Current Situation and Short-Term Prospects
- International Monetary Fund. Research Dept.
- Published Date:
- January 1988
The remarkable resilience of economic activity in the aftermath of last October’s stock market crisis has been a welcome surprise. At the same time, inflation has remained low. In several industrial countries, however, the recent strength of growth and associated increases in capacity utilization have given rise to fears of overheating and of a resurgence of inflationary pressures in the period ahead. Experience suggests that an acceleration in inflation would threaten the sustainability of the current expansion, which is now in its sixth year and exceptionally long by historical standards (see Box on pp. 4–5).
Real GNP in the seven major industrial countries is now estimated to have expanded by 4.5 percent over the year to the first half of 1988 (Chart 1).1 Although growth is expected to moderate somewhat in the course of the year, the staff has revised the projected industrial country growth rate for 1988 as a whole to 3.9 percent, 1.1 percentage point more than envisaged in the April 1988 World Economic Outlook (Table 1).
Chart 1.Major Industrial Countries: Real Output and Total Domestic Demand, 1983–Second Quarter 1988
|Current Estimates||Differences from|
April 1988 Estimates1
|Export prices of non-oil commodities (in U.S. dollars)||3.4||15.7||–3.8||6.3||–4.8|
|Oil prices (in U.S. dollars a barrel)||16.91||14.50||15.00||–1.25||–1.50|
In the United States, both output and demand growth have been stronger than previously appeared likely. Domestic absorption has continued to expand at a rate close to the growth of capacity. In addition, the growth of output has been pushed up by an improvement in the real foreign balance, which could amount to as much as 1 percent of GNP for 1988 as a whole. As a result, real GNP is projected to grow by 4 percent (year-on-year) in 1988, the strongest rate since 1984. One consequence of this strong growth performance has been that the rate of capacity utilization has increased to its highest level since 1979 (Chart 3).
Chart 2.Major Industrial Countries: Comparison of Expansions1
1 Upswings beginning in Q4 1971, Q1 1975, and Q4 1982. The origin of the horizontal axis in each graph represents the first quarter of the upswing. To avoid overlap with the second period, the first expansion period is only shown for the first four years after the trough in 1971.
2 Vertical axis measures the cumulative change in percent from the first quarter of the upswing.
3 Percentage change from the same quarter of previous year.
4 As a percentage of total labor force.
Chart 3.Major Industrial Countries: Capacity Utilization in Manufacturing, 1979–88
1 Percentage of firms operating at full capacity.
The upward revision to the output projections has been particularly large in the case of Japan, where GNP is now expected to grow by over 5½ percent in 1988; continued strong growth of domestic demand seems likely to more than compensate for a marked decline (projected at 1½ percent of GNP in 1988) in real net exports. In addition, growth appears to have revived in the Federal Republic of Germany and France. In Germany, the pick-up can be attributed to stronger domestic demand growth and, to a lesser extent, to a slowing in the pace of external adjustment; in France, also, the strengthening reflects a firming of domestic demand, particularly business investment, as well as an improvement in export performance. Canada, the United Kingdom, and Italy have also experienced relatively rapid growth. In most of the smaller industrial countries growth has continued at a more moderate pace, but the strength of activity in Australia, Spain, and Sweden has raised fears of overheating in these countries as well.
A central feature of the recent growth performance in most industrial countries has been the strength of investment (Table 2)—the component of aggregate demand subject to the largest upward revisions in the projections. This development is particularly welcome since it may contribute to alleviating capacity constraints. The buoyancy of business investment, a particularly difficult component of demand to forecast, seems to reflect a number of factors, some of which may have been operating with a lag. These include the improvements in profitability since the beginning of the decade, the declining trend in real interest rates (until 1987), the strength of stock markets, deregulation and other structural policies, the sustained growth of overall demand, and improvements in business confidence. Another important stimulus to business investment has been provided by the changes in industrial structure that are occurring as a result of policy and exchange rate changes. These have generated rapid investment in domestically oriented sectors in Japan and in tradable goods sectors in the United States. In the Federal Republic of Germany, however, the response of business investment to such structural changes has been more hesitant.
|Gross fixed investment||4.4||2.3||4.3||7.2||4.2|
|Final domestic demand||4.1||3.6||3.4||3.9||3.0|
|Total domestic demand||3.4||3.7||3.6||4.1||3.1|
|Exports of goods and services||3.7||1.0||5.8||7.4||4.3|
|Imports of goods and services||3.9||6.2||7.3||7.5||5.0|
|Germany, Fed. Rep. of2||9.3||4.1||4.0||4.7||3.1|
Current Expansion in Historical Perspective
The current expansion in the industrial countries is now nearing the end of its sixth year, and thus has become the longest period of continuous growth since World War II. Length, however, is not its only distinguishing characteristic; it differs from previous recoveries in the composition of demand and the degree of inflation. The sources of these differences lie not only in the nature of the disturbances that occurred during the various expansion periods, but also in the policy stances adopted.
Chart 2 contains a comparison of aggregate performance indicators for the seven major industrial countries during the expansions of the early 1970s, late 1970s, and 1980s. These three upswings followed cyclical troughs in the fourth quarter of 1971, first quarter of 1975, and fourth quarter of 1982. The two earlier recoveries ended in their third and fifth years, respectively. Real GNP grew moderately in the early part of these upswings. Growth subsequently tended to accelerate; in the earliest expansion at the end of the second year, in the middle upswing at the start of the third year, and in the latest only in the middle of the fifth year. While the current expansion has been associated with much higher levels of unemployment, this has been mainly a consequence of inadequate job creation during the two previous recoveries.
Price behavior in the current upswing has also contrasted sharply with that experienced during the two previous cycles. Consumer price increases have been significantly lower, particularly after the start of the third year. GNP deflator growth has been uniformly lower or steadily declining. Domestic factors have been a critical aspect of this better inflation outcome. The most distinguishing feature has been much greater wage restraint; wage increases in manufacturing, for example, have been less than half of those recorded during the previous two upswings. Moreover, although labor productivity increases have not been much greater than in earlier upswings, an encouraging sign has been the acceleration of productivity growth in the fifth year of the current expansion.
