- International Monetary Fund. Research Dept.
- Published Date:
- February 1995
A year ago, the IMF Interim Committee adopted a “Declaration on Cooperation for Sustained Global Expansion.”1 This statement was prompted by the severe economic slowdown since 1990 and the risk of a further deepening of the recession in many industrial countries, and by a recognition of the need to face these challenges in a global and cooperative framework. Since then, there has been considerable progress in implementing the agenda set out in the Declaration: the Uruguay Round of multilateral trade negotiations has been concluded; programs of fiscal consolidation have been announced in several key countries; European interest rates have fallen, and tensions in the European Monetary System (EMS) have abated; Japan has taken further measures to support its economy; further progress toward stabilization and reform has allowed robust growth to be sustained in many developing countries, especially in Asia and Latin America; the IMF’s new systemic transformation facility (STF) has been used to support the reform and recovery process in several of the countries in transition; and the IMF’s concessional facility for low-income countries (ESAF) has been expanded and extended.
The conclusion of the Uruguay Round is particularly significant and will considerably enhance trading opportunities for all countries. The agreement will give new impetus to world trade in both manufactures and services and should begin to reduce the serious distortions affecting agricultural production and trade, particularly in many industrial countries. In addition to reductions of tariff and non-tariff barriers, multilateral trade rules will be strengthened and extended to new areas. The creation of the World Trade Organization strengthens the institutional basis for trade relations among countries and will help to sustain the achievements of the Uruguay Round and provide a forum for future multilateral trade negotiations. Estimates indicate that the agreement over time should boost the level of world trade by 10 percent and raise world income by $250 billion a year as a result of efficiency gains, and these estimates may be on the conservative side. Such global welfare benefits will materialize gradually as the main elements of the agreements are phased in, but the successful conclusion of the Round has also removed a major down-side risk to the near-term outlook and is helping to bolster business and consumer confidence world-wide. The favorable effects on confidence would be enhanced by a quick resolution of outstanding issues and by an early ratification of the agreement.2
The many positive developments during the past year should permit a gradual strengthening of world activity and world trade in 1994-95 (Chart 1). At the same time, rates of inflation are projected to decline further or to remain broadly unchanged at present levels, which for many countries are the lowest experienced since the early 1960s. Stronger growth momentum, although varying from country to country, is already evident in the United States, Canada, the United Kingdom, Ireland, Australia, New Zealand, and the Nordic countries. There are also distinct and welcome signs of recovery in several of the transition economies of central Europe, and in the Baltic countries.
Chart 1.World Indicators1
1 Blue shaded areas indicate IMF Staff projections.
2 Excluding trade among countries of the former Soviet Union and the Baltic states.
Nevertheless, with the exception of the United States, margins of slack in the industrial countries remain large, and indications of a turnaround are still tentative in many cases. In Japan, there are signs of an improvement in confidence, due in part to the recent additional policy actions, but the fragility of the projected recovery continues to be of concern, as underlined by a significant downward revision of the growth projection for 1994. In much of Europe, the prospective recoveries may not gather sufficient momentum to begin to reduce the level of unemployment until well into 1995. Moreover, rigidities in European labor markets risk leading to a further ratcheting up of already high rates of structural unemployment, which would limit the scope for fully reversing the recent rise in cyclical unemployment. The outlook for most of the former Soviet Union is still particularly uncertain, in part because of delays in implementing coherent stabilization policies and structural reforms in many countries. Much also remains to be done to improve economic conditions in many of the poorest countries, especially in Africa, although the devaluation of the CFA franc in mid-January, and the supporting measures that are now being taken by the member countries of the franc zone, should greatly facilitate the resumption of economic growth.
It is important now to build on the achievements of the past year by addressing the remaining impediments to a strong and durable recovery and by ensuring that the expansion will spread to the largest possible number of countries. The emphasis should remain on cooperative solutions that resist protectionist forces and foster greater confidence among consumers and investors. Policy requirements to achieve these objectives, and hence to complete the agenda set out in the Interim Committee’s Declaration of April 1993, are reviewed below.
