I Economic Prospects and Policies
- International Monetary Fund. Research Dept.
- Published Date:
- October 1994
The recovery of world activity and trade became more firmly established during the first half of 1994. Continental western Europe and Japan have now begun to emerge from some of the deepest recessions in half a century. At the same time, upswings have gained momentum in the United Kingdom, Canada, and Australia, while in the United States a high level of capacity utilization has already been restored. A particularly positive aspect of the world economic situation remains the rapid expansion in many Asian and some Latin American developing countries. The decline in output during the early part of the transition process in central Europe and the Baltic region has bottomed out, and economic growth has resumed in some of these countries. In contrast, registered output has continued to decline in Russia, Ukraine, Belarus, and the Trans-caucasian and central Asian countries in transition. Although the outlook is beginning to improve in some African countries as a result of stronger commodity prices and enhanced economic reform efforts, economic conditions remain difficult in most of the continent.
Overall, world output is projected to expand by 3 percent in 1994 and by 3½ percent in 1995, twice as rapidly as in 1990–93 (chart 1). At the same time, with large margins of economic slack in many countries, there seems to be little immediate risk of a generalized pickup in inflation, notwithstanding a significant rise in the prices of some primary commodities. Nevertheless, in view of the strength of the expansions and the associated danger of an intensification of inflationary pressures, pre-emptive increases in policy-related interest rates have already been undertaken, appropriately, in several countries. Further adjustments of monetary conditions may be warranted before long, especially if activity proves stronger than currently projected.
Chart 1.World Indicators1
1Blue shaded areas indicate IMF staff projections.
2Excluding trade among the Baltic states, Russia, and other countries of the former Soviet Union.
Progress in the implementation of policies consistent with the strategy for sustained global expansion adopted by the Interim Committee in April 1993, and reaffirmed in October 1994 (see facing page), has helped to strengthen conditions for a revival of world activity.1 Further efforts will be necessary, however, to promote financial stability and economic prosperity over the medium term. A critical policy requirement is to safeguard a high degree of price stability—in itself a necessary condition for sustained growth in all economies. Equally important, efforts will need to be stepped up in many countries to reduce public sector absorption of private saving in order to alleviate pressure on real interest rates and permit satisfactory growth to be sustained over the medium term. In all countries, structural reforms to enhance the role of market forces and to increase economic flexibility would help to promote stronger growth and high employment; such reforms would also increase economies’ resilience to adverse economic disturbances.
The planned entry into force of the Uruguay Round trade agreements on January 1, 1995 promises to further enhance the growth potential of the world economy, extending and reinforcing the dynamic relationship between the growth of trade and output that has been the key achievement of the understandings reached at Bret-ton Woods fifty years ago. The multilateral trade liberalization efforts will be complemented by the growing trend toward regional integration, including the planned enlargement of the European Union (EU). New trade opportunities will stimulate growth directly, while increased international competition will help to keep inflationary forces at bay. At the same time, the creation of the World Trade Organization (WTO) will foster a more predictable, rules-based global trading environment. To secure these benefits and thereby bolster consumer and business confidence, it is essential that the Uruguay Round trade agreements be ratified without delay.
The broadening and strengthening of the recovery across the industrial world marks the end of a protracted slowdown that at various times affected virtually all countries. Economic policy has played an important role in alleviating recessionary tendencies and in stimulating the natural forces of recovery. However, although recent indicators have been encouraging and point to some upside potential, many difficult tasks continue to confront policymakers to ensure a strong and durable expansion with low inflation and high levels of investment over the longer run. Ensuring a vigorous and durable expansion is especially important in view of the need to reduce high levels of unemployment in many countries—levels of unemployment that include substantial cyclical components resulting from recent recessions, as well as important structural components whose correction will require determined efforts to reform labor markets in an environment of continuing economic expansion.
