of protectionism. While it is the threat of increased restrictions in industrial country markets that constitutes the greatest risk in a global context, protectionism in developing countries is not without its dangers. For one thing, protectionist actions in developing countries, particularly when they take the form of subsidies to exports to developed country markets, generate predictable calls for retaliation in the latter. For another, a generalized unwillingness to open markets can result in a failure to exploit the possibilities for expanding trade flows among developing countries themselves. More generally, protectionism often sustains those economic activities whose inefficiencies helped precipitate the debt crisis in the first place, and whose continuation may hinder an improved allocation of resources and a restoration of creditworthiness.
Strengthening Growth in the Developing World
It is by now four years since debt-servicing difficulties encountered by Mexico precipitated what has come to be known as the debt crisis. Since that time, considerable efforts have been made to strengthen the economic position of indebted countries, and much progress has been made. Nevertheless, for many major debtor countries, normal access to commercial sources of credit has not been restored, and the momentum of development has remained subdued. It would not be an exaggeration to say that promoting sustainable growth in the developing countries is the single most important objective of international economic management. Indeed, strengthening economic performance in industrial countries, important as it is in its own right, is even more important for the contribution it would make to alleviating the difficulties facing the world’s poorer nations.
Looking first at the more positive developments since 1982, developing countries have substantially reduced their current account deficits and have, for the most part, come to agreements with their creditors on the restructuring or rescheduling of debt. To set against these achievements, however, debt ratios have continued to mount, and economic growth has been generally disappointing. The ratio of debt to exports of capital importing countries, as a group, rose from 151 percent at the end of 1982 to 169 percent at the end of 1985, while their debt-GDP ratio increased from 34 percent to 40 percent. Per capita GDP, which had fallen in 1981 and 1982 in developing countries, increased only marginally in 1983–85.
Even this somber picture does not do justice to the difficulties faced by particular regions. In Africa, for example, output per capita has fallen in each of the past five years, and further declines are projected for 1986 and 1987. By that year, if the staff’s projections are borne out, GDP per capita in Africa will be some 13 percent below the level of 1980, and absorption will have shrunk by even more as a result of the need to channel real resources toward offsetting terms of trade losses and improving the payments position.
In many ways, the current low rates of economic growth in developing countries are the true “crisis” of the mid-1980s. In any event, the servicing of debt clearly has to be combined with the restoration of growth before the position of the developing countries can be adjudged satisfactory.
The slowdown of growth in the 1980s can be traced to the need of most countries to adjust to the reduced availability of foreign exchange. This reduced availability has its roots in several causes: slower growth of export markets; deterioration in the terms of trade: higher carrying costs of existing debt; and reduced lending. Of these four adverse factors, the only one that has been significantly mitigated in the recent past is the interest cost of carrying debt. Otherwise, recent developments and immediate prospects for the external environment facing developing countries are bleak. Given such an environment, the policies that developing countries pursue must be geared to maximizing growth through increases in efficiency and proper allowance for the cost of foreign exchange.
A first requirement, of course, is to ensure that the opportunities for export growth are fully exploited. In this connection, an adequately competitive exchange rate is a first priority. The record of the past several years shows that countries that have avoided debt-servicing difficulties have shifted their exchange rate in a more timely way than those that have encountered difficulties. This has helped them to maintain more rapid rates of export growth, which in turn has helped sustain faster GDP growth. Beyond a competitive exchange rate, however, other policies need to be conducive to increased and more diversified production of tradable goods. Since many developing countries produce primary products for which demand is relatively inelastic, too great a focus on the increased output of traditional exports can have the undesirable consequence of driving down prices and lowering receipts for developing countries as a group. It is important for developing countries to permit the emergence of new products in which they have, or can acquire, a comparative advantage in world markets.