The immediate priority for economic policy in the industrial countries is to further improve conditions for a robust recovery without jeopardizing longer-term growth and price stability, while also proceeding with critical structural reforms that will enhance longer-term growth. These objectives are common to all countries. However, differences in cyclical positions and in the degree of macroeconomic imbalances imply significantly different policy requirements from country to country.
In the case of fiscal policy, in countries where budget deficits are unsustainable—either because of lack of progress during the past decade or because of recent slippages—both medium-term considerations and the risk of short-run adverse spillovers to financial markets generally preclude fiscal expansion as a means of promoting stronger growth. Fiscal policy can best contribute to recovery in these circumstances by reducing uncertainty about future actions through the adoption of specific programs of medium-term fiscal consolidation. In several countries, including the United States, Germany, and the United Kingdom, such programs contributed—together with subdued inflation—to the marked reduction of long-term interest rates that took place in 1993. With the benefit of hindsight, however, part of the decline in long rates in 1993 may have been related to the taking of positions by financial investors in anticipation of significant further declines in European interest rates.
Although it may be difficult to front-load the necessary fiscal adjustments at a time of cyclical weakness, the pace of consolidation must be sufficiently rapid and sustained to reassure financial markets of the authorities’ commitment to eliminate budgetary imbalances. Care must also be taken to pursue sufficiently ambitious medium-term fiscal targets in order to restore the sustainability of the public sector’s financial position and to ensure an adequate contribution of the public sector to national saving, particularly in view of the longer-term need to prepare for the aging of populations. In many industrial countries, however, current deficit-reduction plans do not meet such medium- and long-run objectives, even allowing for the favorable effects of recovery. Further substantial reductions in structural budget deficits will therefore be necessary over the medium term, and in some countries it will be appropriate to bring the budget position into surplus. Consolidation efforts should seek to limit recourse to increases in already heavy lax burdens by reducing subsidies and other outlays that impede the efficient functioning of markets and distort international competition, and by increasing the efficiency of government expenditure programs.
During the previous global slowdown of 1980-82, monetary policy faced a dilemma similar to that confronting fiscal policy today in most countries: an easing of monetary conditions to promote recovery would have exacerbated already serious policy imbalances, with detrimental consequences for inflation, financial stability, and medium-term growth. At that time, the industrial countries determined that ensuring medium-term price stability was the primary objective of monetary policy. The subsequent reduction of inflation to levels not seen for almost three decades stands out as a remarkable achievement.
In the current cycle, the monetary authorities in many countries, having enhanced the credibility of their commitment to reasonable price stability, have had greater scope to lower official interest rates to alleviate recessionary forces. Financial markets have clearly fell that the marked reduction of short-term interest rates has been appropriate, as suggested by the declines in long-term rates during 1993 to the lowest levels in twenty years or longer in many cases. The sentiment among market participants that there was both need and scope for significant reductions in interest rates also played a role during the successive crises in European exchange markets in 1992-93.3
The increase in long-term interest rates across a number of industrial countries in early 1994 does not seem to represent a sudden loss of hard-won credibility. In the United States, stronger-than-expected growth in the recent past may have led to an increase in real rates, as well as expectations of somewhat stronger price increases than otherwise; provided that monetary conditions are now allowed to tighten sufficiently, fears of a rise in inflation should abate, alleviating pressure on long-term rates. In Japan and Europe, where the balance of evidence points in the direction of continued low inflation and a slow recovery, the recent rise in long-term interest rates may reflect the effect of higher long-term rates in the United States, various country-specific factors, and the sudden unwinding of positions in futures markets for long-term instruments. The slowing in the pace of monetary easing in Germany may have contributed to this unwinding.
To emphasize their commitment to price stability, a number of central banks have announced explicit targets for inflation as anchors for monetary policy. This development has been motivated in part by the instability of relationships between money supply and aggregate demand, which has undermined the usefulness of monetary aggregates as intermediate targets in many countries. For many European countries, a close link to the deutsche mark had provided a valuable anchor for the process of disinflation, but since the EMS crisis some countries that opted to float their currencies have felt the need for a new anchor better suited to their circumstances.