A critical policy requirement is the need to deal with the large fiscal imbalances that have persisted for more than a decade in many industrial countries and that have led to sharp increases in levels of public debt: in terms of gross debt, from 40 percent of gross domestic product (GDP) in 1978 to almost 70 percent of GDP at present in the industrial countries as a group; the average ratio of net debt to GDP has approximately doubled over the same period, to 40 percent. During the expansion of the 1980s, fiscal deficits generally diminished, but the degree of consolidation was insufficient to compensate for the decline in private sector saving since the late 1970s. The persistent fiscal imbalances appear to have contributed in important ways to the high level of world real interest rates experienced during the past decade and to the declining trend in the share of private investment in GDP (Chart 2). Structural fiscal imbalances also limited the scope for temporary fiscal support to economic activity during the recent recession. Excessive fiscal deficits continue to affect expectations about future inflation in some countries, despite recent progress in reducing inflation almost everywhere: they also often aggravate external imbalances and can be a source of instability in foreign exchange markets. The Interim Committee Declaration of April 1993 recognized these problems and called on countries with large deficits to adhere to a medium-term strategy of deficit reduction.
Chart 2.Industrial Countries: Saving, Private Investment, and Real Long-Term Interest Rates1
1Blue shaded areas indicate IMF staff projections.
2Ten-year government bond yields (or nearest maturity) for the major industrial countries. The real interest rate is defined as the average of the nominal interest rates minus the four-quarter percentage change in each country’s GDP deflator.
Although fiscal deficits are currently exacerbated by the effects of recession, sizable structural imbalances will remain in most countries after activity recovers. It is encouraging that there is now widespread recognition of this problem, and that many governments are already pursuing medium-term fiscal consolidation plans. In most cases, however, these consolidation plans appear to be too modest, especially in view of the rising burden on the financial position of the public sector over the medium to longer run as populations age. Significant further steps are generally required to strengthen national saving and to put ratios of public debt to GDP on a declining trend after two decades of steady increases. Given the difficulties in curtailing fiscal deficits during periods of economic weakness, it is essential to make maximum use of the expansions now under way to ensure progress toward fiscal consolidation during the period ahead.
Another critical condition for a strong and durable expansion is to safeguard a high degree of price stability. Inflation distorts investment and consumption decisions and adversely affects productivity and economic welfare. There is evidence from many countries that a legacy of relatively high inflation tends to undermine policy credibility—often for long periods after inflation has been brought under control. As a result, countries may face large premiums in financial markets, which raise the cost of capital. Inflation also plays a key role in the business cycle. When excess demand pressures are allowed to develop during an expansion, they plant the seeds of the next recession because of the need, sooner or later, to cool off the economy through tightened financial policies. The success during the past decade in reducing inflation to only 2½ percent for the industrial countries overall, a level last seen in the early 1960s, has therefore re-established a key precondition for sustained growth—provided that inflation is not again allowed to pick up.
The primary responsibility for safeguarding price stability rests with monetary policy. This does not imply that monetary conditions should remain unchanged, or be restrictive, under all circumstances. On the contrary, and as demonstrated during recent cyclical episodes, allowing monetary conditions to ease when activity is weak and inflation is low can be critical to avoid exacerbating recessionary tendencies and to safeguard a balanced and credible mix of economic policies. Conversely, ensuring that monetary conditions shift to a stance that does not accommodate an increase in inflation as margins of slack diminish is equally critical to protect the credibility of monetary policy and to contribute to a durable expansion. Of course, given the long and variable lags in the effects of policy actions, and the imprecise art of forecasting, it is not easy to gauge precisely the requisite adjustments in monetary conditions, and experience suggests that there is no simple operational rule that is valid at all times. Some countries have found it helpful to announce explicit inflation targets to underscore their commitment to price stability. However, such targets need to be used in conjunction with a broader assessment of the monetary stance. In practice, therefore, policymakers rely on a wide range of indicators of economic and financial conditions to judge the appropriate time and extent of the adjustments in monetary conditions needed to keep monetary policy on course toward its longer-term objectives.
The significant movements observed recently in long-term interest rates are of relevance for economic policy, although they need to be interpreted with caution in view of the possible role of temporary factors. To some extent, the rise in long-term interest rates since the end of 1993 appears to reflect an increase in real interest rates that has been felt worldwide as a result of the general strengthening of growth and the firming of expectations that the recovery is broadening and becoming self-sustaining. Such a rise in world real interest rates is normal during an economic upswing. However, that real long-term rates remained relatively high during the recession and are now close to the high levels prevailing throughout the 1980s points to a renewed intensification of competition for financial resources both among private investors and between private and government borrowers. This underscores the need for governments to reduce progressively their absorption of private sector saving in order to lower the path of real interest rates, allow room for private investments that are essential for longer-term growth in the industrial countries, and permit an adequate flow of financial resources to the developing world and to the transition countries.
