The substantial progress made by many developing countries in fostering macroeconomic stability and in their pursuit of structural reform is expected to sustain robust growth in the period ahead. The Mexican financial crisis and its repercussions on other economies have clouded the short-term outlook for some countries, but longer-term prospects remain promising. All developing countries, however, will have to respond both to the challenges posed by large and potentially reversible capital flows and to many other policy challenges. For the strongest performers, these challenges include the need to avoid overheating and to strengthen efforts in the areas of deregulation and privatization. For many other countries whose performance has not been so strong, trade liberalization and structural reform need to be speeded up to enhance resource allocation, while fiscal and monetary policies should consolidate progress toward greater macroeconomic stability. Progress in these areas would strengthen domestic saving, investment, and long-term growth. Stronger domestic adjustment and reform efforts in the poorest countries will need to be supported by the international community through timely financial assistance and external debt restructuring on appropriate terms.

The substantial progress made by many developing countries in fostering macroeconomic stability and in their pursuit of structural reform is expected to sustain robust growth in the period ahead. The Mexican financial crisis and its repercussions on other economies have clouded the short-term outlook for some countries, but longer-term prospects remain promising. All developing countries, however, will have to respond both to the challenges posed by large and potentially reversible capital flows and to many other policy challenges. For the strongest performers, these challenges include the need to avoid overheating and to strengthen efforts in the areas of deregulation and privatization. For many other countries whose performance has not been so strong, trade liberalization and structural reform need to be speeded up to enhance resource allocation, while fiscal and monetary policies should consolidate progress toward greater macroeconomic stability. Progress in these areas would strengthen domestic saving, investment, and long-term growth. Stronger domestic adjustment and reform efforts in the poorest countries will need to be supported by the international community through timely financial assistance and external debt restructuring on appropriate terms.

Recent Developments and Short-Term Prospects

Growth in the developing countries as a group is projected to slow slightly in 1995–96 under the influence of somewhat tighter policies and a decline in portfolio capital flows from the high levels experienced in recent years (Chart 11). In some cases, this tightening of policies reflects responses to contagion effects in the wake of the Mexican financial crisis. In others, it represents an effort to avoid overheating. Among the different regions, the projections show the most pronounced slowdown in the Western Hemisphere, a moderation in the strong pace of economic expansion in Asia, and some strengthening of growth in Africa and the Middle East as a result of the recent intensification of adjustment and reform efforts. In the event of a very sharp and sudden decline in capital flows, activity in the developing world would slow more significantly because of the resulting need to tighten economic policies and reduce domestic demand and imports. Some countries might be able to cushion the adverse impact by drawing on their reserves in the short run, but they would eventually need to adjust.9

Chart 11.
Chart 11.

Developing Countries: Real GDP1

(Annual percent change)

1Blue shaded areas indicate IMF staff projections.

The cyclical recovery of commodity prices is one factor underlying the improved outlook for countries heavily dependent on commodity exports. Prices of non-oil commodities increased substantially during 1994 as a result of the global recovery, and in February this year, the IMF’s world export-weighted index was 10 percent higher than a year earlier. Coffee prices increased sharply in 1994 for the year as a whole owing to adverse weather in Brazil, although they dropped somewhat in December. Prices of copper, nickel, and other metals were up markedly in 1994. Strong demand in the United States has been a major cause of the marked rise in copper prices. The assumption of some rise in oil prices to about $16. 90 a barrel in 1995–96, based in part on oil futures market prices in late January, will help to improve the terms of trade of fuel-exporting countries in 1995–96. Oil prices declined from over $ 17 a barrel in July 1994 to $15. 75 in December, reflecting a significant increase in world production and a decline in purchases due to unseasonably warm weather in the Northern Hemisphere (Chart 12). In early 1995, prices picked up somewhat as demand from the United States and Asia increased substantially.

Chart 12.
Chart 12.

Commodity Prices

(1980 = 100)

1 The nonfuel commodity price index is an export-weighted average of 35 prices denominated in U. S. dollars. The oil price is an equally weighted average of the U. S. dollar spot prices of U. K. Brent, Dubai, and Alaska North slope crude oil. The real indices are deflated by the unit value of manufactures in industrial countries.

Following the financial crisis in Mexico and the repercussions on a number of countries in the region, average growth in the countries of the Western Hemisphere is projected to slow to 2¼ percent in 1995—only half the pace of 1994—and then pick up to 3¾ percent in 1996 (Table 7). Output in Mexico is expected to fall by 2 percent this year, but as financial conditions stabilize, activity is assumed to rise again in 1996. Following a substantial increase in prices in the first quarter of 1995 due to the sharp depreciation of the peso, a tight fiscal stance and a strict incomes policy are expected to contain inflation to just over 30 percent on a year-over-year basis, with a considerably lower rate in 1996. In Brazil, the current stabilization program has reduced monthly inflation from more than 40 percent in June 1994 to an average of less than 1½ percent a month in the first quarter of 1995, despite a sharp expansion of domestic demand. Output growth, which exceeded 5 percent in 1994, is expected to remain robust as monetary and fiscal policies are adjusted to consolidate progress toward greater financial stability. Growth in Argentina is expected to slow significantly in 1995–96, to around 3 percent, partly as a result of a decline in capital inflows. In Peru, following a sharp surge in output in 1994, growth is also expected to moderate in 1995–96, while inflation is projected to continue its downward trend. Chile, which has been less affected by the crisis in Mexico, is expected to see continued solid growth. In Venezuela, the earlier financial crisis and the exchange and price controls that were imposed in mid-1994 have had negative effects on private sector confidence and investment. A further decline in output is expected in 1995.

Table 7.

Selected Developing Countries: Real GDP, Consumer Prices, and Current Account Balance

(Annual percent change, unless otherwise noted)

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In percent of GDP.

African countries that had arrangements, as of the end of 1994, under the IMF’s structural adjustment facility (SAF) or enhanced structural adjustment facility (ESAF).

