Underlying trends in the world economy are encouraging in many respects (Chart 1), with economic policies contributing importantly to the favorable performance and prospects of most countries.
In most of the industrial world, economic expansion has now been under way for some time, with inflation in many cases remaining at its lowest level since the early 1960s. Pre-emptive tightening of monetary policy in 1994 has proven successful in dampening inflationary pressures in countries most advanced in the economic cycle. Low inflation and stronger efforts and commitments to contain budget deficits have helped to reverse earlier increases in long-term interest rates, while coordinated intervention in foreign exchange markets and changes in official interest rates have helped to bring key exchange rates closer into line with fundamentals.
Among most of the developing countries, growth has remained particularly strong, helped by successful stabilization and reform efforts in an increasing number of countries. Confidence has been quickly restored in all but a few countries following the Mexican financial crisis, and capital flows have been sustained at relatively high levels. Conditions for a pickup in growth are also improving in many of the poorest countries.
The economies in transition from central planning are increasingly seeing the fruits of their adjustment efforts, with output now rising in many countries. Stronger stabilization policies in some of the countries less advanced in the transition suggest that conditions for a recovery of activity are improving there also.
Notwithstanding these positive developments, many challenges remain. Some of these stem from longstanding problems, including high structural unemployment and still-excessive budget deficits in most industrial countries. Many challenges also need to be addressed to further deepen the role of market forces among the developing countries and the countries in transition. Robust growth and subdued inflation in the world economy provide excellent conditions for tackling these tasks. At the same time, the integration of world financial markets underscores the urgency both for the performance of individual countries and for global economic and financial stability of addressing weaknesses in economic policies.
In the past eighteen months, the world economy has witnessed several episodes of turbulence in financial markets as investors have adjusted their portfolios in response to changes in risk evaluation. The timing and extent of shifts in market sentiment are often difficult to explain in terms of changes in economic fundamentals. But the large increases in bond yields seen in 1994, and the large movements in capital flows and exchange rates experienced in 1995, are at least in part traceable to concerns about the resolve or ability of governments to deal with economic problems and imbalances and to correct weaknesses in economic policies. If anything, the sensitivity of markets to such concerns seems to be increasing.
The specific focus of market concerns—be it a risk of overheating, the sustainability of fiscal or external imbalances, tensions over trade, or the credibility of an exchange rate peg—varies over time with changing economic circumstances. The shifting focus and sensitivity of investors to perceived risks contribute to market volatility. Understandably, there is concern among policymakers that shifts in market sentiment may give rise to overshooting of interest rates, misalignment of exchange rates, and destabilizing swings in international capital flows. The possibility that a government may misinterpret or ignore the first signs of a confidence crisis only aggravates the risk of more serious disruptions at a later stage. And while markets may sometimes pay insufficient attention to the longer-term consequences of an emerging and accumulating imbalance, they ultimately react forcefully if the imbalance is not corrected.
Abrupt swings in investor sentiment may contribute to fluctuations in output and employment through a variety of channels, including the effects of wealth appreciation or depreciation on the balance sheets of households, enterprises, and financial institutions, With upward trends in stocks of both real and financial assets relative to current income, and the growing use of highly leveraged instruments, the potential impact of fluctuations in asset prices is probably increasing. Asset price changes may sometimes reinforce the effects of policy actions and help to stabilize an economy. This was arguably the case in the United Stales in 1994 when increases in long-term interest rates helped to set the stage for a more sustainable growth path. And exchange rate changes are often helpful and desirable to promote external adjustment and balanced growth. In some instances, however, changes in financial market sentiment may make the task of policymakers more difficult, perhaps even aggravate existing problems. This was clearly the case in Japan at the exchange rate of about ¥85 per dollar prevailing in mid-1995. For Italy and Sweden, very large premiums in interest rates and persistent exchange rate weakness have also complicated the tasks of putting their public finances on a sound footing and of meeting their inflation objectives.
The critical issue, however, is not whether the liberalization of financial markets needs to be reconsidered because of the potential for market turmoil. Admittedly, markets occasionally are mistaken and often appear to react too slowly to emerging imbalances. But shifts in market sentiment are usually justified even though the resulting movements in asset prices can appear excessive. Indeed, closer attention by markets to the quality of economic policies is clearly desirable and needs to be assisted by timely provision of economic information, which would help to reduce the abruptness and costs of adjustment. In any case, closing the capital account of the balance of payments is neither feasible nor desirable. The issue facing policymakers is rather the need to address the policy problems and weak fundamentals that are often at the root of market turmoil and thereby jeopardize the great benefits from capital market liberalization and integration.
The most prominent recent episode of shifts in investor sentiment started in Mexico at the end of 1994, following a period of unsustainable current account deficits; as the economy adjusted to the abrupt reversal of capital flows, real GDP has contracted sharply this year. The impact of the crisis in Mexico was felt not only by its main trading partners but also by some other emerging market countries because of contagion effects, although these were quickly contained in most cases. Among industrial countries, Japan has suffered a serious setback to its fragile recovery as a result of the excessive strength of the yen in the first half of 1995, especially against the U.S. dollar. Several other countries have experienced an intensification of inflationary pressures due to the lagged effects of large exchange rate depreciations in recent years. And the earlier sharp rise in long-term interest rates in some countries with weak fundamentals has affected their prospects for sustained economic recovery.