The improved performance during the current expansion, in both real and nominal terms, can be related to the interaction of the behavior of the external environment, the stance of economic policy, and increased market flexibility. Concerning the global environment, the course of commodity prices has differed considerably in the current expansion from the pattern in the two previous cycles. Even two years before the major decline in oil prices in 1986. the prices of most other major commodities had begun to fall. This development helped to dampen inflation from the middle of the second year of the current recovery, in sharp contrast to the pattern of a steady upward trend in commodity prices during long periods of the two previous expansions. With the fall of oil prices in 1986, the terms of trade of industrial countries improved further, enhancing the disinflationary forces. The decline in inflation and real interest rates also meant higher values of financial wealth, which in turn contributed to support the upswing. On the other hand, external market growth was generally lower in the current expansion than in previous ones, owing in part to the effects on developing countries of weak commodity prices, high real interest rates, and external financing constraints during much of the expansion.
The stance of economic policies has also been different during the current upswing, as illustrated by the medium-term orientation of financial policies since the early 1980s. While the goal of budgetary consolidation was not adhered to in all countries, in most cases the stance of fiscal policy has been somewhat more cautious than during the 1970s, as illustrated by the reduced variability of cyclically adjusted budget balances. Even so, relatively large budget deficits have resulted in steadily rising ratios of public debt to GNP.
Monetary policy has probably played a more important role in explaining the length of the current upswing. Whereas the upswing in the early 1970s was accompanied by expansionary monetary policies, a strict non-accommodating stance was generally adopted in the late 1970s, in response to the marked ratcheting-up of inflation that had taken place earlier in the decade. The tight stance of monetary policy in the early 1980s may have contributed to the slowdown of growth during the 1981–82 recession, but it helped to prepare the ground for the steady deceleration of inflation during the ensuing upswing. From 1984 to early 1987, the monetary aggregates again expanded significantly faster than nominal GNP, as the monetary authorities tended to accommodate perceived shifts in the demand for money that were attributed to financial deregulation and declining inflationary expectations. In some countries, exchange market considerations were also a factor in explaining the acceleration in money growth, partly reflecting occasional intervention in exchange markets. The rapid growth of money supply was felt to be consistent with low inflation because of a steady decline in velocity. A key issue in the staff’s projections is whether the decline in velocity might reverse itself, at least partially.
To some extent, the current expansion appears to be characterized by a paradox of improved macroeconomic performance in the face of rapid money growth and pressures toward crowding out from large fiscal deficits. Although such factors are difficult to quantify, it is natural to seek to explain the paradox by the effects of structural reforms that have improved flexibility in both national and international markets. It is possible, for example, that the internationalization of financial markets has allowed a more flexible distribution of world savings, so that the effects of the fiscal deficits are less concentrated. In addition, improvements in the functioning of both factor and goods markets may have helped to promote flexible responses to wide swings in exchange rates and input prices; without such flexible responses, the transfer of resources among sectors would probably have been less smooth, with adverse effects on macroeconomic performance. More generally, the staff’s analysis of developments in the growth of total factor productivity point to a significant recovery after 1982 compared with the weak performance of the 1970s. This helped to raise the growth of potential output and to improve the “split” between real output growth and inflation.
While acknowledging the validity of these arguments, in the staff’s judgement it is too early to conclude that the resilience of the economic system has improved in any fundamental way. As discussed in the April 1988 World Economic Outlook, the tensions that sooner or later may be associated with the persistence of large fiscal and external imbalances may eventually make themselves felt in a slowdown in economic activity, unless policies are adjusted in a timely manner. If tensions in financial markets were to intensify during the period ahead, the current expansion period might well compare less favorably with earlier upswings.
A final point of comparison concerns the question of how earlier expansions ended. In each of the previous two cycles, oil or commodity market shocks precipitated the end of the upswing. In both cases, however, the stage had been set by a rise in money growth (most pronounced in the upswing of the early 1970s), expansionary fiscal policies, and a deterioration in wage and price performance. The current expansion has also been accompanied by a pickup in non-oil commodity prices and relatively rapid growth of money supply. In the current situation, the persistence of large imbalances in current accounts among the major industrial countries is an additional threat to price stability in some countries because of the potential impact on exchange rates and, thus, import prices. Nevertheless, non-oil commodity prices have remained low in real terms, the weakness of oil markets has acted as a dampening influence on general price trends, and growth of money supply has recently slowed significantly in some countries. The interpretation of monetary aggregates in the face of deregulation and internationalization of financial markets also remains open to question.
In summary, it is apparent that the sustainability of the current recovery, which is already long by historical standards, may largely depend on the behavior of inflation. A pickup in inflation would tend to reverse the positive wealth effects experienced in recent years and would be likely to increase uncertainty, which would be damaging for business confidence and investment. In addition, if inflation performance were to deteriorate, monetary policy might ultimately have to be tightened significantly to prevent a ratcheting up of inflation expectations, as experienced in the 1970s.
In many countries, residential construction has also expanded rapidly in response to the lower interest rates of recent years and to increases in personal income and wealth. Private consumption growth, too, has typically been stronger than expected, even though the downward trend in saving ratios in many countries since the beginning of the decade appears to have been arrested following the stock market decline.
The unexpected robustness of growth in the industrial countries over the past year can be attributed to a number of factors. The most important seems to have been the lagged influence of the large exchange rate and terms of trade changes that occurred in 1985–86. Because the countries or sectors that lost from these changes adjusted faster than the gainers—perhaps reflecting budget and financing constraints—the impact on global demand and activity in the short run was negative. As demand began to respond to the improvements in real incomes and competitiveness enjoyed by the gainers, however, activity accelerated from the middle of 1987. Wealth effects associated with rising equity and other asset prices may also have stimulated demand. Although the global decline in stock market prices in October 1987 constituted a dampening force, the underlying momentum of growth was clearly underestimated at the time. The impact on business and consumer confidence was therefore considerably less serious than initially feared. Moreover, stock prices have subsequently recovered a significant proportion of the losses incurred last October.