An explicit inflation target, used in combination with a range of indicators of financial conditions and inflationary pressures, can allow the monetary authorities to maintain a medium-term orientation for monetary policy in the absence of reliable intermediate monetary targets. However, given the inevitable degree of judgment and discretion involved, it also puts greater responsibility on the authorities to prevent a ratcheting up of inflation of the sort that occurred in the 1960s and 1970s. The credibility of inflation targeting may be increased by a record of success in controlling inflation, fiscal and structural policies that are consistent with medium-term inflation objectives, and central bank independence.
Setting monetary conditions in the context of an inflation target needs to lake into account the relatively long lags between changes in monetary conditions and inflation performance. Forecasting price developments several years ahead is obviously subject to significant margins of uncertainty. It also may be difficult to obtain public understanding of the need to raise interest rates in anticipation of future inflationary pressures at a time when actual inflation is low. Indeed, a critical test of the usefulness of inflation targets will come when capacity utilization rates approach levels at which, on the basis of past experience, inflationary pressures may be beginning to build but are not yet apparent in current price data. Inflation targeting is clearly no panacea, and the increased degree of flexibility it may afford in the short run needs to be exploited with considerable caution. Finally, it is worth noting that many countries have successfully reduced inflation and strengthened policy credibility in the absence of formal anchors or explicit inflation targets.
Even with these caveats, several countries have found inflation targeting to be an attractive approach. New Zealand and Canada have pursued inflation targeting for several years as a central feature of their anti-inflationary strategies. More recently, given the exceptionally difficult cyclical and financial circumstances that forced a number of European countries to abandon their pegs to the deutsche mark, the adoption of inflation targets in the United Kingdom, Finland, and Sweden has helped to reduce uncertainty about the authorities’ policy objectives. Together with improved prospects for fiscal consolidation, it helped to create the basis for significant reductions in both short- and long-term interest rates in 1993 and to allow the currencies of these countries to strengthen in foreign exchange markets, reversing part of the large depreciations that occurred immediately following the abandonment of the previous exchange rate pegs.
Appropriate macroeconomic policies can promote financial stability and higher sustainable growth of output and employment. However, better-functioning labor markets are also essential to permit a reversal of the rise in structural unemployment that has occurred during the past two decades, especially in Europe. In this respect, structural reform efforts in many countries made inadequate use of the opportunities provided by the long expansion of the 1980s. The latest surge in unemployment has again focused the attention of policymakers on the need to improve the functioning of labor markets, both to alleviate the very high rates of structural unemployment in many countries and to reduce the risk that the recent rise in cyclical unemployment will be transformed into a further rise in structural unemployment. In several countries, measures to address some distortions have already been implemented or are under way. Nevertheless, fundamental and more broadly based labor market reforms are required in almost all industrial countries.
Priorities in labor market reform differ depending on the specific features of each country’s labor market. There is a general need to improve education and training in order to strengthen the skills and productivity of those workers most vulnerable to unemployment. At the same time it is necessary to reform regulations that discourage hiring or prevent real wages from reflecting the productivity of low-skill or inexperienced workers, and to ensure that social benefit programs do not discourage job search and employment. Such reforms need to be accompanied by appropriate adjustments to tax and transfer systems to help meet social concerns. In contrast to such measures, which emphasize the role of market forces and seek to address market failures, various shortcuts have been proposed that would be counterproductive. These include legislated reductions in the workweek—so called work sharing—which would reduce the supply of labor, lower living standards, and have little impact on the level of structural unemployment; protection against foreign competition, which would retard overall growth and employment; and attempts to control or reduce the impact of technical change on productivity, which would undermine job growth and prosperity in the long run.
As regards developments in individual countries, the recent period has been noteworthy for the cyclical divergences between two groups of countries. The first group, including the United States, the United Kingdom, and Canada, entered into recession in 1990-91, and these countries are all now experiencing relatively robust recoveries (Chart 2). In the second group, comprising Japan and the continental European economies, which did not fall into recession until 1992, the downturns appear to have bottomed out, but clear signs of recovery have not yet emerged. Except for the United States, the recent recessions rank among the most severe in the postwar period and in most cases have been considerably more protracted than initially expected. The economic forces contributing to these developments have been discussed in previous issues of the World Economic Outlook.