Even if developing countries are relatively successful in encouraging new lines of export production and in promoting their sales abroad, the growth of their export earnings will be limited by the modest rate of economic expansion in the industrial countries and continued protectionist pressures. If the export earnings of these countries are to grow at a rate even approaching that achieved in the 1960s and 1970s, major progress will be necessary both on the domestic front and in global trade liberalization. Even in these circumstances, if the momentum of domestic growth is to be restored, increments to output will have to reflect the high costs of foreign exchange and become relatively less dependent on imports than in the 1970s. This will require: (1) increasing domestic savings to sustain adequate investment levels; (2) facilitating the introduction of technologies that are not heavily dependent on imported capital equipment or intermediate inputs; and (3) using available foreign exchange efficiently.
Improving export performance, increasing domestic saving, and making more economical use of foreign exchange are all closely related to a wide range of policies that developing countries will need to adopt—and in many instances have already adopted—to make the best possible use of the limited domestic and external resources available to them. These possible policies include: correcting misaligned exchange rates and interest rates; freeing individual productive units (whether private or public) from inefficient, burdensome, and often inconsistent government controls over their activities; liberalizing restrictions on foreign trade and payments; removing price distortions created by government action; and eliminating the fiscal burden created by public enterprises (either through privatization or through pricing adjustments and internal reorganization).
In the policy approach just outlined, the operation of market forces and the exploitation of comparative advantage should enable the growth process to become less dependent on imports. For example, in many African countries that face limited export opportunities in the medium term, past pricing policies have discouraged domestic food production and led to an excessive share of imports being absorbed by foodstuffs. A restructuring of price incentives to eliminate existing distortions could in many cases lead to the substitution of domestic for foreign sources of food production and allow the foreign exchange thus released to be used in more directly productive ways. There is a danger, however, that an unfavorable economic environment—poor export opportunities and inadequate external financing—will induce countries to undertake a more pronounced import substitution strategy based on trade restrictions and domestic controls that artifically skew price incentives against the tradable goods sector. Such policies are ultimately self-defeating since they tend to undermine export performance and eventually reduce the scope for domestic growth. Moreover, such policies have the important secondary effect of encouraging protectionist policies in other countries, in the end further dampening the growth of world trade.
A policy strategy of improving growth and current account performance, in the presence of continued sluggishness of external financing flows, requires placing primary reliance on domestic saving as the source of finance for rising investment. For this reason, domestic macroeconomic policies continue to be of central importance. Competitive interest rates are necessary to help mobilize domestic savings, to channel savings toward their most productive use, to discourage capital flight, and to encourage the repatriation of savings that have previously been sent abroad. Fiscal restraint is needed to facilitate the task of bringing, and keeping, inflation under control, and to reduce the share of savings pre-empted by the government. More generally, the restoration of financial stability is an essential part of a climate in which savings, investment, and enterprise can flourish.
International Cooperation and the Role of the Fund
Besides the economic challenges which countries, whether industrial or developing, must face individually, there are issues which need to be tackled at the international level. These issues are of two kinds: first, how to coordinate -policies so that the international interactions of economic developments are exploited in a positive way; and second, how to provide financial assistance and advice to individual countries in a manner that facilitates the restoration of domestic and external balances in an environment of enhanced growth. Underlying these two issues, of course, is the fundamental necessity of resisting the encroachment of protectionist pressures and preserving a liberal trade and payments system.
As regards policy coordination, progress has been made in both procedure and substance. It has been agreed that greater attention should be given in surveillance to the analysis of international interactions of economic policies and developments, particularly as concerns the larger countries. Techniques for sharpening the focus of such analysis, for example through the use of indicators, are being explored, and they find some reflection in the current World Economic Outlook.
