I Economic Prospects and Policies

International Monetary Fund. Research Dept.
Published Date:
May 1995
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The world economy registered important progress on a number of fronts in 1994, indicating the start of a new expansion following the 1990–93 global slowdown (Chart 1). Growth was stronger than expected and inflation was contained in the industrial countries—often at levels closer to price stability than seen in three decades. Among the developing countries, the buoyant expansion in Asia continued while countries in other regions witnessed an encouraging strengthening of their economic performance and prospects. And an increasing number of transition economies in central and eastern Europe began to see positive growth. Despite continued financial instability in Russia and many of the neighboring transition countries, world growth last year was in line with its long-term trend of 3½ to 4 percent while world trade expanded by an impressive 9½ percent, well above its long-term average growth rate.

Chart 1.World Indicators1

(In percent)

1Blue shaded areas indicate IMF staff projections.

2Excluding trade among the Baltic countries, Russia, and the other countries of the former Soviet Union.

Recent changes in financial market sentiment toward some emerging market countries, together with turmoil in exchange markets more generally, have cast a shadow on the otherwise encouraging picture. The global flight to quality, which had already begun prior to the financial crisis in Mexico, has led to a substantial slowdown in the large flows of capital to developing countries witnessed during 1990–93. A key factor behind these earlier capital flows was the encouraging long-term growth prospects of many of the recipient countries. Cyclical factors, notably weak growth and investment demand in the industrial countries and associated low or declining interest rates, also played an important role. In addition to substantial inflows of foreign direct investment, large short-term portfolio investments also flowed into many developing countries, including some where the fundamentals may not have fully warranted the enthusiasm of foreign investors.

Since early 1994, the pickup in global activity has increased demand for funds and put upward pressure on interest rates. Meanwhile, investors appear to have become more cautious. Among the industrial countries, these developments were reflected in a sharp rise in risk premiums for countries with relatively weak anti-inflation credentials and large fiscal imbalances. At the same time, portfolio flows to the developing countries began to ease and equity prices in these markets generally declined. In Mexico, concerns about the external current account deficit and political developments contributed to substantial reserve losses at times during 1994, eventually leading to the devaluation of the new peso in December and triggering a severe crisis of confidence. Contagion effects were felt in asset markets in other emerging market countries, especially in Latin America, as well as in some industrial countries.

This episode serves as a powerful reminder for all economies of the speed with which perceptions about a country’s situation can change, and of the heavy costs of allowing economic imbalances to persist until financial markets force the necessary policy adjustments. The resolution of the current crisis has necessitated a tightening of financial policies in Mexico and several other countries. Some other emerging market economies also need to strengthen their fundamentals. Conditional financial assistance from multilateral and bilateral sources should facilitate orderly adjustment in Mexico and help to contain the systemic repercussions of the crisis. Nevertheless, in the short run it seems likely that portfolio capital flows to many of the emerging market countries will remain volatile and may well decline, perhaps significantly.

Another key development since the beginning of 1995 has been the sharp weakening of the U.S. dollar and many other currencies against the yen, the deutsche mark and closely linked currencies, and the Swiss franc. At the same time, exchange market pressures within Europe have prompted a number of countries to raise official interest rates; most of the countries that have seen their currencies weaken are characterized by relatively large budget deficits. These developments threaten to exacerbate inflationary pressures in the United States, risk weakening the expansion in Europe, and could jeopardize recovery in Japan.

The recent decisions by Germany and Japan to lower official interest rates should help to counter these threats. It would be appropriate for the Federal Reserve to reinforce the actions by the Bundesbank and the Bank of Japan by raising short-term interest rates in the United States. This would help to strengthen the dollar, which is important in view of its role as the key international currency and is consistent with the need to contain domestic inflationary pressures associated with a weak exchange rate. Broader policy actions are also needed to foster greater exchange rate stability. In the United States, more ambitious fiscal consolidation efforts are required to raise the relatively low level of national saving and thereby reduce the external current account deficit. In Europe, fiscal consolidation should also be given greater priority during this period of economic recovery. Stronger efforts at deregulation and market opening in Japan are necessary to increase the exposure of the domestic economy to the benefits of international competition and thereby reduce the pressure on the yen.