Chart 2.Major Industrial Countries: Output Gaps1
1 Blue shaded areas indicate IMF staff projections. For a discussion of the approach lo calculating potential output, see the October 1993 World Economic Outlook, p. 101.
2 Data through 1990 apply to west Germany only.
The cyclical divergences among the industrial countries have been accompanied by an increase in current account deficits and surpluses. This reflects mainly normal cyclical effects, which should not be cause for concern. Over the medium to longer term, current account imbalances should be reduced as cyclical divergences diminish; as exchange rate changes feed fully through; and as the structural characteristics of economies change—for example, due to demographic changes and other factors that may affect saving-investment balances. Nevertheless, underlying current account deficits or surpluses may persist as a result of differences in domestic saving relative to domestic investment opportunities, which may lead investors to continue to diversify their investment portfolios—a key benefit associated with the liberalization of capital movements. Indeed, moderate current account deficits and surpluses are not necessarily undesirable. More generally, bilateral trade and current account positions are clearly not an appropriate focus for trade policy. In this context, it is essential that trade disputes be settled quickly and in a manner that is consistent with multilateral principles. If such disputes were allowed to escalate, they would damage the multilateral trading system and undermine the benefits of the Uruguay Round. Moreover, such trade tensions could adversely affect financial and foreign exchange markets, further retarding recovery.
In the United States, the recovery was initially quite sluggish, but it has subsequently gained momentum. The economy is now in the expansionary phase of the cycle, and output is expected to be at about potential in 1994 and 1995. Balance sheet problems arising from the fall in asset prices in 1990-92 appear to have diminished substantially, in part because of much-reduced interest rates across all maturities. The present challenge for U.S. policy-makers is to improve conditions for a durable expansion. The output gap has already been substantially absorbed, and monetary conditions will need to be adjusted accordingly to prevent a rise in inflationary pressures as the expansion matures. The small increases in the federal funds rate since early February were useful first steps, but further action to bring monetary conditions toward a more neutral stance would seem appropriate. Action to reduce the fiscal deficit helped to reduce long-term interest rates during 1993, and this has contributed to the recent strength of activity. The structural deficit, however, is still projected to average 2 to 3 percent of GDP over the medium term, a level that would remain an impediment to business investment, job creation, future growth, and improvement in the external position. The strength of the expansion provides an opportunity for the needed additional deficit-reduction efforts. In particular, it is important that the proposed reform of the health care system makes a substantial contribution to deficit reduction without placing a burden on the budget in the near term.
In Canada, low inflation, declining short-term interest rates, and a strong impetus from exports have contributed to the pickup in activity. However, the relatively high level of real long-term interest rates remains a threat to the strength of the expansion and could delay significant declines in unemployment. Together with the effect of continued economic expansion, measures in the recent budget are expected to reduce the federal budget deficit to 3 percent of GDP by 1996/97, which would represent an important step toward needed fiscal consolidation. In light of the high and rising ratio of government debt to GDP, however, additional action to cut the deficit further over the medium term remains the key to reducing long-term interest rates. Such action also would provide continued scope for monetary policy to support activity in the short run without jeopardizing price stability.
The recovery in the United Kingdom gathered pace in 1993, largely on the strength of private consumption. Household debt-income ratios have declined from earlier peaks, and lower short-term interest rates have reduced household debt-service payments. The external sector has thus far made only a small contribution to the recovery. The substantial fiscal consolidation measures adopted in 1993, which are to be implemented over the next three years, have helped to improve the policy mix. In the period ahead, inflation is expected to remain within the authorities’ target range of 1 to 4 percent for the near term, although recent wage settlements raise the risk that inflation may have bottomed out and financial market developments suggest some increase in uncertainty about inflation prospects. Further monetary easing should await firm evidence that inflation is well on course toward the medium-term objective of 1 to 2½ percent.
