The year 1985 was somewhat disappointing from the viewpoint of economic growth. Expansion fell back by more than expected in the industrial world, and world trade increased only modestly. As a result, the real export earnings of developing countries stagnated, and their rate of economic growth slowed. This, in turn, made the debt situation more difficult to manage.

The year 1985 was somewhat disappointing from the viewpoint of economic growth. Expansion fell back by more than expected in the industrial world, and world trade increased only modestly. As a result, the real export earnings of developing countries stagnated, and their rate of economic growth slowed. This, in turn, made the debt situation more difficult to manage.

Nevertheless, progress was made toward alleviating some of the financial imbalances that threaten the sustainability of global expansion. The United States took steps toward a major program of fiscal consolidation; the large industrial countries committed themselves to policies that should help avoid serious exchange rate misalignments and combat protectionism; and an important initiative was launched to underpin the management of the debt situation. At the same time, inflation in the major countries receded further and international interest rates declined. While the impact of these various developments cannot be seen clearly at the present time, they should improve the prospects for sustainable, noninflationary growth throughout the world economy.

Looking ahead, the staff sees a consolidation in the pace of economic growth at around 3 percent in the industrial countries. In the developing world, growth would remain at about 3 percent in 1986, then firm gradually to around 4¾ percent per annum in 1988–91. To achieve this result, however (and especially to improve on it), determined pursuit of the required macroeconomic and structural policies will be needed. Monetary, fiscal, and exchange rate policies will have to concentrate on maintaining a stable climate for the growth of private sector activity. Structural policies must be designed to enhance the incentives for the private sector to take advantage of such a climate by increasing investment, savings, output, and employment.

The remainder of this chapter elaborates on these themes. It begins with a discussion of recent economic developments and the short-term outlook for the world economy. The following section deals with medium-term prospects and presents some of the key results of the staff’s scenario analysis. Against the background of these two sections, the concluding part of the chapter reviews some of the major policy issues that require attention if global economic performance is to be sustained and improved.

This general survey is based on the more extended analysis contained in the other chapters of the World Economic Outlook, These include a background review of recent developments and short-term prospects in the world economy (Chapters II and III); an analysis of policy interactions in the industrial countries (Chapter IV); and a comprehensive assessment of the debt situation and prospects (Chapter V). A series of supplementary notes provide detailed analysis of specific topics, and a Statistical Appendix contains more comprehensive statistical information.

Current Situation and Short-Term Outlook

The Economic Setting

Considerable uncertainties exist concerning the international economic environment that is likely to prevail in 1986 and 1987. Among the more significant uncertainties are those surrounding the scope and impact of efforts to reduce the U.S. budget deficit; the effect of these and other factors on the pattern of international exchange rates; the likely evolution of interest rates; the path of oil and other commodity prices; the willingness of private creditors to increase their lending to heavily indebted countries; the pace of structural reforms in the industrial countries; and the ability of governments to resist protectionist pressures.

The future path of oil prices is particularly difficult to forecast at the present time. As may be seen in Chart 1, oil prices have been on a downward trend, in U.S. dollar terms, since 1981, and averaged about $26.50 a barrel in 1985. Beginning in January 1986, however, oil prices began to drop more sharply, and by early March, had fallen below $15 per barrel. For purposes of projection, the staff has made the assumption that oil prices will average $15 a barrel from the second quarter of 1986 until the end of 1987. This would represent a drop of 45 percent in nominal terms (or over 50 percent in real terms) from the level that prevailed in 1985. It must be recognized, however, that prices could well be significantly higher or significantly lower than this level, or could fluctuate in a volatile manner. If oil producers continue to compete for market shares, prices could be driven down well below $15 per barrel; on the other hand, an agreement among major producers to reimpose production restraint might be associated with a price closer to $20 a barrel. In any event, compared with 1985, there is likely to be a substantial shift of real incomes from oil exporting to oil importing countries. Such a shift would tend to reduce demand in the former group and to support demand in the latter group, but it is not easy to determine whether these effects would be symmetrical in their magnitude and timing. Non-oil commodity prices (exclusive of coffee) are expected to rise moderately in U.S. dollar terms during 1986 and 1987, but not by enough to prevent a further erosion in the terms of trade of commodity-producing countries. Coffee prices are a special case, having risen sharply in the closing months of 1985 following the drought in Brazil.

Chart 1.
Chart 1.

Oil Prices, 1972–March 1986

1 In U.S. dollar terms.2 Un weighted average of Brent and West Texas Intermediate spot prices in U.S. dollar terms.3 Oil price deflated by import unit value of oil exporting countries.4 Import unit value of oil exporting countries in U.S. dollar terms.

Macroeconomic policies in industrial countries are likely to be directed toward the medium-term objective of maintaining financial stability, while reducing the claims of governments on economic resources. In the United States, although questions have been raised about the constitutionality of certain provisions of the recent legislation to reduce the budget deficit, it nevertheless seems likely that the fiscal deficit will be reduced in 1986, after having grown rapidly in the previous several years. A further substantial decline in the deficit is projected for 1987. The fiscal position of the other industrial countries is expected to continue to be aimed at budgetary consolidation, so that, for the industrial countries as a group, fiscal policy may well exert a contractionary influence. Monetary policy has been implemented fairly flexibly for some time, reflecting two main factors: (I) the increased room authorities have acquired as the credibility of their anti-inflationary commitment has grown; and (2) the need to adapt monetary targets to velocity shifts caused by financial innovation and declining inflation. This flexibility, together with the moderation of growth and improved prospects for reducing the budget deficit in the United States, permitted a substantial decline in interest rates in the latter part of 1985 and early 1986. The staff expects these somewhat easier monetary conditions to persist during the projection period.

Macroeconomic policies in developing countries reflect the considerable diversity of circumstances of the countries included in this group. Virtually all developing countries, however, continue to face external financial constraints, and at the same time are seeking to promote a revival of domestic private investment. In these circumstances, the staff anticipates that there will be considerable pressure to curb fiscal deficits, and that lower borrowing requirements will facilitate the pursuit of credit policies designed to bring down inflation.

Exchange rate developments will be heavily influenced by the actual and expected evolution of macro-economic policies and performance in the industrial countries. Since March 1985, the U.S. dollar has depreciated significantly against European currencies and the Japanese yen (Chart 2). This decline has been encouraged by the actions of the five largest industrial countries, designed to bring about a more sustainable pattern of exchange rates. The projections reported in this World Economic Outlook are based on the working assumption that exchange rates will remain unchanged, in real terms, from the pattern prevailing in early March 1986. It has to be recognized, however, that exchange rates can move by substantial amounts in response to market reappraisals; the scope for such reappraisals is greater when, as at present, external imbalances are large, and there are significant uncertainties about the course of policy in major countries.

Chart 2.
Chart 2.

Nominal Effective Exchange Rates, 1980–March 1986

Lastly, a major element in the economic setting will be the flow of financial resources available to indebted countries, and their access to the markets of the industrial world. Bank lending to 15 heavily indebted countries was virtually zero, on a net basis, in 1985, and the prospect of a continuation of this trend was a major reason for the initiative announced by the Secretary of the U.S. Treasury, James A. Baker III, in October 1985. If the U.S. initiative meets with success, this would obviously brighten the prospects for growth in the countries concerned. It should be noted, however, that taking on additional debt would be prudent only if the means of servicing this debt are enhanced. This underscores the importance of effective policy reforms in the borrowing countries, as well as of resisting protectionism and ensuring adequate growth in the industrial countries that are the main markets for the indebted countries’ exports.

Output and Employment

Real output in the industrial countries grew by 2¾ percent in 1985, slightly less than had been expected at the beginning of the year, and considerably below the expansion of 4¾ percent recorded in 1984 (Table 1). The slowdown was largely attributable to developments in the United States, which had grown by 6½ percent in 1984 under the combined influence of a strongly expansionary fiscal policy, favorable investment incentives, declining interest rates, and rising consumer confidence. In 1985, however, the effects of these factors began to taper off, and the negative effects of a sharp deterioration in international competitiveness and a reversal of the inventory cycle began to make themselves felt. As a result, output in the United States expanded by only 2¼ percent. Japan also experienced a modest slowdown in growth in 1985, although much milder than that in the United States. The slowing of growth in Japan was attributable to a smaller positive stimulus from the foreign sector, as Japanese export growth slowed in line with the growth of world trade generally. In the industrial countries of Europe, output growth in 1985 was maintained at the same relatively modest pace (2¼ percent) as in 1984. However, an encouraging sign was the tendency of activity to pick up toward the end of the year, led by a further acceleration of business fixed investment.