Although the economic outlook for several countries has been adversely affected by the turbulence in financial markets, growth in the world economy is still expected to remain fairly robust during the period ahead. For many industrial countries, the strong growth momentum seen recently and still-large margins of slack may even suggest some upside potential in the near term. And for those developing countries that continue to face substantial demand pressures, a moderation of capital inflows may actually help some countries to prevent overheating and, hence, to sustain a satisfactory growth performance. At the same time, however, the recent events have underscored the downside risks to the projections, especially the danger of market volatility that may exacerbate, and expose, fragilities in the financial system. To reduce such risks, and to strengthen their economic potential, all countries need to act expeditiously to meet critical policy challenges, as emphasized in the Interim Committee’s Declaration on “Cooperation to Strengthen the Global Expansion” adopted at its last meeting in Madrid.

Industrial Countries

With buoyant economic conditions in North America and the United Kingdom, recoveries in continental Europe, and a modest pickup in economic activity in Japan, output in the industrial countries advanced by 3 percent in 1994. This is the highest growth rate in five years and, except for Japan, uniformly stronger than expected six months ago (Table 1). Although the pattern of growth across countries is likely to change, average growth is projected to remain close to 3 percent in 1995–96. However, unemployment is likely to remain high in many countries, particularly in Europe. Looking further ahead, there is scope for output to continue to expand at a rate of 2½ to 3 percent, but both the level and the sustainability of growth and gains in employment will depend on the resolve of policymakers to contain inflationary pressures as the expansion matures, to restore greater balance in public finances, and to address important structural rigidities. (The projections were finalized in early April and reflect average exchange rates in the first three weeks of March.)

Table 1.Overview of the World Economic Outlook Projections(Annual percent change, unless otherwise noted)


from October

1994 Projections
World output2.
Industrial countries1.
United States3.
United Kingdom2.
Seven countries above1.
Other industrial countries0.
European Union1-
Developing countries6.
Middle East and Europe3.
Western Hemisphere3.
Countries in transition-9.2-9.4-3.83.5-1.5-3.2
Central and eastern Europe-6.2-
Excluding Belarus and Ukraine-
Transcaucasus and central Asia-11.9-14.9-5.7-8.3-6.1
World trade volume3.
Import volume
Industrial countries21.510.
Developing countries10.48.78.611.21.60.7
Export volume
Industrial countries21.
Developing countries9.
Commodity prices
In U.S. dollars a barrel16.1315.4716.9016.900.311.75
Consumer prices
Industrial countries3.
Developing countries43.
Countries in transition675.1295.2126.918.9-18.538.5
Six-month LIBOR (in percent)5
On U.S. dollar deposits3.
On Japanese yen deposits3.
On deutsche mark deposits6.
Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during March 1–24, 1995, except for the bilateral rates among ERM currencies, which are assumed to remain constant in nominal terms.

Fifteen current members of the European Union.

Information on 1993 trade may understate trade volume because of reduced data coverage associated with the abandonment of customs clearance of trade within the European Union. Similarly, the strong rebound in trade volumes in 1994 may partly reflect improved data coverage.

Simple average of the U.S. dollar spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil; assumptions for 1995 and 1996.

Average, based on world commodity export weights, of U.S. dollar prices.

London interbank offered rate.

Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during March 1–24, 1995, except for the bilateral rates among ERM currencies, which are assumed to remain constant in nominal terms.

Fifteen current members of the European Union.

Information on 1993 trade may understate trade volume because of reduced data coverage associated with the abandonment of customs clearance of trade within the European Union. Similarly, the strong rebound in trade volumes in 1994 may partly reflect improved data coverage.

Simple average of the U.S. dollar spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil; assumptions for 1995 and 1996.

