Chapter

I World Economic Outlook: Prospects and Issues

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1987
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The year 1986 was one of substantial changes in the international economic environment. There was a sharp drop in the price of oil, a further weakening in non-oil commodity prices, and a continuation of the decline of the dollar against other major currencies. Not surprisingly, these developments have had a mixture of positive and negative effects.

While lower oil and commodity prices contributed to a significant further improvement in inflation performance, output growth decelerated further in industrial countries. Meanwhile, lower export earnings imposed severe hardships on many developing countries, and led to a further rise in their external debt ratios. The exchange rate realignment among the major currencies, together with the increased emphasis on international policy coordination that led to the Louvre Accord among major industrial countries of February 22, 1987, has significantly improved the prospect for restoring a better pattern of payments balances. Initially, however, imbalances have widened sharply in dollar terms, reaching record levels among the three largest countries. It is clear that changes in price competitiveness are far more effective in reducing external deficits and surpluses when they are supported by appropriate macroeconomic and structural policies.

If one looks ahead to 1987 and beyond, a number of uncertainties cloud the economic outlook. One such uncertainty concerns how quickly financial imbalances in the industrial countries—fiscal deficits and payments disequilibria—can be reduced, and whether their persistence increases the risk of disruptive market developments. A second question is whether world demand growth will be resilient as individual countries pursue their stated policy priorities. And a third centers on the vital issue of how to reinvigorate growth in the developing world while dealing effectively with the debt issue.

The remainder of this chapter explores these issues in more detail. It begins with a discussion of recent developments and short-term prospects and goes on to present a scenario for possible developments over the medium term. The third section provides an analysis of possible tensions in this medium-term scenario and reviews the policy issues to which they give rise. The analysis here makes use of the “indicator” approach discussed in earlier reports.

The staff’s projections are based on the conventional working assumptions of “unchanged policies” and constant real exchange rates and oil prices. Oil export prices have been assumed to average $15 a barrel in 1987 and to be constant in real terms thereafter, while real exchange rates are assumed to remain constant at the pattern prevailing in the last week of February 1987.

Recent Developments and Short-Term Prospects

Demand and Output

World output growth weakened in 1986, in part reflecting strains stemming from the large shifts in the terms of trade and the growing payments imbalances among industrial countries. The large fall in the prices of primary commodities, especially oil, had been expected to boost demand in the industrial countries and depress it in the developing countries, as indeed it did. More unexpected, however, was the rapidity with which that terms of trade shift engendered the corresponding real resource transfer. Such transfers are usually viewed as difficult to effect and likely to be phased over several years. In the event, partly because of financing constraints and partly because a number of developing countries preferred to limit the growth in their debt, much of the adjustment was carried out in 1986. As a result, industrial countries faced a sharp decline in their real net exports and, despite a strengthening of domestic demand, their output growth slowed from 3 percent in 1985 to under 2½ percent in 1986.

The other side of this coin, of course, was an increase in the volume of developing countries’ exports relative to their imports. Partly because of the strength of industrial country demand and partly because developing country products were attractively priced for consumers, much of the adjustment in the developing world took the form of increased exports rather than reduced imports. Consequently, GNP growth in the non-fuel exporting group of developing countries accelerated from 4½ percent in 1985 to almost 5½ percent in 1986. For the world as a whole, output growth in 1986 is estimated to have been 2.9 percent, marginally less than in the previous year (Table 1).

Table 1.World Demand and Output, 1985–87(Annual changes, in percent, except where otherwise noted)
Currrent EstimatesRevision to

October 1986

Estimates1
19851986198719861987
World output3.12.92.70.1-0.4
Industrial countries
Terms of trade gain20.11.50.10.3-0.1
Total domestic demand3.13.52.4-0.1-1.0
Foreign balance3-0.1-1.1-0.1-0.20.2
GNP/GDP3.02.42.3-0.3-0.8
Developing countries
Terms of trade gain2-0.3-3.3-0.5-0.2
Total domestic demand2.60.12.20.20.5
Foreign balance30.73.40.60.6-0.4
GDP3.23.53.00.80.1
Other countries’ output43.54.33.80.90.3

Looking ahead, the question is whether the forces set in motion in 1986 will lead to an improvement in this situation or a slipping back. Will the slowing of industrial country output growth persist as economic agents face the consequences of recent large changes in competitive positions? Or will output growth recover now that exchange rates are better aligned and developing countries have largely completed their balance of payments adjustment to terms of trade losses? Answers to these questions are far from clear cut. Moreover, they cannot be resolved from the perspective of the dynamics between industrial and developing countries alone. Interactions within and among industrial countries are also significant as potential sources of strain on growth.

The slowing of output growth in industrial countries is especially disappointing in relation to the optimistic views that prevailed about a year ago. At that time, the fall in the price of oil was seen as likely to lead to strong growth in domestic demand in industrial countries, and the April 1986 World Economic Outlook projected increases in output of about 3¼ percent per annum from the fourth quarter of 1985 onward. In the event, growth during 1986 (fourth quarter over fourth quarter) is now estimated at only 2 percent (Chart 1). The impact on demand of the improvement in the terms of trade was relatively small in some countries. A principal reason seems to be that a considerable part of the terms of trade gain did not reach final consumers but went instead into profit margins or government revenues, possibly reflecting a sentiment that at least part of the oil price decline might prove to be transitory. Consumer prices of energy products in Japan, for example, reflected only part of the drop in import prices. The same is true in Europe, albeit to a lesser extent. Accordingly, the demand-expanding effects of the terms of trade gain have been somewhat limited, at least so far.

Chart 1.Major Industrial Countries: Real Output and Domestic Demand, 1984–87

(Changes over four quarters, in percent)

1Fund staff projections for changes from fourth quarter of 1986 to fourth quarter of 1987.

The output-contracting effects on industrial countries of the declines in oil and commodity prices, on the other hand, have been greater than expected. The oil exporting countries had, of course, been expected to curtail imports and boost exports so as to bring about the real adjustment required to restore their current accounts to a more sustainable position. This adjustment, however, took place much more rapidly than originally envisaged.

A number of other factors also served to temper the growth of demand and output in the industrial countries in 1986. Investment spending was especially hard hit, rising by only 3¼ percent last year, and by only 2¼ percent on a through-the-year basis. This is an unusually slow pace given the maturity of the current upswing. One reason was the decline in oil prices, which drastically reduced investment spending in the oil sector in the United States and Canada. But, in addition, business fixed investment in the United States seems to have been adversely affected by the curtailment of tax incentives, especially the repeal of the investment tax credit with retroactive effect to the beginning of 1986. A more pervasive factor has been the depreciation of the U.S. dollar, which appears to have reduced demand and output growth in countries with appreciating currencies, especially Japan, much more rapidly than it has boosted them in the United States.

Abstracting from the policy changes that may have triggered a movement in exchange rates, an exchange-rate-induced redistribution of output among industrial countries ought to have relatively little effect on their combined growth rate. Any loss of output of countries with appreciating currencies should normally be offset by the gain of countries with depreciating currencies. The adjustment process is unlikely to be so smooth or rapid in practice, however. Investment plans in the tradable goods sector in Japan and the Federal Republic of Germany, for instance, were scaled back quite promptly in response to the significant appreciation of their currencies, but have yet to show any buoyancy in the United States. Such asymmetries presumably reflect the greater ease of deciding against investment projects than of initiating them. The weakness of investment spending may also reflect general uncertainty about future exchange rates and competitive positions, as well as the fact that rates of capacity utilization in the tradable goods sector have been lower in the United States than in Japan and Germany. This factor would tend to limit the immediate impetus to expand capacity, and could continue to operate for some time.

Turning to short-term prospects, there are conflicting considerations. On the positive side, the fact that external adjustment in developing countries was so rapid in 1986 may mean that less adjustment will be needed in 1987. This would tend to improve the prospects for industrial countries’ net exports in volume terms. Moreover, to the extent that industrial country consumers did not receive the full benefit of terms of trade gains in 1986, lagged effects may help support demand in 1987.

Several considerations, however, suggest that any strengthening of growth in the industrial countries is likely to be modest. First, financial policies, as announced by national authorities, are somewhat more restrictive in 1987–88 than they were in 1986. Fiscal policy is likely to supply less stimulus, especially at the central government level, largely because of a projected substantial reduction in the U.S. federal deficit. And the easing of monetary conditions that occurred during 1986 is not expected to be repeated in 1987. Second, while an improvement in the real foreign balance should help sustain growth in the United States, demand in that country may be dampened by continuing sluggishness in investment spending and a rise in the personal saving rate from the very low levels of the second half of 1986 (2¾ percent of disposable income). For the rest of the industrial world, the gradual waning of favorable terms of trade effects on consumption, together with continuing sluggishness in the pace of output and investment because of negative net exports, is likely to engender a slowing of domestic demand from its recent relatively strong pace.

Consequently, the staff foresees some moderation in the overall pace of domestic demand expansion in the industrial countries in 1987. Weaker domestic demand, however, should be counterbalanced by a much smaller negative impulse from net foreign demand, as real import growth resumes in developing countries. For the industrial countries as a whole, output growth is expected to average 2¼ percent in 1987, slightly less than in 1986.

Turning to the developing countries, the terms of trade loss of $100 billion or so in 1986 did not have as large an impact on output as expected because of the unanticipated strength of these countries’ exports to industrial countries. In fact, output growth even firmed slightly, from 3¼ percent in 1985 to 3½ percent in 1986. The staff is, however, less sanguine about prospects for 1987. While the deterioration in the terms of trade is expected to be much smaller than in 1986, some adjustment to past losses still remains to be carried out. Moreover, given the projected slowing of domestic demand growth in industrial countries from 3½ percent to 2½ percent, prospects for exports are more subdued. Consequently, the staff foresees output growth in the developing countries slowing to about 3 percent in 1987 (Chart 2).

Chart 2.Developing Countries, by Predominant Export: Real Output and Domestic Demand, 1979–87

(Annual changes, in percent)

These aggregate figures conceal a considerable diversity in the situations facing individual countries and groups of countries. The fuel exporters were most adversely affected by recent developments, suffering terms of trade losses equivalent to some 13–15 percent of national income. Although this loss was partly made up in higher export volumes, and partly financed by running down foreign assets, strong adjustment measures were still needed to curb spending and imports. Consequently, the real output of the fuel exporters, as a group, declined in 1986. Moreover, because of a continuing need to bring current account balances back to sustainable levels, output in these countries is expected to grow little in 1987.