Among the countries where margins of slack are likely to widen further in 1994, Japan continues to struggle with the adverse effects of the drop in equity and real estate values, overinvestment in key sectors in the late 1980s, balance sheet adjustments, and strains in the financial sector. The resulting weakness of activity has been aggravated by the recent sharp appreciation of the yen. In contrast to most other industrial countries, Japan’s progress in consolidating its public finances during the 1980s has allowed fiscal policy to be used with some flexibility in response to the downturn without jeopardizing the credibility of medium-term objectives. Several large fiscal packages, including measures announced in early February, and reductions in interest rates have helped to support demand, but confidence has only recently begun to improve. The staff expects a gradual, slow recovery in 1994-95. For the upswing to gain sufficient momentum, continued fiscal support and a further easing of monetary conditions may well be required; of course, once a recovery is firmly established, fiscal consolidation will have to be strengthened again in view of the large demands on the public sector associated with population aging during the remainder of the decade and beyond. Macroeconomic policies alone provide a useful but incomplete response to Japan’s current economic problems. Strong efforts at deregulation and market opening would help to raise living standards and contribute to a revival of confidence. Japanese consumers, in particular, would benefit from lower prices of domestic and imported products. In addition to their key domestic benefits, such reforms would contribute to a reduction of trade tensions.
In continental Europe, conditions for a gradual strengthening of activity have improved over the past year, although it seems likely that the process of rebalancing the policy mix by allowing interest rates to reflect the weakness of economic conditions more closely and by strengthening commitments to fiscal consolidation will need to continue for there to be a sufficiently robust upswing. In Germany, where inflation has been reduced to a pace more consistent with the Bundesbank’s objective of price stability, the discount rate has been lowered by 3 percentage points since the beginning of 1993, to 5¼ percent. Low wage increases, progress toward fiscal consolidation, and the likely moderation in the growth of M3 (as the influence of special factors wanes) should facilitate a continued cautious but significant lowering of short-term interest rates in the months ahead. Nevertheless, activity in the western Länder seems likely to recover only slowly during 1994, and unemployment may continue to increase into 1995. In the eastern Länder, the upturn that began in 1992 is projected to continue in 1994-95.
Prospects for France are also for a relatively slow recovery because the decline in interest rates may be felt only with a lag. Indeed, low inflation and a large margin of slack warrant a progressive further lowering of short-term interest rates. As interest rates continue to decline and the economic outlook strengthens, the fiscal situation should also improve. However, it is important that the scope for reversing the rise in the budget deficit experienced during the recession be fully utilized in order to meet the authorities’ budget consolidation objectives, and preferably to reduce the budget deficit even further. The widening of the bands in the European exchange rate mechanism (ERM) in August 1993 provided the authorities in France and other ERM countries with the option to pursue a more independent monetary policy. However, because of the perceived implications for the credibility of monetary policy, as well as the importance attached to exchange rate stability in the process leading toward economic and monetary union (EMU) and the view that existing central rates were consistent with fundamentals, all of these countries decided to retain a close link to the deutsche mark and to wail for German monetary conditions to ease. Subsequently, interest rates in all the ERM countries have fallen significantly while exchange rates within the system have returned to the previous narrow bands. Provided that the downward adjustment of short-term interest rates in Germany continues, monetary conditions in France and other ERM countries should also continue to be brought more closely in line with domestic requirements for recovery of output and employment.
Notwithstanding the favorable impact on net exports from the significant depreciation of the lira following its exit from the ERM, the Italian economy continued to weaken through much of 1993. Positive features have been better-than-anticipated inflation performance, largely reflecting wage moderation following the July 1993 labor accord and the abolition of backward-looking wage indexation; and the success in 1993 in containing the fiscal deficit. However, the fiscal imbalance remains too high, and further corrective measures are likely to be necessary to prevent the 1994 budget targets from being missed. A significant reduction in both short- and long-term interest rates from their earlier crisis levels has contributed to a decline in the cost of servicing public debt. Early implementation of additional measures to reduce Italy’s large budget deficit, and to stabilize and then reduce the debt/GDP ratio, will be crucial to allow a further decline in long-term interest rates and to permit a sustained economic expansion.