Average, based on world commodity export weights, of U.S. dollar prices.

London interbank offered rate.

The reduction of inflation to only 2½ percent in 1994 in the industrial countries as a whole stands out as a major achievement. To reduce the risk of an early repetition of the often-experienced inflation-recession cycle, and because of the relatively long lags in the effects of policy action, it is necessary to allow a gradual tightening of monetary conditions well before rates of capacity utilization and unemployment return to levels at which inflation begins to pick up. The monetary authorities in a number of countries have already demonstrated by their actions their commitment to contain inflationary pressures. At the same time, however, differences in cyclical conditions continue to warrant somewhat differentiated policy stances.

In the group of countries where the expansion has progressed the most—the United States, the United Kingdom, Australia, and New Zealand—monetary conditions have firmed appropriately during the past year. There are only a few signs so far in these countries of a pickup in broader indicators of inflation. Nevertheless, their rate of economic growth has remained well above potential for some time, there are signs of strains on capacity in some markets for labor and intermediate inputs, and it is not yet clear that short-term interest rates have been raised sufficiently to slow activity to a more sustainable pace, partly in view of the expected strengthening of foreign demand as economic recovery gains momentum in other industrial countries.

To ensure that inflation does not accelerate, the need for a moderation of growth is particularly pressing in the United States, where economic slack has been fully absorbed. Monetary stimulus was gradually withdrawn during 1994 in the face of increasing capacity constraints, including rapidly tightening labor market conditions. While the economy still appears to be operating at or above potential, there are signs that growth is slowing toward more sustainable levels. In the United Kingdom, the strong upswing during 1994 has raised concerns about inflation even though some economic slack remains to be absorbed. Monetary policy has begun to tighten and ongoing fiscal consolidation efforts should also help to contain demand, but underlying inflation appears to have already bottomed out and inflation expectations have remained well above official medium-term objectives. In both countries, the tightening of monetary policy that has occurred already will be felt to its full extent only gradually, but the asymmetric nature of the risks warrants a monetary stance that errs on the side of caution. The recent weakness of the U.S. dollar and of sterling against other Major currencies argues for earlier steps to raise interest rates further than would have been required otherwise.

In Canada, Italy, Sweden, and Spain, monetary policy has also been tightened during the past year, at least partly in response to persistent downward pressure on their exchange rates stemming from concerns in financial markets about the fiscal situation and outlook. Economic recovery is now under way in all four cases—most strongly in Canada—but margins of slack are still significant, and the main immediate threat to inflation is the weakness of these countries’ currencies. The difficult dilemma this situation poses for monetary policy can only be resolved through stronger efforts to reduce fiscal imbalances. Such action is particularly urgent in Italy and Sweden.

The pace of recovery has been disappointing so far in Japan, where the rate of capacity utilization remains quite low. With weak short-term growth prospects, prices stable or even falling in some sectors, and in view of the excessive strength of the yen, a relatively easy stance of monetary policy is warranted for the time being. The further reduction of official interest rates in mid-April is consistent with both domestic requirements and the need to counter exchange market pressures.

In Germany, inflation is within the authorities’ objectives and there is scope for growth to continue at the pace seen recently without any immediate threat to price performance. The strength of the deutsche mark and the sluggish growth of M3 together with other indicators justified the recent further decline in official interest rates. At some point, however, a firming of monetary conditions will be needed. Among the other countries participating in the European exchange rate mechanism, the decision to raise official interest rates in Denmark and Ireland in early March was consistent with their cyclical positions. For France and other European countries with high levels of unemployment and generally large margins of slack, recent increases in short-term interest rates, while justified by the need to resist exchange market pressures, were not warranted by their fundamentals. These interest rate hikes have subsequently been reversed to a significant extent. Although this episode is unlikely to derail the recovery in continental Europe, it has accentuated the downside risks for countries with particularly large interest risk premiums.