Actions to lower short-term interest rates in support of conceited intervention by leading central banks have reinforced market trends and contributed to correct the misalignment of key currencies that arose in the first half of 1995, These developments, which have helped to alleviate downside risks to the expected recovery in Japan and to the prospects for continued noninflationary growth in other industrial countries, illustrate the benefits of cooperative efforts among the major industrial countries to address common concerns, Although intervention is not a reliable tool to influence exchange rates in all circumstances, the recent experience confirms that coordinated actions to affect exchange rates can be effective against serious misalignment when economic and policy developments are supportive and the timing carefully chosen.
Overall, the world economy has proven quite resilient to the recent turmoil in financial markets. While the staff has revised down the projected growth rate for the industrial countries by ½ of 1 percentage point for 1995 and somewhat less for 1996, the projections for many developing and some transition countries are now stronger than indicated in the May 1995 World Economic Outlook (Table 1), The projected rate of growth of world output is therefore essentially unchanged at about 4 percent in both 1995 and 1996.
Overview of the World Economic Outlook Projections
(Annual percent change unless otherwise noted)
Because services were not previously included and some methodological changes have been made to the way calculations are done, comparisons with the May 1995 projections are not presented.
Simple average of spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil. The average price of oil in U.S. dollars a barrel was $15.47 in 1994; the assumed price is $16.67 in 1995 and £15.51 in 1996.
Average, based on world commodity export weights. Comparisons with the May 1995 projections are not presented because the nonfuel commodity price index has been revised.
London interbank offered rate.
Overview of the World Economic Outlook Projections
(Annual percent change unless otherwise noted)
| Current Projections | Differences from May 1995 Projections | |||||||
|---|---|---|---|---|---|---|---|---|
| 1993 | 1994 | 1995 | 1996 | 1995 | 1996 | |||
| World output | 2.5 | 3.6 | 3.7 | 4.1 | — | -0.1 | ||
| Industrial countries | 1.1 | 3.1 | 2.5 | 2.4 | -0.5 | -0.2 | ||
| United States | 3.1 | 4.1 | 2.9 | 2.0 | -0.3 | 0.1 | ||
| Japan | -0.2 | 0.5 | 0.5 | 2.2 | -1.3 | -1.3 | ||
| German | -1.2 | 2.9 | 2.6 | 2.9 | -0.6 | -0.4 | ||
| France | -1.5 | 2.9 | 1.3 | 2.7 | -0.3 | -0.4 | ||
| Italy | -1.2 | 2.2 | 3.0 | 2.8 | — | -0.2 | ||
| United Kingdom | 2.2 | 3.8 | 2.7 | 2.9 | -0.5 | — | ||
| Canada | 2.2 | 4.6 | 2.1 | 2.7 | -2.1 | 0.1 | ||
| Seven countries above | 1.3 | 3.1 | 2.4 | 2.3 | -0.6 | -0.3 | ||
| Other industrial countries | 0.2 | 2.9 | 3.2 | 3.0 | -0.1 | -0.2 | ||
| Memorandum | ||||||||
| European Union | -0.6 | 2.8 | 2.9 | 2.8 | -0.3 | -0.2 | ||
| Developing countries | 6.1 | 6.2 | 6.0 | 6.3 | 0.4 | 0.2 | ||
| Africa | 0.8 | 2.6 | 3.0 | 5.2 | -0.7 | -0.1 | ||
| Asia | 8.7 | 8.5 | 8.7 | 7.9 | 1.0 | 0.5 | ||
| Middle East and Europe | 3.6 | 0.3 | 2.4 | 3.2 | -0.5 | -1.5 | ||
| Western Hemisphere | 3.3 | 4.6 | 1.8 | 4.0 | -0.6 | 0.3 | ||
| Countries in transition | -9.1 | -9.5 | -2.1 | 3.4 | 1.7 | -0.1 | ||
| Central and eastern Europe | -6.1 | -3.8 | 0.2 | 4.3 | -0.2 | 0.8 | ||
| Excluding Belarus and Ukraine | -1.9 | 2.8 | 4.0 | 4.4 | 0.4 | 0.1 | ||
| Russia, Transcaucasus, and central Asia | -11.8 | -15.2 | -4.6 | 2.4 | 3.7 | -1.1 | ||
| World trade volume (goods and services)1 | 3.9 | 8.7 | 7.9 | 6.5 | … | … | ||
| Imports | ||||||||
| Industrial countries | 1.1 | 9.2 | 7.1 | 5.5 | … | … | ||
| Developing countries | 9.3 | 8.5 | 11.1 | 9.5 | … | … | ||
| Exports | ||||||||
| Industrial countries | 2.5 | 8.1 | 6.9 | 5.0 | … | … | ||
| Developing countries | 7.3 | 11.3 | 11.0 | 9.6 | … | … | ||
| Commodity prices in SDRs | ||||||||
| Oil2 | -10.7 | -6.5 | 1.1 | -6.1 | -1.7 | -5.3 | ||
| Nonfuel3 | 2.7 | 10.8 | 1.8 | -0.2 | … | … | ||
| Consumer prices | ||||||||
| Industrial countries | 2.9 | 2.3 | 2.5 | 2.5 | -0.1 | -0.2 | ||
| Developing countries | 43.1 | 48.1 | 19.5 | 13.0 | 2.0 | 4.1 | ||
| Countries in transition | 675.2 | 301.3 | 147.7 | 25.4 | 20.8 | 6.5 | ||
| Six-month LIBOR (in percent)4 | ||||||||
| On U.S. dollar deposits | 3.4 | 5.1 | 6.2 | 6.2 | -0.6 | -0.8 | ||
| On Japanese yen deposits | 3.0 | 2.4 | 1.4 | 1.4 | -0.7 | -1.7 | ||
| On deutsche mark deposits | 6.9 | 5.3 | 4.6 | 5.2 | -0.8 | -0.8 | ||
Because services were not previously included and some methodological changes have been made to the way calculations are done, comparisons with the May 1995 projections are not presented.