The non-fuel exporters, by contrast, fared considerably better, at least when seen as a group. Declining commodity prices were largely made up by savings in oil import payments and the decline in interest rates on external debt. Moreover, the surge in industrial country demand in 1986 boosted the exports of the non-fuel exporting countries by 7¾ percent. As a result, output growth in these countries, taken together, accelerated from 4½ percent in 1985 to almost 5½ percent in 1986.

Perhaps less appreciated, however, is the very uneven impact that external circumstances had on individual non-fuel exporting developing countries. For instance, for over half of the 110 countries in this group, the configuration of commodity price and interest rate changes last year had a negative impact on their external balances. Moreover, half of these countries experienced losses equivalent to 10 percent or more of exports of goods and services. Not surprisingly, growth in these typically smaller, more vulnerable, primary product exporters (many of which are in sub-Saharan Africa) slowed in 1986 and is expected to improve little if at all in 1987. At the other end of the spectrum, those countries that import a lot of oil, that have a high proportion of their debt at floating rates, and that export a lot of manufactures have done rather well.

Financial policies also played a role in determining the pace of output achieved in individual developing countries. In some countries where external developments were favorable in 1986, relaxation of the external constraints was promptly used to initiate or foster consumption-led recoveries, in some cases at the expense of exports. In other countries, on the other hand, much greater emphasis was placed on spurring exports and enhancing creditworthiness through the accumulation of reserves and the repayment of debt. Growth prospects for the latter countries are quite buoyant, in part because of the prospective firming of investment spending in these countries.

Employment and Capacity Utilization

Despite the moderate pace of economic activity, the growth of employment in the industrial countries strengthened further last year. The pickup was especially marked in Europe where employment grew by ¾ of 1 percent, over one and a half times the rate of 1985 and in sharp contrast to the declines in 1981–84. This shift seems to have reflected the end of the phase of large-scale labor shedding that characterized the first half of the 1980s. This, in turn, may owe something to the achievement of a better balance between real wages and the marginal product of labor.

The employment gains of 1986 did not, however, make any significant dent in unemployment rates, since the improved employment prospects attracted new entrants to the labor markets. Unemployment rates in Europe thus remained unchanged at 10¾ percent on average. Unemployment in Japan was also little changed, reflecting the steady growth of employment as well as the emphasis placed on continuity of employment.

The continuing high level of unemployment in industrial countries has prompted questions about the scope that exists to absorb unused resources (both capital and labor) and thus to accelerate growth. These questions are considered in more detail in a staff study, “Potential Output in the Major Industrial Countries,” to be published later this year. This study finds that, if potential is defined as the ceiling path of output that can be achieved without an acceleration in inflation over the medium term, the amount of slack may be rather less than would be suggested by the high unemployment rates in many countries. Nevertheless, the scope for noninflationary growth in the industrial countries may have been enlarged somewhat by the recent decline in oil prices. This effect is not expected to be large enough to allow a return to the high growth rates of the 1950s and 1960s, mainly because the slowdown in growth in the 1970s was primarily attributable to factors other than oil prices.

In the developing countries, the very low rates of increase in per capita income in 1986 probably led to a further worsening of the employment situation, even though recorded unemployment declined in some of the more rapidly growing economies. This situation of deteriorating labor markets is rendered even more acute by the prospect that the capital stock seems increasingly likely to act as a constraint on growth in many developing economies long before reasonably high employment conditions are reached. Investment rates in many developing countries have fallen dramatically since the onset of the debt crisis, but a downward trend was in evidence prior to that time as well. Moreover, the efficiency of those investments does not appear to have always been very high. (This issue is examined in more detail in Chapter III.)

Inflation

One of the most positive aspects of the current economic situation in the industrial countries is the continued deceleration of inflation—a deceleration that clearly sets the present upswing apart from earlier recoveries. Consumer prices in the industrial countries as a group rose by only 2.3 percent in 1986, the lowest rate since the early 1960s. Although last year’s price performance benefited considerably from the sharp decline in oil prices and the weakness of non-oil commodity prices, there also appears to have been some further progress in reducing domestic price pressures.

The favorable inflation performance in industrial countries is projected to continue through the forecast period. In the near term, the lagged effects of last year’s substantial terms of trade gains should continue to be felt, particularly in countries whose currencies appreciated over the past year. Inflation is expected to pick up somewhat in the United States during 1987, to about 3½ percent. For the industrial countries as a group, inflation is projected to return to its “underlying” rate, which seems to be in the 3–3½ percent range, corresponding to the average inflation rate in the 1960s.

Although the staff’s projections suggest that inflation in most of the industrial countries will remain under control, the risk of a resurgence of inflationary pressures is by no means completely absent. This risk is related to the difficulties monetary authorities face in implementing monetary policy in an environment in which changes in the demand for money are hard to predict. In recognition of these difficulties, central banks have exercised considerable discretion in responding to signals from monetary aggregates. Such a judgmental approach appears to have been appropriate under the circumstances—an absence of cost and aggregate demand pressures and an apparent rise in demand for money associated with the reduction in inflationary expectations and financial deregulation. However, there would be a substantial risk of renewed inflation if, as a result of increased discretion in monetary management, interest rates became unduly politicized, thereby making it difficult for monetary authorities to raise rates when the need to do so arose. The outlook for oil and commodity prices is an additional source of uncertainty. These prices have fluctuated significantly in the past, and there is a possibility that the sharp price declines of 1986 may be at least partially reversed over the medium term.

Developing countries as a group experienced a sharp reduction in inflation in 1986 owing in large part to price stabilization programs instituted in a number of high-inflation countries, most notably Argentina, Bolivia, Brazil, and Israel. As a result, the average rate of inflation, after reaching 40 percent in 1985, slowed to 29 percent in 1986. At the same time, the median inflation rate receded from 9 percent to 8 percent. The downward trend in inflation may be harder to sustain this year, however. In fact, prices have begun to accelerate in several countries in recent months as a result of policy slippages. Also, in some other countries, exchange rate corrections undertaken in support of external adjustment needs are likely to result in higher rates of price increase and may give rise to additional inflationary pressures unless they are adequately buttressed by firm financial policies.

Stance of Policies

The mix of financial policies in the industrial countries has changed noticeably over the past 18 months, with monetary conditions continuing to ease and fiscal policy becoming more cautious, at least in countries with large deficits. At the same time the geographical configuration of policies among countries has become somewhat better balanced. For the most part, these changes in the mix and configuration of policies among countries, which received new impetus from the Louvre Accord of February 22, 1987, have supported an orderly realignment of key exchange rates, thereby helping to promote a more sustainable pattern of growth among countries.

The changed thrust of fiscal policy in the United States since late 1985—following a four-year period of substantial injection of fiscal stimulus—is the most important aspect of the new policy situation. It must be recognized, of course, that the improved fiscal outlook in the United States has yet to show up in a major reduction in the recorded deficit. Canada, Italy, and some smaller countries with large imbalances (Belgium, for example) have also made progress in improving their budgetary outlook. Meanwhile, the pace of fiscal consolidation has moderated in several countries that have been steadily reducing their budget deficits, including the Federal Republic of Germany, Japan, and—to a lesser extent—France and the United Kingdom. The initiation of these policy shifts can be detected in the fiscal indicators for 1986; in general, they are expected to become more apparent in 1987.

The fiscal situation in 1988 and beyond is more uncertain, particularly in the United States. The U.S. Administration’s budget proposal for fiscal year 1988 implies a reduction in the federal budget deficit to $108 billion in FY 1988, as compared with an estimated deficit of $173 billion in FY 1987. Although the deficit implied by the budget proposal is in line with the target stipulated by the Gramm-Rudman-Hollings Balanced Budget Act, there is a substantial risk that the actual deficit will be significantly larger, since many of the proposed expenditure reductions have been rejected previously by Congress, and a key element of the sequestration process of the Balanced Budget Act has been ruled unconstitutional. Given the uncertainties, the staff has chosen to use a “current services” path of fiscal deficits as its working assumption. (This path traces the deficits that would obtain if current policies for spending programs and taxes remained in force.) On this basis, federal budget deficits of $182 billion in FY 1987 and $166 billion in FY 1988 are projected. For the other industrial countries, the assumed stance of fiscal policies in 1987 and 1988 reflects current expenditure plans and legislated tax rates, modified in some cases for planned changes whose implementation can be foreseen with reasonable confidence. As a result, fiscal policy in the major industrial countries outside the United States is expected to be slightly restrictive in both 1987 and 1988.

Monetary developments in the major industrial countries have been guided by the objective of maintaining downward pressure on inflation while permitting an adequate growth of output. The better fiscal outlook and the continuing improvement in price performance have provided monetary authorities with scope for some discretion in pursuing announced monetary growth targets. In particular, the instability of the velocity of key monetary aggregates has entailed a broadening of the focus of concern to include also growth and exchange rates. These concerns were reflected in a series of discount rate reductions over the past year in several of the major countries.

Monetary authorities have accommodated substantial declines in interest rates since mid-1984. Despite temporary increases in some countries owing to exchange rate tensions, short-term interest rates are now at their lowest level since 1978, with rates on U.S. dollar-denominated instruments having experienced a particularly sharp reduction. The 3-month London interbank offered rate (LIBOR) fell from 8¼ percent in late 1985 to about 6¼ percent in early 1987. The decline in long-term interest rates has been even more pronounced. The resultant flattening of the yield curve in most countries seems to indicate a marked reduction in inflationary expectations. Short-term interest rates firmed slightly toward the end of 1986 and early in 1987, possibly because of exchange rate tensions, but subsequently eased again. Provided fiscal consolidation plans are implemented, particularly in the United States, monetary authorities appear prepared to continue to support sustained growth in economic activity over the forecast period.

Efforts to enhance the functioning of markets with a view to improving resource allocation continue to receive high priority in all the industrial countries. In addition to the deregulation of financial markets, programs of privatization of public sector enterprises have been implemented or announced in several countries. Governments have also turned their attention to the distortions created by tax systems, and major tax reforms have been implemented or are planned in several countries. However, despite the growing list of achievements in the area of structural reform, much remains to be done, both to reduce labor market rigidities—particularly in Europe—and to dismantle trade barriers—in all countries. In this context, large subsidies to agriculture and to structurally depressed industrial sectors remain major impediments to an efficient allocation of resources, both within individual industrial countries and on a global scale. The slow pass-through of recent terms of trade gains to consumers in Japan also suggests there may be scope for structural changes to enhance competition in that country’s distribution system.