Progress with fiscal consolidation would help to alleviate the burden on monetary policy as the expansion matures. The reduction of budgetary imbalances is also essential in order to raise saving available to finance investment and employment growth in the private sector, to reduce the reliance on foreign saving in some countries, and to lessen the risk of instability in foreign exchange and financial markets. The robust growth seen recently and expected to continue in the near term presents an excellent opportunity to sharply reduce fiscal deficits.

Unfortunately, although the industrial countries all agree on the need to better balance public budgets, existing consolidation plans remain too modest in most cases. Absorption of economic slack will reduce the cyclical components of budget deficits, but relatively large structural imbalances are likely to persist in the absence of stronger deficit reduction efforts. In view of the sharp buildup of public debt during the past two decades, an appropriate objective would be not only to stabilize debt-to-GDP ratios but also to substantially curtail the accumulation of debt over the business cycle and ensure a clearly declining trend in debt ratios in the future.

Germany, the United Kingdom, Denmark, and New Zealand appear to be well on the way in current fiscal consolidation plans to permit some reduction in debt ratios before the end of the decade. In the United States, following significant progress in 1993–94, the structural deficit is estimated at about 2½ percent of GDP in 1995–96 (on a general government basis). But, without policy changes, the deficit is expected to increase again over the medium term. In Japan, while the active use of fiscal policy to counter the recent recession was appropriate, the authorities need to improve substantially the fiscal position over the medium term. Although the overall budgetary balance at present is only showing a small structural deficit of ¾ of 1 percent of GDP, the structural deficit excluding social security—which is of particular interest in view of Japan’s rapidly aging population and the resulting need to build up assets in the pension system—is estimated at almost 5 percent of GDP.

In France and several other members of the European Union, including Austria, Belgium, Finland, the Netherlands, Portugal, and Spain, measures taken so far imply a very slow reduction of underlying fiscal imbalances over the medium term. Their public debt ratios are therefore expected to remain at relatively high levels. For all of these countries, increases in interest rates or a cyclical downturn could easily compromise their objective of bringing fiscal deficits within the Maastricht convergence criterion of 3 percent of GDP—already a modest goal that risks becoming a floor rather than a ceiling. As indicated by the large risk premiums on interest rates, the fiscal situation and outlook are of particular concern in Italy, Sweden, and Greece, where gross debt ratios are close to or well over 100 percent of GDP and still rising. In Canada, the fiscal outlook has improved with the recent budget, but further action is needed to reduce significantly the high level of public debt.

In view of the large requirements for fiscal consolidation, it is reasonable to consider whether a general tightening of fiscal policies would entail risks for the economic expansion. A withdrawal of fiscal stimulus can normally be expected to have some adverse shortrun effects on activity, with positive effects on investment and growth emerging only after one or two years. Under current circumstances, however, it is unlikely that any short-run adverse effects would be very large. The upward pressure on world real interest rates experienced since early 1994 provides an indication of growing tension between private sector demand for investment funds and government borrowing needs. Private demand can therefore be expected to crowd in relatively quickly as fiscal stimulus is withdrawn, as already has been experienced in the United States, the United Kingdom, and Germany. Even if consumers and investors might respond with a delay in some cases, this would not be a serious problem since the need to tighten monetary policy during the expansion would diminish correspondingly. In countries that have large risk premiums on real interest rates, serious efforts at fiscal consolidation hold the promise of reducing these premiums, with additional beneficial effects on business and consumer confidence; in such cases, the economic impact could conceivably be positive even in the short run. On balance, concern about the short-term effects on activity should not be a reason for postponing needed fiscal consolidation during a generally robust economic expansion. By contrast, if action on fiscal consolidation were delayed until the next economic slowdown, both the short-term and the longer-run costs would be considerable.

Achieving a better fiscal balance will require deep-rooted reforms to control the level and growth of public expenditures. Additional revenues may be necessary in some cases, but significant further increases in already very high levels of taxation, particularly in Europe and Canada, may have adverse effects on productivity and employment. User fees for some types of public services and better targeted support programs to meet the legitimate needs of low-income groups will need to be considered, together with labor market reforms to reduce structural unemployment and the associated burden on government budgets. Reforms will also be needed to alleviate future budgetary strains resulting from aging populations.