Table 1.

Changes in World Output, 1968–871

(In percent)

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Real GDP (or GNP) for industrial and developing countries and real net material product (NMP) for other countries. Composites for the country groups are averages of percentage changes for individual countries weighted by the average U.S. dollar value of their respective GDPs (GNPs or NMPs where applicable) over the preceding three years. Because of the uncertainty surrounding the valuation of the composite NMP of the other countries, they have been assigned—somewhat arbitrarily—a weight of 15 percent in the calculation of the growth of world output. Excluding China prior to 1978.

Compound annual rate of change.

The U.S.S.R. and other countries of Eastern Europe that are not members of the Fund.

The developing world felt the consequences of the slowdown in the industrial countries rather rapidly. World trade growth fell from almost 9 percent in 1984 to 3 percent in 1985. The weakness in the volume of trade was transmitted to prices, which declined slightly in SDR terms. As often happens, the cyclical weakness of trade prices was considerably more pronounced for primary commodities than for manufactured goods; on this occasion, however, commodity prices were also kept down by unusually ample supplies, particularly of agricultural commodities. As a result, the terms of trade of developing countries deteriorated by 2 percent, and the purchasing power of their export earnings declined.

The weakness of exports had both direct and indirect effects on economic activity in developing countries. Directly, it towered output in sectors producing tradable goods and in ancillary industries; indirectly, it acted as a constraint on imports and thus forced cutbacks in domestic activities dependent on imported inputs. Together, these various factors resulted in a decline in economic growth in developing countries from 4 percent in 1984 to a little over 3 percent in 1985 (Table 1). This decline was not evenly distributed, however. The fuel exporters were particularly hard hit, with output stagnating in 1985. The non-fuel exporting countries, on the other hand, continued to grow at percent, against 5½ percent the previous year.

Looking ahead to 1986 and 1987, prospects for economic growth in the industrial world have been favorably affected by recent declines in interest rates and oil prices. The oil price assumption employed by the staff implies a reduction in the combined oil import bill of industrial countries of some $60 billion (almost ¾ of 1 percent of their combined gross national product (GNP)) from the 1985 level. This improvement in the terms of trade should provide a significant stimulus to consumption and investment in 1986–87. Moreover, budgetary consolidation efforts have improved confidence in the sustainability of expansion, and have played an important role in bringing down interest rates, particularly in the United States. Partly offsetting these positive influences on demand, the growth of government spending is likely to slow down, and the weaker prospects for developing countries’ export earnings will adversely affect their ability to import from the industrial world. On balance, the staff expects economic growth in the United States to firm somewhat in the period ahead, as the positive effects of lower oil prices, lower interest rates, and a lower value for the dollar outweigh the impact of fiscal restraint and the maturing of the investment cycle. Consumer expenditure is likely to be reasonably buoyant, especially given the beneficial effects on real income of the decline in oil prices and the impact of the boom in securities markets on the willingness to spend. However, the savings ratio in the United States is already very low, and it seems unlikely that it would fall much further.

The prospects for industrial countries outside the United States are significantly affected by recent exchange rate changes and by the efforts of the U.S. authorities to curb the fiscal deficit. These effects will be strongest for Canada and Japan, which have closer trading links to the United States than the principal European countries. Both Canada and Japan are expected to grow at around 3–3½ percent in 1986–87, compared with an average growth rate of 4½–5 percent in 1984–85. In Japan, the slowdown is attributable in substantial part to the swing in the real foreign balance from being a source of considerable stimulus to the domestic economy to becoming a negative influence. This negative impact more than offsets the effect that lower oil prices are expected to have in sustaining domestic demand growth at over 4 percent. In Canada, by contrast, net exports are expected to be a positive factor, but strong fiscal restraint will act to slow the growth of domestic demand.

European industrial countries have less close trading ties with the United States, and are less affected by changes in domestic demand and the strengthening of competitiveness in North America. European countries will benefit from lower interest rates as well as from recent improvements in their terms of trade. However, the persistence of structural rigidities in many countries makes a major acceleration of output growth in Europe unlikely. The staff nevertheless sees a strengthening of output growth to an annual rate of 2¾ percent in 1986 and 1987. Within this figure, investment is expected to be relatively more buoyant than other sources of demand, providing some basis for hope that the pace of output growth could strengthen further later in the decade.

Output growth in the industrial countries could turn out to be higher than estimated, if increases in real income from terms of trade gains are quickly translated into higher demand. Lower oil prices represent a first round addition to domestic incomes in the industrial countries of almost ¾ of 1 percentage point of GNP. The impact of this on economic activity will depend, however, on whether the price decline is accompanied by measures (such as an acceleration of fiscal consolidation or a lowering of monetary growth targets) that have the effect of limiting demand growth. Questions also surround the extent to which real income losses in oil exporting countries would be reflected back in reduced exports, and therefore GNP, of industrial countries.

Output prospects in developing countries are affected both by the international economic environment and by the policies pursued by these countries themselves. The significant deterioration in the terms of trade of developing countries that occurred during the course of 1985 has not yet been fully translated into lower real imports. Thus, there is probably still some negative impact from past price developments to be felt in economic growth. On the other hand, interest rates have come down more quickly than earlier expected, and there are signs that certain developing countries are making progress toward improving the allocation of resources. The balance of these factors varies considerably across groups of countries. The fuel exporting countries, for example, have been hit hardest by recent price movements and probably face a further period of stagnant or slowly growing real output. Among the non-fuel exporters, prospects are considerably brighter, with output expected to increase at an annual rate of 4¾ percent during 1986–87.

In assessing the implications of these projections for economic welfare, account must be taken of a variety of other relevant considerations, including, most importantly, population growth. A new table in the Statistical Appendix (Table A6) provides estimates for increases in output in developing countries, adjusted for the estimated rate of population growth. This table shows that per capita output in the developing world, on the basis of the staff projections, would be virtually unchanged in 1986 from its level at the beginning of the decade. This average, of course, conceals a wide variety of experience across countries; while considerable progress has been made in raising output per head in Asia, per capita output levels in much of Africa and Latin America are expected to remain substantially lower than in 1980. Even deflating by population does not provide a full measure of the divergence in economic welfare among regions. African and Latin American countries have generally suffered substantial deterioration in their terms of trade or have been obliged to bring about major strengthening of their balance of payments positions. Both of these factors have tended to reduce the share of output available for domestic absorption to a much greater extent than has been the case for Asian or European developing countries.

The continuation of world economic growth at only a moderate pace means that relatively little progress will be made in dealing with the serious unemployment problem faced by many countries. Of course, the relationship between unemployment and aggregate demand is neither simple nor clear cut, either in the industrial or in the developing countries. Nevertheless, barring an acceleration of output growth or—particularly in Europe—a deceleration of real wage growth, employment creation will be limited, and unemployment rates are likely to remain high.

In the industrial countries, the implications of the staffs output projections are that total employment would continue to rise at a rate of 1½ percent, slightly more than the growth in the labor force. Nevertheless, the average unemployment rate is unlikely to be reduced more than marginally over the next two years. A positive development in 1985 was the resumption of employment growth in Europe (after four consecutive years of decline, during which the total number in work fell by over 3 percent). The continuation of employment growth in 1986 and 1987 should at last arrest the rise in joblessness that has persisted in most European countries throughout the recovery. Still, recorded unemployment in Europe is expected to remain close to the current level of 11¼ percent—a figure that does not take account of the considerable number of unregistered or discouraged workers, or of younger workers being absorbed temporarily in government-sponsored training schemes or spending additional years in further education.

