II The World Economy in 1994–95

International Monetary Fund. Research Dept.
Published Date:
October 1994
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With expansions in North America now well under way, and with clearer signs of recovery across Europe and in Japan, global output is projected to expand by 3 percent this year and by 3½ percent in 1995, close to the trend rate of growth over the past two decades (Table 1). Thus, the marked slowdown in world trade and growth in the early 1990s—which occurred despite the strength of economic activity in the developing countries as a group during this period—appears to have run its course. Continued strong performance in many developing countries is expected to yield average growth of 5½ percent this year and next. Disparities between individual countries continue to be large, however.

Table 1.Overview of the World Economic Outlook Projections(Annual percent change unless otherwise noted)
CurrentDifferences from May
Projections1994 Projections
World output1.
Industrial countries1.
United Slates2.
United Kingdom-
Seven countries above1.
Other industrial countries1.
European Union1.1-
Developing countries5.
Middle East and Europe7.
Western Hemisphere2.
Countries in transition-15.5-9.0-8.3-1.0-2.2-2.4
Central and eastern Europe-11.7-5.7-5.41.4-2.3-1.0
Excluding Belarus and Ukraine-9.9-
Transcaucasus and central Asia-17.3-10.7-
World trade volume4.
Industrial country import volume14.
Developing country import volume11.
Commodity prices
In U.S. dollars a barrel18.2216.1315.1615.151.400.58
Consumer prices
Industrial countries3.
Developing countries38.746.247.513.26.61.2
Countries in transition730.7687.9330.889.440.716.1
Six-month LIBOR (in percent)4
On U.S. dollar deposits3.
On Japanese yen deposits4.
On deutsche mark deposits9.
Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during August 1–23, 1994, except for the bilateral rates among ERM currencies, which are assumed to remain constant in nominal terms.

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.

Simple average of the U.S. dollar spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil; assumptions for 1994 and 1995.

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 August 1–23, 1994, except for the bilateral rates among ERM currencies, which are assumed to remain constant in nominal terms.

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.

Simple average of the U.S. dollar spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil; assumptions for 1994 and 1995.

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

London interbank offered rate.

Projections for aggregate growth in the economies in transition also mask wide variations in economic conditions among individual countries. In most of central Europe, bold economic reforms have created the macroeconomic environment necessary for sustained growth. As the recoveries in western Europe get under way, export prospects should strengthen and provide further support to these economies. Relatively strong expansions are under way in Albania, Poland, and Slovenia. Activity is also recovering in the Baltic countries, where growth is expected to average about 5 percent in 1994—95. In Russia and most of the other countries in transition, however, the economic situation continues to be difficult, although the decline in output is expected to bottom out in most cases in 1995, and monthly inflation is projected to decline to single-digit levels. Given the uncertainties and special problems of economic transition, the short-term outlook for these economies is reviewed in detail in Chapter V.

The estimate of world trade growth in 1993 has been revised up by 1½ percentage points, to 4 percent, in part because of new information about trade developments in the European Union.2 World trade is expected to expand strongly in the period ahead, rising by over 7 percent this year and by 6 percent in 1995, well above the 5 percent average growth rate observed during the past two decades. This resurgence reflects increased activity in industrial countries, stronger import demand in countries in transition, and continued rapid growth in developing countries. Trade among the developing countries is also expanding strongly, supported by trade liberalization and increased intraregional foreign direct investment.

The past year has witnessed sharp price movements in world commodity and financial markets. From a peak of $17.80 a barrel in April 1993, oil prices fell sharply to $12.65 a barrel in December, rose to $13.40 a barrel in March 1994, and recovered to over $17 a barrel in early July. Increased demand from continental Europe and from North America was an important factor in the rise in the first seven months of the year, but additional price pressure came from supply constraints. Even at these levels, however, oil prices were still well below their highs in the 1980s (Chart 4). Prices declined again in August, and they fluctuated around $15.75 a barrel in the first week of September. Several factors, including seasonal weakening and some easing of concern over the impact of the oil workers’ strike in Nigeria, contributed to the renewed price decline. The oil price assumption underlying the projections in the World Economic Outlook is based in part on oil futures market prices in late August, and is just over $15 a barrel in 1994–95 (see Table 1).3

Chart 4.Commodity Prices

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

(index, 1980 = 100)

Prices of non-oil raw materials have risen significantly, with particularly large price spikes in a few commodities. Severe adverse weather in Brazil and the very low level of producer stocks brought coffee prices to an eight-year high; prices in August 1994 were up almost 150 percent from their average in the first quarter. Copper prices were 30 percent higher in August than in the first quarter of the year, and prices of other metals have also risen substantially. The IMF’s world export-weighted index of nonfuel commodity prices in August was up 14½ percent in dollar terms from a year earlier. Even more striking is the more than 37 percent increase in the twelve months through August 1994 in The Economist’s widely cited commodity price index, which weights prices by the value of imports into the industrial countries. Speculative behavior may have contributed to some of these increases, but the broadening of recovery among the industrial countries seems to have been the most important factor in the general pickup in commodity prices. As in the case of oil, even with these recent sharp increases in nonfuel commodity prices, the index is still well below its peaks in the 1980s (see Chart 4).

Stronger commodity prices are a significant factor in the improved outlook for economies heavily dependent on commodity exports. The revisions to growth projections for several countries in Africa are attributable, in part, to this favorable development in their terms of trade. For the oil exporting countries of the Middle East, the increase in oil prices relative to the large decline in 1993 contributes positively to their short-term prospects. Developing countries are not the sole beneficiaries, however; commodity-exporting industrial countries such as the United Kingdom, Canada, Norway, and Australia also will gain from the general recovery of commodity prices. For the industrial countries, the commodity price increases have raised concern that inflationary pressures may begin to build sooner than expected.

The sharp rise in bond yields in industrial country markets in 1994 is another noteworthy recent market development; as in the case of commodities, the change is of significance beyond just those markets (Box 1). Part of the increase may be attributed to stronger growth, given the emerging recoveries in continental Europe and Japan and the continuing expansions in other large economies. To some extent, therefore, the interest rate increases represent a normal equilibrating mechanism that will tend to slow the pace of expansion from what it otherwise would be. Nevertheless, the run-up in bond yields does represent a risk in the outlook, particularly for those countries where recoveries are still fragile. Moreover, part of the increase in bond yields appears to reflect—in varying combinations across countries—higher expected inflation and increased risk premiums because of uncertainty regarding inflation prospects and policy commitments. Decisive monetary policy responses, where warranted, together with greater clarity regarding both fiscal and monetary policy objectives and commitments, may reduce some of these factors. The increases may also have consequences for debt-servicing costs in indebted developing countries, depending on how rapidly or slowly changes in long-term rates are passed through to debt-service payments. In addition, just as the period of low interest rates in industrial economies was associated with large portfolio shifts that pushed emerging equity market prices up sharply, so this period of rising long-term bond yields has been associated with a moderation of capital flows to developing countries and a downward correction in many of the emerging stock markets.

Industrial Countries

Short-Term Prospects and Risks

The stronger signs of a turnaround in economic activity in continental Europe and, somewhat more tentatively, in Japan suggest that the long and unusually severe downturn may finally have ended. Although the disparities in cyclical positions across the industrial countries are still considerable—with some economies well into the expansionary phase, and others newly recovering—positive growth has now resumed in all countries (Chart 5 and Table 2). The possibility of mutually reinforcing growth in the period ahead is reflected in the upward revisions to the projections for most of the industrial countries, and it may also contribute to a shift in the distribution of uncertainty that necessarily attaches to the projections. Indeed, although the projections attempt to balance the downside risks against the upside potential, precise turning points are difficult to assess, and all forecasts, including those of the IMF staff, often tend to underestimate not only the severity of downturns but also the robustness of subsequent recoveries. Thus, further upward revisions in the period ahead would not be unusual. In particular, one benefit from the long period of slow or negative growth is that it precipitated extensive business restructuring efforts in many countries. Efficiency gains from this process, and the prospect of delayed but ultimately more durable increases in labor demand (as has apparently been the pattern in the United States), have laid an important foundation for relatively solid expansions. The fairly robust growth rates seen recently, or projected, in many of the smaller countries provide grounds for some optimism in this regard.