As has already occurred in the United States, continued recovery can also be expected to reduce cyclical unemployment in other industrial countries. The monetary and fiscal policies to foster a sustained expansion as previously discussed will be essential in this regard. However, average unemployment in Europe is still expected to be around 10 percent of the labor force by the end of 1996, only 1½ percentage points lower than today, with relatively little scope for cyclical forces alone to bring unemployment much below 8½ to 9 percent as the expansion matures. To tackle the very high level of structural unemployment in Europe, there remains a need for fundamental reform of labor market and social policies aimed at strengthening incentives for firms to increase employment and for the unemployed to accept job offers. Such reforms, which may need to include appropriate changes in tax and transfer policies, should not be viewed as a setback to long-standing, legitimate social objectives, but rather as critical to better achieving such objectives without harmful effects on unemployment. In the United States, labor markets are more flexible and structural unemployment has shown little long-run trend increase. However, there remains a key challenge to strengthen education and training policies in order to raise productivity and real wages, especially for low-income groups.

Developing Countries

The recent turmoil in some emerging country financial markets should not detract from the fundamental improvements that have occurred in recent years in economic policies and performances in most of the developing world. These improvements have allowed the developing countries to experience average growth of almost 6 percent during 1991–94, well above the average growth rate of about 4 percent in the decade to 1990. The prospects for sustained gains in output and living standards in the future are also better than they have been for a long time. Despite a likely slowdown in net capital inflows and a significant downward revision of the short-term growth estimates for Mexico and several other emerging market countries, the staff’s projections point to sustained growth in most developing countries during the period ahead. However, developing country growth could be more adversely affected in the short run if the contagion effects from the Mexican crisis were to result in a collapse of confidence in the prospects for the emerging market countries, with a large and sudden slowdown in capital flows.

The strengthening of economic conditions in many developing countries during the past decade has resulted from determined efforts at stabilization and economic reform. Moderate inflation and a lowering of budget deficits have helped to maintain or restore financial stability and to foster a favorable business climate. And market-oriented structural reforms have reduced distortions and stimulated incentives and competition through price liberalization, privatization, and opening to trade and foreign direct investment. The benefits from such policies and reforms have so far been most striking in the developing countries in Asia. But fundamental changes in economic policies have also occurred, or are under way, in Latin America, Africa, and the Middle East. The number of successfully reforming countries has been growing steadily year by year throughout the developing world.

With success comes new challenges and risks of policy mistakes. The surges in capital flows to developing countries in recent years have complicated policymaking and in some cases have led to excessive liquidity expansion and upward pressures on real exchange rates. The resulting widening of current account deficits might appear to be of little concern as long as foreign capital keeps flowing. The recent events in Mexico, however, have illustrated the limits to the sustainability of external imbalances and the dangers stemming from excessive real exchange rate appreciation. In some countries, financial market pressures have also highlighted the fragility of banking systems in the face of capital outflows and greater monetary restraint. The problems experienced in Mexico are closely related to the country’s very low private saving rate, which will require a strengthening of the public sector’s contribution to national saving, as well as measures to stimulate private saving. Countries with a stronger saving performance and greater success in managing the surge in capital inflows are generally less vulnerable to shifts in market sentiment, although they have not been immune to contagion effects from the crisis in Mexico.

The rapid growth in many developing countries in recent years has also increased the risk of overheating, especially in some southeast Asian countries and in China. For these countries, just as for the industrial countries, it will be essential to prevent the buildup of inflationary pressures through gradual policy adjustments before a more drastic adjustment is required. Appropriate responses may need to involve both monetary and fiscal policy changes in order to avoid destabilizing short-term capital inflows that may be attracted by high levels of interest rates; for some countries it may also be appropriate to allow nominal exchange rates to appreciate somewhat. In China, in addition to a cautious stance of macroeconomic policies, it is necessary to strengthen financial discipline in the state-owned enterprise sector.