Among the developing countries, financial performance in 1986 largely reflected the external forces to which they were exposed. For most countries, these forces led to a deterioration in the fiscal situation. In the fuel exporting countries, the loss of revenues as a result of the sharp decline in international oil prices more than offset lower debt-servicing costs from the fall in international interest rates. In response, adjustment efforts were intensified, triggering substantial cuts in public expenditure. However, despite reductions in outlays, the fiscal deficit of the fuel exporting countries deteriorated sharply, from 6 percent of GDP in 1985 to over 10 percent in 1986. In contrast, fiscal policy was eased somewhat in several of the countries that are exporters of manufactures. These countries benefited both from the weakness of oil and commodity prices and from the decline in interest rates; in general, they also enjoyed strong growth of exports. Exporters of primary products also experienced a rise in their fiscal deficits, either as a result of stagnating export revenue, or because of domestic policy initiatives.

Monetary and credit policies in the developing countries have in general remained cautious, as they continued to be directed at dampening inflationary pressures. A further deceleration in the growth of money and total domestic credit was particularly pronounced in a small group of high-inflation countries following the introduction of wide-ranging anti-inflationary measures.

The year 1986 also witnessed considerable use of exchange rate policy as a means for achieving external adjustment. Exchange rate adjustments were prevalent among those developing countries that suffered large terms of trade losses. The currencies of these countries, as well as of others, were often depreciated vis-à-vis the U.S. dollar in an effort to spur the growth of nontraditional exports. While a number of such adjustments were made among primary product exporters, the largest ones were made in countries that export oil, especially those with relatively diversified economies. Also, a number of countries that were not nearly so hard pressed experienced large real depreciations in 1986, with the adjustment often occurring through the fixed relationship of their currencies to the depreciating U.S. dollar. Some of these countries, notably the exporters of manufactures of Southeast Asia, were able to translate gains in competitiveness into sizable increases in market share.

Exchange Rates and Payments Balances

The U.S. dollar fell sharply against other major currencies in early 1987. Added to the changes that had taken place since March 1985 (Chart 3), the cumulative decline represents a major realignment in the pattern of exchange rates. From its peak in the first quarter of 1985 to late February 1987, the U.S. dollar depreciated by 31 percent in nominal effective terms, and by about the same amount in real terms. The decline in the value of the dollar has reversed about five sixths of its appreciation from 1980 to the first quarter of 1985.1 Conversely, the yen and the deutsche mark have appreciated by 23 percent and 20 percent, respectively, in real effective terms since early 1985. The yen’s slightly greater real effective appreciation is due to the large weight of Japan’s trade with countries with dollar or dollar-linked currencies.

Chart 3.Major Industrial Countries: Indicators of Real Effective Exchange Rates, 1980–87

(Indices, 1976–85 = 100)

Note: Bullets (•) denote estimates based on exchange rates prevailing during last week of February 1987.

1 Annual deflators for GDP originating in manufacturing with quarterly interpolations and extrapolations (beyond the latest available data) based on wholesale price data for manufactures.

This large correction in exchange rates has begun to affect real trade flows. As is evident from the shifting relationships between domestic demand and output shown in Chart 1, U.S. net exports have started to increase in real terms, and those of the Federal Republic of Germany and Japan have weakened appreciably. Nonetheless, despite these sizable real adjustments, current account imbalances among the major industrial countries widened in 1986. The U.S. current account deficit rose from $118 billion in 1985 to $141 billion in 1986, while the Japanese surplus rose from $49 billion to $86 billion, and the German surplus from $13 billion to $36 billion (Statistical Appendix Table A30). Although these increases reflect in part the use of a depreciating currency as the standard of measurement, there has also been a widening of the imbalances in relative terms. The U.S. deficit rose from the equivalent of 2.9 percent of GNP in 1985 to 3.3 percent in 1986. while the Japanese surplus went from 3.7 percent to 4.4 percent, and the German surplus almost doubled as a share of GNP, to 4.0 percent.

These growing imbalances, occurring in the face of large exchange rate movements and slower growth in the United States, have prompted questions about what it will take to correct them. In this connection, it has to be recognized that exchange rate adjustments take time to work through to payments flows—probably at least three years to get a reasonably complete effect. The adjustments may take even more time on this occasion. Partly because of increased competition from developing countries, exporters to the U.S. market have cut their profit margins substantially. Prices of U.S. imports other than oil increased by 5½ percent from the first quarter of 1985 to the fourth quarter of 1986, that is, by only about a fifth of the depreciation in the exchange rate over this period. There has thus been a much smaller induced shift in demand than might have been expected. By the same token, however, the profitability of exporting to the United States or into third markets must have been substantially reduced, a development which in time should have substantial effects on the volume of sales.

External adjustment has also been slowed by income effects. Reflecting largely the stance of U.S. fiscal policy, absorption in the United States increased faster than potential output in each year from 1983 through 1986. Conversely, because of generally opposite fiscal developments among U.S. trading partners, demand in these countries grew at a rate well below that of the United States from 1983 to 1985 and only just in line with it in 1986. Neither of these developments was conducive to external adjustment (Chart 4).

Chart 4.United States, Japan, and the Federal Republic of Germany: Current Account and General Government Fiscal Balances, 1978–88

(In percentage of GNP)

1Fund staff estimates and projections.

From now on, some improvement in this situation is expected, albeit not sufficient to eliminate the large existing imbalances. The shift in real foreign balances that began in 1986 is likely to become stronger in 1987, partly because of price effects and partly because of a more appropriate configuration of aggregate demand growth. In relation to GNP, current account imbalances are expected to decline by over ½ of 1 percentage point for the United States, 1 percentage point for Japan, and 1½ percentage points for the Federal Republic of Germany from 1986 to 1988. Nonetheless, the remaining imbalances are large. Moreover, when expressed in U.S. dollar terms, the apparent correction is smaller because of valuation effects.

Shifts in current account balances among industrial countries tend to cancel out when aggregated across countries. Developments for the industrial countries as a group are dominated by the effects of the decline in the price of oil and other primary commodities relative to that for manufactures. Reflecting this development, the trade balance of industrial countries improved and that of developing countries deteriorated by some $40 billion from 1984 to 1986. The bulk of these shifts occurred in 1986, and reflected essentially a deterioration in the trade position of the fuel exporting countries.

The shift in the aggregate payments position of developing countries, although large, is considerably smaller than it would have been were it not for pronounced adjustments in import and export volumes made in response to terms of trade losses. Adjustment was most marked among the fuel exporters, who, through large increases in exports and even larger cuts in imports, were able to contain an almost $100 billion terms of trade loss to a $50 billion deterioration in their trade account. But adjustment took place in other groups as well. The exporters of manufactures in Southeast Asia allowed their currencies to depreciate against nondollar currencies, and in some cases against the dollar also. As a result, they were able to expand rapidly their exports to Asia and North America. Their combined current account balance improved by $13 billion in 1986, shifting into large surplus.

As a result of these developments, the combined current account deficit of developing countries is estimated to have risen relatively little from 1984 to 1986, despite the substantial deterioration in the terms of trade. However, a disproportionate share of the deterioration has fallen on countries that have a history of debt-servicing difficulties. These countries’ combined deficit in 1986 was almost back to its 1983 level, and is expected to decline only gradually over the forecast period.

Trade, Financing, and Debt

The volume of world trade in 1986 was unexpectedly buoyant, increasing by some 5 percent after a rise of only 3½ percent in 1985.2 However, because of the effects of the terms of trade changes on real incomes, the pattern of trade was heavily skewed. The real imports of industrial countries rose by 9 percent while those of fuel exporters fell by 22 percent. As a result, developing countries’ export volumes grew quite strongly, by 8 percent overall and by some 12–13 percent to industrial countries. Industrial country exports, on the other hand, were quite weak, rising only 3 percent overall. The distribution of world exports and imports is expected to become better balanced in 1987 and 1988. However, because of the continuation of relatively slow growth in industrial countries and the effects of the agreement of December 1986 of the Organization of Petroleum Exporting Countries (OPEC) to restrict oil production and raise prices, the volume of world trade is projected to increase by only 3¼ percent in 1987 before recovering to 4½ percent in 1988.

Prospects for world trade prices depend on a number of factors that are hard to predict. As noted earlier, the forecasts contained in this report have been developed on the assumption that oil export prices will average $15 a barrel in 1987 and that real exchange rates will remain constant at the levels prevailing in the last week of February 1987. If the prices established under the recent OPEC agreement were to be maintained, the average price in 1987 would be some 10 percent higher than assumed and about 20 percent above the average price in 1986. The effects of a higher oil price in dollar terms would, however, be partly eroded by the effects of dollar depreciation. Thus, oil countries’ terms of trade would improve by only about 8 percent if the OPEC agreement were to hold.

Non-oil commodity prices declined sharply in dollar terms during the second half of 1986 and are projected to be 5 percent lower, on average, in 1987 than they were in 1986. Consequently, significant losses in the terms of trade of many primary product exporting countries would occur in 1987 since, unlike last year, both oil and manufactured prices will be moving against these countries. Looking further ahead, some strengthening of real commodity prices seems likely since the recent weakness can in good part be explained by developments that should tend to reverse themselves over the medium term. Nonetheless, the projected reversal is quite modest and would do little to alleviate the very low real purchasing power of primary commodities (Chart 5).3

Chart 5.Real Non-Oil Commodity Prices, 1957–87

(Index, 1956–86=100)

1Data after end-1986 are estimates.

The rapid adjustment of developing countries to the terms of trade losses of the past several years is associated with the virtual cessation of private international lending to these countries. This lending, which had amounted to only some $15 billion in 1984 and 1985, came to a virtual halt in 1986. For the countries with recent debt-servicing problems, the net repayment of about $6½ billion that occurred in 1985 increased to $11 billion last year. It is therefore hardly surprising that developing countries were obliged to keep their financing requirement in 1986 close to the previous year’s level, despite the large losses in terms of trade. This was accomplished primarily through large increases in the volume of exports relative to imports. In addition, foreign exchange reserves were drawn down in many countries. Reduced outflows or outright repatriation of private assets also played a significant role in helping finance the deterioration in the terms of trade. Even countries whose creditworthiness was relatively good and who faced relatively favorable external circumstances were very cautious as regards foreign borrowing. For the most part, these countries sought to strengthen their current account, and to accumulate sometimes considerable amounts of official reserves. The countries without debt-servicing problems, for instance, increased their reserves by nearly $25 billion.