Simple average of spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil. The average price of oil in U.S. dollars a barrel was $15.47 in 1994; the assumed price is $16.67 in 1995 and £15.51 in 1996.
Average, based on world commodity export weights. Comparisons with the May 1995 projections are not presented because the nonfuel commodity price index has been revised.
London interbank offered rate.
Overview of the World Economic Outlook Projections
(Annual percent change unless otherwise noted)
| Current Projections | Differences from May 1995 Projections | |||||||
|---|---|---|---|---|---|---|---|---|
| 1993 | 1994 | 1995 | 1996 | 1995 | 1996 | |||
| World output | 2.5 | 3.6 | 3.7 | 4.1 | — | -0.1 | ||
| Industrial countries | 1.1 | 3.1 | 2.5 | 2.4 | -0.5 | -0.2 | ||
| United States | 3.1 | 4.1 | 2.9 | 2.0 | -0.3 | 0.1 | ||
| Japan | -0.2 | 0.5 | 0.5 | 2.2 | -1.3 | -1.3 | ||
| German | -1.2 | 2.9 | 2.6 | 2.9 | -0.6 | -0.4 | ||
| France | -1.5 | 2.9 | 1.3 | 2.7 | -0.3 | -0.4 | ||
| Italy | -1.2 | 2.2 | 3.0 | 2.8 | — | -0.2 | ||
| United Kingdom | 2.2 | 3.8 | 2.7 | 2.9 | -0.5 | — | ||
| Canada | 2.2 | 4.6 | 2.1 | 2.7 | -2.1 | 0.1 | ||
| Seven countries above | 1.3 | 3.1 | 2.4 | 2.3 | -0.6 | -0.3 | ||
| Other industrial countries | 0.2 | 2.9 | 3.2 | 3.0 | -0.1 | -0.2 | ||
| Memorandum | ||||||||
| European Union | -0.6 | 2.8 | 2.9 | 2.8 | -0.3 | -0.2 | ||
| Developing countries | 6.1 | 6.2 | 6.0 | 6.3 | 0.4 | 0.2 | ||
| Africa | 0.8 | 2.6 | 3.0 | 5.2 | -0.7 | -0.1 | ||
| Asia | 8.7 | 8.5 | 8.7 | 7.9 | 1.0 | 0.5 | ||
| Middle East and Europe | 3.6 | 0.3 | 2.4 | 3.2 | -0.5 | -1.5 | ||
| Western Hemisphere | 3.3 | 4.6 | 1.8 | 4.0 | -0.6 | 0.3 | ||
| Countries in transition | -9.1 | -9.5 | -2.1 | 3.4 | 1.7 | -0.1 | ||
| Central and eastern Europe | -6.1 | -3.8 | 0.2 | 4.3 | -0.2 | 0.8 | ||
| Excluding Belarus and Ukraine | -1.9 | 2.8 | 4.0 | 4.4 | 0.4 | 0.1 | ||
| Russia, Transcaucasus, and central Asia | -11.8 | -15.2 | -4.6 | 2.4 | 3.7 | -1.1 | ||
| World trade volume (goods and services)1 | 3.9 | 8.7 | 7.9 | 6.5 | … | … | ||
| Imports | ||||||||
| Industrial countries | 1.1 | 9.2 | 7.1 | 5.5 | … | … | ||
| Developing countries | 9.3 | 8.5 | 11.1 | 9.5 | … | … | ||
| Exports | ||||||||
| Industrial countries | 2.5 | 8.1 | 6.9 | 5.0 | … | … | ||
| Developing countries | 7.3 | 11.3 | 11.0 | 9.6 | … | … | ||
| Commodity prices in SDRs | ||||||||
| Oil2 | -10.7 | -6.5 | 1.1 | -6.1 | -1.7 | -5.3 | ||
| Nonfuel3 | 2.7 | 10.8 | 1.8 | -0.2 | … | … | ||
| Consumer prices | ||||||||
| Industrial countries | 2.9 | 2.3 | 2.5 | 2.5 | -0.1 | -0.2 | ||
| Developing countries | 43.1 | 48.1 | 19.5 | 13.0 | 2.0 | 4.1 | ||
| Countries in transition | 675.2 | 301.3 | 147.7 | 25.4 | 20.8 | 6.5 | ||
| Six-month LIBOR (in percent)4 | ||||||||
| On U.S. dollar deposits | 3.4 | 5.1 | 6.2 | 6.2 | -0.6 | -0.8 | ||
| On Japanese yen deposits | 3.0 | 2.4 | 1.4 | 1.4 | -0.7 | -1.7 | ||
| On deutsche mark deposits | 6.9 | 5.3 | 4.6 | 5.2 | -0.8 | -0.8 | ||
Because services were not previously included and some methodological changes have been made to the way calculations are done, comparisons with the May 1995 projections are not presented.
Simple average of spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil. The average price of oil in U.S. dollars a barrel was $15.47 in 1994; the assumed price is $16.67 in 1995 and £15.51 in 1996.
Average, based on world commodity export weights. Comparisons with the May 1995 projections are not presented because the nonfuel commodity price index has been revised.
London interbank offered rate.
Looking further ahead, the sensitivity of financial markets to economic imbalances underscores the importance of adhering to the cooperative strategy for sustained global expansion set out in the Interim Committee’s Madrid Declaration and reaffirmed in its April 1995 communique.1 If policy shortcomings are addressed in a timely manner, there is the potential for robust growth with low inflation over the medium to longer run. Conversely, slippages in economic policies would increase the risk of further disruptive reactions in financial markets, volatility in output and employment, and significant welfare losses for all countries. Clearly, the key challenge is to address policy weaknesses before markets force the required adjustments.