Chart 5.Major Industrial Countries: Real GDP1

(Percent change from four quarters earlier)

1Blue shaded areas indicate IMF staff projections; data for Italy and Japan for the second quarter of 1994 are also projected.

2Through 1991, west Germany only: thereafter, IMF staff estimates for unified Germany.

Table 2.Industrial Countries: Real GDP, Consumer Prices, and Unemployment RatesAnnual percent change and, for unemployment, percent of labor force
Real GDPConsumer PricesUnemployment Rates
All industrial countries1.
Major industrial countries1.
Untied States12.
United Kingdom3-
Other industrial countries1.
New Zealand-
European Union1.1-
West Germany1.8-

The projections for unemployment have been adjusted to reflect the new survey techniques adopted by the U.S. Bureau of Labor Statistics in January 1994. On the old survey basis, the unemployment figures would have been roughly½ of 1 percentage point lower in 1994–95.

To be more consistent with rates of other industrial countries, the unemployment rate is based on a revised labor force survey and on a new definition of unemployment starting in 1993.

Data for consumer prices are based on the retail price index excluding mortgage interest.

The projections for unemployment have been adjusted to reflect the new survey techniques adopted by the U.S. Bureau of Labor Statistics in January 1994. On the old survey basis, the unemployment figures would have been roughly½ of 1 percentage point lower in 1994–95.

To be more consistent with rates of other industrial countries, the unemployment rate is based on a revised labor force survey and on a new definition of unemployment starting in 1993.

Data for consumer prices are based on the retail price index excluding mortgage interest.

Nevertheless, for several of the recovering countries, some caution is called for in interpreting the favorable figures from the first half of the year, since these appear to have been influenced to some extent by special factors such as government incentive programs and end-of-fiscal-year effects. Among the possible downside risks, the increase in long-term interest rates may dampen some recoveries—although the magnitude of the increases and their possible impact vary across countries. In addition, high unemployment in Europe continues to be a critical obstacle to sustained improvements in consumer confidence. The difficulty of policy-making at cyclical turning points presents another source of risk in the outlook. Contributing just the right amount of support to ensure that recoveries are well-established, while not laying the grounds for subsequent overheating or fiscal deterioration, is a delicate task. Consistent with its more advanced stage in the business cycle, the United States was the first major economy to begin to tighten monetary policy, in light of high capacity utilization rates and near full employment. Monetary conditions in the United Kingdom and in Australia tightened in the third quarter of 1994, reflecting the monetary authorities’ commitment to preventing a buildup of inflationary pressure as the expansions in these economies continue. Large margins of slack in continental Europe and Japan, and to a lesser extent even in the expanding Canadian economy, mean that it may be some time before similar questions become relevant in these countries, although the economic and financial linkages between Canada and the United States may precipitate earlier action in Canada. In the meantime, however, there remains a need to ensure that monetary conditions will help the natural forces of recovery to become firmly established in Europe and Japan. In addition, efforts to reduce budget deficits are of critical importance in virtually all industrial countries. The appropriate timing of new or additional fiscal measures must be judged against the evolving economic environment, but the current or prospective expansions provide the opportunity to make substantial progress. Failure to do so could also affect economic confidence adversely. These policy considerations are discussed in detail in Chapter III.

Developments in Individual Countries

The largest upward revisions to the industrial country projections are for Europe and especially for Germany, where output is now projected to expand by 2¼ percent in 1994 and by 2¾ percent in 1995. Economic activity in the first half of 1994 was stronger than expected. Private consumption proved resilient in the face of tax increases in January, and domestic demand increased at a 1 percent annual rate in the first half of the year, despite the high level of unemployment and moderate wage settlements. However, the main contribution to growth has come from the external sector. Increased competitiveness resulting from industrial restructuring and declining labor costs, and expanding demand in North America and now also in Europe, have boosted export performance. The strength of the yen has also contributed to some gains of market share in Asia. The prospects for continued strength in external demand should contribute to a further recovery of business investment, and in 1995 real gross fixed investment is projected to expand by 5½ percent. Continued wage moderation points to further declines in inflation in the period ahead.

The turnaround in France appears to be fairly evenly balanced between domestic and external sources. Growth in total domestic demand and in overall output are both projected at 2 percent in 1994 and 3 percent in 1995. Part of the strength of consumer spending early in 1994 was attributable to special government incentives for automobile purchases, but spending on other durable goods also rose. Indicators of consumer and business confidence have improved markedly during 1994, although they are still at relatively low levels (Chart 6). Investment is expected to increase in 1994 and 1995, following three years of large declines. The principal source of weakness—with the unemployment rate at just over 12½ percent in mid-1994—remains the labor market. The consequences for business and consumer confidence and for the government’s fiscal position pose significant risks for the period ahead. The margin of slack in France is large, and wage growth has been subdued, so the risk of a buildup of inflationary pressure is remote. Consumer price inflation is already very low, and it is projected to remain below 2 percent during the period ahead.

Chart 6.Major Industrial Countries: Indicators of Confidence1

Sources: For the United States, the Conference Board; for Canada, the Conference Board of Canada; for Japan, the Bank of Japan; and for the lower panel, European Union.

1 Indicators of consumer confidence for all countries except Japan, which is the Tankan survey of business conditions. Given the different methodologies, the indicators are not comparable across countries.

2 Quarterly observations of percent of respondents expecting an improvement in business conditions minus percent expecting a deterioration.

3Quarterly observations.

4Percent of respondents expecting an improvement in their situation minus percent expecting a deterioration.

The outlook for economic activity in Italy has also improved since earlier this year, mainly on the strength of external demand. Exports in the first quarter of 1994 were up 11 percent in volume terms from a year earlier. Despite continued high unemployment, consumer confidence rose in June for the sixth straight month, but domestic spending is expected to remain subdued because of low real income growth and cautious business investment. The growth projections have been revised up to 1½ percent in 1994 and 2¾ percent in 1995. The margin of error surrounding this forecast is somewhat larger than usual, in view of the uncertainty regarding the implementation of the government’s recently announced fiscal plan. A failure to meet the announced targets already somewhat less ambitious than those in the previous plan—could threaten the early signs of a revival of consumer and business confidence and add to the already high level of interest rates, both compared with earlier levels and relative to interest rates in other countries. Inflation performance has nevertheless been encouraging: inflation declined to 3¾ percent in August and is projected to average 3 percent in 1995.

Box 1.Bond Markets

Since the beginning of 1994, long-term bond yields in industrial countries have risen sharply, with increases ranging from 120 to 440 basis points (see table). Given the particularly low level of long-term interest rates in 1993, some observers have suggested that the run-up in interest rates in 1994 is in part a correction to an “overshooting” on the downside in 1993. Nevertheless, the timing and size of the concerted rise appear to have come as a surprise, and although interest rates in most countries reversed some of their large gains in the first weeks of July, upward pressure resumed in August in several cases, and in general the net change since January is still large (see chart).

In searching for explanations, it is useful to distinguish among three conceptual components of long-term nominal interest rates: the long-term risk-free real rate of return, expected inflation, and premiums for risk and liquidity. Integration of capital markets has meant that, to an increasing extent, the equilibrium real rate of return is determined by global demands for, and supplies of, capital. Large demand or supply shifts in an individual country or region will tend to affect, and in turn be somewhat moderated by, market responses in other countries. Bond yields in individual countries nevertheless diverge to compensate for country-specific inflation prospects, expected changes in exchange rates, and varying degrees of risk and uncertainty.

The coincident timing of the upturns in bond yields points to the importance of common global factors. The almost simultaneous upward revisions in growth projections for continental Europe during the early part of 1994, the accumulating signs of the continued strength of activity in North America, and indications that the recession had bottomed out in Japan all suggest that increasing global aggregate demand played a key role in the upturn in interest rates. Given the sustained demands for capital in developing countries—where aggregate growth has been strong for some time—the particularly large investment needs in the transition economies, and the absence of corresponding increases in saving, the return of industrial countries to more normal levels of activity would tend to intensify (actual and expected future) competition for funds among potential borrowers that would be reflected in a rise in the real interest rate. Evidence of a rise in the world real rate of interest is provided by yields in the index-linked bond markets in the United Kingdom and Canada, where real yields rose by just over 1 percentage point between January and August 1994.1

Global demand for and supply of capital are undoubtedly part of the explanation, but the magnitude and precise timing of the rise in interest rates have varied across countries, suggesting that country-specific factors have also been important. Bond yields reached a low point in most countries in January or February, but in the United States the low point was in October 1993, although the rise in yields accelerated in early 1994 along with yields in other industrial countries. The earlier upturn in the United States is consistent with its more advanced recovery relative to other industrial countries, and with market participants’ anticipation that monetary policy would need to tighten as slack was absorbed. The Federal Reserve Board’s decision to raise the federal funds rate in February, for the first time since mid-1992, appeared to contribute to the general upturn in interest rates at that time.