From December 1993 to June 1994, consumer prices in Brazil rose 763 percent. Following the introduction of the real on July 1, 1994, monthly inflation fell to 5½ percent in July. From June 1994 to December 1994, consumer prices increased by 17 percent. From December 1994 to December 1995, consumer prices are projected to increase by about 30 percent.

Average growth in Asia was stronger than expected in 1994, with a number of economies beginning to overheat. With some slowdown in portfolio capital flows to the region, and in view of a tightening of financial policies in response to capacity constraints, growth is projected to slow to 7½ percent in 1995 from about 8¾ percent in 1993–94. In China, output growth moderated slightly in 1994, to 12 percent, while inflation jumped to over 20 percent, partly reflecting adjustments in administered food prices. A strengthening of stabilization efforts is projected to slow growth to a more sustainable pace of 9 percent in 1995 and to reduce inflationary pressures. In Korea, sharp increases in investment demand boosted real GDP by over 8 percent in 1994. Strong investment demand, resulting in large increases in foreign direct investment, also contributed to buoyant growth and emerging inflationary pressures in Malaysia, the Philippines, and Thailand in 1994. Growth in these countries is expected to be sustained at or close to current levels in 1995–96, but some tightening of macroeconomic policies may be necessary to contain inflationary pressures.

In India, the recovery gathered momentum in 1994 as the economy expanded by 5 percent. Efforts to bring down inflation were thwarted by a substantial increase in money growth, induced partly by capital inflows. Continued fiscal consolidation is required to reduce the burden on monetary policy of containing inflationary pressures, to lower public indebtedness, and to bolster national saving. Despite a cotton virus and a drought, real GDP in Pakistan increased by over 4 percent in 1994. Further deregulation in the industrial and services sector, and favorable external conditions should lift growth further in 1995. In Bangladesh, despite lower-than-expected growth in the industrial sector, growth was sustained at 5 percent in 1994, the average of recent years.

The outlook for Africa has continued to improve with the recent implementation of structural reforms and stabilization programs in a number of countries.10 Assuming prudent macroeconomic policies and continuing reforms, output growth in the continent is projected to rise to 3¾ percent in 1995. But the risks of setbacks are considerable, and economic conditions remain difficult in many countries. In South Africa, for example, although GDP grew by only 2¼ percent in 1994, the external current account deteriorated dramatically. Growth is projected to average 3 percent in 1995–96, but the problem of high unemployment remains a major policy challenge over the medium term. In Nigeria, the economic and financial situation deteriorated further in 1994, owing to large fiscal imbalances and the maintenance of the exchange rate and interest rates at unrealistic levels. There is a danger of further fiscal slippages if a budgeted increase in oil revenues does not materialize. In Algeria, activity in 1994 was weaker than anticipated, in part due to continuing political instability, but also reflecting strong stabilization efforts and a decline in agricultural production as the drought continued for a second year. However, further trade and foreign exchange market reforms are expected to raise Algeria’s growth in 1995–96 to around 5 percent, while tight financial policies should help reduce inflation after a temporary increase stemming from the 1994 devaluation.

Many countries of the CFA franc zone are now beginning to see the benefits from the much-needed currency adjustment in early 1994 and the accompanying reform efforts. One of the most important benefits is that opportunities for investment and exports have increased. With support from multilateral and bilateral donors, and continued efforts to prevent inflation from eroding competitiveness, growth is expected to reach an average of 5 percent in 1995–96, a dramatic change after a decade of stagnation. The overall outlook among the African countries that had arrangements at the end of 1994 under the IMF’s structural adjustment facility (SAF) or enhanced structural adjustment facility (ESAF) remains positive. Growth in these countries is expected to average 5½ percent in 1995–96, while inflation is expected to fall to below 10 percent. Kenya, for example, has made great strides in restoring macroeconomic stability, with output growth resuming in 1994 and inflation falling. The current recovery in Kenya is expected to strengthen in 1995–96 as macroeconomic policies strengthen further.

Growth in the Middle East and Europe declined to only ¾ of 1 percent in 1994, largely as a result of developments in Turkey, but is projected to recover to 3 percent in 1995 and to 4¾ percent in 1996. The severe financial crisis in Turkey during the first half of 1994 contributed to a sharp decline of output. The outcome of the stabilization program adopted in mid-1994 has so far been mixed: external performance has improved but inflation has returned to monthly rates of 5–6 percent, indicating that a further strengthening of stabilization policies is needed. Economic prospects for the oil exporting countries in the region continue to be heavily dependent on oil market developments. Oil prices fell in 1994, but the assumed strengthening in 1995 should help to ease fiscal and external imbalances in some of the larger oil exporting countries. The favorable impact on the terms of trade will be mitigated, however, by the depreciation of the dollar against other major currencies and by increases in non-oil commodity prices. In the Islamic Republic of Iran, economic activity remained subdued in 1994, in part due to continued financial constraints that have limited imports.

Foreign Exchange and Financial Markets

The Mexican foreign exchange crisis in December 1994 exacerbated exchange market pressures that had been building in a number of Latin American countries during 1994. Cyclical developments, especially the rise in interest rates in the United States and other industrial countries, also played a role in the changing pattern of portfolio investments. In Mexico, the exchange rate vis-à-vis the U. S. dollar, which had already suffered from intermittent bouts of heavy selling earlier in 1994, in part related to political factors, has depreciated particularly sharply since December 1994. By the end of March this year, the new peso had fallen by almost 50 percent in foreign currency terms since the exchange rate was allowed to float in December 1994 (Chart 13). A number of other currencies in the region have also weakened, albeit to a much smaller extent. The Chilean peso was much less affected by events in Mexico, reflecting the country’s strong economic fundamentals. In Venezuela, following its own financial crisis and the sharp depreciation of its currency in the first half of 1994, the exchange rate was fixed at 170 Venezuelan bolívares per U. S. dollar on June 27, and a series of foreign exchange restrictions were imposed. These restrictions are expected to be lifted gradually during 1995.

Chart 13.
Chart 13.

Mexico: Financial Indicators

(January 1994 = 100, unless otherwise noted)

Source: Bloomberg Financial Markets.1The Mexican Bolsa index, consisting of 38 shares weighted by market capitalization.2The yield on Cetes, which are 28-day treasury bills issued by the Mexican government.