In the developing world, the concepts of unemployment that are most relevant for the analysis of economic or social conditions are rather different from those in industrial countries. In addition, the dearth of comparable statistics makes it necessary to infer unemployment trends from circumstantial data. For example, the fact that the growth of output per head outside the fuel exporting countries slowed from 3 percent per annum during the period 1968–80 to only 1½ percent per annum since then seems unlikely to be fully accounted for by a decline in the rate of productivity growth, or the completion of a process of absorbing previously unemployed workers. Thus, it is probable that problems of unemployment and underemployment intensified. By the same token, the fact that output growth per head has accelerated from ½ of 1 percent per annum during 1981–83 to almost 3 percent in 1984–85 suggests that the demand for labor may not be quite as weak now as in the early 1980s. To the extent that direct evidence is available, it tends to confirm the above hypothesis. The average unemployment rate in 12 Latin American countries for which data are available (mostly relating to urban unemployment) rose by 3.2 percentage points between 1981 and 1984, but tended to fall in 1985.

Inflation and Interest Rates

In contrast to the experience in most earlier recovery periods, inflation in industrial countries has continued its downward trend throughout the current upswing in activity. Having declined from a peak of 9.3 percent in 1980 to 4.3 percent in 1984, the weighted average of inflation rates in industrial countries—as measured by changes in the GNP deflator—fell further to 3.9 percent in 1985. The staff expects an additional decline, to 3.4 percent in 1986 and 3.0 percent in 1987. Lower oil prices are one of the major reasons for expecting continued progress on the price front in 1986 and 1987. By itself, the 45 percent decline in oil prices assumed by the staff is estimated to reduce the average rise in consumer prices in industrial countries by close to 3 percentage points over a two-year period, and the GNP deflator by not quite half that amount. In addition, the factors that were successful in reducing inflation over the past several years are expected to continue to play a role in restraining price pressures. Most important, central banks remain committed to cautious monetary policies, and although such policies may be implemented in a flexible way, the targets that have been announced for monetary aggregates imply that there would be little scope for an acceleration of inflation. Second, wage increases are likely to remain moderate, because of the persistence of high unemployment rates and perhaps also reflecting growing flexibility in the wage determination process. Third, deregulation in goods markets is serving to intensify competition and hold down costs. And fourth, raw material prices have continued to be weak and are not expected to recover more than partially in 1986 and 1987.

Another aspect of inflation performance in industrial countries that is worthy of mention is the narrowing divergence in national inflation rates. The standard deviation of national inflation rates around the industrial country mean had been 5.3 percentage points in 1980, and had fallen to 3.1 percentage points in 1984. It fell further to 2.6 percentage points in 1985, and is expected to remain in that range in 1986 and 1987. The principal reason for this convergence is the improved performance on the part of several previously high-inflation countries. Since 1983, for example, Italy and France have had considerable success in bringing down above-average rates of inflation. This performance has been all the more gratifying since exchange rate factors had, until 1985, tended to push up costs and prices outside the United States. The partial reversal of the dollar’s earlier appreciation is one of the factors contributing to an expected further improvement in price performance in Europe in 1986.

The inflation picture in developing countries is less satisfactory, at least at first glance. The weighted average of rates of consumer price inflation in these countries has accelerated in every recent year, and reached almost 40 percent in 1985. This weighted average gives a somewhat misleading picture, however, since it includes the effects of triple-digit (or even quadruple-digit) rates of inflation in a small number of countries (Argentina, Bolivia, Brazil, Israel, and Peru). Using the median rate of inflation to exclude the influence of these extreme cases suggests that price pressures have been kept under rather better control than in earlier years. The median rate of inflation has been brought down from 14½ percent in 1980 to 9 percent in 1985, and is expected to be held in that range in 1986 before falling further in 1987. One reason to look forward to an abatement of price pressures in 1986–87 is that significant adjustment measures have already been taken in several high-inflation countries (notably Argentina, Bolivia, Brazil, and Israel) resulting in significant, and in some cases dramatic, declines in month-to-month inflation rates. If these efforts persist, the staff expects a sharp fall in inflation rates in the coming period. (As a cautionary note, however, it should be remembered that similar expectations have been reported, and confounded, regularly in the past.)

The continuing decline in overall inflation rates in industrial countries has facilitated a decline in nominal interest rates. The decline observed in 1985 was considerably greater than can be attributed to the concurrent decline in inflation, so that estimated real interest rates have fallen as well. Factors contributing to the decline in nominal U.S. dollar interest rates include (besides falling inflation) the weaker evolution of economic activity, increasing confidence that lower inflation would persist, better prospects for a durable improvement in the fiscal position of the U.S. Government, and the growing belief that the Federal Reserve would continue to allow interest rate declines. The easing of interest rates was also a feature of monetary developments in most other industrial countries. The only significant exceptions were the United Kingdom and (on a temporary basis) Japan, where exchange rate considerations have at times weighed heavily in setting the course of monetary policy.

Looking ahead, prospects seem reasonable for maintaining downward pressure on interest rates, even if in most cases they would remain quite high in historical perspective. In particular, a strengthening of the U.S. federal budget position will tend to reduce government demands on credit markets. At the same time, confidence in the continuance of low inflation seems to be fairly well established, and recent developments in oil and commodity markets will, if anything, tend to reduce price pressures further. Of course, the possibility of exchange market disturbances still exists, and these could give rise to a tightening of monetary policy in the United States that would induce a rise in interest rates. On the whole, however, the risks of such a development have probably diminished as a result of the exchange rate movements that have taken place since March 1985, and the actions that are being considered in the United States to bring fiscal policy under better control.

External Adjustment and Debt

The pattern of payments balances that had emerged by 1984 continued to prevail in 1985. The United States had a further small rise in its already substantial current account deficit (to reach almost 3 percent of GNP). Japan’s large surplus grew by a further sizable amount, and the surplus of the Federal Republic of Germany also increased significantly. The current account deficit of developing countries was roughly stable at about 5 percent of exports of goods and services (less than half the figure of 1982). And the statistical discrepancy, which reflects net underrecording of receipts (or overrecording of payments) remained large.

The similarity of the external payments picture from 1984 to 1985 (and, indeed, the prospect of a similar picture in 1986) does not, of course, connote an absence of strains. The continuation of a current account deficit of well over $100 billion for the United States implies an accumulation of foreign debt that will continue to make heavy demands on global savings and that will make existing exchange rate patterns vulnerable to shifts in investor sentiment. The surpluses of Japan and the Federal Republic of Germany also pose difficulties from a number of standpoints, not least the encouragement they give to protectionist tendencies in other countries. Among developing countries, the deficits that were recorded in 1985, while relatively low in historical perspective, have not resulted in an increased willingness of commercial creditors to roll over existing debt, much less to substantially increase the level of new lending.

The recent depreciation in the dollar (about 25 percent in real effective terms from March 1985 to March 1986), together with the convergence of growth rates among industrial countries, has had a favorable effect on the external prospects of the United States. However, given the fact that imports are already so much larger than exports, a favorable shift in their relative rates of growth may reduce the trade deficit only modestly. At the same time, growing interest payments abroad mean that the invisibles surplus will continue to shrink. Assuming the continuation of the exchange rate pattern prevailing in early March 1986, the U.S. current account deficit is projected to average some $110 billion per annum in 1986–87, still over 2½ percent of GNP. In the short run, both Germany and Japan are projected to have a substantial widening in their surpluses in dollar terms, as a result of the operation of J-curve effects. However, in the medium and longer term, recent exchange rate movements will help reduce their surpluses.

For the developing countries, the balance of payments on current account is largely determined by the available financing, with some flexibility provided through fluctuations in the rate of reserve accumulation and in the level of outstanding arrears. In the non-fuel exporting group, a modest increase in capital inflows in 1986–87 is expected to be more than matched by a faster buildup of external reserves, so that the combined current account deficit of these countries would be held to around 4 percent of exports of goods and services. As a result, the volume of imports into these countries would grow at much the same rate as the volume of their exports—around 5 percent.