Growth also seems to have been stimulated by the relatively low level of short-term interest rates and the rapid growth of money supply in most of the major countries in recent years. Although the interpretation of movements in monetary aggregates is difficult, it is quite possible that monetary conditions may have been more conducive to expansion than previously thought. Monetary conditions did tighten somewhat in the course of 1987, mainly in the United States, but the lagged effects of the fall in interest rates in 1985–86 and the accompanying significant increase in liquidity may have continued to be a source of stimulus. Fiscal policy has played less of a role in the growth picture at the global level, given the offsetting shifts in stance across countries. However, the fiscal package announced by Japan in May 1987 has probably been a factor contributing to the sharp acceleration of growth in that country. The recent pick-up in demand in the Federal Republic of Germany may also have been partly related to the tax reductions that took place at the beginning of 1988.
A final point is that business and consumer confidence has been favorably influenced by official policies aimed at limiting government spending and deficits, preserving price stability, and promoting external adjustment. While cautious monetary and fiscal policies have a generally dampening effect on demand growth in the short term, their medium-term consequences are more positive, and may help explain the recent strength of private sector economic activity.
The staff’s projections are based on the view that some of the factors underlying the acceleration of growth over the past year or so are transitory and that a moderation in output growth is likely during the period ahead. In particular, the recent firming of monetary conditions in most of the major industrial countries is likely to contribute to a dampening of the rate of expansion of interest-sensitive components of demand. Such a moderation would help to prolong the expansion since it would reduce the risk of overheating and thus help avoid a significant tightening of policies at a later stage. The possibility cannot be excluded, however, that nominal demand may continue to expand at a fast pace. This could ultimately threaten not only inflation performance but also the sustainability of the current expansion. These issues are discussed in more depth in the section below on alternative medium-term scenarios.
Even though unemployment in the industrial countries, taken as a group, has remained higher than during most of the postwar period, the recent buoyancy of activity has caused labor markets to tighten significantly in a number of countries. Job creation has been particularly strong in the United States, where employment has increased at an annual rate of over 2½ percent for the past four years, and the unemployment rate has dropped by 5 percentage points from its 1982 peak. By mid-1988, the U.S. unemployment rate had fallen to 5.4 percent, which is within the range of estimates of the unemployment rate at which wage increases could begin to accelerate. Indeed, some signs of higher wage increases can already be detected.
The labor market situation has also strengthened significantly in Canada and the United Kingdom, and Japan has experienced a reversal of the rise in unemployment that occurred in 1986–87. By contrast, in most of continental Europe unemployment has tended to stabilize at very high rates. Because of high levels of structural unemployment, the amount of cyclical slack in European labor markets is likely to be significantly smaller than that suggested by observed unemployment rates.
Economic activity in the developing countries in 1987 now appears to have been slightly stronger than previously estimated. The revised estimates for 1988 and 1989 have changed little, however, and suggest that growth in the developing countries may strengthen only moderately, from 3.4 percent in 1987 to 4 percent in 1989 (Chart 4). Growth performance is expected to continue to vary considerably among countries, with the heavily indebted and the fuel exporting countries experiencing the lowest growth rates.
Chart 4.Developing Countries: Real GDP, 1980–89
The apparent weakness of spillover effects from the buoyancy of growth in the industrial countries and from the strength of commodity prices and world trade can be explained by a number of factors. First, oil markets have been relatively weak during the first eight months of 1988, and real oil prices have declined significantly. On the assumption of unchanged real oil prices over the balance of 1988 and 1989, the loss of export earnings will thus continue to depress activity in the fuel exporting countries, as well as in countries that rely on the fuel exporters as sources of export revenue and migrant workers’ remittances. Second, despite the general strength of commodity prices, the prices of a number of products that are important for many developing countries, notably tropical beverages, have tended to weaken, so that some exporters of primary commodities are actually registering terms of trade losses. Third, the firming of interest rates since early 1987 has increased debt servicing costs, partly offsetting the gains from higher export earnings. And finally, a sharp deterioration in inflation performance in a number of developing countries (discussed below) has adversely affected growth prospects, both because of its direct negative impact on demand, particularly investment, and also through the short-term contractionary effects of corrective policy adjustments. The projections reflect the assumption that the necessary policy adjustment will begin to be implemented during 1988–89.
The developing countries that are benefiting most clearly from the strength of demand in the industrial countries are the exporters of manufactures, which are projected to grow by some 6 percent a year in 1988–89. Growth is projected to continue at a very strong pace among the Asian newly industrializing economies (Hong Kong, Korea, Singapore, and Taiwan Province of China), with output rising on average by about 8 percent in both years. Output is also projected to expand strongly in China, and the Indian economy has begun to recover following last year’s drought. Among the developing countries in Europe, which are predominantly exporters of manufactures, Turkey’s growth rate is projected to average 5 percent in 1988–89, under the influence of strong exports and rapid investment growth. By contrast, output in most of the Eastern European countries is expected to stagnate or grow only modestly, reflecting serious domestic adjustment problems and, in some countries, rapid inflation.
While the external environment for exporters of non-oil primary commodities has also improved during the past year, the impact on growth is expected to differ considerably among countries depending on the particular commodities they export and on the ability of their economies to respond to the external stimulus. In Asia, many exporters of primary commodities are benefiting from higher commodity prices and are at the same time increasing their exports of manufactures. In the case of the Philippines, for example, the strength of exports, in conjunction with domestic policy adjustments, is projected to raise growth from 5 percent in 1987 to 6 percent in 1988.