The contagion effects from Mexico have had only limited effects on foreign exchange markets in other developing country regions. On the basis of the official exchange rate, the Chinese renminbi depreciated by about 24 percent in real effective terms for the year as a whole. However, since a large proportion of transactions were already taking place at the swap market rate in 1993, the real exchange rate measured as a weighted average of the official and swap market rate was broadly stable in 1994. The Indian rupee was also relatively stable during 1994, helped by central bank interventions to stem upward pressure associated with substantial foreign equity investments. Following the large depreciation early in 1994 linked to concerns about the rising rate of inflation and uncertainties about fiscal policy, pressures on the Turkish lira have diminished and the external position has improved. In marked contrast to the trend toward exchange market liberalization in Africa, Nigeria abolished the free exchange rate in the foreign exchange bureaus and fixed the rate well below market clearing levels; for 1995, the authorities have announced the introduction of a dual exchange rate system, in which the official exchange rate will apply to government transactions and an autonomous rate will apply to all other transactions.

Equity markets in the emerging market economies have experienced substantial reversals of the 1990–93 increases in prices. Stock prices, which had already adjusted downward during most of 1994 as interest rates in the industrial countries continued to increase, fell sharply after the Mexican devaluation (Chart 14). Mexican equity prices, measured in U. S. dollars (by the IFC investable index), dropped by over 25 percent by the end of December 1994, and by the end of March 1995 had fallen by another 40 percent. As mentioned earlier, contagion or spillover effects of the crisis were stronger in Latin American countries than in other emerging markets. Stock markets in Argentina and Brazil were hardest hit: in Argentina the IFC index fell by over 13 percent in U. S. dollar terms in the second half of December 1994 and continued to decline in January and February 1995, although prices recovered by over 10 percent in March. In Brazil stock prices fell by almost 40 percent between mid-December 1994 and the end of March 1995. The spillover effects on Asian stock markets were relatively short-lived; by the end of February, a number of markets had recovered most of the initial losses.

Chart 14.
Chart 14.

Selected Developing Countries: Equity Prices

(In U. S. dollars; January 1994 = 100)

Source: International Finance Corporation, Emerging Markets data base.

External Payments, Financing, and Debt

The large increases in capital flows to developing countries in recent years, mainly to Asian and Latin American countries, have been associated with widening current account deficits in most regions, although many countries have been relatively successful in sterilizing a substantial proportion of the capital inflows and building up reserves (Charts 15 and 16). During the period ahead, net portfolio capital flows to developing countries seem likely to decline considerably, but the strong fundamentals and solid long-term growth prospects of most countries suggest little reason to expect any substantial downward shift in foreign direct investment flows. Among individual regions, net capital flows to the Western Hemisphere are expected to slow the most, largely owing to the crisis in Mexico. There may well be some lag in trade flows, however, and projections for current account deficits do not fully offset the likely decline in capital flows.

Chart 15.
Chart 15.

Developing Countries: Net Capital Flows1

(In billions of U. S. dollars)

1Net capital flows comprise net direct investment, net portfolio investment, and other long- and short-term net investment flows, including official and private borrowing.
Chart 16.
Chart 16.

Developing Countries: Balances on Current Account and Reserves1

1Blue shaded areas indicate IMF staff projections.

Recent increases in commodity prices and strengthened competitiveness are important factors in the current account improvements projected for African countries. These improvements are especially significant for the CFA countries, where progress in controlling domestic price inflation has helped maintain competitiveness following the January 1994 devaluation. In Côte d’Ivoire the current account deficit is expected to narrow by over 2 percent of GDP in 1995–96. The external surplus in Egypt is expected to decline further in 1995–96, reflecting in part a real appreciation of the currency. The strengthening of oil prices in 1995 and stronger fiscal adjustment efforts should also contribute to improvements in external positions among the oil exporting countries, especially for the larger oil exporting countries.

The increase in interest rates during 1994 has been reflected in a rise in debt-service ratios for sub-Saharan Africa and for countries in the Middle East and Europe (Chart 17). A more flexible approach to official bilateral debt reduction for low-income countries by the Paris Club, under the “Naples” terms agreed in December 1994 and consistent with the Interim Committee’s Madrid Declaration, is expected to reduce debt burdens for low-income countries. Cambodia was the first country to be offered a 67 percent net present value reduction in eligible debt service by the Paris Club in January 1995; subsequently a number of other countries, Chad, Guinea-Bissau, and Togo, in February, and Bolivia and Nicaragua in March, were offered similar terms, whereas Guinea received a 50 percent reduction in January. Furthermore, in February, Uganda was the first country to receive a stock-of-debt operation under Naples terms involving a 67 percent reduction in the net present value of eligible debt. Concessional terms such as these should help reduce debt and debt-service payments of most low-income countries to more sustainable levels, provided that new debt instruments offered to these countries contain similar concessional elements.

Chart 17.
Chart 17.

Developing Countries: External Debt and Debt Service1

1 Debt service refers to actual payments of interest on total debt plus actual amortization payments on long-term debt. The projections (blue shaded areas) incorporate the impact of exceptional financing items.

In the past six months, progress has continued to be made with debt-restructuring agreements in connection with the London Club and on a bilateral official basis. These include the commercial bank restructuring agreement with Ecuador involving $4.5 billion commercial bank debt and $2.9 billion in interest arrears. Algeria is also negotiating with commercial banks to restructure $4.2 billion debt. Haiti has settled its debt arrears to multilateral lenders, but arrears to the United States and other bilateral lenders remain to be cleared, and South Africa wrote off a $200 million debt owed by Namibia. Talks with regard to the commercial bank debt of Peru and Panama are continuing. Negotiations are also continuing with Nigeria and Venezuela regarding arrears and the management of outstanding debt.