Improvements in policies and in economic performance are still relatively recent in many cases, and many tasks remain to avoid a re-emergence of macroeconomic imbalances and to establish a higher sustainable growth path. In Brazil, for example, the recent stabilization plan has reduced inflation substantially; to ensure that this progress is not jeopardized, the authorities will need to strengthen public finances, which will also help to contain the balance of payments deficit. In India, where the dismantling of controls on private industrial activity has been extensive, relatively high trade barriers and slow public sector reform continue to impede competition and productivity. India, together with the Philippines, will also need to step up fiscal consolidation efforts to alleviate inflationary pressures, strengthen national saving, and reduce the burden on monetary policy. In Egypt, there is a similar need to change the policy mix to establish a solid base for the resumption of growth. Among the large oil exporting countries in the Middle East, the decline in oil revenues since the mid-1980s, which has not yet been fully reflected on the expenditure side of public budgets, will require greater efforts at fiscal consolidation in coming years.

The low-income countries of Africa are increasingly seeking to address the causes of their protracted poor growth performance, and prospects for stronger economic growth are improving. But progress is uneven and there are risks of setbacks linked to political uncertainties. The recent recovery of commodity prices should help to strengthen the external position of a number of countries. In the CFA countries, despite policy slippages in some cases, reform efforts have been stepped up considerably and much of the gain in external competitiveness following the January 1994 devaluation has been maintained. In Kenya, fiscal and monetary policies have been tightened and have helped to restore macroeconomic stability, while both current and capital account transactions have been liberalized. For a number of the highly indebted countries in the region, however, debt burdens continue to dampen growth prospects despite their strengthened adjustment efforts. For these countries, it is essential that external creditors provide adequate financial assistance, including significant debt relief in some cases. Recent enhancements of debt-restructuring terms by Paris Club creditors, which involve an increase in the level of concessionality and greater flexibility with respect to debt rescheduling, should help to reduce debt and debt-service payments of low-income countries to more sustainable levels.

Countries in Transition

Half a decade has elapsed since the process of transition began. All of the former centrally planned economies have implemented market-oriented reforms, some early on and boldly, others more recently or tentatively. Relatively favorable initial conditions have contributed to success in some instances. It is also clear, however, that comprehensive liberalization coupled with financial discipline and broad-based institutional reforms shortens the transitional period and lowers the costs of economic transformation. Vigorous economic growth resumed within three years of the initiation of the more radical stabilization and reform programs. By contrast, measured output continues to decline in those transition countries that have followed a less comprehensive strategy.

In countries such as Albania, Estonia, Latvia, Lithuania, Poland, the Slovak Republic, and Slovenia, growth is projected to reach or exceed 5 percent in 1995, and open unemployment is declining or stabilizing. Moreover, despite the ongoing process of convergence of the domestic price structure toward world market prices, inflation continues to fall or is contained in all of these countries. In the Czech Republic, the pace of the recovery has been somewhat more subdued but macroeconomic performance has been outstanding in other respects. In countries such as Bulgaria, Romania, and the Transcaucasian and central Asian countries, where the pace and scope of reforms have been less bold, disinflation and the turnaround of output have been slower to materialize or are still elusive. Confronted with the social and political costs of drawn-out output slumps and hyperinflation, and the realization that there is nothing to be gained by delay, most of the countries that had postponed decisive reforms have now begun serious adjustment efforts.

Russia has made significant progress in structural reform and, in the summer of 1994, appeared to be within striking distance of macroeconomic stabilization. During the second half of the year, however, fiscal adjustment efforts were relaxed, reversing much of the progress that had been made toward disinflation, and the government’s commitment to the privatization program and other aspects of structural reform was put in doubt. The privatization program now appears to be back on track, and the economic program for 1995 sets both fiscal and monetary policy on a course consistent with rapid macroeconomic stabilization. The prospects for a turnaround in activity as indicated by the staff’s projections depend on the successful implementation of this program.