Prospects for world trade are critical for global economic performance. The rapid growth of trade in relation to the growth of world output—by a factor of almost two to one over the past thirty-five years—has been both a cause and a result of rising prosperity. With new multilateral agreements in place or in prospect for further liberalization of trade in goods and services, and of foreign direct investment, trade is likely to remain an engine of growth for all countries that position themselves to benefit. The new World Trade Organization provides a stronger rules-based institutional framework, but it faces formidable challenges to resist and reverse protectionist pressures. The multilateral trading system has served the world well but is threatened by frequent resort to unilateral trade measures, excessive use of antidumping actions, and the risk that regional trade agreements may lead to trade diversion.
Industrial Countries
The pace of economic expansion in the industrial countries slowed somewhat in the first half of 1995. Among the countries where the upswing has been the strongest—the United States, Canada, the United Kingdom, and Australia—some moderation of growth was appropriate following the rapid absorption of slack during 1994. For Germany, France, and several other continental European countries still recovering from the 1992–93 recession, economic activity is expected to remain relatively strong, although growth expectations for 1995 have been marked down slightly. The most serious deterioration in the economic situation is in Japan, for which the staff has revised down the near-term growth projections substantially.
Japan is experiencing one of its most serious economic slowdowns in the postwar period, the result of successive financial shocks including the bursting of the asset price bubbles of the late 1980s and the continued sharp appreciation of the yen. In mid-1995, with an exchange rate of about ¥85 per dollar, the Japanese currency appeared to be significantly overvalued on most criteria that can be used to assess the consistency of exchange rates with underlying fundamentals. The subsequent depreciation of the yen has brought it back to a level that appears to be closer in line with fundamentals.
The Japanese authorities have eased fiscal and monetary policies substantially, which has helped to con-lain the adverse impact of the financial shocks. In recent months, the protracted nature of the downturn has prompted further action to restore confidence and to avoid an even more prolonged underutilization of resources. The further easing of monetary conditions in July and August, with the discount rate being cut to a record low of ½ of 1 percent, was warranted in light of the declining levels of most price indices and the large output gap. The decline in interest rates, supported by coordinated intervention, helped to reverse the earlier excessive appreciation of the yen. The subsequent substantial economic package announced in September has reinforced the monetary easing. While there will be a need to resume fiscal consolidation once recovery is firmly established, the latest measures appear to provide the desired support for a sustained recovery and point to the potential for somewhat higher growth in 1996 than indicated in the staff’s baseline projection (Box 1).
The recent successfully managed closure of some insolvent financial institutions was a significant step toward the resolution of the bad loans problem in Japan, but many other smaller insolvent institutions may also require restructuring and there is a risk that financial sector problems will continue to slow the pace of recovery. It is therefore essential that the authorities decisively address these problems. Structural reforms also remain essential to revitalize the Japanese economy. Deregulation and other market opening reforms would increase the responsiveness of the economy to world competitive forces.
In North America and Europe, it will be important not to overreact to what is likely to be only a pause or a temporary slowdown in the expansion. In particular, the substantial reversal this year of earlier rises in long-term interest rates should provide significant support to activity during the period ahead. Against the backdrop of subdued inflationary pressures, several countries have lowered official interest rates in recent months to alleviate downside risks to economic activity. However, barring stronger efforts to reduce fiscal deficits than currently envisaged, only a few countries appear to have significant scope for further monetary easing.
Almost all industrial countries are struggling to contain large budget deficits and to reduce excessive levels of public debt. It is therefore encouraging that efforts and commitments to tackle fiscal imbalances appear to be intensifying. Several countries have already made some progress and others are in the process of implementing significant medium-term deficit reduction plans. Nevertheless, underlying imbalances generally remain large and the envisaged pace of consolidation is rather slow in most cases. As a result of the still-large fiscal deficits, many countries are paying heavy costs in the form of high risk premiums in interest rates, increased inflationary pressures from currency depreciation, and diminished long-term growth potential. Under these circumstances, the best contribution fiscal policy can make to sustain the expansion is through determined action to progressively eliminate fiscal imbalances over the medium term. Postponing such action, let alone allowing slippages in needed consolidation efforts, would only increase the risk of financial instability and reduce both near-term and longer-run growth.
In the United States, a moderation of growth in 1995 was needed to prevent a buildup of excess demand pressures. The slowdown that has occurred can be attributed in part to the pre-emptive tightening of monetary policy in 1994, which was reinforced by the rise in long-term interest rates. Spillover effects from the crisis in Mexico, which necessitated a sharp correction of Mexico’s external current account position, also contributed. Although growth appears to have slowed more than expected in the May 1995 World Economic Outlook, conditions are generally favorable for the expansion to pick up again during the second half of 1995 and in 1996.
For the U.S. expansion to be sustained, the risks of renewed upward pressure on inflation and on long-term interest rates must be averted. Since the rate of capacity utilization is still very high, there would need to be evidence of a marked slowdown to warrant a significant relaxation of monetary policy. But the key policy issue facing the U.S. authorities remains the need to eliminate the fiscal deficit and thereby strengthen national saving. Substantial progress toward fiscal consolidation was achieved in 1994, without impeding vigorous growth. In the absence of further measures, however, the underlying federal budget deficit would tend to rise again in the medium term. Budget proposals by the administration and by Congress recognize that further deficit reduction is essential to raise potential output and permit sustained increases in living standards in the future. A more front-loaded program, which postponed the introduction of significant tax cuts until substantial progress toward a balanced budget had been achieved, would allow the economy to reap the benefits of increased saving and lower interest rates more quickly and surely.