The return to calm in European exchange markets since the widening of ERM fluctuation bands in August 1993 should allow the members of the European Union to focus their attention on a number of important challenges as they prepare the ground for EMU. The creation of the European Monetary Institute on January 1, 1994 has strengthened the institutional framework for the coordination of monetary policies, which should be facilitated by recent progress toward price stability in most member countries. However, the key policy challenge in the process toward EMU remains the need to reduce large budgetary imbalances in almost all member countries while sustaining economic recovery. This will require appropriate adaptation of monetary conditions as fiscal consolidation proceeds. Increased flexibility of labor markets is also essential to improve economic performance and to strengthen the resilience of individual economies to adverse economic disturbances.
Robust economic growth in many developing countries has been one of the most encouraging aspects of global economic trends in recent years. In 1994 and 1995, aggregate output in the developing world is projected to continue to advance at a rate of 5½ to 6 percent—similar to the rate of increase in 1992-93. The pattern of growth is likely to remain very uneven, however, mainly because of sharp differences in the quality of countries’ stabilization and economic adjustment policies. Moreover, some of the oil exporting countries are expected to experience a decline in growth in the near term owing to the recent fall in world oil prices. In the longer run, some of the countries that have grown particularly rapidly may see a slowdown to more sustainable rates, in part because of infrastructural and environmental constraints. However, stronger adjustment efforts under way in an increasing number of countries suggest that average growth in the developing countries could be sustained at around 6 percent a year over the medium to longer run.
Past issues of the World Economic Outlook have reviewed the experience of the successfully adjusting developing countries, especially the newly industrializing countries in East and Southeast Asia, as well as a large and increasing number of reforming countries in all regions, including Mexico, Chile, Argentina, China, and India. A number of the successful countries have been facing different kinds of policy challenges, including substantial capital inflows and the risk of overheating.
Improved economic prospects and financial reform in many developing countries in Asia and Latin America have attracted large inflows of foreign direct and portfolio investment in recent years. These inflows have helped to support investment and have facilitated the privatization of public enterprises. They have also contributed to the development of domestic capital markets. Notwithstanding these positive developments, the surges in capital inflows and in stock market prices give cause for some concern about the risk of overheating and the possibility of sudden changes in market sentiment. To minimize the risk of speculative bubbles in the emerging stock markets and a reversal of capital inflows, many of these countries will need to monitor developments carefully to avoid the buildup of imbalances; some countries may need to take corrective measures relatively soon. A number of countries may also need to strengthen prudential supervision of their financial systems and, in some cases, broaden and deepen financial market reforms.
In China, policymakers are facing the challenge of moderating the growth of demand to contain inflationary pressures while also pushing ahead with sweeping reforms that will allow further progress toward a market-based system. The remarkable dynamism of the economy led to double-digit growth (13 percent) in 1993 for the second consecutive year, but this has fueled inflation and strained the country’s infrastructure and supplies of energy and basic raw materials. Steady pursuit of sound financial policies is needed to restore and maintain macroeconomic stability; this remains a key condition for the successful implementation of the new reform program, which started in January 1994 with the unification of exchange rates and other steps toward current account convertibility. Other initiatives on the reform agenda include further trade liberalization, steps to improve monetary control, fiscal reform aimed at strengthening public finances, and the hardening of budget constraints on state enterprises.
The program of macroeconomic stabilization and structural reform initiated in India in 1991 has been effective in restoring external confidence, reducing inflation, and limiting the economic slowdown in the face of a severe balance of payments crisis. Exports and foreign equity investment have responded strongly to the improved incentives, and a comfortable cushion of external reserves has been rebuilt. In addition, the process of restructuring has begun to make inroads into long-standing distortions and rigidities in the economy. Despite continuing progress in many of these areas, developments in 1993 were characterized by certain troubling features, including a weakening of fiscal policy and a rekindling of inflationary pressures. The budget for FY 1994/95, while incorporating significant tax and tariff reforms, envisages only a modest reduction in the fiscal deficit. High real interest rates associated with persistently large budget deficits have contributed to the recent surge in capital inflows, which has complicated monetary management. The key policy requirement is to restore the momentum of fiscal consolidation while pressing ahead with further wide-ranging structural reforms to put India on a sustainable path of dynamic growth and development.