The stronger signs of recovery in continental Europe in early 1994 were reflected in upward revisions in projected demands for investment capital and in a corresponding shift in expectations about the course of official interest rates—particularly in Germany—in the near term.2 To this extent, therefore, some increase in long-term real interest rates would be a normal cyclical phenomenon. In many countries, however, the recent increases in nominal interest rates have been much larger than the apparent rise in world real rates, which leaves the balance to be explained by inflation expectations and risk premiums.

Given the large margins of slack in continental European economies, it is unlikely that inflation expectations have risen by as much as might be suggested by the behavior of nominal bond yields adjusted for the rise in real rates. An additional factor that may be important, and that may also have shifted at about the time of the turnaround in continental Europe, is the uncertainty or risk premium. The size of this premium in an individual country depends on the amount of uncertainty in the outlook for the real economy. The range and likelihood of perceived policy responses will also play a role in this assessment of risks. Both of these elements of uncertainty may be particularly high around turning points, and thus the upward revisions to many growth projections in the first months of 1994, which reflected the increasing evidence that a turnaround had been achieved, may well have precipitated an increase in the uncertainty premiums as well. Moreover, the somewhat unusual characteristics of the recent downturn—the nonsynchronous cyclical movements, the asset price movements and balance sheet adjustment problems that set off the recessions in several countries, the unsustainable fiscal situation in some countries, and the sluggishness of the recoveries themselves—might have justified a particularly high degree of uncertainty. In addition, the upcoming period is likely to present policymakers with critical policy decisions that in many cases have not yet been clearly formulated or that are not perceived as credible.

Selected Industrial Countries: Interest Rate Changes and Selected Economic Indicators(In percent)
Change in


Bond Yield

from January

to August1


Budget Balance2


Net Debt2
Consumer Price

Inflation, 1980–93






United States (Oct. 15, 1993)1.9-3.4-1.456.413.
Japan (Jan. 7, 1994)1.4-0.6-2.16.5-
Germany (Jan. 3, 1994)1.5-3.2-
France (Jan. 12, 1994)2.0-5.8-
Italy (Feb. 2, 1994)2.8-10.01.1109.421.
United Kingdom (Jan. 19, 1994)2.3-8.1-9.132.910.
Canada (Jan. 28, 1994)2.5-7.1-4.661.823.
Australia (Jan. 31, 1994)32.8-4.0-
Austria (Jan. 14, 1994)1.3-3.3-0.255.9-
Belgium (Dec. 31, 1993)1.7-6.7132.
Denmark (Jan. 12, 1994)2.6-4.6-5.164.312.
Finland (Feb. 2, 1994)3.9-7.9-9.223.623.
Ireland (Jan. 12, 1994)2.4-2.90.5104.9-
Netherlands (Dec. 30, 1993)1.5-2.91.760.
New Zealand (Feb. 1, 1994)2.5-1.9-
Norway (Feb. 2, 1994)2.6-2.7-2.7-
Portugal (Feb. 10, 1994)2.6-7.3-2.514.
Spain (Jan. 31, 1994)2.8-
Sweden (Jan. 31, 1994)4.4-13.4-16.916.
Switzerland (Dec. 9, 1993)1.2-4.9-
Weighted average2.0-4.3-2.446.
Sources: World Economic Outlook data base, Bloomberg L.P. data base, and OECD Economic Outlook (Paris, June 1994).Note: Dates in parentheses for each country represent the recent low point in the long-term bond yield (ten-year maturity or nearest).

Percentage point change in monthly average yield on long-term bonds from January to August 1994, except for the United States, where the change is measured from October 1993 to August 1994. Figures represent data available as of September 12, 1994.

Ratio to GDP. Statistics on general government net debt are not directly comparable across countries, owing to differences in national definitions.

Debt figures are for fiscal years ending June 30.

Sources: World Economic Outlook data base, Bloomberg L.P. data base, and OECD Economic Outlook (Paris, June 1994).Note: Dates in parentheses for each country represent the recent low point in the long-term bond yield (ten-year maturity or nearest).

Percentage point change in monthly average yield on long-term bonds from January to August 1994, except for the United States, where the change is measured from October 1993 to August 1994. Figures represent data available as of September 12, 1994.

Ratio to GDP. Statistics on general government net debt are not directly comparable across countries, owing to differences in national definitions.

Debt figures are for fiscal years ending June 30.

To assess potential country-specific explanations, information on recent fiscal performance and the outlook for growth and inflation is presented in the table. Average consumer price inflation between 1980 and 1993 and the standard deviation of inflation serve as possible indicators of central bank credibility. Rigid formulas cannot apply, of course, in part because many important determinants are simply not quantifiable. Extensive structural changes, for example, would make the historical record less useful for predicting future performance. Caution is also warranted on more general grounds: market developments are the outcome of complex interactions among financial markets and across countries, and simple explanations can cover only part of the story. Nevertheless, the data provide a common basis for comparisons.

The particularly low increases in interest rates in Japan, Germany, Austria, and the Netherlands appear to be consistent with records of lower inflation, lower inflation variability, and relatively small 1993 government deficit ratios. In Switzerland, which had the smallest increase in long-term interest rates, investors apparently were not troubled by the relatively high budget deficits, perhaps because the recent fiscal development represents a considerable departure from longer-term norms and therefore may have been perceived as temporary. In France, the somewhat higher deficit ratios than in the former group of countries may have contributed to the larger interest rate increase. Belgium is an exception, in that debt and deficit ratios are extremely high relative to other countries with comparably low interest rate increases, but this does not appear to have exacerbated the interest rate rise. By contrast, high and worsening deficit ratios, together with a recent history of relatively high and variable inflation, have been associated with particularly large interest rate increases in Finland, Spain, and Sweden. In Italy, despite recent favorable inflation performance and some improvement in the government budget balance since 1988, bond yields increased substantially—apparently reflecting the still high deficit ratio, the very large stock of government debt, and the record of higher and more variable inflation.

Strong growth prospects likely contributed to the interest rate increases in the United States, the United Kingdom, Canada, and several of the smaller industrial economies. In addition, in Canada, the negative effects of the relatively large government debt ratio appear to have outweighed the positive effects of the very low inflation outlook. In New Zealand, the extensive macroeconomic and structural reforms that have been undertaken appear to have made the record of high and variable inflation less relevant as a factor in financial market evaluations.

Major Industrial Countries: Long-Term Interest Rates1

(In percent a year)

1 Yields on government bonds with residual maturities of ten years or nearest. Weekly averages of daily data.

1 The index-linked bonds in the United Kingdom and Canada are bonds whose interest payments are tied explicity to changes in a specified price index.2 In early 1994, market participants appear to have been expecting continued easing on the part of the Bundesbank. As favorable information on economic activity emerged, this expectation was revised, and long-term interest rates rose. The role of changing expectations about policy interest rates and the consequences of these revised expectations for the portfolio positions of major investors are examined in detail in International Capital Markets: Developments, Prospects, and Policy Issues (IMF, September 1994).

At the time of the May 1994 World Economic Outlook, a source of uncertainty in the outlook for the United Kingdom was whether the tax increases that became effective in April would dampen the consumer-led recovery that began in mid-1992. Information so far has helped to allay these concerns: in the second quarter output rose at a 4 percent annual rate, reflecting healthy growth in retail sales as well as continued strength in industrial and manufacturing output. Support for the expansion has also begun to emerge from business investment. As the recoveries in continental Europe continue, external demand should provide further stimulus. On the strength of these favorable indications, the projections for growth have been revised up to 3¼ percent for 1994 and 3 percent for 1995. Underlying inflation declined more rapidly than expected in early 1994 and retail prices in August were just 2¼ percent above their level a year earlier. As the expansion continues, bringing unemployment down further and narrowing the output gap, some firming of prices is anticipated, and inflation is projected to average 3 percent in 1995.