The domestic reasons for addressing the U.S. fiscal deficit are reinforced by global considerations. Although the deficit is now lower than in most other industrial countries, the fiscal shortfall is a contributing factor to the low U.S. saving rate and the persistent external current account deficits incurred since 1983. The ability to draw on other countries’ saving has helped to contain the level of real interest rates in the United Slates but has added to pressures on global interest rates.2 There are limits to the willingness of foreign investors to acquire dollar assets, however, which may have been a factor in the earlier weakness of the U.S. dollar against other major currencies. As discussed in the Annex, fiscal consolidation and other measures to enhance domestic saving in the United States would help to strengthen the dollar in the medium to longer run. The short-run effects of fiscal consolidation on the dollar are uncertain and would depend on the speed of consolidation, the cyclical response of the economy, and the impact on confidence and capital flows.
In the group of countries whose current business cycles are most closely synchronized with that of the United States—including the United Kingdom, Canada, and Australia—recent signs of moderation in the pace of expansion should also help to alleviate inflationary pressures. However, levels of long-term interest rates suggest that these countries have yet to fully establish the credibility of their ani-inflation policies. This makes it particularly important to consolidate the recovery through a period of more moderate growth. Safeguarding the commitment to price stability and strengthening financial market confidence will also need to be backed up by further progress on the fiscal front. In the United Kingdom and Australia. It will be important to avoid slippages in fiscal consolidation efforts. In Canada, the credibility of the government’s economic policies would be strengthened by the adoption of a stronger medium-term consolidation program aimed at bringing the federal fiscal deficit well below the present target of 3 percent of GDP; further efforts to contain the deficits of provincial governments are also needed.
Among the continental European countries, where the recovery began only in the course of 1993, there have been mixed signals from recent economic indicators. The widespread moderation of growth since the beginning of 1995 may be due to the lagged effects of last year’s rise in long-term interest rates, the appreciation of the deutsche mark and closely linked currencies, the effects on monetary conditions of tensions within the European Monetary System (EMS) in the spring of 1995, and spillovers from North America and Japan. However, with the renewed decline of long-term interest rates in most countries and the recent abatement of tensions in exchange markets, it seems likely that the European expansion will continue at a pace slightly above potential growth.
At the same time, it appears that the recovery in continental Europe may bring only relatively slow progress in reducing unemployment. There is also a danger that macroeconomic imbalances and high unemployment would pose continued risks of financial market pressures. It is critical, therefore, lo address a number of key policy weaknesses, especially in the fiscal area and with respect to labor markets. Germany has set a good example with substantial progress in unwinding unification-related fiscal imbalances, although additional efforts will be required in coming years to improve further the fiscal position while also lessening the burden of taxation. In France, by contrast, the budget deficit remains sizable despite recent efforts to raise revenues. Further efforts at fiscal consolidation are also needed in most other European countries. It is now generally recognized that Stage III of Economic and Monetary Union (EMU) is unlikely to begin before 1999, mainly because of the slow pace of fiscal consolidation. It is important that this delay does not lead to a relaxation of efforts to tackle fiscal imbalances. It is also critical to ensure continued progress toward price stability. In the current situation, countries that have established their anti-inflationary credibility and that make sufficient progress toward fiscal consolidation probably have some room to allow monetary conditions to ease further in coming months.
In Italy and Sweden, recovery is continuing, partly driven by rapid export growth. In both countries, significant measures have been taken, or are planned, to reduce the unsustainably large fiscal imbalances, but lack of confidence in financial markets has continued to cloud the outlook. This has been reflected in extremely weak currencies and substantial premiums in long-term interest rates, which have added to concerns about the fiscal outlook. There are recent signs that strengthened commitments to fiscal consolidation are beginning to break this vicious circle, but to fully restore confidence in financial markets the required reductions in fiscal deficits must be implemented as soon as possible. Concerns about the budgetary outlook have also resulted in continued high interest rate premiums in Spain and even more so in Greece. In contrast, Finland now appears to be recovering briskly, with an improving fiscal outlook, a correction of a previously sharply depreciated exchange rate, relatively low inflation, and declining interest rate premiums.
September 1995 Economic Stimulus Package in Japan
The Government of Japan announced on September 20 a new economic stimulus package intended to provide additional fiscal support to activity and promote a return to a path of steady recovery. The package includes fiscal measures amounting to ¥14.2 trillion (3 percent of GDP) and consists almost wholly of expenditure increases (see table below). The most important component of the package is an increase in public investment of over 1½ percent of GDP. This includes general public works; public works solely financed by local governments; education, telecommunication networks, science, and technology projects; disaster relief; and other investments including earthquake reconstruction and agricultural support projects.1 The package also includes measures to stimulate activity in the real estate market through land purchases. Furthermore, the Housing Loan Public Corporation is to extend additional loans, and increased public sector loans are to be provided mainly to small businesses and for investment in new business activities. Other measures include employment stabilization, import promotion, additional financial liberalization, and further acceleration of deregulation.
Japan: Summary of Economic Stimulus Packages, 1992–95
(In trillions of yen, unless otherwise indicated)
Includes disaster relief, unidentified land component of public investment, and lending by the Fiscal Investment and Loan Program to public corporations for public works.
Including ¥0.5 trillion of land purchases to be conducted over a five-year period.
Including ¥0.5 trillion of land purchases by a govern men I-affiliated urban development organization.