Despite the very low levels of borrowing, however, ratios of debt to exports continued to worsen, largely because of declining export earnings. The deterioration was especially pronounced among the fuel exporters. The combined debt ratio for the subgroup of countries that has had recent debt-servicing difficulties reached 302 percent of export earnings at the end of 1986, almost three times the ratio among countries that have avoided such problems. Prospects are that this situation will improve only very gradually.

Debt service ratios also worsened in 1986; the easing of interest payments was more than offset by higher amortization payments and declining export earnings. However, a continued low level of borrowing and the persistence of interest rates at recent levels is expected to lead to a distinct fall in the debt and debt service ratios in 1987–88, especially among countries whose debt is mostly on commercial terms.

Medium-Term Outlook

It has been recognized for some time that economic developments and policy options have to be appraised in a medium-term context. That is to say, policy decisions should be taken in the light of medium-term objectives and with a view to alleviating the “tensions” that might build up if potentially unsustainable trends were allowed to persist.

To facilitate assessment of international economic interactions from a medium-term perspective, previous World Economic Outlook reports have contained medium-term scenarios as an integral part of the analysis. The present section extends that approach. The first part of the section describes the possible medium-term evolution of the principal macroeconomic variables in the industrial countries, given current and likely monetary and fiscal policies, and assuming that real exchange rates remain unchanged from the levels assumed for the short-term forecasts. This is followed by a review of the implications of this industrial country environment for medium-term prospects in developing countries. The international interactions implicit in these scenarios, and the potential incompatibilities or “tensions” to which they give rise, are addressed in the following section.

Medium-Term Trends in Industrial Countries

As noted earlier, medium-term trends in industrial countries are projected on the basis of unchanged policies and using the technical assumption of unchanged real exchange rates. Circumstances may arise, of course, in which current policies appear to be either unsustainable or inconsistent with the underlying exchange rate assumption. In such cases, the analysis focuses on the alternative ways in which incompatibilities might manifest themselves, or be reconciled. It is assumed that the principal policy variables (monetary, fiscal, and structural policies) are addressed essentially to domestic economic objectives, such as growth and price stability. The international implications of such objectives and policies can then be examined, holding international competitiveness (that is, real exchange rates) constant. Where these international interactions of policies and developments are considered undesirable, or potentially incompatible, they become the subject matter for international discussion of policy coordination. Before turning to these matters, however, it is first necessary to outline some of the features that are likely or assumed to dominate the medium term.

Macroeconomic policies. Macroeconomic policies are projected into the medium term on the assumption that “present policies” will be retained. Present policies are, however, particularly difficult to quantify in a medium-term context. The existing policy stance comprehends the current setting of monetary and fiscal policies, plus possible future changes in policy settings, ranging from already legislated measures to vaguely expressed intentions. Thus there is an inevitable element of judgment in applying the concept of “present policies” to future time periods.

In all cases, monetary policy has been assumed to be consistent with approximate stability (or some downward pressure) in underlying inflation rates. It is implicitly assumed that increases in nominal demand that do not run counter to the basic inflation objective are accommodated. Fiscal policy developments are assessed on the basis of governments’ expressed policy intentions, balanced by a recognition that these intentions often take longer than expected to be put into effect. For the United States, the reduction in the fiscal deficit that is projected by the end of 1991 is the one that would result from existing “current services” spending plans and tax laws, i.e., it does not take account of any deficit-cutting proposals that have not yet been adopted by Congress. On this basis, the federal deficit is projected to shrink from some 5.3 percent of GNP in FY 1986 to about half that size in FY 1991. This does not, it should be stressed, necessarily imply that the staff views further cuts as unlikely; however, it is virtually impossible to find a neutral basis for estimating their potential size.

The other industrial countries do not generally have such explicit “current services” fiscal estimates extending into the medium term. Based on staff judgments about how the fiscal intentions of the authorities will interact with practical constraints—of a social and political as well as economic character—it is estimated that fiscal deficits in the other large countries might shrink by ½ – ¾ of 1 percentage point of GNP, on average, over the period 1987–91. Canada and Italy are projected to have relatively larger fiscal corrections, and France, the Federal Republic of Germany, Japan, and the United Kingdom, somewhat more modest ones.

Output and demand. Over a period extending beyond the short run (defined here as beyond 1988), the trend growth of output is probably more dependent on supply factors than on demand. The medium-term projections are therefore based on the assumption that the average rate of growth in the period 1989–91 will match the underlying potential rate, with an adjustment to reflect the possibility of absorbing presently unused labor and capital resources. In practice, therefore, GNP is assumed to grow slightly faster than potential during 1989–91, reflecting an assessment that most economies are still somewhat below the output level at which inflation would begin to reaccelerate (Table 2).

Table 2.Major Industrial Countries: Indicators of Economic Performance, 1975–91
ActualProjected
AverageAverage
1975–8419851986198719881989–91
(Annual growth rates, in percent)
Real GNP/GDP
Canada3.14.03.12.03.0
United States2.52.72.52.33.1
Japan4.34.72.52.73.3
France2.11.42.21.82.1
Germany. Fed, Rep. of1.92.52.41.92.0
Italy1.82.32.82.92.3
United Kingdom1.43.42.53.02.3
Seven countries12.63.02.52.42.93.0
Real domestic demand
Canada2.84.63.52.52.8
United States2.83.43.51.62.6
Japan3.23.84.03.83.9
France2.22.14.02.22.4
Germany, Fed. Rep. of1.81.53.73.22.4
Italy1.52.43.64.13.0
United Kingdom1.32.83.23.72.8
Seven countries12.53.13.62.52.83.1
GNP/GDP deflator
Canada8.03.42.83.53.2
United States7.21.12.62.83.4
Japan3.91.41.81.12.6
France10.65.85.33.02.6
Germany, Fed. Rep. of4.02.23.32.52.6
Italy16.78.89.15.75.2
United Kingdom13.06.13.64.65.0
Seven countries17.53.63.12.73.33.0
(As percentage of GNP/GDP)1991
General government financial balance
Canada-3.5-6.6-5.4-4.6-4.1
United States-1.9-3.5-3.2-2.9-2.5
Japan-3.8-1.0-1.1-1.4-1.3
France-1.6-2.6-2.8-2.8-2.6
Germany, Fed. Rep. of-3.1-1.1-1.0-1.0-1.1
Italy-10.5-14.0-12.3-11.5-11.5
United Kingdom-3.7-2.8-2.9-2.7-2.6
Seven countries-3.0-3.4-3.2-2.9-2.7-2.0
Private sector saving surplus2
Canada2.46.53.72.41.8
United States1.50.5-0.1-0.2-0.2
Japan4.54.75.55.14.7
France1.32.63.33.12.8
Germany, Fed. Rep. of3.23.25.04.13.5
Italy10.112.813.212.111.7
United Kingdom4.13.63.21.91.7
Seven countries2.92.83.02.62.41.6
Current account balance
Canada-1.1-0.1-1.7-2.2-2.3
United States-0.4-2.9-3.3-3.1-2.7
Japan0.73.74.43.73.4
France-0.30.50.40.2
Germany, Fed. Rep. of0.32.14.03.12.4
Italy-0.4-1.20.90.60.2
United Kingdom0.40.8-0.3-0.8-0.9
Seven countries-0.1-0.7-0.2-0.3-0.3-0.4

Inflation. Projections for inflation come rather directly from the monetary policy assumptions discussed earlier. Price increases are generally assumed to settle in the neighborhood of the rates projected for 1987–88. (A temporary increase in 1988 in Japan is attributable to the one-time effects of the introduction of a value-added tax.)

Current account positions. Underlying balance of payments developments are traceable to three major sources: shifts in competiveness (that is, in domestic costs and prices relative to those abroad); differentials in growth rates; and a trend factor that reflects changes in competitiveness or other factors not captured in cost indices. With all major economies projected to grow close to their underlying trend rates, and with such trends fairly similar across countries, growth differentials play a relatively small role in projected changes in current account positions over the medium term. Past shifts in competitiveness are rather more important; the lagged effects of recent exchange rate movements should, over the next two to three years, reduce the U.S. current account deficit by a little over 1 percentage point of GNP (relative to what it would otherwise be), while cutting the Japanese surplus by about 1 percentage point and the German surplus by 2½ percentage points. Trend factors, however, would tend to work in the opposite direction, if they operate in the same way as in the past. With all countries growing at potential and no change in measured competitiveness, the Japanese payments position has historically shown a tendency to strengthen, while the U.S. position has tended to deteriorate. By 1991, on the basis of the late February 1987 real exchange rates, the staff estimates that the U.S. current account deficit would be about 2½ percent of GNP, while the Japanese surplus might be of a similar relative size, and the German surplus would be under 1 percent of GNP.

Domestic saving and investment. The counterpart of shifts in current account balances and fiscal positions is to be found in movements in the balance between private domestic saving and investment (Table 3). In the scenarios presented here, economic growth in the medium term is assumed to be determined by supply considerations, while fiscal policies are taken as given and current accounts are the result of the exchange rate assumption and growth differentials. Thus, the savings/investment balance of the private sector is determined endogenously in the medium term. To some extent, this could be taken to reflect a view that, with monetary policy geared to maintaining a given growth of nominal aggregate demand, changes in the external balance or the fiscal position will tend to “crowd in” or “crowd out” net private spending. It is clear, however, that such a process rarely takes place without friction. Examining the potential difficulties that will arise in bringing about the changes in domestic private spending implied by fiscal and balance of payments trends is at the heart of the analysis of international policy interactions.