The rise in inflation premiums that has accompanied the recent rise in real long-term interest rates seems quite small in countries such as Germany and Japan, where margins of slack are still substantial and where the track record of low inflation may be perceived as an indicator of greater commitment to medium-term price stability than in other countries. The more pronounced increases in long-term interest rates in the United States, the United Kingdom, and Australia appear to reflect the strength of activity in these economies. Although inflation is currently quite low in all three countries, recent steps to move monetary conditions to a less accommodating stance should help to alleviate fears of future inflation. Of most concern is the substantial increase in interest rate premiums in countries such as Italy, Sweden, and Finland, where inflation is quite low (or is subsiding) and margins of slack are still large, but where there may be perceived risks to the price stability objective associated with large fiscal imbalances, past difficulties in controlling inflation, or other country-specific factors; the high premium for Spain also appears to be related to both the budgetary situation and inflation concerns. In these countries, there is a particularly urgent need to strengthen the fiscal outlook in order to establish greater credibility.
Recent movements in the exchange rates of the major currencies reflect in part the same factors that have influenced long-term interest rates, and to some extent carry similar implications for economic policy. In general, countries for which there may be concerns about rising inflationary pressures or doubts about the prospects for fiscal consolidation have experienced downward pressure on both bond prices and exchange rates. The most important counterpart to these downward pressures, and the most disruptive from a cyclical perspective, has been the continued sharp appreciation of the yen, which prolonged the recession in Japan until early 1994. The weakening of the dollar in the first half of 1994 against both the yen and the deutsche mark also appears to run counter to the short-term objective of moderating growth in the U.S. economy to a more sustainable pace. By contrast, it is not clear that the recent exchange rate movements conflict with medium-term considerations, to the extent that they might help to reduce Japan’s current account surplus and the U.S. deficit. For the United States’ external position to improve as a result of the depreciation of the dollar, however, without contributing to excess demand pressures, domestic saving will have to strengthen substantially relative to domestic investment, which is first and foremost a question of stepping up the pace of fiscal consolidation.
Whereas macroeconomic policies will need to play a key role in countries’ medium-term strategy, a roster of structural issues also requires urgent attention. In most of Europe, the chief problem is the high rate of structural unemployment, and the worrying tendency for it to rise over time. In addition to adequate demand growth to bring down the cyclical component of unemployment, durable reductions in the substantial structural component of unemployment will require the implementation of fundamental labor market reforms, including lowering and restructuring unemployment benefits and related programs, lowering minimum wages in some countries, reducing nonwage labor costs, liberalizing employment and wage-setting practices, and strengthening training programs. Such reforms need to be accompanied by appropriate adjustments to tax and transfer systems to help meet social concerns. The implementation of the recently concluded Uruguay Round agreements will be an important step forward in fostering international trade. Nevertheless, further liberalization of markets in many industrial countries is required to increase access and promote competition. Important initiatives are needed to dismantle nontariff and administrative barriers to imports and international investment and to cut trade-distorting industrial subsidies. In all countries, reforms to contain rising pressures on outlays for health care and public pensions will be required if fiscal imbalances are to be contained over the medium term.
After a period of nonsynchronous business cycles among the industrial countries, growth rates are expected to converge during 1994 and 1995. However, rates of capacity utilization, the magnitudes of financial imbalances, and the associated policy requirements will continue to differ across countries. In the United States, the expansion has already brought about a high rate of resource use. Inflation is no longer declining, and price performance may begin to deteriorate if output growth continues to exceed potential growth. The tightening of monetary conditions that began in February 1994 and has continued in steps should help to restrain the pace of activity. But further increases in policy-related interest rates are needed, and are expected by financial markets, if overheating and a rise in inflation expectations are to be avoided. Hence, the projected moderation of growth to 2½ percent in 1995 from 3¾ percent in 1994 is predicated on the assumption that short-term interest rates will continue to be adjusted in keeping with the cyclical position of the economy.