Japan: Summary of Economic Stimulus Packages, 1992–95
(In trillions of yen, unless otherwise indicated)
| Date Proposed | ||||||
|---|---|---|---|---|---|---|
| August 1992 | April 1993 | September 1993 | February 1994 | September 1995 | ||
| Total package | 10.7 | 13.2 | 6.2 | 15.3 | 14.2 | |
| (In percent of GDP) | (2.3) | (2.8) | (1.3) | (3.2) | (3.0) | |
| Tax reductions | — | 0.2 | — | 5.9 | — | |
| (In percent of GDP) | (—) | (—) | (—) | (1.2) | (—) | |
| Public investment1 | 5.5 | 7.6 | 2.0 | 4.0 | 8.1 | |
| (In percent of GDP) | (1.2) | (1.6) | (0.4) | (0.8) | (1.7) | |
| Land purchases | 1.6 | 1.2 | 0.3 | 2.82 | 3.233 | |
| (In percent of GDP) | (0.5) | (0.3) | (0.1) | (0.6) | (0.7) | |
| Increased lending by Housing Loan Corporation | 0.8 | 1.8 | 2.9 | 1.2 | 0.5 | |
| (In percent of GDP) | (0.2) | (0.4) | (0.6) | (0.3) | (0.1) | |
| Increased lending by government-affiliated financial institutions | 2.1 | 2.4 | 1.0 | 1.5 | 2.4 | |
| (In percent of GDP) | (0.5) | (0.5) | (0.2) | (0.3) | (0.5) | |
Includes disaster relief, unidentified land component of public investment, and lending by the Fiscal Investment and Loan Program to public corporations for public works.
Including ¥0.5 trillion of land purchases to be conducted over a five-year period.
Including ¥0.5 trillion of land purchases by a govern men I-affiliated urban development organization.
Japan: Summary of Economic Stimulus Packages, 1992–95
(In trillions of yen, unless otherwise indicated)
| Date Proposed | ||||||
|---|---|---|---|---|---|---|
| August 1992 | April 1993 | September 1993 | February 1994 | September 1995 | ||
| Total package | 10.7 | 13.2 | 6.2 | 15.3 | 14.2 | |
| (In percent of GDP) | (2.3) | (2.8) | (1.3) | (3.2) | (3.0) | |
| Tax reductions | — | 0.2 | — | 5.9 | — | |
| (In percent of GDP) | (—) | (—) | (—) | (1.2) | (—) | |
| Public investment1 | 5.5 | 7.6 | 2.0 | 4.0 | 8.1 | |
| (In percent of GDP) | (1.2) | (1.6) | (0.4) | (0.8) | (1.7) | |
| Land purchases | 1.6 | 1.2 | 0.3 | 2.82 | 3.233 | |
| (In percent of GDP) | (0.5) | (0.3) | (0.1) | (0.6) | (0.7) | |
| Increased lending by Housing Loan Corporation | 0.8 | 1.8 | 2.9 | 1.2 | 0.5 | |
| (In percent of GDP) | (0.2) | (0.4) | (0.6) | (0.3) | (0.1) | |
| Increased lending by government-affiliated financial institutions | 2.1 | 2.4 | 1.0 | 1.5 | 2.4 | |
| (In percent of GDP) | (0.5) | (0.5) | (0.2) | (0.3) | (0.5) | |
Includes disaster relief, unidentified land component of public investment, and lending by the Fiscal Investment and Loan Program to public corporations for public works.
Including ¥0.5 trillion of land purchases to be conducted over a five-year period.
Including ¥0.5 trillion of land purchases by a govern men I-affiliated urban development organization.
With the implementation of the September package, the structural deficit (excluding social security), in relation to GDP, is estimated to widen to 5½ percent in FY 1995 and to ¼ percent in FY 1996, compared with 5 percent in FY 1994 (see table on the right). The additional stimulus provided by the package through FY 1995/96 would thus more than offset the small withdrawal of stimulus that otherwise would have occurred owing to the unwinding of the earlier packages. The projections in this issue of the World Economic Outlook, which were finalized before the September package was announced, are based on the assumption that fiscal measures would have been adopted to prevent a withdrawal of stimulus through 1996.
In addition to the direct effects on demand and activity from the further increase in public investment outlays, the new measures will operate through indirect effects on consumption and investment, partly by bolstering consumer and business confidence. The measures to stimulate activity in the real estate market could help to improve the health of the financial sector, which has been weakened by the decline in land prices, thereby alleviating a potential restraint on the recovery. Moreover, structural policy measures, including further deregulation, should help to stimulate entrepreneurship and private sector vitality, and thus strengthen overall confidence in economic prospects. The effects of these measures could potentially be large. Overall, the latest measures have significantly improved the prospects for recovery during the period ahead and point to the potential for somewhat stronger growth in 1996 than indicated in the baseline forecast.
Japan: Structural Budget Balance, Excluding Social Security
(In percent of GDP)
The estimates for FY 1996 are based on IMF staff assumptions about the FY 1996 budget as well as the phasing of the implementation of the September package.
Japan: Structural Budget Balance, Excluding Social Security
(In percent of GDP)
| Fiscal Year | ||||||
|---|---|---|---|---|---|---|
| 199l | 1992 | 1993 | 1994 | 1995 | 19961 | |
| Without September 1995 package | -1.1 | -3.3 | -3.6 | -5.0 | -4.9 | -4.7 |
| With September 1995 package | -1.1 | -3.3 | -3.6 | -5.0 | -5.5 | -6.3 |
The estimates for FY 1996 are based on IMF staff assumptions about the FY 1996 budget as well as the phasing of the implementation of the September package.