Growth prospects remain less favorable for many of the primary product exporters in Africa, owing in particular to adverse terms of trade developments and to the narrowness of their export base. Nonetheless, several African countries, including Ghana, Kenya, and Morocco, are expected to achieve growth rates of 5 percent or more, partly because of strong growth of exports. Among several of the primary product ex-porters in the Western Hemisphere, growth is projected to remain weak, notwithstanding relatively strong growth of export revenues. A major factor that is hindering growth in these countries is a delayed policy response to the problem of inflation. This is the case, for example, in Brazil, where output growth is projected to slow to 1 percent in 1988. Some of the exporters of minerals and metals in the region, notably Chile, are expected to be more successful in translating rapid growth of export earnings into higher output growth while containing inflation.
The economic situation of the fuel exporting countries remains difficult. In addition to the weakness of oil markets, these countries are now faced with the need to absorb significant increases in import prices and, in some cases, rising debt service costs. For most of them, the scope for financing a potential deterioration in their external positions is likely to be limited. These countries are therefore expected to continue to seek to reduce imports; as a result, output is projected to grow only modestly in 1988–89.
Despite the concerns about a possible pick-up in inflation alluded to earlier, moderate price increases have remained a distinguishing feature of the current expansion in the industrial countries. Consumer prices did accelerate slightly during 1987 as the dampening effects of the sharp drop in oil and other commodity prices in 1986 gradually diminished (Chart 5). Even so, in most countries inflation has remained quite moderate by recent historical standards. In the second quarter of 1988, consumer prices in the seven major countries were about 3 percent higher than a year earlier, with individual inflation rates ranging from 0.3 percent in Japan to 5 percent in Italy (Chart 6).
Chart 5.Inflation Indicators, 1980–88
1 Three-month centered moving averages of 12-month inflation rates. Consumer prices are measured in local currencies and are averaged using GNP weights. The commodity price index is a global export-weighted basket of 40 commodities that includes oil and gold, using the same average exchange rate as the one used for the composite inflation index.
2 Nominal prices deflated by export prices in manufactures.
Chart 6.Major Industrial Countries: Consumer Prices, Hourly Earnings in Manufacturing,1 and Unemployment Rates, 1985–Second Quarter 1988
1 Percentage changes over a year earlier.
An important factor in this good price performance has been the moderate rise in labor costs in most of the major countries, the United Kingdom and Italy being exceptions. Wage increases tended to accelerate somewhat in the course of 1987 in some countries, reflecting both the pick-up in consumer prices and the rapid reduction of labor market slack. The pick-up in wages was most pronounced in several of the smaller industrial countries, particularly some of the Nordic countries. With these exceptions there have been few signs so far of any serious setback in domestic price and wage performance in the industrial countries.
Nevertheless, in view of the rapid growth of demand in the industrial countries over the past year, coupled with declines in unemployment and increases in capacity utilization, there have been fears that output may be approaching capacity limits and that in some countries inflation may accelerate in the period ahead. Capacity utilization rates in manufacturing and in the economy as a whole have indeed risen to the highest levels since 1980 in all the major countries. (See Chart 3 and Annex.)
Concern about inflation also stems from the sharp recovery of non-oil commodity prices over the past year. Industrial materials prices have been rising particularly strongly, stimulated by the strength of world activity, low levels of inventories, and modest increases in production capacity. In August 1988 prices of metals, for example, were some 40 percent higher (in dollar terms) than a year earlier. Food commodity prices also rose by close to 40 percent over the same period, partly as a result of the severe drought that has affected much of North America. Although prices of some important commodities, notably tropical beverages and some agricultural raw materials, have been relatively weak, the staff projects that non-oil commodity prices in 1988 will, on average, be some 16 percent higher than in 1987. In 1989. commodity prices are assumed to decline slightly as some of the factors influencing commodity markets this year (inventory increases, drought, overall demand growth) are reversed or become less important.
The oil market has not been affected so far by the firming of other commodity prices and the strength of world activity. Following the substantial recovery from the trough reached in mid-1986, world oil prices started to weaken again in the latter part of 1987. In the first half of 1988 they were about $2 a barrel below the average price level in 1987. The weakness of the oil market reflects mainly a considerable rise in world oil production, stemming from an expansion of output in a number of countries outside OPEC and from the difficulties experienced by OPEC members in implementing their policy of concerted output restraint. At the OPEC meetings in December 1987 and June 1988. no changes were made in the production quotas (in effect since mid-1987), but total output has recently been in excess of the overall output ceiling. For the purposes of this report, it is assumed that the average export price in 1988 will be $14.50 a barrel.2 This would represent a decline from the 1987 average price of about 14 percent in nominal (U.S. dollar) terms and a more substantial decline (20 percent) in real terms. From 1989 onwards, the price of oil is assumed to remain constant in real terms.
Notwithstanding the fact that primary commodities account for a relatively small share of the value of final output (in 1985, 9 percent including oil; 5 percent excluding oil), there has been a historical tendency for turning points in commodity price inflation to lead turning points in general price developments. This relationship reflects both the cyclical sensitivity of demand for industrial inputs and the greater flexibility of prices set in primary commodity markets.
Whether or not the recent surge in commodity prices will lead to a general deterioration in price performance depends on the stance of economic policies and, related to that, changes in inflation expectations. The recent firming of monetary conditions in several of the major industrial countries is likely to have reduced the risk of a serious worsening of price performance. However, the large increase in liquidity since 1985 may still contain inflationary risks. If the rapid expansion of the money supply during this period primarily reflected permanent shifts in the demand for money related to the progressive deregulation of financial markets, such risks would be relatively slight. If, on the other hand, the decline in velocity in recent years was partly attributable to expectations of lower inflation, a reversal of those expectations might lead to an increase in the velocity of circulation, which would permit a significant increase in price levels to be accommodated.