Further substantial action to address the structural fiscal deficit in the United States would also help to foster a strong and durable expansion. The fiscal program adopted in August 1993 provided for a significant measure of fiscal adjustment in 1994—95, but it implies little further reduction of the structural deficit in later years. To put the debt-to-GDP ratio on a clear downward trend, additional deficit-reduction measures will be necessary. It is particularly important that the authorities succeed in controlling the growth of health care outlays and other entitlements, and in maintaining the soundness of the social security system. Early steps to strengthen fiscal policy further should help to improve the longer-term outlook for growth and the current account, and to contain inflation.
In Canada, the recovery has become more broadly based, with improvements in job and growth performance and virtual price stability contributing to rising consumer and business confidence. Margins of slack remain large, however, and the high level of both short-term and long-term real interest rates could have potentially adverse effects on the pace of recovery. There also seem to be doubts among financial investors about the prospects for continued price stability and for durable reductions in the budget deficit, although political uncertainties may have influenced market sentiment. The best response to these developments is to intensify the process of fiscal consolidation in order to ensure that the fiscal deficit and the debt-to-GDP ratio are set on a clear downward path.
The recovery in the United Kingdom has now gained momentum, and unemployment has declined significantly. The wide margin of slack that developed during the 1990–92 recession has helped to bring inflation down faster than generally expected, to below 2½ percent, the midpoint of the authorities’ current target range and the top of the medium-term target range. While there appears to be room for the expansion to continue at the pace seen recently without endangering near-term price performance, a rapid rise in rates of capacity utilization would risk increasing inflationary pressures. The decision to raise base rates on September 12 therefore provides an important signal of the authorities’ commitment to the goal of low inflation. The medium-term fiscal consolidation plan announced in 1993 has already brought about a sizable reduction in both actual and structural deficits this year, and its full implementation in the coming years will help to realize the objective of eliminating public borrowing by the end of the decade. Expenditure restraint is critical to consolidation objectives, and reducing nominal spending ceilings in the upcoming budget to reflect lower-than-expected inflation will therefore be important to enhance policy credibility.
In Japan, the economy has begun to turn around, albeit hesitantly. Improvements in consumer and business confidence and the continuation of supportive macroeconomic policies suggest that activity should strengthen further in the second half of the year. However, earlier over investments, lingering effects of asset price deflation, and the strength of the yen point to the likelihood of rather moderate growth in the short run. A relatively easy stance of monetary policy should therefore be maintained to allow the recovery to gather pace and to alleviate upward pressure on the exchange rate. After a series of large fiscal packages, the structural budget balance has deteriorated by almost 3 percent of GDP since 1991, reflecting a considerable effort to support activity. Although it seems appropriate to maintain fiscal support in 1995, including an extension of the income tax cut, fiscal consolidation will need to resume over the medium term, including comprehensive social security and tax reform to forestall an unsustainable increase in public debt as the population ages. It is also essential to persevere with structural reforms. Such measures are desirable in their own right, for reasons of economic efficiency and economic welfare, and they may also help to reduce protectionist sentiment in foreign markets.
There are now clear signs of recovery in continental Europe. In Germany, output stabilized in the second half of 1993, and grew moderately in the first half of 1994, supported by exports, residential construction, and stock building. Although consumer spending is expected to remain weak and there is uncertainty about the strength of business investment, real GDP growth is expected to reach 2¼ percent in 1994 and strengthen to 2¾ percent in 1995. The significant easing of monetary conditions since late 1992 has helped to improve the near-term outlook both at home and in many partner countries. Following the latest cuts, official interest rates appear to be at broadly appropriate levels, taking into account the turnaround in activity and progress in reducing inflation, as well as uncertainties arising from the rapid growth of the money supply until recently. The future path of official interest rates will need to be judged on the basis of the speed of recovery and prospects for inflation and in light of the growth of money and credit. Substantial progress has been achieved in reducing the large structural fiscal deficit that arose after unification. The general government deficit is expected to recede to 2½ percent of GDP in 1994 and to decline further over the medium term as a result of cyclical recovery and continued consolidation efforts. To fully restore a sound budgetary position and to create room for a reduction in the high tax burden, it will be necessary to step up efforts to curtail industrial and agricultural subsidies as well as to streamline and better target public pensions, health care expenditures, and welfare benefits.