The situation in the fuel exporting developing countries is significantly different. Given the price assumption used by the staff, these countries are likely to be faced with a decline in the purchasing power of their exports of 30–40 percent. Despite a sharp cutback in the volume of their imports, fuel exporting countries would nevertheless see a sharp widening of their current account deficit, to perhaps 25–30 percent of exports of goods and services in 1986. To some extent, this increase in the combined deficit can be financed through drawing on reserves and lines of credit; over time, however, it is to be expected that the fuel exporting countries will undertake further adjustment efforts to reduce their current account deficits to a significantly lower level.

It was noted earlier that the process of current account adjustment in developing countries is closely linked to changes in the availability of external sources of finance. In considering financial flows to capital importing developing countries (which are all developing countries except the major Middle Eastern oil exporters), it is convenient to distinguish between sources of finance that are relatively “stable” (i.e., that do not vary by very much from year to year according to global economic conditions) and those that are liable to change as a result of reappraisals by creditors or borrowers. The first category includes non-debt-creating flows (official transfers and direct investment) and long-term official lending. These flows averaged about $53 billion per annum from 1981–85 and are expected to increase slightly (to an average of $56 billion per annum) in 1986 and 1987. The second category includes other forms of external borrowing, which have in practice proved highly vulnerable to changes in market assessments. Such borrowing reached a peak of $73 billion in 1981, then fell rapidly to $13 billion in 1984. There was a further fall to about $11 billion in 1985, but the staff projects that such private lending would yield about $14 billion per annum in 1986–87 on the basis of existing policies. At such a level, the increase in private lending to capital importing developing countries is little, if any, more than would be required for the normal financing of increases in import trade.

As may be inferred from these figures, the growth in the external indebtedness of developing countries has slowed dramatically in recent years. The gross international indebtedness of capital importing developing countries, which had increased at an average annual rate of almost 20 percent in dollar terms, in 1978–81, grew by only 5½ percent in 1984 and in 1985. The rate of increase in outstanding debt is expected to be slightly faster in 1986, in part because exchange rate changes will cause an upward revaluation of nondollar liabilities.

Although the rate of debt accumulation has been slowing quite markedly, the ratio of debt to exports has not been reduced, owing to the recent weakness of export markets. For the group of capital importing developing countries, this ratio increased in 1985 to a record level of 163 percent. Increases were quite widely experienced in all categories of countries, and were perhaps particularly disturbing for the small low-income countries, which now face a debt ratio of 383 percent. Debt service ratios have been less severely affected for most countries, since declining interest rates on their variable rate debt have helped cushion the effects of further increases in amortization payments. Countries that have benefited less from falling interest rates (because a relatively high proportion of their debt represents official borrowing at fixed, concessional, interest rates) have continued to have a sharp rise in the share of their export earnings needed to cover interest payments on external debt. Small low-income countries now devote 12½ percent of their export earnings to interest payments, and this proportion is expected to rise to 13 percent by 1987. In contrast, the capital importing countries as a group are expected to have some easing in their interest payments ratios in the coming period, from just over 13 percent in 1985 to 12 percent in 1987. (A further discussion of debt issues is contained in Chapter V.)

Medium-Term Prospects

The analysis of medium-term prospects presented here, and in Chapters IV and V, is based on a “scenario” of economic developments to 1991. It should be recognized that a scenario is in no sense a forecast; it represents an assessment of the consequences of certain assumptions about exogenous economic conditions, given other assumptions about the behavioral relations that link these conditions to actual developments. Only to the extent that the assumptions are considered plausible, and the underlying “model” is reasonable, can the scenario be considered a realistic projection. Even then, it must be recognized that policies and conditions may change—perhaps in recognition of the consequences if they do not—thus invalidating the projections of the scenario.


In present circumstances, a key assumption in the construction of any medium-term scenario concerns the stance of macroeconomic policies in industrial countries, particularly the United States. For the purposes of the scenario analysis, a baseline scenario has been constructed on the cautious assumption that, following the budgetary cuts the United States is implementing in 1986, further expenditure cuts (equivalent to $12 billion per annum from “current services” estimates) are instituted in each year of the period 1987–91. (The implications of the full implementation of the automatic expenditure cuts provided for under the Gramm-Rudman-Hollings Act are considered in Chapter IV.) In other industrial countries, fiscal policy is assumed to be moderately restrictive, in line with recent trends, and to involve a slight further withdrawal of stimulus. Monetary policy in all industrial countries is assumed to be such as to prevent any significant acceleration of inflation from the underlying rate expected to prevail in 1987, while accommodating the real growth rate being projected for the medium term. Economic policies in developing countries are those judged “most likely” by the Fund’s area department staff. Such policies, on the whole, involve continued restraint on the demand-management side, and an intensification of structural measures leading to some improvement in export performance.

The underlying rate of inflation, following the assumptions made about monetary policy, would tend to be stabilized at around 3¾ percent for the industrial countries as a group. (This is marginally higher than the rate projected for 1987, but makes allowance for the fact that the once-for-all benefit of lower oil prices will not persist in the medium term.)

The foregoing assumptions are believed to be consistent with a nominal interest rate on short-term U.S. Government securities of just over 7 percent, and a LIBOR (London interbank offered rate) of around 8 percent. The reduction in average fiscal deficits in industrial countries would be a factor tending to lower interest rates, but the weakening of the dollar (see below) and the assumed action of the Federal Reserve to limit inflationary pass-through effects, could work in the opposite direction.

The pattern of exchange rates among industrial countries is particularly difficult to project. For reasons given in more detail in Chapter IV, it is assumed that the U.S. and Canadian dollars will depreciate by 10 percent in real terms relative to the other major currencies over the period to 1991, but that real bilateral rates among the other major currencies will remain unchanged.

Oil prices are assumed by the staff to average $15 per barrel from the second quarter of 1986 until the end of 1987, and then to be unchanged in real terms throughout the remainder of the medium-term scenario period. Given current uncertainties in the oil market, this is clearly no more than a working hypothesis.

Non-oil commodity prices (other than coffee) are projected to rise over the medium term, at approximately the same rate as prices of manufactured goods. (Coffee prices, having risen sharply in late 1985 and early 1986, would tend to recede, in real terms, in the medium term.)

Implications for Industrial Countries

The implications of the foregoing assumptions for medium-term economic developments are set out in Table A53 of the Statistical Appendix. They suggest an annual growth rate in the industrial countries of about 3 percent for the four years of the medium-term scenario period, 1988–91. This reflects the fact that the shift in fiscal policies (measured by the reduction in actual fiscal deficits) would be relatively mild and gradual, while monetary policies would be broadly accommodative. Thus the rise in actual output would approximate the estimated growth in potential output, once the initial adjustments to changes in fiscal stance had taken place. In European countries, growth would exceed the increase in estimated productive potential by a small margin to reflect the implementation of structural policies and a marginal reduction in existing very high unemployment levels. By 1991, unemployment in Europe, under this scenario, would have come down to around 10 percent. At this level it would be 1 percentage point below the current level, but more than 4 percentage points above the level prevailing in 1978–80.

Of just as much interest as the results of the baseline scenario shown in Statistical Appendix Table A53 is the sensitivity of the scenario to alternative developments. In this connection, particular interest attaches to the implications of the application of the full provisions of the Gramm-Rudman-Hollings Act in the United States. The consequences of such a development are explored in more detail in Chapter IV, but the broad conclusions can be stated quite briefly. Empirical evidence suggests further cuts in government expenditure in the United States, sufficient to produce a balanced budget in 1991, could, especially if unaccompanied by any policy changes in other countries, tend to reduce the rate of growth of world output in the short run and increase it thereafter. It is possible, however, that the effects on confidence of firm action to reduce the budget deficit could tend to dampen the initial negative effects, or reduce the lag before positive effects emerged. (The strength of equity and bond markets in late 1985 and early 1986 would be consistent with this interpretation.) The distribution of any change in output would depend very much on what happened to the exchange rate for the U.S. dollar and hence to the pattern of international trade flows. On plausible assumptions, it seems likely that any initial decline in output (as well as the subsequent rise) would be largest in the United States, relatively large also in Japan and Canada, and more modest in the industrial countries of Europe.