Among the developing countries, price developments during the first half of 1988 point to an acceleration of inflation well in excess of what had been expected at the beginning of the year. The weighted average rate of inflation is now projected to reach about 60 percent in 1988, compared with 40 percent in 1987 (Chart 7). While the pick-up in inflation is mainly accounted for by a small number of high-inflation countries, particularly in the Western Hemisphere, price performance has also deteriorated in many countries with lower rates of inflation. The recent increases in commodity prices and the strength of activity in some countries that are exporters of manufactures may have contributed to the continued acceleration of inflation in the developing world. The most important factor, however, has been lax financial policies. On the assumption that stabilization efforts will be intensified, inflation is projected to fall back in 1989.
Chart 7.Developing Countries: Consumer Prices and Broad Money, 1980–92
Trade and Current Accounts
The strength of activity in industrial countries has been accompanied by rapid expansion of world trade, which is now projected to increase by 7½ percent in real terms in 1988. Import growth is expected to be particularly buoyant in Japan, with a projected rise in 1988 of 15 percent (in volume), compared with 9 percent in 1987. The growth of import volumes is also projected to accelerate in the United States, from 5½ percent in 1987 to about 7 percent in 1988, mainly reflecting the faster rise of total output. The non-fuel exporting developing countries are also expected to experience more rapid import growth, a continuation of the recovery that began in 1987. Imports are projected to grow only marginally in the fuel exporting countries, however, as a result of the most recent decline in oil prices.
Export growth is likely to be somewhat less evenly distributed. The United States is expected to supply about one third of the growth in world trade in 1988. with a projected expansion of merchandise export volumes of 26½ percent—twice the rate registered in 1987. By 1989, U.S. exporters are expected to have regained most of the losses of market shares experienced between 1981 and 1985 (Chart 8). These gains in market shares are at the expense of Japan—where exports are projected to continue to grow only marginally—and. to a lesser extent, of European countries. A tendency for the industrial countries as a group to lose export market shares reflects the continued buoyancy of exports from developing countries. This is mainly attributable to exporters of manufactures—notably Korea and Taiwan Province of China. However, many primary product exporting countries in the Western Hemisphere and in Asia are also enjoying relatively rapid export growth. The export performance of some of the low-income countries in Africa is projected to strengthen somewhat owing to improved crops of key commodities. For the majority of these countries, however, the growth of exports is expected to remain unsatisfactory because of deeply entrenched problems related to these countries’ narrow export bases.
Chart 8.Major Industrial Countries and Newly Industrializing Economies of Asia: Export Market Shares, 1980–89
Terms of trade developments have also been influenced by the overall strength of economic activity. Exporters of industrial inputs, such as metals, other minerals, and agricultural raw materials, have seen quite large favorable shifts in their terms of trade. Exporters of fuels and tropical beverages, however, have experienced terms of trade losses, as their export prices have been relatively stable or falling while import prices were boosted by the surge in other commodity prices.
The large shifts in export performance among the three largest countries are causing a significant narrowing of trade imbalances in real terms (Chart 9). The progress is less pronounced when the focus is on current account positions expressed in dollar terms, largely because of exchange rate changes. In addition, the servicing of changes in net external asset positions is lending to add to current account imbalances. Relative to GNP. the imbalances on current account of the United States and Japan are projected to narrow by almost I percentage point between 1987 and 1989: and that of Germany by 0.5 percentage points. The aggregate current account surplus of the four Asian newly industrializing economies is also projected to decline (Table 3).
Chart 9.United States, Japan, and the Federal Republic of Germany: Oil and Non-Oil Trade Balances, 1980–89
1 In constant 1982 prices.
2 In constant 1980 prices.
|In billions of dollars||1.9||–115.1||–138.8||–154.0||–128.9||–128.7|
|In percent of GNP||0.1||–2.9||–3.3||–3.4||–2.6||–2.5|
|In billions of dollars||–10.7||49.2||85.8||87.0||78.0||80.9|
|In trillions of yen||–2.6||11.5||14.2||12.5||10.1||10.6|
|In percent of GNP||–1.0||3.7||4.3||3.6||2.8||2.7|
|Germany, Fed. Rep. of|
|In billions of dollars||–13.8||16.4||39.1||45.0||44.9||41.5|
|In billions of DM||–25.1||48.4||85.0||80.8||79.8||76.9|
|In percent of GNP||–1.7||2.6||4.4||4.0||3.8||3.5|
|In billions of dollars||–4.9||0.7||3.0||3.3||3.6||3.4|
|In percent of GNP||–4.1||0.9||2.6||2.3||2.4||2.3|
|In billions of dollars||–1.0||5.3||4.8||3.4||4.3||5.6|
|In percent of GNP||–0.6||4.2||2.7||1.6||2.0||2.5|
|In billions of dollars||–0.5||5.1||6.8||7.0||7.0||6.7|
|In percent of GNP||–0.5||5.1||4.8||3.9||3.7||3.6|
|Four Asian NIEs1|
|In billions of dollars||–9.0||10.2||22.9||29.8||25–30||20–25|
|In percent of GNP||–6.8||5.5||10.8||11.2||8–10||5½–7½|
Several other countries are experiencing a weakening in their current account as well, partly because of differences in relative growth rales, but also because of deteriorating competitiveness. The United Kingdom, in particular, has experienced a sharp deterioration in its current balance over the past year, while Italy has also had increasing external deficits. Among the smaller industrial countries. Spain’s current account surplus has fallen sharply. Other countries have experienced smaller deteriorations in their external positions.
The current account for the developing countries as a whole improved to near balance in 1987 but is projected to move into deficit again over the next few years. These movements, however, mask rather different situations in three major groups of countries. Most of the strengthening of external positions in 1987 occurred in the fuel exporting countries and the Asian newly industrializing economies. For the former, this reflected an intensification of adjustment efforts in the wake of the decline in oil prices in 1986; for the latter, the strengthening was attributable to a surge in exports. Both groups are likely to undergo some reversal in their current accounts in 1988–89 as a result of the renewed weakness of oil prices and increased efforts of the newly industrializing economies to limit the size of their surpluses by increasing imports and allowing their currencies to appreciate.