Activity also now has begun to pick up in France, where real GDP is expected to expand by close to 2 percent in 1994 and by 3 percent in 1995. The recovery has stemmed the rise in unemployment—which peaked at 12¾ percent of the labor force in May 1994—but it remains uncertain whether growth will gain sufficient momentum to substantially reduce the unemployment rate in the near term. The easing of monetary conditions during the past eighteen months is a key reason for the improved outlook. The levels of both short-term and long-term interest rates remain high in view of the low inflation rate and the wide margin of slack, but substantial internally generated funds in the enterprise sector should help to finance investments and contribute to recovery. The large general government deficit that has emerged over the past three years is in part structural. Although the authorities are committed to bringing down the deficit to 2 percent of GDP by 1997, a further strengthening of the consolidation efforts would be desirable in the medium term; the possibility of faster-than-expected growth in revenues would provide an opportunity to reduce the deficit more quickly in the short term. Fiscal consolidation should help to reduce long-term interest rates to a level more consistent with France’s recent and prospective inflation performance. Fundamental reform of French labor markets is also needed to strengthen incentives for job creation and job search if the high level of structural unemployment is to be reduced.
In Italy, improvements in external competitiveness associated with the lira’s departure from the exchange rate mechanism (ERM) of the European Monetary System (EMS) are contributing to a moderate export-led recovery. Inflation abated to a twenty-five-year low of just over 3½ percent in July 1994, but large interest rate differentials persist relative to Germany. The long-term differential has widened sharply in recent months, probably reflecting renewed doubts about the prospects for further reduction of the large budget deficit. The government approved in late July its three-year fiscal program, which aims to reduce the state-sector deficit from almost 10 percent of GDP in 1993 to 8 percent of GDP in 1995, and to about 5½ percent of GDP by 1997—somewhat weaker objectives than in the previous plan. The achievement of these targets would require fiscal measures of some 3 percent of GDP in 1995, and further adjustment in later years. On the assumption that such measures are fully implemented, and taking into account expected privatization proceeds, the debt-to-GDP ratio would be stabilized during 1996. Although this is an appropriate short-term goal, the public finances remain vulnerable, in particular to unfavorable interest rate developments; it is thus important that appropriate measures to meet the targets be fully identified as soon as possible. Beyond this, credible efforts to put the unsustainably high debt ratio on a declining trend during the balance of the decade are essential for Italy’s longer-term financial stability and growth prospects. More vigorous efforts at consolidation than now planned would pay important dividends by diminishing interest rate premiums and thereby aiding both growth and budgetary improvement.
The convergence of policy requirements across continental Europe has permitted a general easing of monetary conditions, which has contributed to the recovery that is now under way. For the moment at least, the dilemma between external and domestic considerations that monetary policy had faced in many countries has receded. There nevertheless remains the question of how the difficulties experienced in 1992–93 can be avoided in the future. Eventually, the adoption of a common currency by the countries participating in the planned economic and monetary union would resolve the issue. During the transition to the final stage of EMU, however, there remains a need to strengthen policy cooperation in order to promote sustained economic growth with high levels of employment and low inflation. The emphasis will need to be on credible efforts at fiscal consolidation—to bring fiscal imbalances well below the maximum deficit ceiling stipulated by the Maastricht Treaty—and on structural reform to enhance the flexibility of European labor markets. The scope for closer coordination of monetary policies should increase as economic performance improves and converges across Europe.
Growth in the developing countries is expected to average 5½ percent in 1994–95, close to the rate of expansion in 1992–93. The continued strong performance masks considerable diversity, however: growth remains weak and standards of living continue to stagnate or decline in many countries; in contrast, others are among the most dynamic economies in the world and enjoy rapid increases in per capita incomes. To an important extent, these divergences are related to the varying degrees of success that countries have had in implementing appropriate macroeconomic stabilization and structural reform policies. As discussed in previous issues of the World Economic Outlook, the most successful countries are those that have created a stable macroeconomic environment, encouraged domestic saving, and implemented structural reforms that increase efficiency.
The renewed confidence of international investors in the outlook for many developing countries has been reflected in the dramatic rise of private capital inflows since 1989 (Chart 3). To some extent, the surge in capital inflows can also be attributed to the recent weakness of activity in industrial countries—as suggested by the moderation of capital inflows in the first half of 1994 as growth strengthened and interest rates rose in the industrial world—but the most decisive factor has generally been the economic policies pursued by the developing countries themselves.