It is not necessarily the case, of course, that policies in other countries would remain unchanged in the face of a downturn in activity. (Nor would U.S. monetary policy necessarily be unaffected.) If countries outside the United States were to offset part of the impact of a fiscal contraction through a temporary postponement of fiscal restraint, this would tend to reduce the initial loss of output. However, by the same token, such a temporary relaxation would also postpone the attainment of the longer-term gains from a stronger fiscal position. An easing of monetary conditions would tend to improve the path of real output, but at the cost of risking an acceleration of inflation.

Implications for Developing Countries

The implications of the assumptions of the baseline scenario for economic prospects in developing countries are set out at some length in Chapter V, “The Debt Situation: Prospects and Policy Issues.” The main results of the analysis presented there can be briefly summarized, however.

(1) The developments that are expected for the capital importing developing countries with regard to export earnings should permit a growth in these countries’ import volumes of just under 5 percent per annum during the period 1988–91. In the World Economic Outlook, April 1985, import volume growth of 6¾ percent was considered possible over the medium term; the revision reflects less favorable projections for export volume growth and terms of trade developments.

(2) Taking into account the stance of domestic policies, including the effects of policies on the relationship between the rate of growth of imports and that of real gross domestic product (GDP), the combined output of the capital importing developing countries could grow at about 4¾ percent per annum during the medium-term scenario period. This is the same rate as the projection made in last year’s World Economic Outlook. Recent evidence has caused the staff to increase its estimate of the output increases that can be achieved from a given growth of imports, and this factor tends to offset the expected lower rate of growth of imports.

(3) Current account deficits are expected to increase only slightly in relation to exports of goods and services (to about 6 percent). This reflects the fact that availability of finance (or in some countries the desire to avoid additional debt) is the main constraint on external positions, and is not likely to ease in the medium term.

(4) While the current account deficits being projected are similar to those in last year’s World Economic Outlook, they result in a much slower decline in the external debt ratio in the present scenario analysts. The reason for this is to be found in the slower growth of export earnings rather than in a faster accumulation of debt. Export earnings were considerably weaker than expected in 1985, and thus the projected medium-term increase starts from a lower base. At the same time, the rate of increase in world trade prices is now expected to be more modest than was foreseen last year. The net result is that the average debt ratio in capital importing developing countries is now projected to decline from 163 percent at the end of 1985 to 140 percent in 1991. (A decline to 108 percent in 1990 was envisaged in last year’s scenario.)

(5) Despite the less satisfactory outlook with regard to debt ratios, the burden of debt service is seen to be only slightly greater than last year. The improved prospects for the continuation of interest rates at their recent lower level broadly offsets the impact of higher debt levels on the ratios of both amortization and interest payments.

(6) Differences among countries remain an important feature of the scenario analysis. Recent developments have had a particularly heavy impact on countries depending on exports of oil and other primary commodities. Declining export earnings in real terms have forced these countries to restrict their imports severely, and this has resulted in a sharp downward revision in prospective growth rates for many of these countries. This downward revision is most marked for the oil producing countries in the short term, but also has effects extending forward. For example, the projected rate of growth for the indebted fuel exporting countries is now expected to average about 3 percent over the entire period 1986–91 (against a corresponding estimate of some 5 percent per annum made in early 1985). For small low-income countries exporting chiefly primary products other than oil, the corresponding downward revision is from 4¼ percent to 4 percent.

The scenario displays considerable sensitivity to alternative assumptions. This sensitivity is reflected more in projected rates of economic growth than in current account positions. Since borrowing possibilities are severely constrained for most developing countries, changes in export earnings (or in import costs) tend to generate adjustments in the volume of imports so as to bring the current account back to its “baseline” level.

Higher oil prices would change the pattern of output growth among developing countries considerably. Naturally, oil importing countries would tend to lose while exporting countries would benefit. On balance, abstracting from secondary effects resulting from higher international interest rates or lower activity in industrial countries, the gains would tend to predominate. This reflects the fact that the developing world, in the aggregate, is a net exporter of oil. A price of oil $5 per barrel higher than assumed in the baseline scenario is estimated to raise the average growth rate in indebted fuel exporting countries by about 2 percentage points, while reducing marginally the average growth rate in other capital importing developing countries.

Lower interest rates would have positive consequences, and would benefit all groups of developing countries. A 1 percentage point decrease in interest rates (holding other assumptions constant) is estimated to increase output growth by about ¼ of 1 percentage point. It would have very little effect on debt ratios over the medium term, since lower borrowing costs would be largely balanced by higher imports, leaving the rate of debt accumulation little changed. A further depreciation of the dollar would tend to push up the price of traded goods, thus tending to lower debt-export ratios, and perhaps facilitating an improvement in creditworthiness.

A different rate of growth in the industrial countries from the one envisaged in the baseline scenario would have potentially significant effects for developing countries. For example, a 1 percentage point decline in output is estimated to result in a 1½ percentage point drop in the real exports of developing countries. Even if there were no accompanying terms of trade effects, a weakening of industrial country growth to 2½ percent per annum in 1988–91 would cause the annual growth rate in developing countries to fall to 4 percent. Given the likelihood that lower export volumes would be associated with lower prices, the drop in real export earnings would probably be larger, and could cause the growth rate in developing countries to fall even further.

A general conclusion of the foregoing is that while it remains possible to combine an acceleration of per capita income growth in developing countries with declining debt ratios, the scope for achieving such a result has narrowed over the past year. This makes it all the more urgent to pursue policies that will help lead to a more favorable outcome.

Policy Issues in Industrial Countries

For the past several years, economic policy in industrial countries has generally been framed in a medium-term context. This strategy has been based on the objective of restoring financial stability, controlling the growth of government spending, reducing fiscal deficits, and fostering the more efficient working of private markets for goods, services, and factors of production. Short-term policy adaptations, or “fine-tuning,” have been seen as inimical to the process of building confidence in the medium-term stability of the policy environment.

This broad strategy has been unevenly implemented. There have been notable successes, but also significant shortfalls. Among the successes, the most striking is the widespread and continued reduction in inflationary pressures. A number of factors have contributed to this improved price performance, but the most important is certainly the commitment of monetary authorities to a policy of continued restraint, expressed in many cases through gradual reductions in target rates of growth of monetary aggregates. Several countries have also enjoyed success in curbing the growth of public expenditure, and encouraging more efficient working of private markets; these successes have contributed to the revival of investment and output in the recent recovery.

Nevertheless, it must be recognized that there have been important weaknesses in the implementation of the industrial countries’ overall strategy. The budget deficit in the largest industrial country (the United States), as well as in certain others (Canada and Italy), has not been brought under adequate control. This has contributed to the persistence of real interest rates that remain very high in historical perspective; it has also contributed to a pattern of exchange rates and balance of payments positions that threatened (and still threatens) to generate a potentially destabilizing pattern of indebtedness. Outside the United States, European countries have made only limited progress in tackling structural rigidities in their economies, and have made virtually no progress in bringing down disturbingly high rates of unemployment, while Japan has been unable to prevent its already large current account surplus from growing, and has thus accumulated increasing amounts of foreign assets. In many countries, protectionist pressures have continued to mount, and protectionist actions have been taken in several cases.

Some important initiatives have now been taken to deal with these recognized weaknesses in the implementation of the economic strategy. As discussed above, the United States has adopted the ambitious objective of eliminating the federal deficit by 1991. The five largest industrial countries have committed themselves to pay greater attention to exchange rate developments, and to act in a coordinated fashion to avoid serious exchange rate misalignments. And Japan and the major European countries have pledged themselves to pursue policies that will foster stable non-inflationary growth of demand and output in their economies. In addition, all countries have reconfirmed the necessity of resisting protectionist pressures.

In this new environment, the nature of the policy issues facing industrial countries has changed somewhat, but the need for effective solutions has not become any less urgent. A first question concerns the setting of macroeconomic policies. In particular, would the implementation of the Gramm-Rudman-Hollings Act call for policy adaptations, either in the United States through a change in monetary policy, or in the other industrial countries? Second, given the somewhat disappointing experience of recent years, how can structural policies more effectively promote the growth of investment and employment where these have lagged? Third, does the growing awareness of the need to avoid misalignment of exchange rates call for additional efforts at international coordination? This last question embraces both the procedural and substantive aspects of coordination.