The strong growth enjoyed by a large number of developing countries in recent years contrasts with the difficulties of many other countries that have failed to register any significant improvements in economic performance. In many of these countries, living standards have stagnated or even declined over the past ten to twenty years. Helping these countries to realize their potential and catch up with economic trends in the rest of the world remains of vital importance for the international community.
There is rarely only one reason for the failure of a country to realize its economic potential. In most cases, unsuccessful countries are characterized by many interrelated obstacles to growth, including large budget deficits, high and volatile rates of inflation, financial repression that distorts resource allocation, underdeveloped financial sectors, and excessive government intervention in the economy. In many countries, growth is also impeded by protection from foreign competition, overvalued exchange rates, unsustainable population growth, failure to build consensus for reform, and poor governance. With such obstacles to economic development, which are reflected in low saving and investment rates compared with the strong performers (Chart 3), many unsuccessful countries have failed to raise productivity in their commodity-producing sectors and to diversify their economies. As a result, these countries are often particularly vulnerable when terms of trade shocks and natural disasters occur.
Chart 3.Developing Countries: Domestic Saving and Investment1
1 Three-year centered moving average. Blue shaded areas indicate IMF staff projections.
2 The top third of growth performers during 1984-93; growth rate for the group averaged about 6 percent during the 1970s and about 7 percent since 1980.
3 The bottom third of growth performers during 1984-93; growth rate for the group averaged 4¾ percent in the 1970s and about 1½ percent since 1980.
Given the complexity of their problems, the challenges facing the low-growth countries—which include many of the poorest countries, especially in Africa, as well as a number of lower-middle-income countries in other regions—are truly daunting. Sustained adjustment efforts will be required over several years, and the success of domestic policy efforts will depend also on the timeliness of external financial assistance and debt restructuring, and on the absence of adverse external disturbances. However, the growing number of countries that have successfully adjusted their economies illustrates the considerable scope that exists for growth to recover when the necessary reforms and a stable macroeconomic environment are put in place.
Among the poorest countries, there is evidence of improved growth performance in the 16 countries in sub-Saharan Africa that are pursuing comprehensive adjustment programs supported by the IMF’s ESAF. The recently adopted enlarged ESAF allows such assistance to continue to be offered to low-income countries that adopt comprehensive reform programs. However, together with new concessional lending, timely and realistic debt relief will also be needed for many of the poorest countries. A closer link between official development assistance and the quality of countries’ adjustment efforts would both increase the effectiveness of external aid and increase the chance of success of many adjustment programs. The recent devaluation of the CFA franc has helped to improve the growth prospects of countries in the franc zone, but the success of the devaluation will depend on steadfast implementation of the programs supported by the IMF and the international community. Developments in South Africa could have beneficial spillover effects on southern Africa in general; a post-election reduction in political strife would reinforce the incipient economic recovery and allow the new government to embark on a program of reconstruction and development while safeguarding macroeconomic balance.
The international environment is important for the developing world. In contrast to the recent strength of activity in many developing countries during a period of cyclical weakness in the industrial world, many commodity-exporting countries have suffered considerable terms of trade losses that have exacerbated problems of domestic economic management. Trade barriers in potential markets have also hampered export growth, and many developing countries have been adversely affected by the agricultural policies of the industrial countries. These policies have tended to lower world food prices and have reduced incentives for production by domestic farmers in the developing countries. In many respects, however, the external environment seems likely to improve during the next several years. The projected resumption of stronger growth in the industrial countries should allow real commodity prices to strengthen; maintenance of low inflation in the industrial countries should permit world interest rates to remain at relatively moderate levels; and the completion of the Uruguay Round will not only open up new trade opportunities for all countries, but should also begin to address the distortions affecting trade in agricultural products.
Countries in Transition
There are encouraging signs of progress toward economic stabilization, restructuring, and recovery in a number of the economies in transition. However, repeated setbacks in many other transition countries point to the likelihood that economic conditions may continue to deteriorate in the absence of a substantial strengthening of stabilization and reform efforts. Continuing economic decline risks eroding popular support for the reform process. Adequate external assistance is essential for the process of economic transformation, but it will be effective only if it is linked to determined adjustment efforts in the reforming countries.