Table 3.Major Industrial Countries: Current Account and Saving-Investment Balances, 1975–88(In percentage of GNP or GDP)
ActualProjected
Average
1975–8419851986119871988
Canada
Current account balance-1.1-0.1-1.7-2.2-2.3
General government financial balance-3.5-6.6-5.4-4.6-4.1
Private saving22.324.021.620.720.0
Gross private investment19.917.517.918.318.2
United Slates
Current account balance-0.4-2.9-3.3-3.1-2.7
General government financial balance-1.9-3.5-3.2-2.9-2.5
Private saving17.817.016.216.316.8
Gross private investment16.316.516.316.517.0
Japan
Current account balance0.73.74.43.73.4
General government financial balance-3.8-1.0-1.1-1.4-1.3
Private saving29.328.428.728.528.5
Gross private investment24.823.723.223.423.8
France
Current account balance-0.30.50.40.2
General government financial balance-1.6-2.6-2.8-2.8-2.6
Private saving20.418.519.219.619.9
Gross private investment19.115.915.916.517.1
Germany, Fed. Rep, of
Current account balance0.32.14.03.12.4
General government financial balance-3.1-1.1-1.0-1.1-1.1
Private saving19.619.420.720.120.1
Gross private investment16.416.215.716.016.6
Italy
Current account balance-0.4-1.20.90.60.2
General government financial balance-10.5-14.0-12.3-11.5-11.5
Private saving26.325.926.325.625.5
Gross private investment16.213.113.113.513.8
United Kingdom
Current account balance0.40.8-0.3-0.8-0.9
General government financial balance-3.7-2.8-2.9-2.7-2.6
Private saving21.919.218.717.917.8
Gross private investment17.815.615.516.016.1
Seven major industrial countries
Current account balance-0.1-0.7-0.2-0.3-0.3
General government financial balance-3.0-3.4-3.2-2.9-2.7
Private saving21.120.219.920.020.6
Gross private investment18.217.516.917.418.2
Other industrial countries
Current account balance-1.20.l0.70.60.3
Note: Private saving is calculated residually as the sum of current account balance and gross private investment minus the general government financial balance. It thus includes any statistical discrepancies in the various balances.

In the United States, the decline in the fiscal deficit that is assumed for the medium term is larger than the contemporaneous cut in the external current account deficit that is projected on the basis of unchanged real exchange rates, meaning that private investment would have to grow relative to private saving. Household saving is already quite low in the United States, and seems unlikely to fall further in the conditions postulated. Thus the staffs scenario envisages instead an expansion in the investment ratio, equivalent to about 1½ percentage points of GNP between 1986 and 1991. This is estimated to be just sufficient to sustain the growth of potential output in the range of 2½–2¾ percent a year. In the Federal Republic of Germany, the decline in the fiscal deficit and the projected fall in the foreign trade surplus will release resources for use by the domestic private sector. It is projected that these will be absorbed by a large increase in investment, as companies seek to continue to rebuild their capital stock following a number of years of weak investment performance. Japan will also have additional resources for use by the private sector. Tax reforms are expected to lead both to some decline in the country’s high propensity to save, as well as to a stimulus to investment. Other major industrial countries are expected to experience similar changes within sectoral saving/investment balances as the three largest ones; cuts in government budget deficits, supplemented in several cases by declines in external surpluses, will make resources available for absorption by the private sector. It is assumed that a combination of structural reforms and an accommodative (but not too accommodative) monetary policy will provide an environment in which these resources can be taken up in additional investment expenditure, and some increase in consumption propensity.

Medium-Term Scenario for Developing Countries

The scenario for the developing countries involves a “best guess” on the part of Fund area departments of how individual countries will react to the particular mixture of opportunities and constraints they are expected to face over the medium term. The resulting projections are shown in Table 4; the individual country assessments underlying the aggregates shown in this table draw on the work that has been done to develop medium-term scenarios in the course of Article IV consultations and discussions on the use of Fund resources.

Table 4.Capital Importing Developing Countries: Indicators of Economic Performance, 1976–91(In percent)
1976-781979-811982-841985198619871988-91
Growth of real GDP15.34.12.84.04.23.74.7
Current account balance2-15.7-18.8-4.2-4.4-4.7-4.8-2.4
Growth of private lending1,332.924.57.22.60.81.81.6
Countries with recent debt-
servicing problems
Growth of real GDP14.73.62.73.23.14.4
Current account balance2-23.2-29.2-4.5-3.4-10.2-10.9-4.9
Growth of private lending1,328.622.65.8-1.8-1.60.90.7
Countries without recent debt-
servicing problems
Growth of real GDP16.14.65.85.35.14.45.0
Current account balance2-9.0-10.2-4.0-5.1-1.5-1.5-1.1
Growth of private lending1,342.928.210.512.45.63.43.1
Fifteen heavily indebted countries
Growth of real GDP14.73.8-0.63.13.53.24.6
Current account balance2-28.1-30.6-0.4-0.1-9.2-10.6-3.0
Growth of private lending1,330.226.16.0-1.8-2.11.51.1

Of key importance to the developing countries in the medium term is the international environment they are expected to face. Five elements of this environment are particularly significant: the growth of their export markets; access to these markets; terms of trade; interest rates; and the availability of finance. Prospects in these five areas are not qualitatively different from those at the time of earlier scenario exercises; however, recent declines in interest rates and, more importantly, commodity prices mean that the expected path of these two variables is at a lower level than projected previously.

Since there are no clear reasons to expect further major changes in the terms of trade, the level of real interest rates, or the ease of access to industrial country markets, a reasonable central estimate would seem to be that the purchasing power of developing countries’ export earnings could henceforth grow approximately in line with industrial countries’ import demand. With output in the industrial world projected to expand at an annual rate of around 3 percent in the medium term, past relationships would suggest that developing country exports could grow at around 5 percent per annum.

In assessing the implications of this environment for the economic performance of developing countries, a number of changes in these countries’ situation over the past few years need to be taken into account. First, debt ratios are higher. While earlier scenario exercises had envisaged that export earnings would grow faster than debt, and thus reduce the relative burden of debt over time, this has not happened so far, largely because of lower export prices. Thus, instead of falling in 1986, as projected a year ago, the debt ratio for the 15 heavily indebted countries mentioned in the U.S. debt initiative of October 1985 reached a new record of over 338 percent of exports of goods and services. Second, investment has failed to revive. Gross investment in the heavily indebted countries in 1986 averaged 16¾ percent of GDP, barely enough to keep the capital stock from falling, and far below the figure of 24½ percent at the beginning of the present decade. Third, the fiscal deficit of developing countries rose again in 1986, by about 1½. percentage points of GDP, after declining in 1984–85. For the 15 heavily indebted countries, fiscal deficits jumped by some 2 percent of GDP and are now not far below the record levels reached in 1982–83. Fourth, banks have become reluctant to lend on a voluntary basis to a wide range of developing countries. They have also become increasingly reluctant to participate in concerted lending packages to heavily indebted countries, as additional time passes without significant signs of progress toward increased creditworthiness. This unwillingness has at times injected an adversarial tone into the relationship between some indebted countries and their major creditors.

An implication of the foregoing is that private capital flows to indebted developing countries will be even more severely curtailed than in previous scenarios. Banks appear to be simply unprepared to lend to a range of countries whose prospects for resuming normal debt service in the near future are considered remote. Countries with a stronger financial position appear to be determined to reduce their vulnerability to future difficulties by minimizing future borrowing and, in a number of cases, by seeking to repay part of their maturing liabilities. If nothing happens to modify these attitudes, the staff estimates that new borrowing from private creditors would be at very low levels during 1989–91. This would be associated with a situation in which the aggregate recorded current account deficit of developing countries would reach historical lows in relation to exports of goods and services over the scenario period. In fact, making allowances for unrecorded receipts presently captured’ in the global statistical discrepancy, developing countries would probably be in approximate balance on current account.4

This bleak picture for external financing flows could have serious adverse consequences for economic development in indebted developing countries. It should be remembered, however, that even when capital inflows were at their height, domestic savings provided over four fifths of the resources used by developing countries to finance investment. It is the effectiveness with which domestic savings are mobilized and used that will be the principal determinant of whether developing countries are able to regain a satisfactory momentum in economic growth and improve their creditworthiness.

Policies to mobilize additional domestic saving include substantial fiscal correction, improved incentives to private saving, and exchange rate policies that encourage international competitiveness. These policies, while they might be instigated by external financial pressures, would have beneficial effects on domestic economic performance. If followed resolutely, they would, in the staff’s view, be consistent with a rate of growth of GNP of around 4½–5 percent per annum in the capital importing developing countries as a group. However, to achieve such a growth rate, the proportion of national income spent on investment among the most heavily indebted countries would have to rise strongly over the scenario period. Given the fact that no additional saving is expected from abroad (rather the reverse), this would require a substantial rise in national saving. Much of this rise would have to come from a strengthening of the fiscal position; the remainder would represent an increase in saving by the private sector brought about by the maintenance of appropriate interest rates and exchange rates, as well as generally sound demand management policies.

The scenario just sketched would enable the capital importing countries’ debt ratio to be reduced by a fifth, from 183 percent of exports of goods and services in 1986 to 147 percent in 1991. At the same time, it would be consistent with a resumption of per capita income growth in most individual developing countries. Clearly, this moderately satisfactory result cannot be attributed to any improvement in the external environment. It results from an assessment that needed policy improvements are feasible, and would have relatively quick-acting effects on economic performance. The realism of this assessment, and some of the consequences if it were not borne out, are examined in the next section.

Economic Interactions and Policy Issues

This section considers economic interactions and policy issues in light of the medium-term prospects that were discussed in the preceding section. It will be recalled that the Interim Committee Communiqué of April 1986 requested work on “indicators relating to policy actions and economic performance, having regard to a medium-term framework.” The World Economic Outlook. that was published in October 1986 provided the staff’s initial response to this request by emphasizing medium-term factors relevant to policy questions. The present section extends that discussion and also addresses further issues mentioned in the Interim Committee Communiqué of September 1986, which noted that: “A key focus of indicators should be on points of interaction among national economies, in particular developments affecting the sustainability of balance of payments positions, and on the policies underlying them. . . . The Committee asked the Executive Board to develop further the application of indicators in the context both of the periodic consultations with individual member countries and of the World Economic Outloo. so as to facilitate the multilateral appraisal and coordination of economic policies.”

Industrial Countries

As in the past, the ultimate objective of macroeconomic policy in each industrial country remains to achieve sustained output growth and a lasting reduction in unemployment while maintaining reasonable price stability. Given the large fiscal imbalances that appeared in a number of major industrial countries in the 1980s, and the associated highly skewed pattern of current account imbalances, it has been evident for several years that these ultimate goals must be sought within a framework that emphasizes the implementation of policies that are sustainable over the medium term, from both a domestic and an international point of view. From this medium-term perspective, the emphasis must be on setting an appropriate multiyear course for fiscal, monetary, and structural policies.