Macroeconomic Policies

The increased determination of the U.S. Administration and Congress to deal effectively with the problem of the federal budget deficit is certainly to be welcomed. The growth of this deficit represented a threat to domestic and international financial stability, and its removal or reduction would be a beneficial development of the first importance. Of course, the Gramm-Rudman-Hollings Act, if implemented according to its automatic provisions, would limit the flexibility with which fiscal policy can be implemented. If prior agreement between the Administration and Congress can enable flexibility to be regained, consistent with maintaining the credibility of major cuts in the deficit, this would be all to the good. In any event, a major issue in the formulation of macroeconomic policy in member countries is to gauge the impact of the likely fiscal stance in the United States, and to assess whether adaptations in policies elsewhere are called for.

Substantial budget cuts in the United States would have a positive effect on the sustainability of economic activity in the medium term. There may, however, be an initial dampening effect on domestic demand. The budget cuts would also act to lower domestic interest rates and thus to exert downward pressure on the exchange rate. (To a significant extent this has already happened, perhaps in anticipation of the change in the fiscal stance.) Econometric evidence cannot be regarded as conclusive (particularly given the importance of expectations) but quantitative studies suggest that the negative effects on U.S. output of lower government expenditure would initially outweigh the positive output effects of a more favorable external balance and lower interest rates. In countries outside the United States, negative trade effects (resulting from the loss of competitiveness vis-à-vis the United States) would also be partly offset by favorable effects from lower interest rates. Nevertheless, in countries with close trading links to the United States (for example, Japan and Canada), the net effects are likely to be negative in the short run. In other industrial countries (for example, in Europe), the short-run effects would be less strong but still probably negative. (A more detailed analysis of these effects is provided in Chapter IV.)

Given these results, it is tempting to conclude that countries outside the United States should adjust their fiscal stance so as to mitigate the short-run contractionary effects emanating from the U.S. action. Such a conclusion needs to be qualified, however, in at least three important respects. First, an important purpose of budget cuts is to permit savings that are currently being absorbed by the public sector to be released for private sector use. To compensate for spending cuts in one country by increasing the budget deficit in another would retard this process. Second, all countries have suffered a loss of fiscal flexibility as a result of high ratios of public debt to GNP, and the high and growing share of debt service payments in government expenditure. The reduction of deficits over the medium term continues to be necessary in order to restore this flexibility and to prepare for the expected growth in government transfer payments that most countries face as a result of the working of demographic forces. Third, the imbalance in fiscal policies is much more in the direction of “too high” deficits in the United States and some other countries, than toward “too low” deficits elsewhere.

While there is no disagreement that countries should maintain their medium-term objective of reducing fiscal deficits, it can be argued that a change in the fiscal strategy of the largest country influences the scope for flexibility in other countries in the management of their fiscal policies. If the United States is successful in reducing substantially its deficit, other countries are likely to face a situation of declining worldwide interest rates, lower inflation, and softer demand in which to frame their macroeconomic policies. Germany and Japan, for example, may have somewhat more room for maneuver. In the case of Japan, the prospective weakness of output, combined with the progress already made in reducing the general government deficit and the high savings propensity of the Japanese private sector, argues for a somewhat less restrictive fiscal position in fiscal year 1986/87, particularly, given the high central government deficit, at the non-central government level. There may also be scope to reduce the incentives to save that are inherent in existing tax provisions.

The Federal Republic of Germany, like Japan, has a sizable external surplus and has made good progress in bringing down inflation and the deficit of the public sector. Unlike Japan, however, Germany is expected to have a moderately expansionary fiscal stance in 1986 (the consequence of tax cuts introduced at the beginning of the year) and is expected to grow in 1986 at a rate (3¾ percent) higher than the growth of productive potential. The justification for a change of fiscal plans in Germany would thus seem to be more prospective than immediate. However, if U.S. budget cuts are implemented as planned, if the pace of output growth in Germany tends to slow down during the coming year, and if signs of excess demand pressure remain absent, there could, in the staff’s view, be a case for considering action to make the stance of fiscal policy in 1987 more supportive than currently envisaged.

It has been argued above that fiscal policies in countries outside the United States should be assigned a relatively modest role in compensating for any temporary weakness of activity caused by the implementation of U.S. budget cuts. The question remains, however, of whether monetary policies would need to be adapted. In assessing this issue, it is important to draw a distinction between monetary policies—the ex ante stance adopted by the monetary authorities—and monetary conditions—the terms of borrowing set by the interaction of supply and demand for credit. If government demands for credit are reduced in a situation in which the rate of growth of monetary aggregates remains unchanged, real and nominal interest rates will tend to fall, other things equal. It is important that this decline in interest rates be allowed to occur, since it is the mechanism by which private expenditure is “crowded in” to absorb the resources released by budgetary restraint. Beyond this, there may be scope for some additional relaxation of monetary policy in circumstances where policy had previously been kept very tight because of exchange rate constraints, and where these constraints are seen to have eased. Further scope for a planned easing in monetary conditions may come from the lowering of inflationary pressures as reductions in oil prices work their way through the economic structure. It should be emphasized, however, that the scope for such judgmental flexibility is limited: the credibility of the anti-inflationary commitment of the monetary authorities in industrial countries is a valuable asset that was painstakingly acquired. Preserving this credibility must remain the central objective of monetary policy.

Structural Policies

Structural rigidities are a widespread problem in the industrial world. In varying degrees, they affect all countries and all markets—goods, labor, and capital. There seems to be a consensus, however, that such rigidities are particularly troublesome in labor markets, and that such problems are at their most acute in Europe and to a lesser extent, in Australasia and Canada. Certainly, the high levels of unemployment prevailing in these countries serve to focus attention on their labor markets.

For some time, economic analysts have debated the role of “classical” or “structural” factors relative to “Keynesian” or “demand deficiency” factors in explaining the rise in unemployment. A consensus view on this extremely controversial issue is unlikely to emerge in the foreseeable future, in part because of the difficulties associated with empirical verification of the various hypotheses for any individual country. Nevertheless, a considerable body of evidence points to the conclusion that the differences in labor market performance as between, in particular, Europe and the United States, primarily reflect classical or structural factors. These factors include much stronger trend growth of real wages in Europe than in the United States, lack of flexibility in European wage behavior in the face of adverse disturbances, substantial tax wedges between wage costs to producers and net earnings of employees, government policies favoring capital deepening over capital widening, and lack of occupational and geographical mobility. These factors may be considered in turn.

Real wages have grown much more rapidly in Europe over the past decade and a half than in the United States, and during certain periods have significantly outstripped accompanying rises in productivity. Recently, the growth of real labor costs has tended to moderate, which should enhance prospects for labor demand. However, this moderation probably owes more to the impact of high unemployment than to any fundamental change in wage behavior. It is sometimes suggested that a further decline in real wage growth should be engineered through the application of incomes policy. According to this proposal, organized labor would be asked to accept lower wage settlements in return for an undertaking by the authorities that fiscal or monetary measures would be used to sustain demand and promote output. An agreement of this general kind could perhaps be attempted in countries where centralized wage bargaining remains the rule and safeguards against slippages exist. In many other countries, however, experience suggests that such “social contracts” are difficult to sustain. The risk is that the authorities’ part of the bargain (demand stimulus) is implemented more fully than the wage restraint, so that there may be a short-run, Keynesian spurt of output and employment, but no underlying improvement in structural conditions.

The relatively rapid growth of real wages in Europe seems largely to have reflected inadequate flexibility of wages in the face of adverse disturbances, such as higher energy prices and a decline in the growth of overall factor productivity. To the extent that real wages do not respond to such shocks, employers are likely to substitute capital for labor. The Japanese system of providing a substantial share of total compensation in the form of variable annual or semiannual bonuses is often thought to have contributed substantially to wage flexibility (and hence employment) in that country. While the bonus system may not be applicable in Europe in precisely the Japanese form, mechanisms for increasing wage flexibility could nevertheless play an important role in increasing employment levels.