Elsewhere in the developing world, exporters of manufactures other than the four newly industrializing economies experienced a reduction in their current account deficits in 1987. In the remaining countries, which include mainly primary product exporters, current account deficits increased slightly. It is expected that the aggregate deficit of these countries will narrow somewhat in 1988–89.
International Monetary Developments
Following the period of turbulence at the beginning of 1988, when the U.S. dollar recovered sharply from all-time lows against the deutsche mark and the yen, exchange rates among the three major currencies were relatively stable until the dollar became subject to strong upward pressure from June to August (Chart 10). During August, the dollar averaged DM 1.89 and ¥ 134, compared with DM 1.69 and ¥ 125 during May. In real effective terms the dollar appreciated by about 7 percent between May and August, reaching a level some 9 percent above its low at the end of 1987. The strengthening of the dollar took place against all the other major currencies except the Canadian dollar (Chart 11).
Chart 10.Interest Rate Differentials and Exchange Rates, January 1986–September 19881
1 Short-term interest rates.
2 U.S. rate minus German rate.
3 U.S. rate minus Japanese rate.
Chart 11.Major Industrial Countries: Monthly Average U.S. Dollar and Real Effective Exchange Rates, January 1978–August 1988
1 Real effective exchange rates are calculated on the basis of normalized unit labor costs in manufacturing.
Within the European Monetary System (EMS), exchange rates have been relatively stable in recent months; the incipient strength of the French franc following the national elections initially permitted an easing of monetary conditions, in contrast to the trend toward higher interest rates in the Federal Republic of Germany and several other EMS countries. Subsequently, however, French rates also were adjusted upwards. Sterling, after rising sharply against other European currencies during March and April, subsequently fell back against both the dollar and the currencies participating in the exchange rate mechanism of the EMS; from mid-July, however, sterling’s nominal effective value stabilized as interest rates in the United Kingdom were raised by more than in other industrial countries.
Changes in market perceptions of the pace of correction—and also possibly the sustainability—of external imbalances appear to have played an important role in the exchange rate shifts of mid-1988. In this context, it is apparent that the relatively small monthly U.S. trade deficits reported by the United States for April, May, and July were seen by market participants as clearer evidence than was available in 1987 that external adjustment was occurring. Confidence in the dollar may also have improved as a result of the strong performance of the U.S. economy, the succession of steps to tighten monetary policy taken by the Federal Reserve between end-March and mid-August, and other clear indications that the Federal Reserve is sensitive to the danger of overheating and to the adverse effects on inflation of dollar depreciation.
The reversal of pressure on the U.S. dollar during the first eight months of 1988 has been associated with a marked change in the composition of international capital flows. During 1987, the reluctance of private investors to continue to increase the share of dollar assets in their portfolios had led to a sharp increase in official acquisition of dollar assets. Increased official holdings of dollar assets constituted the bulk of the exceptionally large expansion of official reserves (excluding gold) outside the United States last year. Most of the increase was accounted for by Japan, the Federal Republic of Germany, the United Kingdom, and Taiwan Province of China (Chart 12).
Chart 12.Total Reserves Minus Gold, 1985–July 1988
Source: International Monetary Fund, International Financial Statistics, various issues.
Official financing of the U.S. current account deficit was at a much lower level during the first half of 1988, as private investors again stepped up their acquisitions of dollar assets (Table 4). In the Federal Republic of Germany, official asset transactions in fact turned negative as the authorities intervened in dollars to limit the depreciation of the deutsche mark. In Japan, official asset transactions declined to a level only one third as large, on average, as in 1987. The reduced importance of official financing has resulted in a leveling-off of the growth in official reserves.3
|United States||First Quarter1|
|Capital account, net||122.3||105.6||97.0||35.6|
|Net official transactions3||10.3||–27.8||–50.4||–109.9|
|As percent of current balance||–8.8||20.0||32.8||78.3|
|Capital account, net||–49.0||–70.1||–47.8||–63.1|
|Net official transactions3||0.2||15.7||39.2||12.4|
|As percent of current balance||0.4||18.3||45.1||16.5|
|Germany, Fed. Rep. of|
|Capital account, net||–15.8||–35.9||–20.5||–43.2|
|Net official transactions3||0.8||3.2||24.4||–13.1|
|As percent of current balance||4.7||8.1||54.3||–43.7|
Among the developing countries, changes in real effective exchange rates were moderate during the first half of 1988 following marked depreciations during the 1985–87 period. Despite continuing depreciations in nominal terms, several countries in the Western Hemisphere even experienced appreciations of their real effective exchange rates, owing to rapidly increasing domestic prices. Exchange rate trends in the Asian surplus countries differed from developments elsewhere. Since early 1987, the real effective exchange rates of the Korean won and the New Taiwan dollar have risen considerably, notwithstanding some reversal of this movement in the case of the New Taiwan dollar during the first few months of this year. Many African countries whose exchange rates are pegged to the French franc have also experienced appreciation of their real effective exchange rates since 1985 although the recent recovery of the dollar has helped to limit the deterioration in competitiveness.
Financing and Debt in Developing Countries
Current Account Financing
The significant improvement in the developing countries’ aggregate current account balance in 1987 was associated with a substantial recovery in external reserve positions and a moderate decline in net external borrowing, compared with 1986. However, these adjustments were almost entirely attributable to developments in the fuel exporting countries and the newly industrializing economies. The combined net financing requirement of these two groups (measured by the deficit on goods, services, and private transfers) declined by $35 billion in 1987. allowing them to increase reserves by $48 billion while still reducing net external borrowing. The improvement in the aggregate position of developing countries other than the fuel exporters and newly industrializing economies was more moderate. Their net financing requirement in 1987 fell by some $6 billion to $43 billion. Additions to reserves were modest, and net external borrowing rose slightly to around $29 billion, which was more than fully accounted for by official flows.
Looking ahead, the projected weakness of oil prices is expected to lead to a tightening of the oil exporters’ financing position in the short term. Reserves are projected to decline slightly from their 1987 level and external borrowing is expected to rise; there may also be a renewed accumulation of arrears by this group. The position of the newly industrializing economies in 1988–89 looks very different. Policy adjustments should lead to some reduction in their current account surpluses, but they will nevertheless probably continue to add significantly to their reserves and begin to repay substantial amounts of their outstanding debt.