Chart 3.Developing Countries: Net Capital Flows
Sources: IMF, Balance of Payments Statistics Yearbook; and IMF staff estimates.
However, not all countries that have benefited from recent capital inflows have done so because of productive investment opportunities and strong underlying fundamentals. In a few cases, the rise in capital flows appears to have reflected the general enthusiasm for emerging financial markets, rather than well-founded confidence in the economic prospects of specific countries receiving the flows. For these countries, the risk of sudden changes in market sentiment is particularly serious. In a number of other countries, some of which have implemented far-reaching structural reforms, an inappropriate mix of lax fiscal policies and tight monetary policies has boosted capital inflows because of high short-term interest rates. For these countries, there is also concern about the sustainability of the capital inflows.
With this note of caution, most of the beneficiaries of capital inflows have been those countries where growth has been strong or where growth is expected to strengthen because of the pursuit of appropriate macroeconomic, trade, and exchange rate policies. Even so, the inflows have often complicated economic policy management because of possible risks of overheating and real exchange rate appreciation. Most countries, however, have managed the inflows much better than in the 1970s, when capital inflows took the form of increasing foreign indebtedness, in contrast to today’s largely non-debt-creating flows. In addition to substantial flows into emerging equity markets, many countries have benefited from large inflows of foreign direct investment, which directly strengthen longer-term growth prospects and are less vulnerable to changes in market sentiment.
China, one of the largest recipients of capital inflows during the past two years, remains one of the fastest-growing economies in the world. The rapid growth, however, has exacerbated demand pressures, which have pushed inflation to an annual rate above 20 percent. A stabilization program was adopted in mid-1993, but its implementation was not sustained. At the end of 1993, financial policies were again tightened, and this has led to a moderation of growth to a more sustainable pace, and to clearer signs of reduced inflationary pressures. Major structural reforms were introduced at the beginning of 1994 in the areas of foreign exchange, the financial sector, the tax system, and intergovernmental fiscal relations. The challenge for the authorities is to ensure the achievement and maintenance of macroeconomic stability while continuing with structural reforms needed to transform the Chinese economy to a market-based system.
In India, the successful 1991–92 adjustment program has helped to improve the country’s growth potential. But recent capital inflows have also reflected relatively high interest rates in the face of large fiscal slippages in 1993/94; despite some monetary tightening, inflation has rebounded to over 10 percent. To reduce inflation on a sustained basis and to limit upward pressure on the real exchange rate from the capital inflows, it will be necessary to implement a credible fiscal adjustment program together with more rapid trade liberalization. A major tax reform was introduced in the 1994/95 budget, and several important sectoral reforms have been initiated, notably in communications and mining. Other structural reforms—including liberalization of consumer goods imports, labor market reforms, restructuring of public enterprises, and financial sector reforms—will need to be accelerated in order to sustain robust growth and allow India to share in the prosperity and rapid development enjoyed by a growing number of countries in east and southeast Asia.
Most countries in the Western Hemisphere have seen a marked improvement in economic performance in the early 1990s. With few exceptions, countries in the region have geared fiscal and monetary policies toward the achievement of macroeconomic stability and have increased reliance on market forces to improve economic efficiency. As a result, growth has generally improved—especially in Argentina, Chile, Colombia, and Peru—while inflation has subsided, debt burdens have been reduced, and there has been a welcome return of domestic and external confidence in the economic prospects of the region. This renewed confidence has been reflected in substantial capital inflows.
Argentina is enjoying a third year of rapid, investment-led growth, with inflation converging almost to industrial country levels. In 1994 the strong rise in investment has been reflected in a further widening of the external current account deficit, but domestic saving continues to strengthen. In Mexico, economic growth remained weak in early 1994, and there was a loss of international reserves in March-April in the wake of the assassination of the leading presidential candidate. The authorities maintained a strong fiscal position and coped with exchange market pressures through the flexible management of interest rates and the use of exchange rate margins. Pressures in financial markets eased once the outlook for the election became clearer, and economic growth is projected to increase in 1995, helped by an expansion in private investment.