The high share of payroll taxes in the total labor bill of producers can be important in reducing the impact of such wage flexibility as exists. A given percentage cut in direct wage receipts by workers translates into a much smaller percentage decline in employers’ wage costs if indirect labor costs are substantial and fixed in absolute amounts. There may be scope for reducing the absolute burden of these nonwage costs, and making them more flexible in the face of changes in direct wage costs. Similar considerations apply to both direct and indirect taxes, even though the scope for major tax reductions is limited by budgetary constraints.

Government policy toward investment is a controversial subject. Government policies have traditionally favored higher levels of investment on the grounds that investment has positive “externalities” (through higher real wage and employment levels) not captured in the return to the individual or company undertaking the investment. It has to be recognized, however, that higher investment may also have negative externalities, in particular if it results in the displacement of a factor of production that is taxed (labor) by one that is subsidized (capital). If an appropriate balance is to be restored—whereby efficient and employment-creating capital formation is encouraged, but less efficient investment is not—greater selectivity in the design of investment incentives may well be necessary.

Occupational and geographical immobility can only be tackled by measures addressed to its specific causes. Improved training facilities are part of the answer, and so is action to enhance the transferability of acquired rights (such as pension and medical benefits), and assistance with relocation costs (through, for example, tax deductibility of moving expenses).

Policy Coordination

One aspect of international policy coordination has already been discussed, namely, the advantages and disadvantages of countries outside the United States taking deliberate action in light of the effects stemming from a change in the U.S. fiscal position. The conclusion reached was that while changes in the U.S. fiscal stance could increase the scope for certain other countries to use flexibility in the pursuit of their medium-term economic objectives, they did not fundamentally detract from the desirability of those objectives. In particular, they did not diminish the importance of strengthening the fiscal position in most countries over the medium term.

This lack of direct linkage between policy actions in one country and responses in another should not be construed as denying the importance of coordination. In current circumstances, coordination is being pursued through a convergence of fiscal policies toward a more similar and sustainable position. Beyond the issue of fiscal policy, however, is the question of whether, in the wake of the September 22, 1985 meeting of the Group of Five finance ministers and central bank governors, a new approach to policies affecting exchange rates is called for. This meeting did not, of course, suggest that exchange rates could be viewed in isolation from their fundamental determining factors. What was suggested in the communiqué was that the participating countries were committed to actions that changed these fundamentals, and that such a commitment had not at that time been reflected in exchange markets.

Exchange markets can be influenced by different types of action, each having a rather different time horizon. In the very short term, exchange market intervention can have a substantial effect on the pattern of market exchange rates. This was clearly illustrated in the immediate aftermath of the Group of Five meeting. To the extent that intervention is sterilized, however, it has only a transitory effect on the fundamental factors determining the balance of supply and demand in the foreign exchange market. Monetary policy shifts can have a more lasting effect, because such action influences interest rates and hence validates the exchange rate that results from intervention. (The employment of monetary policy in this role may be seen in the actions of the Bank of Japan in the last quarter of 1985.) As time passes, however, a sustained shift in the stance of monetary policy is likely to exert an impact on the course of demand and prices, thus tending to erode the earlier change in the real exchange rate. A lasting change in real exchange rates requires a shift in underlying saving/investment balances that, in the absence of a change in the private sector’s propensity to save or invest, requires an adjustment to the government’s fiscal position.

The implication of the foregoing is that a policy of paying greater attention to exchange rate factors in the implementation of a macroeconomic strategy requires a set of intervention, monetary, and fiscal policies that is internally coherent, and internationally consistent. Specifically, intervention will be of limited value unless supported by monetary policy, and adaptations of monetary policy will be counterproductive unless buttressed by a shift in underlying savings/ investment balances. If, for example, the exchange rate between two currencies has become unsustainable through a divergence in their underlying savings/investment balances, using monetary policy to correct this situation will tend to compound the adverse domestic consequences of the underlying divergence.

While monetary policy decisions must be taken with due regard to exchange rate considerations in any individual country, there may be better scope for adjusting monetary policy simultaneously in several countries, without significantly affecting the prevailing pattern of exchange rates. This point may be illustrated by the concerted cut in official discount rates in the three largest countries early in March 1986. However, there again it must be underlined that the recent easing of monetary conditions has been made possible by the improved prospects of fiscal retrenchment in the United States (as well as by the decline in oil prices).

The policy coordination that has occurred as a result of the Group of Five meetings has been aimed at encouraging a desired movement in the pattern of exchange rates. Since the actions that have been taken by the major countries were planned in advance, adequate coordination was assured. A rather different situation could emerge, however, if the need was to respond to an unexpected or potentially disruptive exchange rate change. While there might be agreement that it was desirable to resist such a change, the consequences would be quite different depending on whether the action were taken by the country whose currency was appreciating or the country whose currency was depreciating. If an undue share of the resistance was provided by the authorities of the country with the depreciating currency, this would require a tightening of monetary conditions that would tend to weaken global growth prospects. It is therefore important that actions to resist sudden exchange rate movements be consistent with medium-term economic objectives.

Policy Issues in Developing Countries

For several years, developing countries have been pursuing a strategy aimed at re-establishing international creditworthiness and restoring the momentum of domestic growth. To achieve these goals, they have been seeking to narrow their balance of payments deficits on current account, and to put in place domestic reforms aimed at improving the functioning of their economies. However, while substantial progress has been made in improving current account positions, external creditworthiness remains fragile, and growth has continued to be quite moderate. The reasons for this are twofold: first, the international economic environment has remained inhospitable, with high real interest rates, weak commodity prices and only modest growth of world trade; second, the needed policies have not been fully implemented, so that domestic economic performance has not improved sufficiently, and these countries’ vulnerability to adverse developments in the external environment has not been substantially reduced.

For the future, the task facing the developing countries is to strengthen both net exports and domestic sources of growth, against the background of a realistic appraisal of international economic prospects. With respect to the latter, it would not be prudent to count on any substantial further reduction in real interest rates, nor on any greatly increased willingness of foreign creditors to lend without policy improvements. It is also unrealistic to expect a substantial strengthening of export prices or a rapid growth in the volume of trade. The staff’s medium-term scenario suggests that developing countries’ exports might rise at about 5 percent per annum in volume (about 10 percent per annum in value) over the medium term. With no improvement in the terms of trade, this would permit imports as well to rise at about 5 percent per annum in real terms over the medium term—to be compared with an average growth of 8½ percent in the decade and a half to 1981.

In these circumstances, demand management policies must continue to be directed toward the mobilization of domestic resources for investment and net exports, and toward the creation of a stable financial setting for a revival of private sector activity. In addition, structural reforms are needed that will improve the efficiency of the price mechanism, enabling countries to better exploit their comparative advantage, and thereby reduce the import intensity of increments to output. In what follows, the policy implications of these objectives are considered from the standpoint of macroeconomic policies and structural policies in turn.

Macroeconomic Policies

Over the past two or three years, developing countries have made moderate progress in reducing the share of national savings used to finance government deficits. The weighted average size of central government deficits has fallen from 5 percent of GDP in 1982–83 to 4½ percent in 1984–85. This reduction has freed resources for the needed improvement in the net foreign balance. Despite the progress that has been made, however, the shift in the pattern of absorption of resources remains seriously incomplete, for two main reasons. First, fiscal deficits are still considerably higher than their historical average levels. In 1985, for example, the average size of fiscal deficits in developing countries was still 2 percentage points above the average figure for 1978–80. For the capital importing countries alone, the corresponding figure was 1 percentage point (though from a higher base). Second, the reductions in domestic absorption that have formed the counterpart of balance of payments improvements have fallen disproportionately on investment. As a share of GDP, consumption in developing countries has barely changed; it is investment that has declined—by an estimated 3 percentage points of GDP from 1981 to 1985—as the counterpart of reduced net imports.