Among the smaller European economies, recoveries have also taken hold and are gathering pace (see Table 2). Following an only moderate slowdown in 1993, growth in Ireland is expected to average about 5 percent in 1994—95, and inflation is projected to remain at 2½ percent. Output in Denmark in the first quarter of 1994 was up 5¼ percent from a year earlier, and indicators of consumer confidence have risen sharply. Growth in Belgium and the Netherlands is projected at 1½ percent and 2 percent, respectively, in 1994 and 2½ percent in 1995, with stronger export prospects compensating for slow investment in Belgium. Finland is finally emerging from an exceptionally deep recession, which led to a 13 percent cumulative decline in output between 1990 and 1993; positive growth is projected for 1994, with substantial further improvement expected in 1995, although the serious fiscal deterioration presents a risk of setbacks. Output growth in Sweden is expected to be 2½ percent in 1994, a clear improvement from the contraction in the past three years, and is mainly due to strong exports, which have benefited from the large depreciation of the krona since November 1992. The sharp rise in long-term interest rates since early 1994 could, however, pose a risk to the recovery. The economic outlook for Norway has strengthened further, with growth now projected at 4 percent in 1994, moderating to a more sustainable 3 percent in 1995. Inflation remains subdued, and unemployment is projected to continue its gradual decline. In Spain, depreciation has also boosted export performance, and overall growth is expected to pick up to 3 percent in 1995. Unemployment of almost 25 percent of the labor force may nevertheless continue to affect consumer confidence and might dampen domestic demand. Greece is the only country in Europe that is not expected to see much of a recovery in the near term. High inflation and severe fiscal imbalances have contributed to a very difficult financial situation and have resulted in very high levels of nominal and real interest rates.

In Japan, conditions for a gradual recovery now appear to be in place, and the projections for growth have been revised up slightly, to just under 1 percent in 1994 and to 2½ percent in 1995. Recent indicators have been positive: growth in the first quarter of 1994 was relatively strong, reflecting a pickup in private consumption; industrial production fluctuated somewhat but in net terms rose over the first seven months of the year; indices of coincident and leading indicators have moved upward; and the Tankan survey of current business conditions showed an improvement in May for the first time since 1989, and rose again in August. However, signs of improvement were also evident early in 1993, but they subsequently evaporated. Nevertheless, sentiment is now more positive, and further progress has been achieved in capital stock and inventory adjustment. Private consumption is expected to lead the recovery, supported in part by the income tax cuts set for the second half of the year. Although business investment remains weak, the sharp reduction in the growth of the capital stock during the recession suggests that investment should begin to recover in 1995.

The principal risks in the outlook for Japan are the high value of the yen, which, if it continues, would limit the gains from improving demand in key export markets; the burden on the financial sector from its substantial portfolio of nonperforming loans; and weak employment conditions and prospects that may restrain consumer confidence and income growth. On the positive side, fiscal policy has been able to provide considerable support for economic activity, and a high level of fiscal stimulus is expected to remain in place for 1995. Growth in Japan’s foreign markets has also strengthened considerably. Moreover, the large margins of slack and the very low rates of increase in consumer prices—which probably overstate inflation because the indices apparently are not capturing the increased practice of discounting—together with the disinflationary effects of the yen appreciation, suggest that a relatively easy stance of monetary policy can be maintained in the near term.

A broadly based, domestically driven expansion appears to be well established in the United States. Industrial production in August 1994 was 6¾ percent above levels a year earlier. Business investment, which strengthened in 1993 in response to increases in corporate profits and the low levels of interest rates, has continued to rise at a strong pace in 1994 as enterprises expanded capacity to meet current and prospective demand growth and to replenish inventories. Household spending slowed somewhat in the second quarter of 1994, following very rapid expansion in the previous two quarters, but employment growth and measures of hours worked have remained strong, and unemployment was down to 6 percent by May and remained steady through August, providing a sound basis for continued growth in private consumption. The increases in long-term interest rates from their low point in the fall of 1993 are expected to dampen investment and consumption somewhat, but this is offset by stronger contributions from employment growth and external demand, leaving the projections for growth only marginally changed from the May 1994 World Economic Outlook: 3¾ percent for 1994 and 2½ percent in 1995.

The small margins of slack in the United States, the strength of domestic demand, and the anticipated increases in external demand have raised concerns that inflationary pressures may be building. The pickup in commodity prices has added to this concern. However, there are as yet only limited indications of higher inflation. The producer price index was stable during the second quarter but rose in July and August. Although the consumer price index rose in the summer months, in August it was still just less than 3 percent above the level a year earlier. The inflation projection for 1994 has been revised down slightly in light of the lower-than-expected consumer price increases observed in April and May, but inflation is expected to edge up late in the year and to average 3½ percent in 1995.

The expansion in Canada continued at a robust pace in 1994, with exporters benefiting from strong demand in the United States and resource-based industries being lifted by the rise in commodity prices. Domestic demand also contributed to strong second-quarter growth. Growth is projected to average 4 percent in 1994 and 1995. Indicators of labor demand have shown steady improvement in recent months, and earnings growth has increased further. Unemployment declined by a full percentage point between January and August, although it is still relatively high at 10¼ percent. The 2½ percentage point increase in long-term interest rates since January is expected to restrain demand and accounts for the slight downward revision to the growth projection for 1995. Inflation has declined further than expected in recent months, reflecting in part the recent cut in tobacco taxes; consumer prices actually fell in May, and increases in June and July were small. Even with the small increase in inflation projected for 1995, Canada remains well within the range of price stability (Chart 7).

Chart 7.Major Industrial Countries: Consumer Prices1

(Annual percent change)

1Blue shaded areas indicate IMF staff projections.

Data through 1990 apply to west Germany only.

Australia and New Zealand are also expected to sustain their recent strong growth. Although Australia’s inflation rate was still low through the second quarter of 1994, inflationary pressures are projected to increase somewhat during the period ahead because of the rise in commodity prices and as slack is absorbed. However, the pre-emptive increase in interest rates by the Reserve Bank of Australia in August should help to limit the rise in prices. Substantial macroeconomic and structural reform in New Zealand, including measures to liberalize labor markets and improve wage flexibility, have contributed to a very favorable overall outlook for both prices and employment.

Trade, Exchange Rates, and Financial Markets

The U.S. current account deficit is projected to widen slightly in 1994 and then to stabilize at 2½ percent of GDP in 1995. The slight upward revision to the deficit projection for 1994 has occurred despite the weakness of the dollar against the deutsche mark and the yen, and it is consistent with the further strengthening of domestic demand. The Japanese current account surplus is projected to decline marginally relative to GDP in 1994 and then to shrink further to 2½ percent of GDP in 1995. A larger decline is already indicated in the real foreign balance, since import volume has risen considerably more than earlier projected. The current account deficit that emerged in Germany in 1991 is projected to continue its decline and to fall to ½ of 1 percent of GDP in 1995. Current account balances for France and Italy are projected to remain in surplus at 1 and 3½ percent of GDP, respectively, in 1995. In the United Kingdom, unexpectedly strong net income flows in the first quarter are reflected in a downward revision in the projected current account deficit for 1994, to 1¼ percent of GDP. In Canada, the deficit is expected to decline to just over 3 percent of GDP in 1995.4 In general, although cyclical recoveries in Europe and Japan can be expected to affect the pattern of current account positions, the underlying surplus of Japan and deficit of the United States are expected to remain significant (Box 2).

In exchange markets, the U.S. dollar has declined by 12 percent against the yen through mid-September of this year, of which 5½ percent has taken place since the beginning of June. Against the deutsche mark and the French franc, the dollar has dropped by roughly 11 percent since the beginning of the year. On a nominal effective basis, however, the U.S. dollar recorded a smaller depreciation of about 6 percent during the first eight months of 1994, in part reflecting a strengthening against the Canadian dollar (Chart 8). Meanwhile, in addition to hitting postwar highs against the U.S. dollar, the yen increased by 8 percent in nominal effective terms between January and August 1994. However, as of mid-September it was up only marginally against the deutsche mark, having depreciated by 8 percent against the German currency after hitting a temporary high in February. The deutsche mark strengthened slightly in nominal effective terms in the first eight months of 1994.