The financing of the projected growth in the current account deficit of the non-fuel exporting developing countries, other than the newly industrializing economies, will depend in part on the evolution of various schemes for restructuring debt service payments. Disbursements under the Fund’s schemes to assist low-income countries (the structural adjustment facility and the recently established enhanced structural adjustment facility) are expected to reduce net reflows to the Fund in 1988–89. Other official creditors are expected to maintain their lending at a level broadly similar to that of recent years. Lending by private creditors is expected to recover slightly in the near term, following the sharp decline in 1986–87, but is unlikely to return even to the relatively modest levels recorded in 1983–85. Non-official financing flows to both the heavily indebted countries and the small low-income countries are expected to remain weak; some of the projected reduction in private creditors’ exposure to the former group is a result of debt conversion schemes and debt-equity swaps in a number of countries.
The developing countries’ total debt outstanding rose to $1,218 billion at the end of 1987. Abstracting from valuation adjustments, the underlying rise in debt is estimated to have been about 4 percent. Four fifths of the increase was provided by official creditors, in part reflecting the acquisition by export credit agencies of claims previously held by the private sector. Despite the continued rise in the stock of debt, the strength of export earnings caused the aggregate ratio of debt to exports to decline from 169 percent at the end of 1986 to 158 percent at the end of 1987.
This decline in the debt ratio is expected to continue in 1988 and 1989. primarily reflecting continued strong growth of exports in many developing countries. As explained earlier, the exceptions are the fuel exporting countries and the low-income countries in Africa. By 1989 the average debt ratio of countries that have avoided debt servicing problems is expected to have returned to a level broadly in line with the position in the early 1980s (Chart 13).
Chart 13.Developing Countries: Debt Outstanding and Ratios of Debt to Exports, 1980–89
While the position of countries with a history of debt difficulties is also showing marked improvement, it remains significantly worse than in the period before the onset of the debt crisis. These countries’ debt-to-export ratio is projected to be some two thirds higher at the end of 1989 than at the beginning of the decade, indicating that growth prospects in these countries remain seriously constrained and vulnerable to adverse external developments. Debt restructuring arrangements are expected to continue to play an important role in limiting debt service payments. It is projected that the debt service ratio, after allowing for prospective reschedulings, will continue to decline from the peak reached in 1986, notwithstanding the recent rise in international interest rates.
Policy formation in the industrial countries has taken place against a background of increasing evidence of the resilience of economic activity. At the same lime, efforts have continued to intensify policy coordination and to help underpin the greater stability of exchange rates. In the United States, domestic considerations—in particular, the strength of demand and the high and increasing rate of capacity utilization—were felt to warrant a moderate tightening of monetary conditions beginning in late March 1988, As upward pressure on the dollar gradually developed, the conflict between domestic and external objectives that had previously constrained monetary policy in some other industrial countries (most clearly the Federal Republic of Germany and the United Kingdom) diminished. In the event, therefore, monetary conditions were tightened somewhat in both surplus and deficit countries (Chart 14) while the dollar was allowed to appreciate slightly.
Chart 14.Major Industrial Countries: Interest Rates and Money Supply, January 1985–August 1988
1 Quarterly averages of daily rales on money market instruments of about 90 days’ maturity.
2 Canada, France, Italy, and the United Kingdom.
3 Quarterly averages of daily or weekly yields on government bonds, with maturities ranging from 7 years for Japan to 20 years for the United Kingdom.
4 Percentage changes over 12 months earlier.
From their lows in early February 1988, both U.S. and German short-term interest rates rose by about 160 basis points over the following seven months. In contrast, Japanese short-term interest rates rose by only about 30 basis points over the same period so that the differential in favor of the United States widened significantly. Between early March and late May, U.K. short-term interest rates were under considerable downward pressure owing to the strength of sterling, and declined by about 150 basis points. As the pressure on sterling reversed, however, short-term interest rates were increased more than in other major money markets, rising by 450 basis points during the subsequent three months. In France, contrary to the general trend in the other major countries, interest rates remained on a downward trend following the general election but have recently turned upward. In most of the major countries, increases in short-term interest rates in recent months have been generally more pronounced than those in long-term rates.
Budgetary developments in the industrial countries in 1987 reflected efforts to reduce the federal deficit in the United States and to support the growth of domestic demand in the large surplus countries. Taking the major industrial countries as a group, fiscal policy was more contractionary in 1987 than in any recent year, and the combined budget deficit of the major countries fell by almost 1 percent of GNP. Looking ahead to 1988 and 1989, however, the aggregate fiscal stance in these countries is expected to be more neutral, as the process of fiscal correction in the United States slows down. In fiscal year (FY) 1987, the U.S. federal deficit was reduced by the equivalent of 2 percent of GNP, partly as a result of special factors of a temporary nature. In FY 1988 (covering the period to end-September 1988), the federal deficit is expected to fall only slightly; the staff’s projections for FY 1989 suggest that progress in reducing the federal deficit on the basis of current spending plans and tax rates will remain modest (Table 5).
|Maximum deficits stipulated by:|
|Original Gramm-Rudman-Hollings (GRH) Act||144||108||72||36||0||…|
|Amended GRH Act2||…||144||136||100||64||28|
|Fund staff working assumption3||2211||1511||152||141||127||123||123|
|As a percent of GNP||5.3||3.4||3.2||2.8||2.3||2.1||2.0|
In Japan, the stimulative package adopted in May 1987 increased public investment outlays and lowered income tax rates. The budget balance for both the central and general authorities nevertheless improved because of continued restraint in current expenditures and rapid growth of tax revenues—reflecting both the buoyancy of economic activity and levies from high stock market and land transaction values. The budget position is expected to continue to improve in FY 1989 and FY 1990, in line with the government’s medium-term fiscal objectives. The proposed tax reform, if adopted, would substitute a generalized indirect tax for most of the existing selective indirect taxes. In addition, the reform would include permanent cuts in individual income taxes and reductions in corporate taxes. The total value of the cuts is estimated at ⅔ of 1 percent of GNP by the end of a three-year phase-in period. In advance of consideration of the proposed tax reform, the Diet approved a temporary cut in income taxes (equivalent to 0.3 percent of GNP), effective for 1988 only.