Capital Flows and Economic Performance

In the aftermath of the Mexican financial crisis, equity markets in a number of developing countries experienced significant increases in volatility, raising concerns about the potential contagion effects that could result from a general reappraisal of developing country investments. Policymakers in many of the countries that have witnessed large capital inflows face a difficult task of managing the impact of these inflows, especially in limiting the potential adverse consequences on real exchange rates and the buildup of inflationary pressures. In the current environment, they need to guard against the risk of sudden reversals of capital flows. These risks are likely to be particularly acute in countries where the capital inflows are primarily short term.

There are important differences between the recent surge in capital inflows to developing countries and the experience of the late 1970s and early 1980s, when capital inflows consisted largely of bank lending to public sector borrowers. In Asia and in some Latin American countries, such as Chile, the rising share of foreign direct investment and portfolio investments in emerging stock markets has helped to reduce reliance on debt-creating flows. The October 1994 issue of the World Economic Outlook focused on many of the factors that have contributed to the increase in private capital flows, including the effect of the recent recessions and the associated decline in interest rates in the industrial countries, and discussed the policy response in some of the large recipient countries.11 The rise in interest rates in the industrial countries since early 1994 and the strengthening of the recovery have resulted in some moderation of portfolio capital flows to developing countries, but domestic factors such as macroeconomic stability and the sustainability of external balances are still likely to be the key determinants of the sustainability of capital flows. The crisis in Mexico, however, will undoubtedly lead to a period of increased vigilance in financial markets. Even though the longer-term move toward greater international portfolio diversification for industrial country investors can be expected to continue, albeit at a much slower rate, foreign investors are likely to be more selective with regard to developing country investments.

Significant progress in implementing structural reforms and fostering macroeconomic stability, particularly in Latin America and Asia, has generally played a key role in attracting capital inflows. Nevertheless there have been marked differences in macroeconomic performance and in how the recent capital inflows have been utilized (Table 8). Capital inflows have raised aggregate expenditures in all countries. In the Asian countries, however, the ratio of private consumption expenditure to GDP declined by over 4 percentage points in the early 1990s compared with the mid-to-late 1980s, and the ratio of investment to GDP rose by almost 5 percentage points. In the Latin American countries, by contrast, the ratio of consumption to GDP increased by over 3½ percentage points in the early 1990s compared with the 1980s, while the investment ratio was only marginally higher.12 For Latin America, this suggests that the capital inflows have tended to become a substitute for private sector saving. Although these countries have made substantial progress in reducing fiscal deficits, the improvement in public saving has been insufficient to offset the decline in private saving. In several of these countries, stronger programs of fiscal consolidation and structural reform would help to strengthen domestic saving, in line with the experience of Chile.

Table 8.

Selected Developing Countries: Macroeconomic Indicators

(Annual averages; in percent of GDP, unless otherwise noted)

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India, Indonesia, Korea, Malaysia, the Philippines, and Thailand.

Annual percent change.

For Indonesia, data for private saving are only available from 1986 onward. The data reported for 1983–89 are for 1986–89.

Reflects only central government expenditures and revenues, and therefore the fiscal balance does not equal net public sector saving.

Argentina, Brazil, Chile, Colombia, Mexico, and Peru.

During the early years of the recent surge in capital inflows, most countries attempted to intervene in foreign exchange markets to limit the appreciation of their nominal exchange rates, to reduce the impact of capital flows on money and credit growth, and to lessen the vulnerability of the financial system in the event of a sudden reversal of capital flows. The Asian countries were relatively successful in sterilizing the monetary effects of the rise in foreign exchange reserves. This helped to contain pressures on domestic inflation and to maintain relatively stable exchange rates. Among the Latin American countries, foreign exchange intervention was limited, and real exchange rates generally appreciated. In many cases, financial markets are not sufficiently well developed for central banks to sterilize the magnitude of capital flows that have been attracted in recent years. However, even when financial markets are relatively developed, sterilization is likely to be effective only in the short term and may not be sufficient to resist persistent pressures on the exchange rate. A particularly important drawback with sterilization is that it tends to raise domestic interest rates, which may attract more short-term capital flows. Even in countries such as Chile, where sterilization has been relatively successful, net costs to the central bank—the difference between domestic interest rates and the return on foreign currency reserves—have been substantial. In Chile, these quasifiscal costs were estimated to be around ¾ of 1 percent of GDP in 1991.13

The inability to sterilize the effects of the inflows played an important role in Mexico’s financial crisis. Since the late 1980s, the Mexican economy has attracted substantial capital inflows, accounting for over 40 percent of total flows to all Latin American countries during 1990–93. These large inflows, including significant increases in foreign direct investment, were attracted by prudent macroeconomic policies, privatization and extensive structural reforms, and the country’s promising long-term prospects, not least in the light of the North American Free Trade Agreement. The large capital inflows, however, coupled with the quasi-fixed exchange rate system, also resulted in a substantial appreciation of the real exchange rate and a sharp increase in the external current account deficit. Much of this deficit reflected higher consumption expenditure and a substantial decline in private savings. Against this background, and because of adverse political events, foreign investors’ concerns about the sustainability of the current account deficit began to increase during 1994. At the same time, significant increases in liquidity ran counter to the need to tighten domestic monetary conditions in order to stem the capital outflows. (See Annex I for a detailed discussion of factors behind Mexico’s financial crisis.)

Concerns about the potential instability of capital flows, especially of portfolio investment in stock and bond markets, have led a number of countries to impose a variety of restrictions to deter short-term inflows, while still maintaining convertibility for longer-term capital account transactions. Among the more common measures are restrictions or ceilings on foreign borrowing by domestic enterprises and high reserve requirements on foreign currency deposits. Chile, for example, has limited the inflows of capital by imposing reserve requirements of 30 percent on all foreign currency credits. The Indian authorities have recently raised reserve requirements on foreign currency deposits to discourage new inflows. Such restrictions tend to raise the cost of finance for domestic firms and reduce the efficiency of the financial system. Nevertheless, in the short term they may help to limit the potential destabilizing effects of capital inflows on real exchange rates and provide policymakers time to address weaknesses in financial markets and to improve macroeconomic fundamentals. It is particularly important to limit the foreign exchange exposure of the banking system, which may exacerbate difficulties in the event of a sudden reversal of capital flows. This may require more effective bank regulations that limit potential mismatches of maturities and currency denominations of bank assets and liabilities, particularly in countries where low-cost deposit insurance encourages excessive risk exposure. Such prudential controls should be distinguished from broader controls on international capital flows, which are rarely effective in stemming either capital inflows or capital outflows over the longer term, especially when they become a substitute for efforts to address macroeconomic imbalances and to correct unsustainable exchange rates.