Chart 8.Major Industrial Countries: Nominal and Real Effective Exchange Rates

(Index, 1980 = 100; logarithmic scale)

Note: An increase represents an appreciation of the currency. Equal vertical distances represent equal percentage changes.

1Defined in terms of relative normalized unit labor costs in manufacturing, as estimated by the IMF’s Competitiveness Indicators System, which uses trade weights for manufactured goods averaged over the period 1989–91.

2Estimated using the same weights as those used to compute the real effective exchange rate.

The recent improvement in growth prospects for Europe and Japan has played a role in the strengthening of the yen and the deutsche mark against the dollar in recent months. Markets also appear to have expected a more substantial tightening of U.S. monetary conditions than what actually took place, and they also appear to have revised interest rate expectations in light of the pause in interest rate reductions in Germany. Trade tensions between the United States and Japan—against a background of persistent U.S. current account deficits and large Japanese surpluses—appear also to have played a role. Similarly, shifts of investor sentiment away from dollar-denominated assets and, in particular, a recent flow of capital toward investment in Japanese equities may have further contributed to the strength of the yen.

Although the U.S. currency has recently depreciated sharply against the Japanese yen, as well as against the deutsche mark and closely related currencies, from a longer-term perspective the dollar does not appear to be unusually weak. In real effective terms it is about in the middle of the range prevailing since 1990 (after the correction of the substantial overvaluation of the dollar in the early 1980s). By August, for example, the dollar in real effective terms was about 3 percent above the low levels reached in August 1992, when both short- and long-term interest rates in Europe were well above those in the United States. By mid-September 1994, the dollar was about 11 percent above its August 1992 level against the deutsche mark, and roughly 30 percent above its level vis-à-vis the pound sterling. The U.S. currency has also strengthened steadily since 1991 against the currency of its largest trading partner, the Canadian dollar. Thus, the U.S. dollar is currently well above the lows of the past several years, and it is not especially weak from this medium-term perspective.

As for the Japanese yen, the real effective exchange rate has risen sharply since end-summer 1992, briefly falling back in late 1993 as recovery failed to materialize, and then again strengthening. Much of this appreciation since 1992 has tended to be general and not merely against the dollar. Developments this year have been different, however, and the movements in the yen-dollar rate so far in 1994 mainly seem to reflect the general weakness of the U.S. currency. While the German currency has fluctuated about a fairly stable level against the dollar in the past four years, it fell sharply against the yen last year. Against European currencies, however, the deutsche mark has been relatively stable in real terms, with a moderate upward movement coming in the aftermath of the European exchange market crises of the summer and autumn of 1992.

The Italian lira strengthened by 8 percent against the dollar between January and mid-September, although in nominal effective terms in August it was down 1½ percent from its level in January. Similarly, the pound sterling has also strengthened against the dollar but, with a weakening against the deutsche mark, the U.K. currency was down by 4½ percent in nominal effective terms in the first eight months of 1994.

Among the smaller industrial countries, the Australian dollar has strengthened against the U.S. dollar by 7½ percent since the beginning of the year. The Swedish krona depreciated by 7 percent against the deutsche mark between late January and mid-September, although in nominal effective terms the krona was down just 3 percent through August 1994. The Finnish markka and Norwegian krone have also declined against the deutsche mark since late January, by 1 percent and 2¼ percent by mid-September, respectively. In nominal effective terms, however, the markka rose by 3 percent in the first eight months of the year, and the Norwegian currency was up 2 percent.

The positive effects on stock markets from the growing signs of recovery have been counterbalanced by the impact of rising long-term interest rates. Thus, in three of the four major European equity markets, prices have declined from their mid-May peaks; by mid-September, stock market indices were down 5 percent in Germany, 10 percent in France, and an even sharper 20 percent in Italy (partially reversing large earlier gains). Relative to the beginning of the year, however, equity prices in Italy were still up by about 4 percent. Stock prices in Japan also rose considerably in the first half of the year, and, notwithstanding subsequent declines, prices in mid-September were still almost 15 percent above their level at the end of 1993. Although large declines in equity prices in the United Kingdom in the first half of the year have been partially reversed, prices in mid-September were still down by 8 percent since the beginning of the year. Equity prices in the United States have recovered the ground lost in the first months of the year, and by mid-September they were slightly above their end-1993 level.

Developing Countries

Short-Term Prospects and Risks

The projections for average growth in developing countries in 1994–95 are little changed from those of the May 1994 World Economic Outlook, but there have been significant changes in the underlying projections for individual countries. Large downward revisions in a few major economies have counterbalanced smaller but more widespread upward revisions, which reflect the effects of the resumption of growth in many industrial countries and the recent rebound in commodity prices. The expected moderate strengthening of growth in Africa and a mild slowdown in the other regions suggest a narrowing of the substantial growth disparities among the developing country regions that characterized the early 1990s (Chart 9).

Chart 9.Developing Countries: Real GDP1

(Annual percent change)

1Blue shaded area indicates IMF staff projections.

Box 2.Cyclically Adjusted Trade Balances

The nonsynchronous nature of recent business cycles in the industrial countries has been reflected in transitory movements in trade balances. Abstracting from other factors affecting trade, the cyclical changes in demand would have tended to improve the trade balances of countries such as the United States, the United Kingdom, and Canada—which went into recession first, in 1990–91—because of weak import demand and largely unchanged export demand; by the same token, the trade accounts of countries not in recession at that time would have tended to deteriorate. Subsequently, as Japan and much of continental Europe entered recession in 1992–93, their external account balances would have tended to improve because of cyclical declines in imports and the boost to exports from the recoveries under way in North America and the United Kingdom.

The results reported below provide an indication of the potential magnitude of these kinds of cyclical effects on trade. The cyclically adjusted trade balances are based on calculations of what trade would be if countries’ actual output were equal to potential output. As such, they are analogous to estimates of structural budget balances. For simplicity, the calculations focus on the impact of economic activity and ignore possible cyclical repercussions through real exchange rates, inflation, and interest rates. In principle, the calculations should allow for a gap between actual and potential output in all countries. The estimates reported below, however, only adjust for the output gap in the industrial countries; output of the developing countries as a group is implicitly assumed to be at potential. Consequently, the only impact on developing countries’ trade balance is through their exports to industrial countries.

In 1994, actual output is projected to be below potential by 2 to 6 percent in all of the major industrial countries except the United States, and by 2 percent in the smaller industrial countries as a group.1 Output in the United States is estimated to be marginally above potential in 1994. The impact of the cycle on each country’s imports was calculated using the increase in output required to bring the country to potential, and the short-run import elasticity of demand for imports in the MULTIMOD model. These import elasticities average 1.8 for the major industrial countries and 2.1 for the smaller industrial countries.2 The impact on each country’s exports was then calculated using bilateral merchandise trade shares and the change in partner countries’ imports.

The calculations suggest that in 1994 the cyclical effects on trade balances are generally small (see table). Because the United States is close to potential, there is little impact on imports. However, the increase in output needed to reach potential in all other industrial countries raises U.S. exports, improving the trade balance by about $20 billion, or ¼ of 1 percent of GDP. In general, those countries with a relatively high proportion of exports going to the United States show comparatively little improvement in exports, and those countries with the largest estimated output gaps show the largest adjustments in imports.

These illustrative calculations should, of course, be interpreted with caution. The calculations do not allow for indirect effects and, as noted, they exclude the effects of recovery on, for example, real exchange rates and inflation. To judge the cyclical impact on current accounts, rather than just on the trade balance, it would also be necessary to calculate the cyclical adjustments to services and factor payments.

Cyclically Adjusted Trade Balances, 1994
Cyclical Effects on:Cyclical Effects on Trade BalanceActual BalanceCyclically Adjusted Balance
ExportsImportsTrade balance
In billions of U.S. dollarsIn percent of GDP
United States18.4-1.720.20.3-2.5-2.2
United Kingdom5.912.3-6.4-0.6-2.1-2.7
Smaller industrial countries26.653.0-26.4-1.01.0
Developing countries52.652.61.1-0.70.4
1 Estimates of the output gap are reported in Box 5 in Chapter III.2 These are the import elasticities for manufactures, trade, and tourism.