In the Federal Republic of Germany, modest growth meant that automatic stabilizers contributed to a loss of tax revenue in 1987. In an effort to stimulate domestic demand, part of a tax relief package scheduled for 1990 was brought forward to January 1988. In addition, profits transferred from the Bundesbank in 1988 will be sharply reduced as a result of valuation losses. The overall result has been a marked increase in the budget deficit of the territorial authorities, from 2.2 percent of GNP in 1986 to 2.7 percent of GNP in 1987 and a projected 3.4 percent of GNP in 1988. The Federal government has adopted an increase in indirect taxes of about DM 8 billion for 1989 (equivalent to 0,4 percent of GNP). While this increase is designed to offset increased expenditures (principally a rise in transfers to the European Community), the change in the overall fiscal position is nevertheless estimated to involve a withdrawal of stimulus of ¾ of 1 percent of GNP.
In the United Kingdom, the overall public sector position (including asset sales) is expected to change little in FY 1988–89, following a shift into surplus in FY 1987-88. In Canada, the projected budget deficits in 1988–89 have been lowered, mainly because of improved real growth prospects. In France, the decline in the general government deficit by ½ of 1 percent of GDP in 1987 is expected to be followed by smaller deficit reductions in 1988 and 1989: the authorities have announced that faster than expected growth of tax revenue may provide some room for a tax cut in the next budget. In Italy, the new government has tightened fiscal policy moderately after the deficit in 1987 significantly exceeded the initial target.
Among the smaller industrial countries, the stance of fiscal policy is expected to be somewhat restrictive on average. Announced policies suggest that budget positions can be expected to improve in 1988 in Australia, Austria, Finland, Ireland, Netherlands. Spain, and Sweden.
In large parts of the developing world, sizable external and internal imbalances, persistent foreign financing constraints, a large debt overhang, and the recent surge of inflation present serious challenges for economic policies. Many countries have responded to these challenges by significantly strengthening adjustment efforts, notably in the area of fiscal policy. Projections of central government fiscal balances as a proportion of GDP suggest that fiscal policies generally are expected to be tightened in 1988. However, a number of countries with a history of high inflation continue to experience serious policy slippages.
In the fuel exporting countries, the renewed weakening of the oil market since mid-1987 has increased the need for further cuts in public expenditure. Although the process of fiscal consolidation appears to be proceeding more slowly than earlier expected, many of these countries are projected to achieve significant reductions in their budget deficits in 1988. In a small number of them, however, most notably Nigeria, fiscal imbalances are projected to continue to widen. In response to the fall in oil prices in 1986, many fuel exporting countries allowed their real effective exchange rates to depreciate considerably. Devaluations have been particularly large in countries, such as Indonesia and Nigeria, that have more diversified economies; the resultant stimulus to non-oil exports has helped to facilitate adjustment.
External constraints continue to dominate economic policies in many primary product exporting countries in sub-Saharan Africa. Over the past three years, these countries have experienced a decline in the purchasing power of their exports of almost 17 percent. The consequent deterioration in their external positions has been paralleled by a marked deterioration in fiscal balances reflecting, in part, heavy reliance on trade-based revenue. In order to strengthen their fiscal and external positions, to broaden the basis for sustained growth, and to reduce their vulnerability to external shocks, many of these countries have embarked on comprehensive structural adjustment programs that combine measures of fiscal consolidation and firm monetary control with far-reaching structural reforms affecting prices, interest rates, and exchange rates. On average, fiscal positions in sub-Saharan Africa are projected to strengthen in 1988, and the rate of monetary expansion is expected to decline.
In the Asian newly industrializing economies, economic policies have become increasingly directed toward the large external surpluses that have emerged in these countries in recent years. With output close to capacity, however, the scope for reducing current account surpluses through fiscal expansion is limited. In Korea, the budgetary stance in 1988 is now likely to be broadly neutral: little fiscal stimulus is projected for Hong Kong and Singapore either. In contrast, in Taiwan Province of China, domestic demand, notably investment, has been relatively weak, and fiscal policy appears to have become considerably more expansionary than in recent years. The adjustment strategies in the Asian newly industrializing economies rely increasingly on import liberalization and exchange rate policies. Taiwan and, in particular, Korea, have recently allowed their currencies to appreciate and have announced a number of steps to open their markets to foreign imports.
In many developing countries in the Western Hemisphere and in Europe, the recent acceleration of price increases has placed the fight against inflation at the top of the policy agenda. In response to the financial crisis precipitated by the stock market crash in October 1987, Mexico adopted a comprehensive stabilization program designed to bring about a drastic reduction in the rate of inflation. The centerpiece of the program is a marked further tightening of the budget well beyond the substantial adjustment already achieved during 1987. In contrast, in a number of other countries with very high rates of inflation, efforts to restrain price increases have suffered serious setbacks because of inadequate support from fiscal and monetary policies. More recently, Brazil and Yugoslavia have adopted Fund-supported programs intended to bring down inflation and Argentina is engaged in negotiating a new program.
In China and in several countries in Eastern Europe, such as Poland and Yugoslavia, the gradual liberalization of highly regulated price systems and the resulting adjustments in relative prices have revealed underlying inflationary pressures and have heightened concerns about the appropriateness of current financial policies. Monetary expansion in these countries has accelerated significantly, but it is assumed that measures will be taken to bring monetary developments under control. Concerns about rising inflation fueled by mounting wage demands have also led to a tightening of the stance of economic policy in Turkey, following several years of expansionary fiscal policy.