For countries that are confronted with shifts in market sentiment, the Mexican episode underscores two important policy principles. First, in order to restore confidence and relieve exchange market pressures in a crisis situation, domestic and external macroeconomic imbalances have to be addressed forcefully, and as quickly as possible. In the short term, the appropriate measures should include a tightening of monetary conditions through increases in domestic interest rates as well as fiscal adjustments. Fiscal action may be needed even when the initial imbalances emanate from the private sector. Over the longer term, governments must address the underlying causes of external imbalances and low saving, including structural measures to correct relative price distortions. A second policy lesson concerns the potentially difficult decision regarding exchange rate regimes. Where countries have adopted nominal exchange rate anchors as part of a wider inflation stabilization strategy, the initial response to exchange market pressures should consist primarily of monetary tightening. However, under circumstances of sustained pressures, accepting a devaluation or abandoning a fixed exchange rate parity may be the only credible policy response. In order to limit the inflationary impact of the devaluation, the transition to a new parity or a floating exchange rate regime needs to be accompanied by supporting measures that include tight monetary and credit policy, as well as a fiscal stance that is consistent with the new policy regime.

Medium-Term Outlook and Policy Challenges

In recent years, the aggregate growth performance of developing countries has been sustained at remarkably high levels despite periods of protracted weakness in the industrial countries. In large part, this resilience to weak external conditions has been due to the strong macroeconomic stabilization and structural reform programs in a number of countries. But high aggregate growth rates also mask considerable differences among individual countries and regions. Although these divergences in growth rates are expected to narrow over the medium term, as policies and reform efforts strengthen in some of the weaker performing countries—primarily in Africa, but also in other parts of the developing world—significant disparities are likely to persist (Table 9).

Table 9.

Developing Countries: Medium-Term Projections

(Average annual percent change, unless otherwise noted)

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Percent of GDP.

The divergences in performance and stages of development give rise to very different priorities and policy challenges across individual countries, even though the basic requirements of market-oriented, outward-looking policies are common to all countries. In addressing the policy challenges facing developing countries, it is useful to classify countries into three broad categories: strong performers that are characterized by substantial high growth and rapid improvements in living standards; moderate performers that are catching up more slowly; and countries that have experienced negative growth over the recent past and where living standards continue to decline.

The strong performers comprise countries that have managed to sustain a rapid pace of economic growth. Several of these now have high per capita incomes, while others are rapidly catching up from relatively low-income levels. Singapore’s per capita growth rate, for example, has averaged over 7 percent a year over the past thirty years; measured at purchasing-powerparity exchange rates, per capita income in Singapore now exceeds that of many industrial countries.14 A number of countries in Asia, including Korea and Malaysia, have recorded similar strong growth performances. Many of these countries are confronted with policy challenges that are similar to those faced by industrial countries: sustaining growth while minimizing the risk of overheating. Some countries, such as Chile, China, Korea, Malaysia, and Thailand, are experiencing relatively tight conditions in labor markets and capacity constraints arising from the slower pace of improvements in infrastructure. For these countries, it is important to ensure that macroeconomic policies, particularly financial conditions, are adjusted appropriately in light of the strength of economic performance. In China, for example, growth rates of around 13 percent in 1992 and 1993 could not be sustained, and resulted in inflationary pressures. This required the adoption of stabilization measures to slow aggregate demand. In Korea, the authorities have faced similar difficulties in recent years.

Higher investment in infrastructure to keep pace with growth represents a major challenge for these countries.15 In China, weaknesses in intercity transport systems have adversely affected the supply of coal, which is used to meet a large proportion of the country’s rapidly growing electricity needs. In Thailand, the concentration of growth in Bangkok has placed increasing strains on infrastructure in and around the city. Other strong performers, such as Indonesia, Korea, Malaysia, and the Philippines, are experiencing increasing demands for public utilities and transportation systems. The challenge for many of these countries is to address their infrastructure needs, including environmental requirements, without putting undue strains on public finances or on their external positions. To this end, a number of countries have implemented large-scale privatization programs. Malaysia has successfully privatized a container port, telecommunications, and electricity supply; and privatization has played a significant role in eliminating chronic power shortages in the Philippines. Korea and Thailand, on the other hand, are encouraging private participation in infrastructure development. Several large public and private utility companies in Latin America, particularly in Argentina, Chile, and Mexico, have been able to finance infrastructure investment through foreign direct investment. Many of the infrastructure projects under consideration will require large-scale investments. There is often a presumption that such investments necessarily require foreign financing, but policies in a number of Asian countries are appropriately geared toward mobilizing domestic saving to help meet much of the financing for these projects.

In the group of countries characterized by relatively moderate economic performance, many weaknesses remain to be addressed to consolidate important initial achievements. A number of countries with moderate growth performance have attracted substantial capital flows, in part due to greater openness and liberalization of trade and payments systems. Many of these countries have also attained a fair degree of macroeconomic stability, although in comparison with the strong performers macroeconomic stability still appears fragile in some cases. Nevertheless, fiscal deficits—often the underlying reason for wider macroeconomic and external imbalances—are now significantly lower than in the late 1980s in many countries in Latin America and among the moderate performers in Asia, such as Bangladesh, India, and Pakistan. This is an important reason for the improved outlook for many of the moderate performers: the contrast between Brazil, a moderate performer, and Korea, a strong performer, whose per capita incomes were broadly comparable in 1960, provides a stark illustration of the value of stable macroeconomic conditions, outward orientation, and structural reform (Box 5).