Japan: Structural Budget Balance, Excluding Social Security
(In percent of GDP)
| Fiscal Year | ||||||
|---|---|---|---|---|---|---|
| 199l | 1992 | 1993 | 1994 | 1995 | 19961 | |
| Without September 1995 package | -1.1 | -3.3 | -3.6 | -5.0 | -4.9 | -4.7 |
| With September 1995 package | -1.1 | -3.3 | -3.6 | -5.0 | -5.5 | -6.3 |
The estimates for FY 1996 are based on IMF staff assumptions about the FY 1996 budget as well as the phasing of the implementation of the September package.
This agricultural support constitutes a part of the six-year program that was decided in the wake of the Uruguay Round agreement in 1994.
High rates of unemployment remain a central concern in most industrial countries. In Europe, where the problem is most serious, the cyclical recovery under way will help to improve labor market conditions but is unlikely to bring unemployment much below 8 to 9 percent, which is the estimated level of structural unemployment. Reducing structural unemployment will require fundamental reform of all regulations and policies that hamper incentives for creating jobs and seeking employment. The reforms should be designed to ensure that social objectives are achieved in ways that are compatible with better functioning labor markets, including through better education and increased training to enhance productivity and real earnings potential of the labor force. In several countries, steps are being taken to reduce the levels of social security contributions, which deter the creation of low-skilled jobs in particular. Such measures, however, will need to be accompanied by Other fundamental reforms and should be fully financed so as not to impede continued progress toward fiscal consolidation.
Developing Countries
The storm that broke with the financial crisis in Mexico has been weathered well by most emerging market countries. Contagion effects have been contained, and in all but a few cases capital inflows have been sustained at relatively high levels. Growth in some developing countries has even been marked up somewhat and should average about 6 percent in both 1995 and 1996. The maintenance of market confidence and the continued solid economic performance by a large number of countries are testimony to the substantial progress throughout the developing world toward greater economic and Financial stability and market-oriented structural reform.
The Mexican authorities responded to the abrupt reversal of capital flows at the end of 1994 by adopting a bold stabilization program that has received substantial international support. The program, which includes a significant improvement in the fiscal position, aims at re-establishing the basis for sustainable economic growth by strengthening domestic saving, reducing the external deficit and dependence on foreign saving, and containing inflation in the aftermath of the sharp depreciation of the peso. Despite the inevitable contraction of output early in the adjustment process, the initial results are generally encouraging and the country has been able to meet its international obligations. Moreover, investor confidence has improved as illustrated by a rising stock market, declining interest rates, and a stable currency. The rapid pace of adjustment suggests that the Mexican economy should soon begin to recover.
Argentina, which has been most affected by the Mexican crisis, has also put in place significant adjustment measures aimed at bolstering saving and reducing the external deficit. As in Mexico, the adjustment process is under way, although further efforts are required to strengthen the financial system. In Brazil, capital outflows in the wake of the Mexican crisis were less acute, and more recently there have been strong inflows. The impressive decline in inflation following the introduction of the real in mid-1994 should help to foster sustained economic recovery; consolidation of this progress requires, in particular, further efforts to strengthen the public finances and the implementation of structural reforms. Chile was virtually untouched by the Mexican crisis owing largely to its strong policy fundamentals.
For a number of developing countries, continued buoyancy of growth has increased the risk of overheating. This is a particular concern in Asia, which accounts for most of the upward revision to the output projections for developing countries. If not checked, rising inflationary pressures may eventually require more significant policy tightenings with potentially large economic costs. Despite some adverse effects on investor confidence in the immediate aftermath of the Mexican crisis, capital flows into Asia have been sustained at high levels. In many countries with inflexible exchange rates, the large capital inflows contribute to excess demand pressures, in part because of the difficulty of effectively sterilizing such inflows. A key policy requirement for many of these countries is to strengthen the public sector’s financial position in order to reduce pressures on interest rates and, hence, incentives for capital inflows. Exchange rate appreciation may also contribute to better macro-economic balance, especially in countries where rapid productivity growth is helping to maintain external competitiveness.
In China, with efforts to tighten financial policies, demand and inflation appear to have moderated but a cautious policy stance remains appropriate. Hard budget constraints in the state-owned enterprise sector would help to reduce overall credit expansion and free up real and financial resources for the vibrant private sector, A faster pace of trade liberalization and upward flexibility of the exchange rate would also help to contain inflationary pressures. In India, recovery is now well established, with increased supply responses from structural reforms introduced since 1991, while inflation has recently abated as a result of a tightened monetary policy. To reduce the risk of a renewed rise in inflationary pressures and to increase resources available for private investment, the large fiscal deficit should be reduced further and structural reforms should be accelerated.
In the Middle East, several non-oil producing countries have achieved significant progress. However, weak oil prices and persistent macroeconomic imbalances have limited economic growth in most of the region during the recent period. Considerable strengthening of fiscal positions will be required in most countries to increase domestic saving and investment and reduce external deficits. The oil exporting countries need to expand non-oil tax revenues and improve expenditure control to ensure that improvements in fiscal positions can be sustained. To diversify their export base and strengthen growth, many countries will also need to broaden the scope and increase the pace of structural reform, including through trade liberalization and public enterprise reform. The medium-term prospects for the region should benefit from increased confidence brought about by the peace process and from greater intraregional cooperation.