Average growth in the developing countries of the Western Hemisphere is projected to slow to 2¾ percent in 1994, with weaker-than-expected growth in Mexico and increased difficulties in Venezuela offset by upward revisions to the projections for Argentina and Brazil (Table 3). On July 1, 1994, Brazil implemented the third and final stage of a stabilization plan with the introduction of a new currency, the real, whose exchange value has, as its lower bound, parity with the U.S. dollar. The new monetary arrangement, supported by adjustments in financial policies and the elimination of backward-looking indexation, is intended to bring inflation down sharply in the second half of the year. Growth for the year is projected at 3 percent. The growth projections for Argentina have been revised up to 6 percent in 1994, with domestic demand—mainly investment—expanding more strongly than expected; inflation is projected to continue its declining trend, however, averaging 3½ percent in 1994 as a whole. Peru’s economic performance is expected to continue to improve sharply, following a particularly strong recovery of investment and activity across sectors in 1993. The recovery of activity in Mexico has been moderate because of higher-than-expected real interest rates and the uncertainties associated with an election year. Larger output increases are projected for 1995 as aggregate demand—in particular private investment—expands. In Venezuela, inflation has risen substantially, and the fiscal imbalance is large. A crisis in the financial sector has prompted a substantial injection of liquidity, and there has been a large loss of net foreign reserves. In July 1994, exchange controls were introduced, and price controls intensified. Under these difficult conditions, output is projected to contract.

Table 3.Selected Developing Countries: Real GDP and Consumer Prices(Annual percent change)
Real GDPConsumer Prices
Developing countries5.96.15.638.746.247.5
Cote d’lvoire-
South Africa-
SAF/ESAF countries1-
Taiwan Province of China6.
Middle East and Europe7.04.81.424.224.727.0
Iran, Islamic Republic of4.
Saudi Arabia2.20.50.3-
Western Hemisphere2.53.42.8165.8236.4244.8

African countries that had arrangements, as of end-1993, under the IMF’s structural adjustment facility (SAF) or enhanced structural adjustment facility (ESAF).

During the first six months of 1994, consumer prices in Brazil rose by 763 percent. Following the introduction of the real on July 1, 1994, monthly inflation fell to 5.5 percent in July and 3.3 percent in August 1994.

African countries that had arrangements, as of end-1993, under the IMF’s structural adjustment facility (SAF) or enhanced structural adjustment facility (ESAF).

During the first six months of 1994, consumer prices in Brazil rose by 763 percent. Following the introduction of the real on July 1, 1994, monthly inflation fell to 5.5 percent in July and 3.3 percent in August 1994.

Capital inflows have been an important feature in recent developments in Asia. Growth for the region as a whole is projected to decline slightly in 1994, primarily because of an expected moderation of the expansion to a more sustainable pace in China. Renewed efforts since late 1993 to reduce overheating in China should help to contain inflation, while growth is projected to slow to 11 percent in 1994—compared with over 13 percent in the two previous years. Inflows of foreign direct investment have declined but remain large. Capital inflows have also remained significant in India, where there are signs of some modest recovery in domestic investment, compensating for a moderate slowdown in export growth. Activity recovered further in Korea in the first half of 1994, and the economy is approaching full employment; inflation has edged up and is now projected at 6 percent for 1994. Rapid growth in exports has been an important factor in the Philippines, contributing to stronger projected growth in 1994 and 1995. Inflation accelerated early in 1994 as demand pressures built up, but it is expected to ease as financial restraint takes effect. Buoyant domestic demand in Indonesia is projected to maintain growth at 6½ percent in 1994, and inflation is expected to continue to decline gradually. Strong export performance and a further strengthening of domestic demand in Thailand are also contributing to an increase in projected growth.

Growth for the Middle East and Europe region as a whole is projected to decline further in 1994, to 1½ percent, but then to recover to 2½ percent in 1995. Growth prospects for the oil exporting Middle Eastern economies remain closely tied to developments in the oil market. The sharp rise in oil prices through July reversed some of the large decline in late 1993, but prices are still well below levels in the first half of the 1980s. Moreover, the improvement in the oil exporters’ terms of trade was moderated by the depreciation of the U.S. dollar and the rise in non-oil commodity prices. Persistent financial imbalances are also obstacles to stronger growth in several large countries in the region. Economic activity in Egypt rose moderately in 1993; with continued structural reforms and improvements in competitiveness, growth is expected to strengthen further in 1994. Growth in the Islamic Republic of Iran is expected to decelerate somewhat in 1994, partly due to continued low imports, but to begin to recover in 1995–96, reflecting in part increased availability of foreign financing as the country pursues efforts to normalize its relations with external creditors. Growth in Saudi Arabia is projected to weaken marginally further in 1994, but then to increase somewhat in 1995. Economic and financial conditions in Turkey deteriorated sharply in the first half of 1994, with high inflation, a large fiscal deficit, and external imbalances contributing to a significant exchange rate depreciation and the downgrading of government debt in world markets. The adoption of a stabilization program in mid-1994 should allow growth to resume in 1995—96.

Box 3.Exchange Market Reforms in Africa

Until a few years ago, African countries tended to react to difficulties in their balance of payments and to scarcity of foreign exchange by tightening exchange and trade restrictions. These restrictions led to the diversion of transactions to the parallel market and the emergence of a large premium in that market; a weakening of balance of payments performance, with a virtual depletion of official foreign exchange reserves; and an increase in relative price distortions. In recent years, however, a rapidly growing number of African countries have realized that the imposition of restrictions impedes economic growth and the return of financial viability. A strong trend has emerged, characterized by a move toward more open exchange systems, in which the exchange rate has become market-determined in floating interbank or auction markets. Major steps have been taken in the liberalization of exchange systems by countries as diverse as Kenya, Madagascar, Malawi, Tanzania, Uganda, and Zimbabwe.

In Kenya, the exchange system was unified in October 1993, in conjunction with the abolition of the official exchange rate, which had previously been pegged to a basket of currencies. Since then, the unified exchange rate has been determined freely in the interbank market. In addition, the system allowing exporters to retain 50 percent of their export proceeds was broadened to 100 percent in February 1994. All controls on imports were removed in May 1993; controls on capital movements, except for inward investment in securities, were removed in several steps ending in May 1994.

Madagascar adopted a sweeping reform of the exchange and trade system in early May 1994. The 40 percent surrender requirement for export proceeds was eliminated, most import prohibitions were removed, and virtually all current transactions were freed in the foreign exchange market. In addition, residents as well as nonresidents were granted full freedom to open foreign exchange accounts. The currency now floats freely, and the exchange rate is determined by supply and demand in an interbank exchange market. As a result of the new policy, the Malagasy franc had depreciated by about 50 percent in foreign currency terms by end-August 1994.

A new exchange system was introduced in Malawi in February 1994, with market determination of the exchange rate; the exchange system is now unified. As part of the system, the Reserve Bank of Malawi holds weekly foreign exchange auctions; between auctions, transactions are conducted daily by authorized dealers and brokers, and in the bureaux de change. In addition, exchange regulations were liberalized, since orders and payments for imports of goods and most services are no longer subject to central bank prior approval, and the foreign exchange surrender requirement was abolished except for 10 percent of tobacco, tea, and sugar export earnings. As a result, Malawi’s real effective exchange rate declined by 17 percent during the six-month period following the reform.

In Tanzania, the Bank of Tanzania has been conducting weekly foreign exchange auctions since July 1993. In June 1994, the authorities introduced an interbank foreign exchange market, where the official exchange rate is now determined. Concurrently, the exchange and trade system was liberalized and, following the establishment of foreign exchange bureaus in 1992, the surrender requirements on nontraditional and traditional exports (except coffee) were abolished in July 1993 and June 1994, respectively. In services, the limits on travel allowances were raised, and those on medical services, education, and profit remittances were eliminated altogether.