Where fiscal deficits are still large, inflation reduction has often been achieved primarily through monetary restraint, which has often given rise to capital inflows attracted by relatively high short-term interest rates. Aside from concerns about vulnerability to changes in investor sentiment, such flows may not necessarily finance capital outlays and investment rates have remained relatively low in countries such as Egypt, Pakistan, and Turkey. As emphasized earlier, the pattern of investment and saving behavior among many of the moderate performers stands in sharp contrast to that observed in economies such as Indonesia, Malaysia, and Singapore, where investment-to-GDP ratios have consistently averaged around 30 percent over the last decade. Indeed, this is one of the key factors that has contributed to high growth in the successful Asian economies.

Although a low saving rate may be explained in part by demographic developments and a country’s level of development, it also may reflect the lack of sufficient progress with structural reform, especially financial sector reform. In many countries, public sector deficits are financed mainly by domestic banking systems, often at below market interest rates. Moreover, state-owned banks often provide subsidized credit to public and quasi-public enterprises. Governments that have resorted to directed credit programs may subsequently be faced with the challenge of dealing with a high proportion of nonperforming loans. In Bangladesh, banks have enlarged lending margins in an attempt to restore profitability, with the result that credit growth to the private sector has been constrained. Other countries have experienced similar difficulties. In Nigeria, Uganda, and many countries of the African franc zone, governments have had to assume a large part of the obligations of banks and public enterprises, and this has put added strain on their fiscal policies. Directed credit programs have also resulted in other inefficiencies. By subsidizing the cost of capital over that of labor, there is a risk of encouraging the use of less labor-intensive technologies in economies that have a surplus of labor relative to capital.

The experience of several countries that have recently taken measures to liberalize their financial systems, including a number of countries in Latin America and Africa, suggests that the removal of controls has to be accompanied by the establishment of effective supervisory systems and appropriate legal and accounting frameworks. In a number of countries, there is also a need to restructure banks and develop financial market infrastructure to enhance the operation of monetary policy via the use of indirect instruments.16 A further important prerequisite for successful liberalization is the reduction of macroeconomic imbalances. The Philippines, for example, attempted financial liberalization during the 1980s before addressing macroeconomic imbalances; subsequent banking crises and a sharp recession ultimately led to a partial reversal of the reforms.17

The poor growth performance of many oil exporting developing countries is attributable in large part to delays in rolling back the scale of public sector involvement in economic activity. During much of the 1970s and early 1980s, substantial oil revenues enabled these countries to finance large government expenditure programs that are no longer viable given the substantial declines in oil revenue.18 These countries are now faced with fiscal deficits that are not sustainable even under reasonably optimistic long-term projections for oil prices, and notwithstanding efforts to raise more revenue from non-oil taxes. Declining oil revenues have also exposed a number of structural weaknesses, including the limited development of non-oil sectors, in large part due to extensive controls on private sector economic activity.

A large number of developing countries have made substantial progress in adopting outward-oriented trade policies. In many instances, however, there are still significant barriers to trade, especially in sectors where domestic producers were originally granted protection on the assumption that they would be able to compete internationally if given time to develop. There is little theoretical or empirical evidence to support this “infant-industry” argument, however, and there is now a widespread consensus that trade liberalization is vital for growth. In this context, it is particularly worth emphasizing the evidence on the role of international R&D spillovers (Box 6).

Despite the positive effects that can be expected from trade opening, many countries are removing trade barriers only gradually. In India, where deregulation of the industrial licensing system has been extensive since the beginning of the reform efforts in 1991, tariffs on most imports, including many capital goods, are still at the maximum rate of 65 percent, while imports of consumer goods are still largely prohibited. In Egypt, although there have been significant reductions in the general level of tariffs, maximum tariff rates remain relatively high. Such restrictions, together with pervasive nontariff barriers in many developing countries, have often constrained the growth of export sectors. To fully benefit from the Uruguay Round trade agreement, a number of developing countries will need to accelerate and pursue more ambitious trade and other structural reform programs. Some developing countries will lose preferential access to industrial country markets and will need to adjust to greater competition from other low-cost producers.

Brazil and Korea

A comparison of the economic performance of Brazil and Korea over the past thirty years provides a powerful illustration of the contribution that stable macroeconomic policies, structural reforms, and outward orientation can make toward sustaining high growth. During the 1960s and 1970s, per capita incomes were broadly similar and GDP growth averaged about 9 percent a year in both countries. Trade policies were also similar in the late 1960s and early 1970s when both countries promoted their export sectors and experienced substantial increases in exports.1 Starting in the early 1980s, however, their growth rates diverged, and over the past ten years real GDP in Korea has grown more than twice as fast as in Brazil (see chart). As a result, per capita incomes in Korea are now almost twice as high as in Brazil.

In response to the first oil price shock in the early 1970s, both countries increased protection for domestic industry and pursued expansionary policies in an attempt to moderate the impact on output. The results were similar—inflation increased, export growth declined as real exchange rates appreciated, and current account deficits widened to more than 5 percent of GDP in 1979. After the second oil price shock in the late 1970s, external imbalances forced a rethinking of strategy in both countries. Korea implemented a comprehensive stabilization program, while Brazil gave priority to expenditure and credit expansion to finance investment in the agricultural and energy sectors.2 In Korea, the rapid tightening of macroeconomic policies, and adoption of outward-oriented trade policies to improve competitiveness, gave rise to higher investment and saving rates that allowed the economy to benefit from the improved external environment in the latter part of the 1980s. Brazil also attempted to restore external competitiveness, primarily through large devaluations, but persistent fiscal imbalances in the context of pervasive indexation led to an acceleration of inflation, the crowding out of private investment, and stagnation.

Following the decisive adjustment of 1979–80, Korea pursued moderately countercyclical macroeconomic policies during the 1980s, while maintaining a relatively stable exchange rate to control inflation, especially since the mid-1980s. In Brazil, after the stop-and-go policies of the first half of the 1980s, several heterodox stabilization plans were attempted, largely based on price and wage freezes. These efforts were not supported by sufficiently tight policies, however, and proved unsuccessful in controlling inflation, which reached four-digit levels by 1989. External conditions were broadly similar in Brazil and Korea in the 1980s, although Latin American countries as a group suffered larger terms of trade shocks than east Asian countries.3 Higher national saving and larger current account surpluses during the mid-1980s also sheltered Korea from the debt crisis.