In discussing the medium-term evolution of fiscal policies and the scope for reducing current account imbalances among the industrial countries, past World Economic Outloo. publications have given increasing emphasis to the relation between a country’s current account balance, the levels of private saving and domestic investment, and the government’s fiscal position. The present paper extends that framework by considering more explicitly the asset stocks underlying those flows, in particular a country’s net foreign asset position and the level of government net debt as indicators of the sustainability and international consistency of national economic policies. The mix of fiscal and monetary policies is also important, both from the standpoint of maintaining the hard-won goal of inflation control and in influencing aggregate demand in a shorter-term perspective. Thus these issues of monetary-fiscal policy mix are also considered later in this section.

Tensions in the Projections

A set of medium-term projections such as those developed in the preceding section can embody two types of tension. First, current trends in fiscal or balance of payments positions may not be sustainable over the medium term, in that they involve a build-up of indebtedness that creates the possibility of market disruptions. Second, even where such trends are sustainable, they may not be compatible with the objective of stable non-inflationary growth. These two types of tension are obviously related, but they can be treated separately for analytical purposes.

(1) The sustainability of fiscal and current account positions. From a domestic perspective, industrial countries have sought in recent years to reduce gradually fiscal deficits, both to release financial resources for use by the private sector and to avoid the risk of a build-up of government debt to unsustainable levels.5 If announced fiscal policies are fully implemented, most industrial countries will be pursuing medium-term strategies that will stabilize or reduce the ratio of government net debt to GDP. Indeed, of the major seven countries, all except Italy and Canada are expected, on the basis of the staff’s medium-term projections, to have a falling ratio of debt to GDP by 1991.

From an international perspective, the policy stances of different countries must also be such as to yield external payments balances that are sustainable. One possible approach to this criterion is to consider whether the current account balance that results from the stance of fiscal policy (as well as from private saving and investment behavior) involves a continual increase or decrease in a country’s net claims on, or liabilities to, nonresidents. If, on the contrary, this ratio does change persistently in one direction or another, then large movements eventually may occur in real exchange rates and in the relative size of traded and nontraded goods sectors.

Table 5 shows the implications of the current account positions for the levels of net foreign claims of the industrial countries, expressed as a percentage of GNP. These are calculated simply by cumulating current account positions—valuation effects are not taken into account. As emphasized in the previous section, the principal determinants of current account positions are relative activity levels and real exchange rates (assumed to remain unchanged).6 The main issue that arises from Table 5 concerns the accumulation of large net foreign claims or liabilities in relation to GNP implied by the current account projections—especially for the United States, Japan, and the Federal Republic of Germany. These positions are projected to grow by substantial amounts over the medium term, and would not have stabilized by 1991. The United States’ net debtor position would reach approximately 17 percent of GNP in 1991, while, given the assumptions of this scenario, Japan’s net creditor position relative to GNP would be even larger. While such net claims ratios are not unprecedented—Canada’s net debtor position currently exceeds 20 percent of GNP, as does the net creditor position of the United Kingdom—given the size of the countries concerned and, hence, the absolute amounts involved, the change in the positions for the United States, Japan, and Germany corresponds to a substantial shift in the international ownership of financial assets.

Table 5.Major Industrial Countries: Current Account Balances and Net Foreign Claims, 1984–88(As percentage of GNP or GDP)
19841985198619871988
Current account balance1
Canada0.8-0.1-1.7-2.2-2.3
United States-2.8-2.9-3.3-3.1-2.7
Japan2.83.74.43.71.4
France-0.20.50.40.2
Germany. Fed. Rep. of1.12.14.03.12.4
Italy-0.8-1.20.90.60.2
United Kingdom0.40.80.3-0.8-0.9
Total-0.9-0.7-0.2-0.3-0.3
Net foreign claims
Canada34.3-36.3-36.0-35.9-36.5
United States0.7-2.2-5.3-8.2-10.4
Japan5.99.313.316.518.9
France1.11.11.51.91.8
Germany, Fed. Rep, of6.17.911.514.115.9
Italy-6.1-6.5-4.9-3.9-3.4
United Kingdom22.922.320.718.516.3

As regards the aggregate current account position of the major industrial countries relative to the rest of the world, this is projected to be at the same level, as a ratio to GNP, in 1991 as in 1986. Since the smaller industrial countries are also not expected to change their position substantially, this implies—if the world statistical discrepancy does not change—that no significant change in the transfer of resources to developing countries would occur over the projection period.

(2) Tensions in sectoral balances. The question posed by the preceding discussion was whether the prospective payments positions that emerged from assuming exchange rates unchanged are likely to be sustainable over time. However, it is also important to ask whether the implied changes in financial balances within national economies are realistic.

Table 3 (p. 14) shows the sectoral financial balances. This table together with the medium trends discussed above suggests that several types of tension might appear over the period to 1991. As noted earlier, in the case of the United States, general government deficits are projected to fall appreciably from 1986 to 1991, by 1¾ percent of GNP; nevertheless, the U.S. current account deficit would decline only marginally. Thus, most of the resources released by fiscal consolidation would go into a rise of U.S. private sector investment relative to saving; in fact, investment is assumed to rise by almost 1½ percent of GNP. An increase of this magnitude implies an optimistic assessment of the ability of declining government borrowing to “crowd in” private spending. To some extent, of course, investment in the United States may be expected to respond positively to a weaker dollar and the longer-run incentive effects of tax reforms. Nevertheless, the increase that is required to be compatible with the projection for the fiscal position and the current account is large by historical standards, and must therefore be considered subject to considerable uncertainty. Failure of investment to grow at the implied pace would tend to result in weaker activity and a lower external deficit than shown in the baseline scenario. It would also put downward pressure on interest rates and the exchange rate and would, if it persisted, result in lower potential output growth in the medium term.

In the case of Japan, the current account surplus is projected to narrow by a moderate amount. With relatively little change in the fiscal position of the general government, the resources released from the export sector are assumed to be absorbed in higher private investment or lower private saving. It is expected that the pending tax reform, together with the waning of the adverse effects of past exchange rate changes, will encourage both these trends. Compared to 1986, both the private saving and private investment rates are expected to be somewhat higher in the medium term. The trends in domestic savings and investment in Japan that are required to validate the projected shifts in the fiscal position and the current account do not appear implausible, given the present orientation of government policies. Once again, however, if the projected increase in investment relative to saving did not occur, economic activity would tend to be weaker than projected and the external surplus larger.

In contrast to both of these countries, in the Federal Republic of Germany the current account surplus is projected to decrease substantially by 1991. The current account adjustment is larger than that for Japan because: (1) the foreign trade sector represents a bigger share of GDP; (2) the relevant elasticities are higher, especially on the import side; and (3) the underlying favorable trend of nonprice competitiveness appears to be less strong than in Japan. The projected fall in Germany’s current account surplus, accompanied by continued fiscal consolidation, implies a large increase in net private investment. The stability of real exchange rates postulated in the scenario, together with the progressive reduction in the amount of slack in the economy and the reform of business taxation, should help stimulate investment in the medium term. Nevertheless, the rise in investment required to avoid a slowing in the growth of aggregate demand is large, and the dependence of the scenario on such a development must be regarded as a further source of medium-term uncertainty. If the rise in investment that is projected does not occur, this would, as in the case of the United States and Japan, manifest itself in weaker economic activity or a higher current account surplus.

The tensions just described between the exchange rate assumption and its implications for trade flows, on the one hand, and saving/ investment balances, on the other, suggest that both the levels of these variables and of sensitive market prices such as interest rates and exchange rates could be different from those assumed in the baseline scenario. For example, if private investment in the United States did not increase as projected, it might require a decline in real interest rates to ensure that the resources released by fiscal consolidation were taken up in private spending. But, if interest rates did decline in the United States without a commensurate decline elsewhere, this could be associated with a depreciation of the real exchange rate of the U.S. dollar, which would tend to reduce the U.S. current account deficit relative to the staff projection. A reduction in the U.S. current account deficit would help avoid the potential strains that would be created by a buildup of external indebtedness. At the same time, of course, it would imply a weakening in the net exports of other industrial countries, thus rendering more complex the problem of maintaining output growth in these countries.

A major issue raised by this analysis of possible tensions is that of whether private investment can be expected to rise, relative to saving, to the extent that is needed to ensure consistency with governments’ fiscal plans. The projections assume that despite the ongoing process of fiscal consolidation in a number of industrial countries over the period to 1991, growth in the industrial countries will remain relatively stable at a rate near to or slightly above that of capacity output, so that unemployment rates will tend to decline. However, questions arise concerning whether the beneficial effects of a stronger fiscal position in encouraging the growth of private sector activity will be felt rapidly enough to avoid a short-term slowing of economic activity as government spending is cut back. In assessing this question, conflicting considerations come into play. On the one hand, the gradual and continuing process of consolidation that is contemplated could lead to a rather drawn-out period of sluggish activity; on the other, this negative effect could be mitigated as the favorable effects of budgetary consolidation, especially in North America, could rather quickly lead to a fall in real interest rates and a rebound in private spending.

In summary, a number of tensions may emerge. On exchange rates, looking solely at the effect of payments positions on exchange rates, there could be further upward pressure on the currencies of countries with large surpluses if economic agents became unwilling to finance existing imbalances as the absolute levels of net debtor/creditor positions grew. However, that willingness depends upon many factors besides current account balances, including growth rates, structural factors, interest rates, and financial policies. On aggregate demand, there could be downward pressure if private sector spending did not fill the gap left by lower fiscal deficits as rapidly as expected. On the distribution of demand, there could be a shift of demand away from surplus countries toward deficit countries if the exchange rate pressures referred to above were to materialize. And on interest rates, there could be downward pressure if the initial response of economies to fiscal consolidation and the reduction of external surpluses were some weakening of activity. By the same token, however, lack of fiscal correction in the United States would probably raise interest rates, increase exchange rate volatility, and exacerbate current account imbalances.

Policy Implications

Given the pressures that could emerge in a situation where policies and exchange rates are assumed to remain unchanged over the medium term, it is of interest to consider the kinds of policy shifts and other developments that would help reduce tensions and lead to a more resilient set of projections. The shifts that are required clearly have to address the twin problems of unsustainably large external imbalances and implausible movements in domestic saving/investment balances.

A scenario in which the external competitiveness of the United States was allowed to be significantly stronger than at present would naturally go a considerable distance toward reducing the potential unsustainability of external positions. However, the redistribution of demand that would result from such a development would not necessarily alleviate the difficulties faced in achieving satisfactory noninflationary growth of output. The implied increase in net exports of the United States could be helpful in enabling demand in that country to be sustained, even if private investment grew by less than in the staff’s scenario; however, stronger net exports would make it more essential than ever that the government release resources, as intended, through firm action to cut the budget deficit. For other countries, exchange rate appreciation and a more rapid erosion of their combined current account surplus would intensify the need to stimulate private sector demand, if the objective of continuing to reduce fiscal deficits is to be met.