In recent years Uganda has gradually unified its foreign exchange markets, thereby eliminating the existing large spreads between official and parallel exchange rates. In 1990, a foreign exchange bureau market was established, and the differential between the official and bureau rates was progressively reduced in tandem with the gradual phasing out of the foreign exchange surrender requirement for noncoffee exporters. In March 1992, the average bureau exchange rate was adopted as the official exchange rate, and in November 1993 all restrictions on current international transactions were eliminated and an interbank market in foreign exchange was introduced. Since then, the spread between the bureau and interbank rates has been about 1 percent.

In January 1994, Zimbabwe increased the retention rate on export earnings from 50 percent to 60 percent, and exporters were allowed to keep their export proceeds in foreign currency accounts. At the same time, the official exchange rate was devalued by 17 percent. In July 1994, the export retention rate was increased from 60 to 100 percent. Between January and June 1994, the differential between the official and interbank market exchange rates declined from 5 percent to less than 1 percent. In July 1994, the two exchange markets were unified, and full export retention was permitted. Since then, all foreign exchange transactions have been conducted at market-determined exchange rates.

The move toward liberalization of exchange systems in Africa is reflected in the growing number of countries that have removed restrictions on current account transactions and have accepted the obligations of Article VIII, Sections 2, 3, and 4 of the IMF’s Articles of Agreement—that is, have established current account convertibility (see Box 7 in Chapter IV). Since January 1993, five sub-Saharan African countries—The Gambia, Ghana, Kenya, Mauritius, and Uganda—have accepted these obligations, and other African countries are expected to follow in the near future. In addition to the countries discussed above, a number of other African countries have also made significant progress in liberalizing their exchange systems. In Angola, Ethiopia, and Sierra Leone, the exchange system was recently unified, or virtually unified. In Zambia, following the suspension of the Exchange Control Act in January 1994, foreign exchange transactions are now essentially unregulated. In Mauritius, the Minister of Finance has recently announced the elimination of remaining controls on capital transactions.

To be successful, the liberalization of exchange systems requires that the removal of exchange controls and the introduction of a market-related exchange rate be accompanied by sufficiently strong macroeconomic policies. It also requires that the reforms be implemented in a steadfast manner, so as to provide appropriate incentives to the private sector and to restore confidence.

The short-term outlook for Africa continues to show signs of improvement—a welcome development following a decade in which growth has averaged just 2 percent. The recent pickup of commodity prices and the recovery of demand in industrial country export markets are positive factors for the region. Broad moves toward exchange market liberalization in many African countries have also created opportunities for stronger economic performance (Box 3). Conditional on continued implementation of structural reforms and stabilization programs, average growth on the continent is projected to rise above 3 percent in 1994. Output growth in South Africa is projected to pick up to over 3 percent in 1994, as both exports and domestic demand—particularly investment—expand in an environment of increased stability and confidence. Rapid growth of public expenditure may also boost activity in the short run, but it poses a challenge to the maintenance of financial stability in the long run. A substantial increase in growth is projected for Morocco, as production recovers from the two-year drought and export demand from Europe accelerates. For Algeria, the recovery of oil prices and trade liberalization—which has increased the availability of intermediate inputs—contributed to an upward revision of 1994 growth projections, although the continuation of drought conditions poses a risk for the outlook. Inflation is expected to decline over the course of the year, although the 40 percent devaluation early in 1994 will keep average price increases high for the year. Financial and policy imbalances in Nigeria have adversely affected activity and prospects. The countries of the CFA franc zone continue to adjust to the devaluation in January, with support from multilateral and bilateral donors. Price adjustments have contributed to substantial jumps in consumer prices, but inflation has been slowing quickly because of the accompanying stabilization efforts. Improved exports and investment opportunities should support stronger growth, and signs of a rebound in the tradable goods sector are already emerging in several countries. The overall outlook among African countries that had arrangements at end-1993 under the IMF’s structural adjustment facility (SAF) or enhanced structural adjustment facility (ESAF) has remained broadly unchanged since the May 1994 World Economic Outlook. Growth in these countries is projected to average 5 percent in 1994—95, and inflation is expected to decline marginally in 1994 and then more substantially in 1995, to 8¾ percent.

Foreign Exchange and Financial Markets

As regards exchange market developments in the larger developing countries, the Brazilian currency was roughly constant in real effective terms in the first half of 1994, following a real effective appreciation of 12 percent in 1993. Brazil introduced a new currency, the real, together with supporting policies on July 1, 1994, and in its first weeks the currency appreciated in real terms. In the first eight months of 1994 the exchange rate depreciated in Mexico, by nearly 10 percent, partly as a result of political uncertainties. In Venezuela, the currency depreciated sharply in the first half of the year because of the financial crisis and capital outflows. Exchange controls were introduced in July, and the exchange rate subsequently strengthened against the dollar. The Chinese yuan fell significantly in January, after the unification of exchange markets, but firmed later in the year against the dollar following supportive interventions by the People’s Bank of China. The Indian rupee was stable during the first half of 1994, helped by central bank interventions, rising foreign currency reserves, foreign investment in equities, and a shrinking trade deficit. Pressure on the Turkish lira eased somewhat after large depreciations earlier in the year due to high inflation and uncertainty over domestic fiscal developments. In the Islamic Republic of Iran, the exchange rate unification undertaken in 1993 was partially reversed, and a dual exchange rate system was introduced in May 1994 after the emergence of a wide gap between the fixed official rate and the free market rate. As noted above, there have been far-reaching changes in exchange systems in Africa during the past two to three years (see Box 3). In Kenya, Madagascar, Malawi, Tanzania, Uganda, and Zimbabwe, notably, considerable progress has been made in removing restrictions on current and capital transactions, with the result that official rates have been unified and spreads with parallel market rates have either been eliminated or sharply reduced. However, in Nigeria a significant effective revaluation of the currency took place earlier this year as the free exchange rate in the foreign exchange bureaus was abolished and all transactions were channeled through the official fixed exchange rate market.

Following strong performances during 1993, many emerging stock markets experienced declines in the first half of 1994. The rise in long-term bond yields in industrial countries and political and financial uncertainties in some large developing countries appear to have contributed to the fall (Box 4). The International Finance Corporation (IFC) investable index for emerging markets fell by 15 percent in dollar terms in the first half of 1994, after rising by over 70 percent in 1993, with a significant share of the decline occurring in March. However, the general declines experienced in the emerging markets in the early part of 1994 were at least partially reversed in many countries by August. The largest first-quarter fall was in Turkey, where the IFC index declined by 55 percent, reflecting adverse financial conditions and the downgrading of Turkey’s debt by U.S. credit-rating agencies, although prices regained some ground by the third quarter. Equity prices in China declined by over 30 percent in the first quarter of 1994, which was in line with, although sharper than, movements in other markets in the region. The stock market in China rallied temporarily in May but has not risen further since. Prices also declined sharply in Malaysia and, at least initially, in Thailand, following massive gains during 1993. In contrast, south Asian markets benefited from heavy purchases by institutional investors early in the year. Equity prices in Mexico have been volatile in 1994, as is characteristic of emerging equity markets. After declining 13 percent in the first quarter, the Mexican stock market recovered in May, but then fell again. Substantial gains since mid-July have reversed almost all of the earlier 1994 losses. In Argentina stock prices fell by over 10 percent in the first quarter of 1994, recovered in May, but fell again later in the year before recovering in August. Significant gains were registered in Colombia, where activity by foreign buyers increased considerably; in Brazil, because of favorable reactions to the stabilization program; and in Peru, helped by the privatization process.

Box 4.Emerging Markets

From 1989 to 1993, equity prices in emerging markets increased substantially, exceeding the price increases in industrial country markets by significant margins.1 Since the beginning of 1994, however, equity prices in the emerging markets have declined sharply. The International Finance Corporation (IFC) index of equity prices, based on the 24 largest emerging markets, declined by nearly 9 percent in U.S. dollar terms during the first six months of 1994. The IFC investable index, which takes account of legal restrictions on foreign portfolio investment and capital flows, declined by over 15 percent, falling by nearly 40 percent in the Middle East and Europe region, 17 percent in Asia, and 10 percent in Latin America (see chart). In individual markets, the sharpest declines were in China, Turkey, Poland, and Venezuela, where equity prices fell by 30 percent or more, followed by Argentina, Mexico, Indonesia, Malaysia, and Thailand, where they declined by 15 to 30 percent. The main exceptions to the downward trend were Chile, Colombia, Peru, and Zimbabwe, where prices increased by 15 percent or more, and India and Korea, with price increases of around 10 percent.