In addition to the role of macroeconomic policy, differences in productivity growth explain much of the divergence in GDP growth over the recent past. Korea’s annual productivity growth increased sharply during the past two decades, from about 1 percent in the 1960s and 1970s to 2½ percent in the 1980s.4 Estimates of productivity growth for Brazil, by contrast, suggest that it fell from about 2 percent a year in the period 1940–80 to a negative ¾ of 1 percent during the 1980s.5

A recent study provides some evidence on the sources of these productivity differences.6 The results suggest that economic performance in both Brazil and Korea reflected primarily domestic rather than external factors. Korea’s strong economic performance can be attributed mainly to macroeconomic stability and the gradual implementation of structural reforms that enhanced the country’s long-run growth potential. The opening up of the Korean economy, combined with financial policies geared toward maintaining a stable macroeconomic environment, allowed Korea to take full advantage of the favorable external environment during the latter part of the 1980s. In contrast, Brazil’s less outward-oriented economic strategy—as reflected in substantial import restrictions—and the lack of structural reforms reduced competitive pressures and diminished the benefits from international integration and the strong expansion of world trade.

In Brazil, there has been an important turning point in economic strategy since 1990. Emphasis is now firmly placed on macroeconomic stability and market-oriented structural reforms, including currency reform and trade liberalization. Sustained implementation of these types of policies should help Brazil to maintain low inflation on a durable basis and to sustain stronger growth in the medium term.


Brazil and Korea: Selected Indicators

1See Eliana Cardoso, “From Inertia to Megainflation: Brazil in the 1980s,” in Lessons of Economic Stabilization and Its Aftermath, ed. by Michael Bruno, Stanley Fischer, Elhanan Helpman, and Nissan Liviatan (Cambridge, Massachusetts: MIT Press, 1991); and Vittorio Corbo and Sang-Mok Suh, Structural Adjustment in a Newly Industrialized Country: The Korean Experience (Baltimore: Johns Hopkins, 1992).2Angus Maddison and associates, Brazil and Mexico: The Political Economy of Poverty, Equity and Growth (Oxford and New York: Oxford University Press, 1992).3See Jeffrey Sachs, “External Debt and Macroeconomic Performance in Latin America and East Asia,” Brookings Papers on Economic Activity: 2 (1985), pp. 523–64.4See Alwyn Young, “The Tyranny of Numbers: Confronting the Statistical Realities of the East Asian Growth Experience,” NBER Working Paper 4680 (Cambridge, Massachusetts: National Bureau of Economic Research, March 1994).5See Victor Elias, “Sources of Growth: A Study of Seven Latin American Economies” (San Francisco: Institute for Contemporary Studies Press, 1992).6See Alexander Hoffmaister and Jorge Roldos, “The Sources of Macroeconomic Fluctuations in Developing Countries: Brazil and Korea,” IMF Working Paper (forthcoming, 1995).

Developing countries that have barely grown over the last five to ten years face by far the most daunting policy challenges. A large number of countries in this falling behind category have experienced declining real per capita incomes, sometimes exacerbated by unsustainable population growth. In Zaire, for example, per capita incomes have fallen by over 5 percent a year over the past decade. Other broader indicators of economic development such as infant mortality have also worsened dramatically. Many countries in this category, especially countries in sub-Saharan Africa, are highly dependent on exports of primary commodities, making them particularly vulnerable to fluctuations in their terms of trade. The declining long-term trend in real world commodity prices has led to a large cumulative decline in the terms of trade facing many African countries. For sub-Saharan African countries as a group, the terms of trade loss since the mid-1980s has amounted to over 30 percent, with some countries, such as the Congo and Zaire, experiencing even steeper declines.

Notwithstanding these adverse external developments, economic conditions have begun to improve in recent years in countries that have undertaken comprehensive domestic policy reforms. It is noteworthy that those sub-Saharan African countries that have experienced positive per capita growth since the mid1980s have suffered larger terms of trade losses than countries with negative per capita growth (see Annex II). Among the African countries with flexible exchange rate regimes, real exchange rate depreciations have helped to offset much of the negative impact on the external current account resulting from the decline in their terms of trade.19 By contrast, in the CFA countries, prior to the recent devaluation, real exchange rates were maintained at unrealistic levels that impeded adjustment to terms of trade losses.

North-South R&D Spillovers

Research and development (R&D) in the world economy is almost entirely concentrated in the industrial countries. This high concentration of an activity that leads to the development of new technologies, products, materials, and manufacturing techniques raises the question of whether the benefits of R&D are limited to the countries that carry it out. Theoretical and empirical research suggests that the answer is no: a country’s productivity depends not only on its own investment in research and development, which may be small or nonexistent, but also on the R&D done by its trade partners. R&D spillovers are thus another aspect of economic linkages among industrial countries and from industrial to developing countries, one that supplements and complements the more traditional channels of trade, commodity prices, interest rates, and financial flows.

There are a number of channels through which the productivity of countries are interrelated.1 First, international trade enables a country to employ a larger variety of intermediate products and capital equipment, which enhances the productivity of its own resources. Second, international trade and foreign direct investment provide channels of communication that stimulate cross-border learning of production methods, product design, organizational methods, and market conditions. Each one of these helps to employ domestic resources more efficiently and to adjust the mix of products so as to obtain more value added per unit of input. Third, international contacts enable a country to copy foreign technologies and adjust them to domestic use. Imitation is widespread and it has played a major role in the growth of high-performing economies such as Japan and the newly industrializing economies of east Asia.2 Finally, international trade and foreign direct investment can raise the ability of a country to develop its own new technologies, or to imitate foreign technologies more efficiently, thereby indirectly affecting productivity in the entire economy.

The extent to which a developing country will benefit from foreign trade in these ways depends on the ability of its trade partners to provide it with products and information in which it is in short supply. Both depend on the trade partners’ accumulated knowledge that is embodied in products, technologies, and organizations. By trading with an industrial country that has a larger “stock of knowledge,” a developing country stands to gain more in terms of both the products it can import and the direct knowledge it can acquire than it would by trading with a country with a smaller stock of knowledge.