It is clear from the foregoing analysis that improving the sustainability of fiscal and balance of payments positions in the industrial countries while maintaining the momentum of growth in demand and output will not be easy. It will require policies that are appropriately differentiated according to the circumstances of individual countries, harmonized in light of their interactions at the global level, and pursued with a firmness that inspires credibility.

In the case of the United States, the danger in not proceeding promptly and vigorously with fiscal restraint is that financial markets may eventually react unfavorably to continued large borrowing needs on the part of the government. The decline in interest rates and in the exchange value of the dollar that occurred in 1985–86 may well reflect to a certain extent the expectation that the United States will proceed with a deficit reduction program. Any reversal of these trends would make the eventual adjustment all the more difficult. A renewed rise in interest rates, by increasing the government’s borrowing costs, would further increase deficits; a rise in the real effective exchange rate of the dollar would inhibit the needed adjustment in export and import volumes. Of course, since a failure to achieve adequate reduction in the fiscal deficit would create renewed concerns over the buildup of debt, it could also lead to exchange market instability and downward pressure on the dollar.

In light of risks to confidence in financial markets, a program of deficit reduction in the United States that goes beyond the present “current services” estimates seems appropriate. Such a policy, however, would be likely to lead to a deceleration in economic growth unless accompanied by developments elsewhere that helped to sustain demand. To some extent, of course, the short-run effects of fiscal consolidation on demand in the United States will probably be offset by higher net exports resulting from recent improvements in the U.S. competitive position; if a further improvement in competitiveness were to occur, this would increase the extent to which subsequent cuts in the fiscal deficit were reflected in a stronger balance of payments. Naturally, however, higher net exports by the United States would serve to weaken activity in other industrial countries.

The situation facing the Group of Seven countries outside the United States differs. Several of them, notably Italy and Canada, are currently running substantial general government deficits. Consequently, they are themselves pursuing policies of fiscal consolidation. In these countries, indeed, continuing increases in the ratio of government net debt to GNP suggest that consideration might even be given to policies that would achieve cuts in the fiscal deficit more quickly.

In Japan and the Federal Republic of Germany, on the other hand, relatively greater concern attaches to sustaining the pace of demand and output. In Germany, the increase in private investment under the medium-term scenario is particularly large; if net investment appeared to be faltering, there would be a case for a less ambitious program of fiscal consolidation. In Japan, if the current account surplus is to decline significantly—something that seems desirable to facilitate the needed improvement in the U.S. external position—then sources of domestic demand will have to grow more rapidly. Ideally, this would be achieved through structural reforms that encourage private investment, particularly in those types of social infrastructure where Japan still lags behind some other advanced countries. In addition, as part of the undertakings noted in the Louvre Accord, a flexible implementation of policies aimed at stimulating domestic demand would be appropriate. A few other industrial countries have also achieved considerable success recently in restraining fiscal deficits, and these countries may have scope for a more moderate pace of consolidation from now on.

It has to be acknowledged, however, that the scope for easing fiscal policy is limited if, as the staff believes appropriate, the goal of medium-term budgetary strengthening is to be adhered to. This situation therefore directs attention to the question of how the needed reinvigoration of private sector activity is to be achieved and sustained.

One possibility would be through a more accommodative monetary policy. All of the major industrial countries have achieved a significant reduction in their inflation rates since the beginning of the present decade. To a large extent, this necessary adjustment has been achieved through determined monetary policies. In the past year, the fall in oil prices has had the further effect of pushing down recorded inflation, which is even negative in some countries. Some of this effect, however, is likely to be temporary; while it persists, it is difficult to assess underlying inflationary trends. As detailed above, in several of the major industrial countries monetary expansion has recently been proceeding at a fast pace, considerably faster than nominal income. Although in some countries the interpretation of developments for monetary aggregates is complicated by apparent shifts in demand, the generalized nature of the monetary expansion suggests that risks of an acceleration of inflation in coming years are by no means absent. In light of the recent painful experience of inflation reduction, these risks are not to be taken lightly, and the staff’s view is that any efforts to underpin demand through further easing of monetary conditions should proceed very cautiously.

The limited scope for monetary easing means that considerable importance attaches to the effective implementation of structural policies. Efforts to improve the functioning of markets have been under way in industrial countries for several years, and these should certainly be pursued with vigor. In present circumstances, tax reform could be a particularly significant vehicle for enhancing incentives to invest and ensuring that private saving incentives are not maintained at artificially high levels. Deregulation, especially in the financial sector, can also play a major role in ensuring that when real and financial resources are released from one use, they are quickly and effectively reabsorbed elsewhere.

The foregoing analysis has suggested that policies in each of the major countries have an important role to play in sustaining noninflationary output growth, and bringing about a better geographical distribution of demand expansion. Firm fiscal restraint in the United States, accompanied by a willingness in other countries to make use of whatever room for maneuver exists in macroeconomic policies, will make a major contribution to more sustainable prospects for output and payments balances.

It needs to be emphasized, however, that macroeconomic policy adjustments, by themselves, may not be sufficient to ensure a fully satisfactory result. Improvements in economic structure are essential if the private sector is to absorb resources released by public sectors as the latter pursue the essential goal of medium-term fiscal deficit reduction. Monetary policy can accommodate an expansion of private real spending, but it cannot actively stimulate expenditure without risking a rekindling of inflation.

Developing Countries

Uncertainties and Interactions

The medium-term scenario for developing countries presented earlier envisages a situation in which economic growth in the capital importing developing world recovers to an average rate of around 4¾ percent in 1989–91, and the debt ratio of indebted countries is gradually reduced over time. In such circumstances, it seems likely that creditworthiness would tend to recover, and maturing debt would be rolled over without insurmountable difficulty.

This scenario embodies a number of points of interaction with developments in industrial countries, and contains certain potential strains that warrant attention. First, developing countries’ current account deficits are projected to shrink significantly over the medium term; on a “discrepancy adjusted” basis, the heavily indebted developing countries would reach approximate balance on current account (and have a large trade surplus). This prospect means that private sector demand in the industrial countries will have to expand sufficiently rapidly to absorb both the projected decline in fiscal deficits and a further reduction in net exports to the developing world. Second, and related, the implied resource transfer from developing to industrial countries is the reverse of what has traditionally been considered normal from the point of view of efficiency of investment. A question arises of whether these changes in the location of savings and investment will tend to sap income growth at the global level.

Third, a continuing dilemma for developing countries is whether to devote available foreign exchange to domestic investment or the retirement of past debts. Many countries, of course, have very little choice in the matter; for those that have, there appears to be a growing tendency to give priority to debt reduction. Fourth, the dilemma just described has its counterpart at the domestic level. To achieve the rate of growth projected in the staff’s scenario, investment in the heavily indebted countries, which declined from 24½ percent of GDP in 1980 to less than 17 percent in 1986, would have to increase significantly over the period to 1991. Clearly, such a shift in the distribution of output requires strong incentives to limit consumption in favor of saving, and to generate the foreign exchange needed to finance the import component of the increased investment spending. The dilemma here arises from the need to postpone still further the fruits of adjustment, in circumstances where living standards in most countries are still well below their levels at the beginning of the decade.

Lastly, underlying the whole of this analysis is the issue of the proper allocation of the costs of paying for past financing mistakes, which are reflected in the substantial discount at which the liabilities of heavily indebted countries are trading. Uncertainty about how these costs will, in effect, be allocated inhibits both new foreign investment (on the ground that new claims will be subject to the same illiquidity, and possible loss of capital value, as old claims) and additional domestic investment (on the ground that heavy taxes will need to be levied on it if debts are serviced according to their originally agreed terms).

Policy Issues

The considerations discussed above raise serious questions about the ability of many developing countries to improve their growth performance over the next five years and to lay the basis for more rapid and sustained rates of growth for the remainder of the century. To be sure, many of the countries without recent debt-servicing problems have maintained satisfactory rates of economic growth without a weakening of their external position. For the debt-problem countries, however, and for some of the low-income countries not included in this group, the burden of external debt has continued to grow, while economic growth has been subdued and capital formation, the sine qua non of future growth, has declined.

The situation is particularly serious for countries with a level of debt that is perceived by creditors as being difficult to service on present terms and according to present repayment schedules. For these countries, the pattern of adjustments that have already occurred has tended to be associated with reduced domestic investment in productive capital. Domestic saving rates in these countries have in general not risen sufficiently to offset the fall in the inflow of net saving from abroad. While further improvements in the fiscal situation would help raise domestic saving, it is important that fiscal strengthening take place in a way that protects crucial public sector investment and does not diminish private saving and supply-side incentives. To help mobilize saving and discourage capital flight, a first priority is to establish interest rates and exchange rates that are related to market conditions—indeed, where domestic institutions permit, that are market-determined. Such a setting requires effective stabilization policies, which, as explained below, have been especially difficult to implement in the presence of heavy debt burdens.

(1) The volume and efficiency of investment. Investment has been hampered not only by the reduced investable funds but also by poor incentives. The debt burden itself affects incentives to invest, both by contributing to lower growth prospects and, as already mentioned, by creating expectations of higher future taxes to finance debt service and higher interest rates to discourage capital flight. In addition, in many of the debt-problem countries, the set of relative prices, interest rates, and exchange rates has for many years been distorted, and the actions taken immediately after the onset of the debt crisis have often included emergency measures, such as quantitative restrictions on imports, which brought short-term relief at the cost of less efficient resource allocation in the longer run. An added problem is that the public enterprise sector in these countries has often grown to an unwieldy size, and has acquired a political constituency that complicates the task of introducing efficiency-enhancing reforms. Achieving greater efficiency of resource allocation would help raise rates of return, leading to a higher level of investment and stronger rate of growth for a given level of saving and investment. Since net external financing is likely to remain very limited, improved efficiency in the use of domestically generated investable resources is of key importance.

(2) The choice of foreign trade strategy. The sluggish growth of world trade in recent years and the poor price performance of many primary commodities have led to a certain degree of “export pessimism.” Nevertheless, for countries experiencing debt-servicing difficulties, export expansion appears to be an essential element in any long-term improvement in the external position. In several of these countries the effective prices facing domestic producers (including all taxes and subsidies) have tended to favor the production of import substitutes and nontraded goods rather than exports. For non-oil primary commodity exporters with an industrial base but hitherto limited success in exporting manufactures—generally middle-income countries, but including India and China—it seems clear that the path to a higher rate of growth of exports must lie with export diversification, since manufactures face higher income elasticities of demand in world markets than do primary commodities. What is needed in these countries is a combination of stabilizing aggregate demand, correcting price distortions, and maintaining international competitiveness through appropriate exchange rates.