The implications of the foregoing for future policy adjustments are several. First, a further reduction in the absorption of national savings by governments is still required. This is particularly important for those countries that encountered slippages in 1985, and for countries where the access of the private sector to credit markets is having to be restricted. Second, in the process of reducing deficits, viable investment projects in the public sector should be protected. In present circumstances, special priority should be given to those public sector investment projects that help increase capacity or improve factor productivity in the private sector. Third, special focus should be given to measures of domestic resource mobilization. Difficult though it is to cut the growth of consumption in already poor countries, additional resources have to be devoted to investment if growth prospects are to be enhanced. Improved revenue collection, undertaken in connection with fiscal consolidation, will play a role in raising national saving, and so too will increasing the attractiveness of private savings outlets. More attractive terms for saving are a crucial factor in containing capital flight, and eventually encouraging the repatriation of assets held abroad.

Exchange rate policy also plays an important role in managing the structure of aggregate demand. An appropriate exchange rate is essential if a country is to achieve the export growth of which it is capable. Just as important, however, the right exchange rate enables scarce foreign exchange to be allocated efficiently among competing domestic uses and provides appropriate incentives for efficient kinds of import substitution. The fact that real export earnings are likely to grow more slowly in the future than they did during the 1960s and 1970s means that growth in developing countries will have to be less import dependent if it is to regain its earlier dynamism. A more competitive exchange rate enhances the profitability of import-competing sectors (for example, the agricultural sector in African countries) and encourages investment in existing and potential industries without the need for costly and artificial subsidy mechanisms. There is already some evidence that increased exchange rate flexibility in developing countries has permitted them to adapt to weakness in international markets at less cost to domestic output growth than might otherwise have been the case.

A willingness to adjust exchange rates downward reinforces the need for monetary policy to be oriented toward containing the secondary inflationary consequences of higher import costs. Of course, monetary policy in developing countries is hard to separate from fiscal policy, because of the linkages between government borrowing requirements and the credit expansion of the banking system. Nevertheless, the close association between inflation and monetary growth shows that control over credit expansion has to be an important component of any program of financial stabilization. Closely related to overall monetary policy is the setting of interest rates that bear a realistic relationship to current and prospective inflation rates. As just noted, this is not only a key element in mobilizing domestic savings and allocating scarce investment funds, but also in avoiding capital flight and inducing residents to repatriate foreign assets.

Structural Policies

Structural policies are by their nature specific to the needs and circumstances of individual countries. Nevertheless, it is possible to identify several important problems that appear to be common to a number of countries. One of these that links up with issues of fiscal improvement mentioned above is the excessive dependence of many countries on international trade taxes as a source of budgetary revenues. This has disadvantages from a macroeconomic viewpoint, since the fiscal position tends to weaken in periods when trade growth is relatively subdued. It also has structural disadvantages, since it tends to bias the pattern of output away from the often more dynamic traded-goods sectors. An important priority in many developing countries will be to orient their revenue structure toward other sources, and toward forms (such as taxes on consumption) that also enhance savings incentives.

A second source of widespread problems is rigidity in pricing policies. This extends from macroeconomic prices, such as the exchange rate and interest rates, to microeconomic prices, such as the cost of services provided by government entities and the setting of government-regulated private sector prices, notably agricultural producer prices. Where possible, it is more efficient to allow prices to be set in free and competitive markets. Where this is not possible, governments should administer prices with a full awareness of the opportunity costs of the resources used and the scarcity value of the goods or services provided.

Closely connected with the issue of public sector pricing policy is that of the efficiency of state enterprises. Over the years, inefficiency has flourished in many state enterprises, its overt consequences masked by the ready availability of budgetary support. State enterprises have often been vehicles for the implementation of social policy, for example, by being forced to locate in particular regions, or being required to hire excessive quantities of labor. They have had decisions influenced in other respects too, for example, by being required to purchase inputs from domestic suppliers, or to adopt particular types of technology. While each individual decision affecting the operation of a state enterprise usually has a legitimate motivation, their combined effect has been highly detrimental to economic efficiency. It is important that state enterprises be conducted according to efficient operating principles, and that departures from such principles for reasons of government policy be clearly identified, and preferably provided for through distinct budgetary appropriations.

A further important structural issue concerns the size and distribution of investment expenditure. Ideally, investment would be determined as the outcome of decentralized decisions undertaken at the enterprise level on the basis of adequate information of government policy and the likely evolution of final demand. As a practical matter, however, this does not happen in many developing countries, and the national investment strategy is often planned at the government level. The mistakes that have most often been made in this process include underestimation of the gestation period of major investment projects; excessive concentration on “state-of-the-art” as opposed to “appropriate” technology; the favoring of large or prestige projects; and inadequate flexibility in investment plans, making it difficult to cut back particular projects without adverse effects on the overall efficiency of the investment plan.

A final issue that may be mentioned is the role of import liberalization. A number of countries have felt that trade restrictions are the most effective way of curbing imports without inducing a decline in output and a sharp increase in inflation as a result of exchange depreciation. In anything other than the short run, however, the maintenance of restrictions has consequences that impair the functioning of an economy and reduce its capacity to adapt to external disturbances. Trade restrictions enable the exchange rate to be maintained at a higher level than would otherwise be the case. Thus, while specific industries are protected, others, which could be competitive at a realistic exchange rate, are prevented from becoming established. A structure of production emerges that is based on administrative decision rather than comparative advantage. Inevitably, this process tends to favor existing industries over potential ones. The fact that new traded-goods industries do not come into existence complicates the task of responding to a sudden loss of export earnings in the future, since the domestic productive base that can be used to cushion the economy from a fall in imports is narrower. For these reasons, it remains highly desirable for developing countries, as well as industrial countries, to resist protectionist pressure, and to adopt a medium-term strategy of dismantling trade barriers.

International Cooperation and the Role of the Fund

During the past year there has been a renewed emphasis on the role of international coordination in improving the functioning of the world economy. The largest five industrial countries have committed themselves to the pursuit of policies aimed at promoting convergence, reducing exchange rate misalignment, and combating protectionism; a new initiative has been launched to strengthen growth and buttress the adjustment efforts of developing countries; and the Interim Committee of the Board of Governors (of the Fund) on the International Monetary System (Interim Committee) has taken up the subject of reform of the international monetary system. If these initiatives are to bear fruit, however, important challenges remain for the international community.

Concerning the improvement of economic policy coordination in industrial countries, an important first step was taken with the Group of Five meeting in New York in September, 1985. In a modest way, the present World Economic Outlook exercise attempts to carry this process forward through more explicit consideration of economic policy interactions among the industrial countries. It should be noted that coordination does not connote either fine tuning or joint formulation of policy. It is rather a matter of increasing mutual awareness of policy interactions, designed to arrive at mutually compatible medium-term strategies, and internationally consistent responses to short-term divergences.

A second major development in the field of international collaboration was the debt initiative introduced by the Secretary of the U.S. Treasury in October 1985. This initiative underlined the joint responsibility of three sets of agents in the debt situation: that of the indebted countries, to intensify their efforts to improve the functioning of their economies; that of the multilateral development banks, to increase their disbursements to heavily indebted countries; and that of the commercial banks, to step up their lending to these same countries. There is, in addition, an implied responsibility of the industrial countries, to ensure that markets for developing country exports are kept open and growing and to provide the needed funding to maintain appropriate levels of official development assistance. The Fund will play an important role in this process, not only through the contribution of its own financial resources, but because its function of assisting countries to design, implement, and monitor growth-oriented adjustment programs will act as a catalyst for other financial flows. It will also play a role, through surveillance, in fostering the adoption of policies in industrial countries that take adequate account of the interests of other members.

In this connection, special mention should be made of the need to avoid protectionism. It is heartening that the leaders of the major countries have reaffirmed their joint determination to avoid protectionism. Other countries, both in the developed and developing world, have evinced a similar determination. What is therefore needed is to translate the existing political will into a strategy designed not just to prevent the spread of restrictions, but to roll back those that already exist.

Lastly, the improvement of the functioning of the international monetary system is currently under study by the Fund’s Executive Directors and by the Interim Committee. A key element in this is reaching agreement on the kinds of policies and institutional arrangements that will promote greater stability of exchange rates, an orderly basis for providing international liquidity, and a reliable source of resource transfers to developing countries that does not lead to avoidable difficulties of indebtedness. Agreement in these areas would provide a framework within which new procedural arrangements would enable the Fund to carry out its surveillance responsibilities more effectively.