As far as the substance of policy coordination is concerned, the major countries have directed efforts toward achieving a more sustainable pattern of exchange rates and greater convergence in inflation and growth rates. In addition, they have renewed their common commitment to resist protectionist pressures. The movement in exchange rates that has taken place, in particular the depreciation of the U.S. dollar and the strengthening of the Japanese yen and most European currencies, will make an important contribution toward establishing a more sustainable pattern of current account balances. Nevertheless, two points need to be borne firmly in mind. First, the exchange rate movements that have taken place have been assisted by market anticipations of a correction in the U.S. fiscal position. If such a correction were not to occur, questions would arise about the pattern of exchange rates. A second important point is that the recent exchange rate changes will take time to have their effects on payments flows. Thus patience will be needed during the period when “J-curve” effects are working their way through, and efforts will be needed to ensure that the transfer of real resources from domestic to external demand (or vice versa) is facilitated. Domestic demand will have to grow more rapidly than output in countries whose currencies have appreciated and whose payments surpluses are expected to diminish, while the reverse will have to be the case in countries where a depreciation has occurred.
In addition to encouraging mutually supportive policies in individual countries, the mechanism of international coordination can be used to strengthen the response to the debt difficulties facing many developing countries. The U.S. debt initiative, launched in October 1985, recognized the complementary roles of the various parties to the problem, as well as the close interconnection between the servicing of debt and the resumption of adequate growth. As is highlighted by a number of recent cases, the Fund has continued to support the adjustment efforts of member countries and has tailored the specific features of programs to the particular circumstances facing individual countries. The dramatic changes in the past year in the conditions facing different groups of countries have amply underlined the continued need for a case-by-case approach.
Looking to the future, it seems inevitable that indebted countries will remain under strong financial pressure and that their financing needs will be influenced by external circumstances beyond their control, such as shifts in interest rates and the terms of trade. At the same time, the altitude of commercial lenders is likely to remain cautious, given the implicit discount on their existing portfolio of foreign assets and the pressures they are under from domestic regulators and shareholders. In these circumstances, there is a clear need for the international community at the official level to play a major role. This role includes not only encouraging debtor countries to adopt policies that lead to stable and sustainable growth, but strengthening mechanisms to help ensure that well-conceived medium-term strategies are not disrupted by fluctuations in net financial flows. The Fund has played a catalytic role in this process, and continues to do so. Nevertheless, additional efforts seem called for to help channel private and official financial flows to countries that can make effective use of them. There is, in particular, a need for additional resource flows to low-income countries in forms that do not lead to unrealistic increases in debt burdens.
Lastly, protectionism remains a threat that needs to be resisted forcefully and collectively. A first step lies in recognizing the essentially destructive character of trade restrictions. As already noted, trade restrictions distort the allocation of resources and provoke retaliatory measures that risk a downward spiral of world trade. At the same time, such restrictions undermine the basis on which the current debt strategy has been built, which envisages indebted countries returning to creditworthiness through soundly-based growth of exports, imports, and GDP. As well as resisting pressures for protectionism, however, it is important to deal with the factors that give rise to them. This underscores the importance of effective international coordination to achieve stable growth and to establish a more sustainable pattern of exchange rates and current account balances. If efforts in these directions can be shown to be bearing fruit, it will become easier to undertake the measures needed to re-establish a momentum of liberalization in world trade. Among such measures that are worthy of note are an early start to (and successful conclusion of) a new round of negotiations under the General Agreement on Tariffs and Trade: full implementation of existing trade agreements and the rolling back of recently introduced trade restrictions; and a reduction of the production subsidies that are contributing to low world prices for certain major primary commodities.
The analysis presented here is based on the assumption that the fiscal intentions of governments will be substantially realized over the medium term. Significant progress on the U.S. fiscal deficit is particularly important in this respect. Lack of progress would generate uncertainties about interest rates and exchange rates that would undermine the analysis.
The staff projections, which were elaborated before the authorities’ measures were announced, assumed that the package would contain substantial additional fiscal expenditures. However, the projections have not been adjusted to take into account any difference between the staff assumptions and the measures actually taken by the authorities.
This estimate is based on the assumption that the offsetting weakening in the balance of other countries would be limited to industrial countries. To the extent that the balances of developing countries were also to weaken, the exchange rate adjustment required for a given change in the trade balance would be correspondingly reduced. This estimate also ignores the possibility of structural changes in the economy that might substitute for exchange rate movements, as well as a strengthening of the invisibles balance being induced by the currency movement.