By contrast, for non-oil primary commodity exporters with a highly limited industrial base—generally small, low-income countries—the greatest potential productivity increases are often in the domestic food sector. Improvements in pricing policies and the careful choice of public investment projects so as to favor this sector can serve not only to improve the current account on the import side but also to create the basis for diversification among primary commodity exports. For oil exporting countries, faced with lower revenues after years of rising oil prices, the task will be to invest oil income in ways that strengthen non-oil sectors; in particular, where previously healthy export sectors declined following the oil boom of the 1970s, exchange rate and other policies should aim at reviving those sectors.

Because markets in industrial countries will be growing more slowly than in the 1960s and 1970s, attention also needs to be paid to ways in which developing countries with debt problems or with poor export prospects can strengthen the development process without undermining external viability. In this connection, appropriate exchange rates and interest rates can moderate the demand for imported consumer goods within a framework of open markets, can help make the most of export opportunities, and can encourage investment projects and production techniques that are consistent with the economy’s comparative advantage. In addition, the careful use of efficiency criteria in the choice of investment projects can contribute to improving growth performance, and thus facilitate the expansion of international trade.

The choice of remunerative investments, cost-effective techniques, and efficient resource allocation in developing countries is rendered suboptimal by the barriers to foreign trade and capital movements that have been erected by industrial and developing countries alike. The set of available choices would be greater in a world with fewer direct and indirect trade restrictions, especially the subsidies of agricultural exports and quantitative restrictions on certain manufactured imports that are applied by industrial countries. Progress on these fronts in the forthcoming multilateral trade negotiations conducted by the GATT (General Agreement on Tariffs and Trade) could have considerable impact on the pattern of structural adjustments undertaken in the developing economies.

(3) Macroeconomic stabilization policies. Underlying the efforts at restoring adequate economic growth rates in countries affected by the debt crisis is the effort to shift the balance between aggregate expenditure and income. In the developing world as a whole, considerable progress has been made in this respect, although some slippages, particularly in the area of fiscal policy, were apparent in the past year. The countries with debt-servicing problems have had especially serious difficulties in achieving price stability while at the same time restoring investment and growth to satisfactory rates. Some of these difficulties are related to the level of debt itself. Because high external debt is generally correlated with large public sector indebtedness, variations in foreign and domestic interest rates have a large impact on government expenditures. When interest rates rose in the early 1980s, the resulting rise in fiscal deficits was financed in many cases by domestic and foreign borrowing that raised debt service requirements and generated inflation. The fiscal correction often entailed deep cuts in government investment programs and temporary increases in tax rates (or one-shot programs of tax amnesty and recovery). At the same time, the external adjustment needed to strengthen the payments position involved currency depreciation that fueled still-strong inflationary pressures. In turn, such exchange rate developments and their consequences were exacerbated by large-scale capital flight. Where inflation has become “quasi-institutionalised,” through formal or informal indexation of prices and wages, an especially complex policy problem has been created. However, without effective action to halt the vicious circle of deficits and inflation, the prospects of improving the level of saving and the volume and efficiency of investment are limited.

The more deeply entrenched inflation is, the harder it is to eradicate without serious effects on output, since prices and wages tend to be adjusted on the basis of past experience rather than on the basis of announced official intentions. Officially freezing wages and prices, which has recently been attempted in several high-inflation countries, can provide a “breathing space” for the authorities, during which producers and employees mutually abstain from demanding higher nominal incomes. However, such an approach can succeed only if the period of the freeze is used for decisive action to eliminate fiscal disequilibria, as well as correcting other economic distortions.

(4) Dealing with debt. Countries whose capacity to continue servicing outstanding debt is to some degree in question have faced particularly serious difficulties in formulating and implementing economic policies. As explained earlier, levels of indebtedness significantly beyond countries’ debt-servicing capacity have the effect of discouraging both external financing and domestic investment, and of rendering much more difficult the joint achievement of the goals of price stability, adequate growth, and a sustainable current account balance. In examining these debt-problem countries, two types can be distinguished: first, countries that have a liquidity problem, that is, an incapacity over the short run to meet their debt-servicing obligations but at least a potential capacity to do so over the long run; and second, countries that appear to be incapable for the foreseeable future of meeting these obligations. The first of these cases might be typified by a middle-income developing country with a diversified economic base but past problems of economic management; the second, by a low-income country that has accumulated external payments arrears far in excess of even total annual export earnings.

In the case of the country whose problem can be classified as one of illiquidity, it is, of course, difficult to judge whether adjustment efforts to date have been as effective as politically feasible. But it is becoming clear that the sheer size of existing liabilities has in some cases been an impediment to progress, especially to a revival of domestic investment. It is equally clear, of course, that many adjustment programs have suffered from inadequate implementation and that stronger initiatives by the international financial community to restructure debt must be accompanied by firmer adjustment efforts by the debtor country.

Where a debt reorganization is deemed necessary to bring about a more satisfactory economic adjustment, there arise difficult questions concerning the organization of a package of debt restructuring and new finance: How can the commercial banks be induced to participate, especially the smaller banks (the “free rider” problem)? What role should be played by official creditors (including the Paris Club) and multilateral organizations, especially the World Bank and the Fund? And what policy actions would be necessary to complement the new package and improve the prospects for investment and growth? While in the first few years of the debt crisis a number of “concerted lending” packages were organized under the aegis of the Fund, new packages have recently become more difficult to negotiate. Commercial banks have been reluctant to provide new financing to countries where progress toward a satisfactory growth path and capacity to meet debt-servicing obligations in a regular manner have been limited. Moreover, some debtor countries, for both financial and political reasons, do not wish at present to have stand-by arrangements with the Fund. In some of these cases, other ways of indicating the Fund’s approval of the government’s economic program have served as alternative means of giving assurance to creditors.

In the case of countries generally regarded as incapable of meeting even rescheduled debt service obligations within the foreseeable future, additional finance at nonconcessional terms, whether from the Fund or from other creditors, merely exacerbates an untenable external debt position. In these cases, structural adjustment programs with the Fund or the World Bank, with a medium- to long-term horizon and supported by concessional financing, may be the most appropriate means to support needed economic restructuring. Balance of payments viability over the long term may also require some means of dealing with those cases where there is a large divergence between the market value and the contractual value of existing debt. Dealing effectively with the debt issue will require greater convergence between the two. It is essential, however, that all parties concerned contribute toward an eventual solution: the debtor country, through more effective adjustment measures; donor countries and multilateral development institutions, through increased flows and better coordination of concessional financing and technical assistance; the commercial banks, through restructuring existing debt on viable terms; and the Fund, through financial support and policy conditions geared appropriately to the country’s circumstances.

International Cooperation and Role of Fund

The preceding analysis has already touched on several areas where international cooperation will be of crucial importance and where there is a major role to be played by the Fund and other international organizations. Three areas warrant special attention: (1) improving the effectiveness of policy coordination among the major industrial countries, with a view to strengthening the prospects for noninflationary economic growth; (2) managing the debt situation in a manner that helps restore conditions for voluntary new lending and an appropriate balance of financing and adjustment; and (3) avoiding the dangers of an increase in protectionist measures and, where possible, rolling back existing trade restrictions.

Policy Coordination in Industrial Countries

Maintaining a close and effective dialogue on macroeconomic policies among the industrial countries becomes of key importance when these countries are embarked on a cooperative effort to tackle major financial imbalances in a mutually supportive way. It is therefore encouraging that the Interim Committee has underlined the importance to be attached to multilateral surveillance, and has sought new mechanisms (the greater use of indicators, for example) to make the surveillance process more effective. Other forums, too, have been used as a means for promoting policy coordination, including meetings of the Group of Ten, the Group of Seven, and the Group of Five. The Fund can play a useful role in these meetings, since the Managing Director is normally present in each of the above groupings. The analytical contribution that the Fund is able to bring is that of focusing on interactions of policies and developments among the countries involved, as well as between these countries and other member countries.

Financing and Debt

It has for some time been recognized that the management of the debt situation requires a cooperative strategy. The key elements of this strategy are: the maintenance of growing and open markets in the industrial world; effective growth-oriented adjustment policies in indebted countries; and the availability of an appropriate level of financing needed to underpin the policy efforts of developing countries. The creation of a conducive international environment is largely dependent on the success of industrial countries’ efforts to achieve higher growth, adequate price stability, lower real interest rates, and an absence of financial market strains. Effective adjustment policies depend, in the last analysis, on political will in the countries called upon to adopt them; the international community can provide support, however, through policy advice and an appropriate level of financing.

In the area of financing, a considerable role exists for international cooperation. The Fund’s role in the financing process is twofold: providing its own resources, on appropriate terms, to countries adopting adjustment programs that meet agreed criteria, and acting as a catalyst for the provision of financing from commercial banks and other sources. Finance has become increasingly difficult to mobilize from private creditors; meanwhile, the amount of lending the Fund itself can provide is limited. In addition to this, budgetary stringency has made official bilateral donors also reluctant to increase the amount of their financial support. In these circumstances, it is important for the international donor and lender communities to recognize the common interest they share with developing countries in reviving the growth process. A key challenge to international cooperation in the period ahead will be to find ways of arresting the decline in financial flows that has characterized the past few years. There is little doubt that developing countries can find productive ways to use new capital investment. If such investment opportunities exist, and the surrounding macroeconomic policies are sound, it would be highly unfortunate if an inability to agree on financing mechanisms were to prevent the investment from taking place.

Resisting Protectionism

As noted earlier in this chapter, protectionist pressures have become a major cause of concern because of their implications both for structural reforms in the industrial countries and for structural adjustments aimed at enhancing the growth of exports in developing countries. The September 1986 Communique of the Interim Committee was emphatic about the need for a liberal trading environment as a key element for a satisfactory solution to current debt difficulties and for improvement of world growth prospects. While major trading nations were seen as having a special role to play in keeping markets open and tackling trade policy problems flexibly, developing countries were also urged to resist pressures toward inward-oriented policies. The announcement in January 1987 that the multilateral trade negotiations under the GATT would now definitely be initiated later in the year was an important first step toward achieving these goals.

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