The first half of 1994 has also witnessed a marked turnaround in the prices of emerging market debt. There had been a sharp rally in sovereign debt in 1993, when total returns on Brady bonds—sovereign debt backed in part by U.S. treasury bonds, the most liquid of emerging-market bonds—exceeded 44 percent. Since the beginning of this year, however, prices have declined sharply, with Brady-bond prices falling by nearly 15 percent in the first quarter alone. Mexican Brady bonds, which had been trading at a yield of about 150 basis points over that on thirty-year U.S. treasury bonds, moved to a spread of 230 basis points over U.S. bonds. Similarly, the spread of Argentinean Brady bonds over U.S. bonds widened from 220 to 320 basis points. Other countries that have not yet arranged a Brady deal with their creditors also saw the price of their debt decline. Peru’s debt, for example, fell from 75 percent of face value to 55–60 percent, and Panama’s from 75 percent of face value to 65 percent.

In general, changes in the external environment appear to account for most of the recent declines in emerging equity and bond prices.2 The recent strengthening of growth prospects for the industrial countries had the initial effect of raising expectations of corporate earnings, which may have diverted some funds from the increasingly expensive emerging markets. Enhanced growth prospects were also accompanied by a sharp increase in bond yields across industrial countries in the face of both current and expected increases in credit demand. Whereas the unusually low interest rates prevailing in the United States and some other countries had attracted investors to the high yields available in emerging markets in both fixed-return and equity investments, rising long-term interest rates throughout the industrial countries have been instrumental in reversing this trend (see Chart 17 in Chapter IV). At the same time, the increase in interest rates in the industrial countries may have had a tendency to heighten investor concern and to raise premiums for liquidity and asset quality. Because nearly three-fourths of fixed-income securities issued by developing countries in the international bond market are denominated in U.S. dollars, the recent weakness of the dollar may have further aggravated price declines in these markets.

Emerging Markets: Stock and Bond Prices

(In U.S. dollars; indices, December 1991=100)

Sources: For equity prices, International Finance Corporation; for Eurobond prices, Reuters, J.P. Morgan, and Wall Street Journal.

Several country-specific factors have also contributed to the price declines.

  • In China, the decline in equity prices, which started about mid-1993, followed a strong bull run and coincided with the adoption of a stabilization program that led to a tightening of credit policy and higher interest rates.
  • In Turkey, the currency turmoil in the first quarter of the year was reflected in a loss of confidence in the stock market, which was compounded by increasing fears of inflation, economic stagnation, and disappointing first-quarter financial results.
  • In Venezuela, there has been increasing uncertainty about economic prospects, starting with the collapse of a major commercial bank in January and its subsequent bailing out, with significant budgetary costs to the government; investor confidence may also have been shaken by the reversal of many market-oriented policies adopted in recent years and by plans to introduce exchange and price controls.

In addition to country-specific factors, there may also have been concern that the marked increases in equity prices in many developing countries, which raised price-earning ratios in several emerging markets by 50 percent or more during the second half of 1993,3 could have been the result of speculative bubbles, and that these markets therefore were vulnerable to changes in market sentiment.

1 See Box 4 in the May 1994 World Economic Outlook, pp. 26–27.2 See Robert A. Feldman and Manmohan S. Kumar, “Emerging Equity Markets: Growth, Benefits, and Policy Concerns,” IMF Paper on Policy Analysis and Assessment 94/7 (March 1994); and Box 4 in the May 1994 World Economic Outlook for a discussion of the domestic factors—such as a stable macroeconomic environment, structural reforms, and regulatory changes—that had tended to boost prices over the preceding years, and many of which continue to be a positive force.3 See IFC Facebook 1994 (Washington).

External Payments, Financing, and Debt

The counterpart to the surges in capital flows to developing countries in recent years has been a sharp increase in current account deficits in most regions, although many countries have also seen a substantial buildup of foreign exchange reserves (Chart 10). The extent to which these larger deficits reflect increases in consumption or in investment varies considerably across countries and regions, although in Asia the pattern has tended to be more in favor of investment, compared with other regions. The increases in reserves have been particularly large in Asia and in the Western Hemisphere. Capital inflows have also been concentrated in these two regions.5 Foreign direct investment and a competitive exchange rate have raised export growth in China, where the current account deficit is expected to decline to just below 1 percent of GDP in 1994–95. India’s current account deficit has narrowed considerably in the past several years, and it is projected to remain relatively small as a ratio to GDP in the period ahead. Significant foreign investment in Latin America has eased financial constraints on imports and has contributed to a widening of current account deficits since 1990—particularly in Mexico, where the deficit as a percent of GDP was 3¼ percent in 1990 and is expected to be almost 6½ percent in 1994. Capital inflows also contributed to the appreciation of real exchange rates in a number of countries, and this has exacerbated the tendency for external positions to deteriorate. African countries have attracted very little private capital and rely much more heavily than other developing countries on official transfers as a source of external financing. However, the recent increases in commodity prices may contribute to some improvement in their export earnings. Relatively large current account deficits are expected in Cameroon and Cote d’Ivoire in 1994, but these are projected to narrow considerably by 1995. The devaluation of the CFA franc in January 1994 has improved the external competitiveness of the countries of the franc zone and should also help to ease external financing constraints and to reduce debt-to-export ratios. In the Middle East, Kuwait’s current account balance is projected to move into surplus in 1994–95, from a position of small deficit in 1993. The large surpluses prevailing in Egypt in the early 1990s are expected to decline considerably in 1994–95, reflecting in part a real appreciation of the currency.

Chart 10.Developing Countries: Balances on Current Account and Reserves1

1Blue shaded areas indicate IMF staff projections.

The increase in long-term interest rates since early 1994 poses a risk for developing countries with substantial debt burdens. The consequences for individual indebted countries will vary, depending on how rapidly or slowly any changes in long-term rates are passed through to debt-service payments. The still relatively low level of short-term interest rates may provide some relief. Nevertheless, the intention—announced at the Summit of the major industrial countries in July—to go further in relieving the debt burdens of the poorest countries is of even greater importance in the new environment. Debt and debt-service ratios for developing countries in the Western Hemisphere remain well above the developing country average, although these ratios have declined considerably from the peak reached in the mid-1980s (Chart 11). Average debt ratios in Africa have remained steady at the high levels of the 1980s, although the disparity among parts of the continent has widened. By 1993, the ratio of debt to exports in sub-Saharan Africa was three times the developing country average, and only modest improvements are projected for 1994–95. In further contrast to other regions, debt-service ratios in sub-Saharan Africa are projected to continue to rise through 1995, despite debt-relief efforts. Debt ratios in Asia and in the Middle East and Europe region are considerably lower than elsewhere, although the ratios in these regions have also shown only marginal net improvement during the past four years.

Chart 11.Developing Countries: External Debt and Debt Service1

(In percent of exports of goods and services)

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

Since the last World Economic Outlook, progress has been made on several important commercial bank debt-restructuring agreements. Brazil, Bulgaria, and the Dominican Republic completed debt- and debt-service-reduction operations in April, June, and September 1994, respectively. Zambia concluded a debt buyback agreement under the aegis of a World Bank program to clear the bank debt of the world’s poorest countries. Bolivia completed a $31 million debt-for-aid swap organized by the Debt for Development Coalition. In August 1994, the Islamic Republic of Iran rescheduled $8 billion of short-term commercial bank debt, and Saudi Arabia obtained partial agreement on a two-year deferral of repayment on commercial bank balance of payments loans. In March 1994, Poland reached agreement in principle with its creditors to restructure $13 billion in debt to foreign commercial banks; this deal is expected to be concluded in November 1994. Ecuador announced agreement in principle on a debt package with its bank creditors in May 1994, with the conclusion of the deal expected in December 1994, Commercial bank debt negotiations on behalf of Vietnam, Cote d’Ivoire, Panama, and Peru are continuing or are planned. London Club discussions have been held with Croatia and Slovenia. The distribution of the commercial bank debt of the former Yugoslavia among the successor states is a major issue to be resolved.

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