Growth prospects in Africa have improved somewhat with the adoption of market-oriented policies in an increasing number of countries. Stronger adjustment efforts have fostered macroeconomic stability, and currency realignments and liberalization of exchange and trade regimes have helped to restore external competitiveness and improve the investment climate. Efforts are also under way in many countries to address distortions in resource allocation and to remove obstacles to private sector development. However, notwithstanding encouraging progress on a number of policy fronts, many African countries still suffer from declining or stagnating levels of per capita income, widespread poverty, and unsustainable external debt burdens. Significantly higher growth rates will be required to improve living standards. Domestic policies will be the key determinant of success, with policy priorities including the need to intensify efforts to strengthen government revenue mobilization, reduce fiscal imbalances, and step up structural and institutional reform. Actions in these areas are being complemented by measures to reduce debt to Paris Club creditors using Naples terms, together with comparable action by Other bilateral and commercial creditors. The international community needs to ensure that all highly indebted poor countries undertaking strong adjustment programs can receive the financing and alleviation of their debt burdens needed to allow them to grow to their potential.
Strong and consistent reform and stabilization efforts have contributed importantly to the impressive growth performance of the developing world in recent years. These efforts have not only permitted greater participation by the developing countries in the world economy but also appear to have made them more resilient to cyclical downturns in the industrial countries, as seen in 1991–93. They have also given them access to financial resources to support higher levels of investment and growth. At the same time, however, the integration of the developing countries into global financial markets makes them more vulnerable to external financial disturbances. Indeed, a key issue is how these countries can best benefit from increased integration into the global economy while minimizing risks to domestic financial stability arising from external shocks.
Liberalization of capital movements helps to increase the efficiency of resource allocation. It also fosters competition in domestic financial markets and allows domestic investors to diversify their portfolios. These objectives have been the driving force behind the liberalization of capital movements by the industrial countries and more recently by many emerging market countries. Experience shows, however, that certain conditions have to be met for capital account liberalization to be successful. Because financial markets adjust more quickly than other markets, capital account liberalization requires both a reasonable degree of macroeconomic balance and structural reforms, especially of the domestic financial system.
Transition Countries
Economic performance varies considerably across the countries in transition, largely reflecting differences in the stage of economic stabilization and restructuring. Among the countries that are still going through the process of disinflation—Russia, Belarus, Ukraine, and most Transcaucasian and central Asian countries—output continued to decline in 1994 and the first half of 1995, although official data probably exaggerate the output contraction. In contrast, those economies that are more advanced in the transition have now clearly turned the corner and are enjoying, in most cases, robust growth. These countries, which include Poland, the Czech and Slovak Republics, Hungary, Slovenia, Albania, the Baltic countries, and Mongolia, owe their success to the achievement of relative macroeconomic stability coupled with major structural reform efforts. The results are a substantial strengthening of economic incentives, improvements in the allocation of real and financial resources, rapid increases in productive investment, and impressive growth of both exports and imports.
Even so, many challenges will need to be addressed to consolidate the initial gains and to maintain a strong growth momentum. As in the emerging market countries in the developing world, many of the transition countries are receiving significant capital inflows, Such inflows, which include repatriation of flight capital, are a sign of the confidence of both domestic and foreign investors in the strong growth prospects of the recipient countries. Inflows of foreign direct investment are particularly encouraging because of their beneficial effects on management practices and productivity. By easing financing constraints, capital inflows should help to stimulate activity and permit higher levels of investment; this is critical for future growth since much of the capital stock inherited from the command system has proven to be obsolete.
Also important to keep in mind, however, are the lessons from other parts of the world about the potential instability of such inflows and the need to guard against the risk of overheating and excessive current account imbalances. As the transition countries increasingly gain access to international capital markets and receive portfolio inflows by nonresidents, foreign saving should not become a substitute for domestic saving. A key requirement is a continued cautious stance of macroeconomic policies with further reductions in government deficits. Many of the transition countries also need to accelerate privatization, enterprise restructuring, and institution building. This will help to further deepen the role of market forces and increase the chances that both domestic and external financial resources are channeled toward productive investments.
The countries that are less advanced in the transition process suffer from a complex set of problems and policy shortcomings, although there are encouraging signs of greater determination to resolve them. Indeed, many of these countries have made good progress in reducing inflation during the first half of 1995. In Russia, there have now been significant achievements over a number of years in the area of structural reform. Tightened financial policies have brought down inflation, and there are early signs that activity may have begun to turn around. The nominal appreciation of the ruble in the second quarter of 1995 and the authorities’ successful policy of maintaining it within a band during the third quarter should help to bring down inflation further. Sustained progress in reducing the large fiscal imbalances, particularly through increased revenues, will be essential to continue the process of disinflation and to free up resources needed for the restructuring of the economy. There has been substantial progress with macroeconomic stabilization since late 1994 in Ukraine, and more recently in Belarus.
A serious structural weakness in many of the transition countries, including some of the most advanced, is the fragility of their banking systems. The legacy of nonperforming assets has its roots in the old central planning regime; however, the accumulation of bad loans has continued during the early years of transition, including by many of the new banks that have been established in recent years. The slow pace of restructuring of the nonfinancial state-owned sector is an important underlying reason for these difficulties, often because of political pressures to extend bank credit to financially insolvent enterprises. In addition, banks have frequently provided financing for new ventures that turned out to be failures.
Preventing banking crises and dealing with them when they arise are major challenges in these countries as in several other countries. A key issue is the need to limit potential macroeconomic disruptions and setbacks to stabilization efforts. Problem loans to ailing enterprises need to be resolved in the context of a comprehensive enterprise and bank reform strategy, including appropriate social safety net measures. There is also a need for strengthened prudential supervision, better assessment of credit risk, more stringent capital requirements, and greater access for foreign banks, which in turn will spur the necessary strengthening of banking practices. In any case, banking reform measures will take time before they become effective, and should be preceded by clear strategies to address banking crises in a way that prevents their contagion and limits the fiscal costs, without creating an excessive risk of moral hazard.