In early 1994, Brazil adopted a new economic program to achieve a lasting reduction of inflation. In the first half of the year the authorities’ efforts were devoted to strengthening the public finances and to eliminating backward-looking indexation. These efforts were followed by the introduction of a new currency on July 1 and by measures to curb the inflow of foreign capital, which has been very large since late 1991. The sharp drop in inflation has been encouraging. The firm and continued implementation of sound credit, fiscal, and wage policies together with further structural reforms are needed to achieve sustained economic growth. Economic conditions in Venezuela have worsened since the beginning of 1994, and output is projected to contract significantly this year. The public finances continue to be weak. A large injection of liquidity associated with a banking crisis intensified exchange market and price pressures and complicated monetary management. Recently, plans to strengthen fiscal management were announced, together with steps to liberalize foreign investment and to resume the privatization program.
In contrast to the robust growth in many developing countries recently, economic conditions in most of sub-Saharan Africa remain unsatisfactory. Economic growth in 1990–93 did not keep pace with the increase in population, with the result that real per capita incomes fell in the region as a whole by more than 8 percent over the four years to 1993. There are, however, a number of factors that point to some improvement in the near-term outlook. The strengthening of demand in the industrial countries and the firming of commodity prices should help to bolster the commodity-exporting countries’ terms of trade. Major liberalizations of exchange systems and significant exchange rate adjustments in recent years in many African countries should help to improve resource allocation. Countries pursuing comprehensive adjustment programs supported by the IMF’s enhanced structural adjustment facility (ESAF) have grown faster than other countries in the region, and the emergence of capital inflows to some countries—including Kenya, Uganda, and some of the CFA countries following the recent devaluation—suggests increased market confidence in the region’s adjustment efforts. Prospects for realistic debt relief for the poorest and most indebted countries have improved as the major industrial countries now appear willing, where appropriate, to reduce the stock of debt to official creditors and to increase concessionality for those countries facing special difficulties. Finally, the closer integration of South Africa into the regional and world economy could boost trade and productivity throughout the region.
Notwithstanding these positive developments, it is worth stressing that the projections of some strengthening of growth in Africa in 1994–95 rest on the crucial assumption that policy adjustments and reforms pursued in the context of IMF programs will remain on track and that the effects of these efforts will materialize within the assumed time frame. Also, the projected improvements in growth will result in only a modest rise in living standards—generally from very low levels—and almost certainly will not be shared by all countries. Clearly, many problems remain to be addressed if Africa’s economic performance is to strengthen on a durable basis—including increasing domestic saving, reducing inflation in some countries, enlarging the scope for market mechanisms to enhance resource allocation, and improving governance. In addition, the international community will need to provide adequate levels of financial and technical assistance in support of strong domestic policies.
In the Middle East, inflation has remained relatively high, and growth has slowed somewhat as the temporary boost from reconstruction in some countries during 1992–93 has dissipated, and as the decline in oil prices has reduced government revenues and expenditures in oil-producing countries. With the erosion in real oil prices since the mid-1980s, there has been a substantial reversal of earlier capital outflows to finance current account deficits. A few countries have made some progress toward macroeconomic stabilization and structural reform. However, many of the countries in the region need to strengthen macroeconomic policies and step up structural reforms to sustain growth, reduce their vulnerability to external shocks, and lower chronic high levels of unemployment. The prospect of a lasting peace settlement in the region offers the opportunity to revitalize investment and growth, by strengthening adjustment and reform efforts, reducing defense expenditures, and tackling important regional issues, particularly in the areas of infrastructure, water, transportation, and regional integration.
Countries in Transition
The transition process began in earnest five years ago when some countries in central Europe moved decisively to implement reforms to establish a market economy. By now, virtually all of the former centrally planned economies are, to a greater or a lesser degree, attempting to establish a market economy, and most countries have experienced substantial and sustained output declines. The experiences of the countries of central Europe that first and most boldly implemented market reforms—including the Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia—and of Albania, the Baltic countries, and Mongolia clearly show that macroeconomic stabilization and structural reform are essential prerequisites for a resumption of growth, and that there is no advantage to postponing them. These countries are now growing, or appear to be on the threshold of recovery, and prospects for continued growth are good.