Recent research has examined the empirical significance of these R&D spillovers.3 The results suggest that a developing country’s total factor productivity is larger the larger is the R&D capital stock of its trade partners—which is used as a proxy for the stock of knowledge embodied in the country’s trade composition—the more open is it to foreign trade with industrial countries, and the more educated is its labor force.4 An additional implication is that a developing country whose trade is directed toward industrial countries that have large cumulative experiences in R&D has higher productivity. Moreover, a developing country’s productivity may primarily be affected by foreign R&D capital through its imports from the industrial countries. This implies that a developing country that is more open to trade with industrial countries derives a larger marginal benefit from foreign R&D; likewise a developing country whose trade is mainly with industrial countries that have heavily invested in R&D will tend to have a larger impact on productivity from a marginal increase in imports from these countries.

The sensitivity of total factor productivity in developing countries with respect to the R&D capital stock of industrial countries is estimated to be large. On average, a 1 percent increase in the R&D capital stock of the industrial countries increases total factor productivity in the developing countries by about 0. 1 percent. Increases in the R&D capital stock of the United States, which has by far the largest domestic R&D stock, has the largest impact on productivity in the developing countries as a group. There are, however, substantial differences across countries depending upon bilateral trade patterns between the developing countries and the industrial countries. The substantial rates of return to industrial country R&D, measured in terms of the resulting increase in developing country output, are consistent with other studies that have found much higher rates of return on R&D than on investment in structures, machines, and equipment.5

1See Gene Grossman and Elhanan Helpman, Innovation and Growth in the Global Economy (Cambridge, Massachusetts; London: MIT Press, 1991).2For a discussion of the importance of direct learning channels in Japan when it opened up to the rest of the world in the post-Meiji era, see William W. Lockwood, The Economic Development of Japan: Growth and Structural Change 1868–1938 (Princeton, New Jersey: Princeton University Press, 1954), Chapter 6; and in Korea during its industrialization process, see Yung Whee Rhee, Bruce Ross-Larson, and Garry Pursell, Korea’s Competitive Edge: Managing the Entry into World Markets (Baltimore: Johns Hopkins University Press for the World Bank, 1984). See also Edward M. Graham, “Foreign Direct Investment in the World Economy,” IMF Working Paper (forthcoming, 1995).3See David T. Coe, Elhanan Helpman, and Alexander W. Hoffmaister, “North-South R&D Spillovers,” IMF Working Paper 94/144 (December 1994). Evidence of the importance of R&D spillovers among industrial countries is presented in David T. Coe and Elhanan Helpman, “International R&D Spillovers,” IMF Working Paper 93/84 (November 1993).4The R&D capital stock is calculated as a weighted average of the domestic R&D capital stocks of its industrial country trade partners, with bilateral import shares serving as weights. The R&D capital stock of the industrial country trade partner is computed as cumulative real R&D spending, with an allowance made for depreciation.5For a review of the literature, see Zvi Griliches, “Productivity, R&D, and the Data Constraint,” American Economic Review, Vol. 84 (March 1994), pp. 1–23.

For many commodity-based countries, policy measures to enhance the efficiency of their agricultural sectors will be critical in the period ahead. Whereas in the past, commodity price booms may have concealed inefficiencies in agriculture, including those resulting from government policies, the generally weak outlook for real commodity prices over the longer term makes it essential that countries implement policies to increase productivity in agriculture and to ensure that domestic producers are in a position to utilize fully the increased access to industrial country markets resulting from the Uruguay Round trade agreement. A number of countries in Africa, such as Zambia and Zimbabwe, have recognized the importance of relaxing price controls in agriculture and liberalizing the marketing and distribution of agricultural products.

Further structural reform and macroeconomic stabilization will be essential to improve living standards and alleviate poverty in the long term. In the short run, however, reform programs may well entail adverse outcomes for some sections of society. The reform efforts therefore need to include well-targeted and affordable social assistance programs, such as the food distribution and income supplement program in Mozambique and the food stamp program implemented in Sri Lanka. General consumption subsidies are not efficient or effective to achieve distributional objectives, and are too costly. Increasing spending on health and education programs in rural areas would help enhance longer-term growth prospects for many countries. Weak growth performance may also reflect political and social instability, however, and in countries that have recently experienced wars, such as Afghanistan, Angola, Ethiopia, Mozambique, Somalia, and Rwanda, growth prospects have been set back by extensive damage to basic infrastructure. Unfortunately, economic performance in some countries has suffered as a result of poor governance and a widespread lack of accountability in the public sector that have tended to limit popular support for stabilization and reform efforts.

Many low-growth countries are highly indebted. Despite debt-relief efforts, debt burdens continue to increase; for some countries in sub-Saharan Africa, debtservice ratios have doubled during the past decade, reaching 400 percent in 1994. For a large number of countries, even under favorable conditions, external viability is unlikely to be attained in the foreseeable future. Countries such as Angola, Central African Republic, Mozambique, and Zaire, among others, will require timely financial support on concessional terms, including in some cases significant further debt reduction. To support and promote stronger reform efforts in a number of African countries, official and private creditors will need to ensure that excessive debt-service obligations do not weaken incentives to strengthen reforms and stabilization programs.

In recent years a large number of developing countries have enjoyed sustained periods of high growth. For many of these countries, success has brought new policy challenges. Their strong performance and growth potential have attracted substantial capital flows from investors in industrial countries, giving rise in some countries to macroeconomic imbalances and financial market instability. A key policy challenge for a number of these countries is to ensure that domestic saving is sufficient to meet a large part of their financing requirements. Although capital inflows often have beneficial effects, they cannot be a substitute for adequate levels of domestic saving. For countries where growth performance has been modest, the problem of low saving rates will need to be addressed by stronger fiscal adjustment efforts and structural reforms to mobilize and enhance private saving. Further trade liberalization and structural reforms will also be necessary to take full advantage of the opportunities offered by the Uruguay Round agreement, especially the increased access to industrial country markets.