Those transition countries that are beginning to experience a recovery of output are all characterized by a reasonable measure of macroeconomic stability and significant progress in structural reform. In Poland, the first transition country to witness a turn-around, real GDP rose by 4 percent in 1993, and sustained output gains are likely during the period ahead provided that the recent upturn in inflation can be reversed. The Czech Republic has been particularly successful in containing the budget deficit and inflation and is expected to experience positive growth in 1994. In Albania, real GDP rebounded by 11 percent in 1993 owing to strong supply responses in the agricultural, construction, and service sectors. There has also been progress toward the stabilization of inflation and output in Slovenia, and activity has begun to recover in the three Baltic countries following considerable success in reducing inflation, although price increases have recently picked up somewhat in these countries. In other central European countries, output appears to have begun to stabilize, but the prospects for sustained recovery depend on further efforts to reduce budgetary imbalances and to contain inflation. In Mongolia, where important fiscal and monetary reforms have been implemented, positive growth is expected to resume in 1994.
The recent signs of improvement in economic performance in much of central Europe and the Baltic countries is in stark contrast to the continued deterioration in economic conditions in Russia and most other countries of the former Soviet Union in 1993. Excessive budget deficits and lack of monetary control have continued to fuel rapid inflation, distort price signals and economic incentives, and delay the crucial restructuring of the enterprise sector. Privatization has proceeded quickly in Russia and in the Kyrgyz Republic, but there has been insufficient progress toward market-oriented behavior at the enterprise level. Outside Russia, structural reforms are generally less advanced, and economic difficulties greater, in part because of the continued repercussions from the breakup of the Soviet command economy. Only Turkmenistan has managed to stabilize output, owing to buoyant gas exports. Most of the countries of the former Soviet Union have experienced growing hardship among the unemployed and the elderly, and this points to the urgent need to reform social safety nets.
The lack of adequate progress with macroeconomic stabilization in Russia and most of the other countries of the former Soviet Union over the past two years can be attributed in part to the lack of adequate adjustment and restructuring at the enterprise level and to the failure of the authorities to resist pressures from the agricultural and enterprise sectors for large-scale financial support, both subsidies and credits. The lesson for the period ahead is clear. Reform-minded governments must limit total financial support to enterprises to a level consistent with overall budget objectives and with the need to make room for adequate levels of government expenditures on infrastructure, social safety nets, and other priority areas. Governments must enforce reasonable financial discipline and ensure that individual enterprises operate within their financial constraints. The transformation process will clearly take time, but financial assistance should be directed toward enterprises that have meaningful prospects for longer-term viability and that are making conscientious efforts to realize these prospects. It is necessary to tackle these problems without delay, and the authorities should give a clear signal that enterprises that build up arrears to the government or to other enterprises will not be bailed out; and that enterprises that have been privatized must learn to live without government support. All of this can and should be done in an open trading environment and within the context of a macroeconomic program geared toward a rapid reduction of inflation to a sustainable level. The comprehensive program adopted by Russia, and supported by the STF, constitutes a significant step toward restoring financial stability and ensuring further progress in the structural area.
Many of the central European countries are approaching a situation where requirements for exceptional external financial support from multilateral and bilateral official creditors can be expected to decline during the next several years. In contrast, such assistance will continue to play a key role in the other transition countries for the foreseeable future. The STF, an addition to the IMF’s usual facilities, has been established to assist countries in transition; but significant amounts of untied financial aid on favorable terms from other sources will also be needed. The experience of countries that have recently turned the corner clearly shows, however, that such assistance will be truly helpful only to the extent that appropriate macroeconomic and structural reforms are put in place. In the absence of sharp reductions in credit growth, fiscal deficits, and inflation, balance of payments assistance may delay adjustment, encourage capital flight, and postpone improvements in creditworthiness. The effectiveness of assistance to specific projects at the microeconomic level will also be impeded unless the macroeconomic environment improves. Renewed growth will ultimately depend on the implementation of policies to achieve macroeconomic stabilization and fundamental economic reform. The examples of the central European and Baltic countries show that this approach can succeed.