By contrast, output continues to contract, or is at best stagnant, in most of the other countries in transition. Some of these countries, including Russia, Moldova, and the Kyrgyz Republic, have made some progress toward stabilization and reform, but most have yet to contain government budget deficits and to reduce and stabilize inflation at low levels. In Russia and Ukraine, despite a sharp decline in inflation in the first half of 1994, substantial further progress toward price stability is required. Inflation remains extremely high in most other countries. Rapid inflation is sapping political support for reform and contributing to uncertainty, thereby worsening the investment climate and exacerbating the decline in output. Structural reforms frequently have been implemented in a piecemeal and inconsistent fashion, although substantial progress has been made in some areas in a number of countries. But without a substantial and sustained reduction of inflation and a more stable macroeconomic environment, there is little likelihood of a turnaround in this group of countries in the short term.
A key indicator of the transition countries’ commitment to the stabilization of inflation is the fiscal balance. This is because government deficits must largely be financed through money creation, given the absence of well-developed long-term government securities markets and limits to noninflationary external financing. Containing government deficits, however, has proved elusive in all but a handful of countries, and it is increasingly recognized that the transformation process itself has profound implications for government revenues and expenditures. The resulting deficits are, to some extent, a by-product of the transition process and in some cases have resulted from transferring previous quasi-fiscal activities to government budgets. Nevertheless, the large fiscal imbalances highlight the urgency of reforms to adapt governments’ fiscal systems to a market economy in order to contain fiscal imbalances and prevent excessive rates of inflation that would endanger the reform process.
Another by-product of the transition process is the emergence of open unemployment. Moving to a market-based system requires enterprise restructuring on a large scale to improve the allocation of economic resources as a prerequisite for sustained growth in the future. Some of the workers who lose their jobs will find work in the emerging private sector or may become self-employed, but many others will become unemployed. To protect the most vulnerable members of society and to sustain public support for the transformation process, appropriate social safety nets need to be put in place. At the same time, it is important that new labor market regulations and institutions encourage job creation and job search and help to ensure that the rise in unemployment is a temporary phenomenon associated with the initial phases of the transformation process. Increased expenditures on social safety nets need not exacerbate fiscal deficits—which are already excessively large in many countries—provided that such expenditures are well targeted and if they are accompanied by reductions in subsidies and other nonproductive expenditures.
The countries in transition face other fiscal challenges as well, including pressures to increase spending to revitalize infrastructure, to clean up the environment, and to support aging populations. The scope to increase public spending on infrastructure and the environment will depend, in part, on the successful curtailment of spending in other areas, such as enterprise subsidies, as well as on the implementation of revenue-enhancing reforms. To support the growing number of pensioners, pension systems will need to be reformed. In addition, private pension schemes will need to be encouraged in order to facilitate the development of capital markets, hasten enterprise privatization and restructuring, and strengthen prospects for macroeconomic stability and financial sector reform.
Although there has been substantial progress in the implementation of structural reforms in Russia and some of the other transition countries, there are enormous difficulties yet to be faced. Many banks and enterprises are insolvent, requiring major efforts to restructure, recapitalize, and, in some cases, close them. Large payments arrears have built up and threaten to undermine monetary policies. Relatively little progress has been made on agricultural privatization and land reform. Market signals continue to be distorted by subsidies, cheap credits, and tax exemptions. The framework for a market economy—including business laws, accounting standards, and a modern banking system—is only gradually being put in place, and widespread corruption and crime threaten to undermine support for market reforms. Unless these problems are successfully addressed, the recovery of output is likely to be delayed in the short run, and the pace of growth will be impeded in the long run.
External financial assistance will continue to play a critical role in many transition countries in the period ahead. The IMF, for its part, is considering proposals to increase its lending capacity through an expansion of the systemic transformation facility (STF) and higher access under its usual facilities, as well as proposals for an additional SDR allocation. But this multilateral assistance needs to be accompanied by significant amounts of untied aid on favorable terms from official bilateral and other sources. An increase in external financial assistance, however, will only be helpful in the context of strong adjustment policies and accelerated efforts at structural reform in the transition countries. In particular, additional foreign financing should be used only to finance private and public expenditures that advance the reform process and that yield a high social rate of return. It will be critical to ensure that the accumulation of additional foreign debt by countries in transition is accompanied by an improved climate for domestic and foreign investment and structural transformation, so as to contribute to growth that will enable these countries to service such debts in the future.