At the start of the transformation process, many observers expected that substantial capital inflows would be one of the engines of economic recovery. Foreign direct investment, in particular, was expected to play a critical role in the transfer of market-oriented technologies and business practices to the countries in transition. Although there are strong incentives for foreign enterprises to invest in the transition countries and there has been a substantial increase in foreign direct investment to some countries, the overall level of capital inflows remains modest in most cases. Foreign investors have been deterred by macroeconomic instability, by uncertainties about the pace of and commitment to structural reforms, and by the lack of transparent and stable legal structures.

Many of the countries in transition have made extraordinary efforts. In some, there have been remarkable achievements in the critical areas of macroeconomic stabilization and structural and institutional reform. Considerable challenges remain, particularly in the area of enterprise reform, but the process of transformation to market economies now appears to be irreversible in virtually all cases. As the reform process continues, there should be scope for larger flows of foreign direct investment. The relatively low level of capital inflows thus far, however, underscores the experience of other countries that most investment needs will have to be financed domestically. This highlights the need for adequate incentives for private saving, for the establishment of an environment that does not encourage capital flight, and for macroeconomic policies that contain inflation and limit the absorption of private saving to finance excessive budget deficits. It is vital that the international community continue to support the transition process in those countries that implement and persevere with appropriate stabilization and reform policies.

Adequacy of World Saving

The high level of world real interest rates that has persisted since the early 1980s is prima facie evidence of strong demand for investment funds relative to the supply of world saving (Chart 2). Taken together with the decline in the world saving rate during the same period, it is reasonable to ask whether the high level of real interest rates implies a suboptimal supply of saving that adversely affects world growth and economic welfare. With the substantial investment needs of the countries in transition, and in light of the large capital flows to many developing countries in recent years, this question leads to another: Is there a risk of further upward pressure on global real interest rates as demands for funds intensify?

Chart 2.World Saving and Real Long-Term Interest Rate

1Three-year centered moving average. Data before 1970 represent less than complete country coverage.

2GDP-weighted average of real ten-year (or nearest maturity) government bond rates for the United States, Japan, Germany, the United Kingdom, Canada, Belgium, the Netherlands, and Switzerland.

It is debatable whether the level of private saving in the world economy is inadequate. There is ample evidence, however, to suggest that world growth and economic welfare are adversely affected by the strong pressures on the available level of financial resources. This is mainly due to the persistent absorption of private sector saving to finance fiscal imbalances in the industrial countries, which accounts for the bulk of the decline in the world saving rate since the 1970s. The supply of private saving may well be higher than otherwise in response to public sector deficits, but empirical evidence suggests that the degree of “offset” is little more than about half, on average. Notwithstanding conflicting results in the economic literature, this is consistent with analyses that have found a close relationship between the need to finance the accumulation of public debt in the industrial countries and the increase in global real interest rates since the 1960s. Overall, there is little doubt about the key responsibility of the industrial countries to address their fiscal imbalances and thereby alleviate pressure on global real interest rates.

It is less clear that real interest rates are likely to rise further because of the investment needs of the emerging market economies in the developing world and among the transition countries. The experience of both the industrial countries and the most successful developing countries suggests that the growing number of emerging market countries are likely to register substantial increases in domestic saving as economic performance strengthens, creating a virtuous circle between growth, saving, and investment. These countries may also contribute toward alleviating pressure on global interest rates by mobilizing domestic saving, by reducing the reliance on foreign saving, and by permitting greater international portfolio diversification by domestic investors. Indeed, while some countries will continue to attract net capital flows from abroad, others may become net suppliers of capital. Finally, experience suggests clear limits on the extent to which world financial markets can be expected to finance persistent external imbalances, especially when a heavy reliance on foreign saving becomes a substitute for adequate domestic saving. Overall, it seems unlikely that the potentially rapid catching up of these countries will seriously aggravate pressures on global saving.

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