IMF World Economic Outlook Fall 1996 - Chapter 1 · World economic outlook: a survey by the staff of the International ... Partnership for Sustainable Global Growth xii Chapter I

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Assumptions and Conventions ix

Preface xi

Partnership for Sustainable Global Growth xii

Chapter I. Global Economic Prospects and Policies 1

Industrial Countries 3Developing Countries 10Economies in Transition 12

Chapter II. World Economic Situation and Short-Term Prospects 14

Economic Activity, Inflation, and Policy Stances in Industrial Countries 15Economic Situation and Prospects in Developing Countries 25Developments and Prospects in Countries in Transition 29Financial and Foreign Exchange Markets 30External Payments, Financing, and Debt 35

Chapter III. Policy Challenges Facing Industrial Countries in the Late 1990s 42

Changes in Transmission of Monetary Policy 43Banking Sector Risks and Economic Performance 47Strengthening the Functioning of Labor Markets 52

Chapter IV. Financial Market Challenges and Economic Performance inDeveloping Countries 57

Challenges of Capital Market Integration 57Financial System Requirements in Countries Lagging Behind 67Problems Facing the Heavily Indebted Poor Countries 74

Chapter V. Long-Term Growth Potential in the Countries in Transition 78

Growth Lessons of the Transition Process 79Growth Experience in Other Countries 81Illustrative Long-Run Growth Scenarios 86Policy Issues and Challenges to Sustaining Growth 89

Chapter VI. The Rise and Fall of Inflation—Lessons from the Postwar Experience 100

Sources of Inflation: Three Inflation Episodes in Industrial Countries 100Role of the Exchange Rate Regime 104Guideposts for Anti-Inflationary Monetary Policy 106Special Features of Inflation in Developing and Transition Countries 107Stopping High Inflation 111Some Empirical Evidence on Factors Influencing the Inflationary Process 114

iii

Contents

CONTENTS

Costs of Inflation 116Costs of Disinflation 122Achieving and Sustaining Price Stability 126

Annexes

III The Difficult Art of Forecasting 132III World Oil Market: Recent Developments and Outlook 135

Crude Oil Prices 135Consumption 136Production 138Medium-Term Outlook 142

III World Current Account Discrepancy 144IV Capital Inflows to Developing and Transition Countries—Identifying

Causes and Formulating Appropriate Policy Responses 148Identifying the Causes of Capital Inflows 148Policy Responses 151

Boxes

Chapter

III 1. Policy Assumptions Underlying the Projections 4III 2. Using the Slope of the Yield Curve to Estimate Lags in Monetary

Transmission Mechanism 48IV 3. Assessing Overheating in Emerging Market Countries 62

4. Progress in the Development of Exchange Markets in Africa 705. Financial Repression 73

IV 6. Trade and Growth in the Countries in Transition 847. Bank-Restructuring Strategies in the Baltic States, Russia, and Other

Countries of the Former Soviet Union: Main Issues and Challenges 98VI 8. Inflation Targets 108

9. Indexed Bonds and Expected Inflation 11810. Effects of High Inflation on Income Distribution 12111. Central Bank Independence and Inflation 128

Statistical Appendix 154

Assumptions 154Data and Conventions 154Classification of Countries 155List of Tables 165

Output (Tables A1–A7) 167Inflation (Tables A8–A13) 178Financial Policies (Tables A14–A21) 186Foreign Trade (Tables A22–A26) 195Current Account Transactions (Tables A27–A32) 203Balance of Payments and External Financing (Tables A33–A37) 215External Debt and Debt Service (Tables A38–A43) 226Flow of Funds (Table A44) 236Medium-Term Baseline Scenario (Table A45) 241

Tables

Chapter

III 1. Overview of the World Economic Outlook Projections 2III 2. Industrial Countries: Real GDP, Consumer Prices, and Unemployment Rates 15

3. European Union: Convergence Indicators for 1995, 1996, and 1997 20

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4. Major Industrial Countries: Questions About Inflationary Pressures 215. Industrial Countries: General Government Fiscal Balances and Debt 226. Selected Developing Countries: Real GDP and Consumer Prices 267. Selected Developing Countries: General Government Budget Balance 278. Countries in Transition: Real GDP and Consumer Prices 289. Selected Countries in Transition: General Government Budget Balance 29

10. Changes in Foreign Exchange Reserves 3411. Selected Countries: Current Account Positions 3812. Developing Countries: Capital Flows 3913. Summary of World Medium-Term Baseline Scenario 41

III 14. Selected Major Industrial Countries: Responsiveness of Bank-Lending Rate to a Change in the Policy Interest Rate 44

15. Changes in the Structure of the Financial System 45IV 16. Selected Emerging Market Countries: Macroeconomic Indicators 61

17. Developing Countries: Selected Financial Indicators 74IV 18. Countries in Transition: Medium-Term Scenario for Output and Inflation 79

19. Industrial and Developing Countries: Long-Run Growth of GDP Per Capita 8220. Rapidly Growing Economies and Countries in Transition: Factors

Influencing Growth 8321. Postwar Recovery: Sources of Growth in GDP, 1950–73 8322. Developing Countries: Total Factor Productivity Growth 8723. Countries in Transition: Per Capita Income and Selected

Demographic Indicators 8824. Countries in Transition: Trends in Educational Attainment of the

Population Aged 15 and Over 8925. Countries in Transition: Indicators of the Quality of School Inputs 9026. Countries in Transition: Population Growth 9127. Selected Countries in Transition: Simulated Growth Rates 9228. Selected Countries in Transition: Reform of Social Protection Systems 9329. Selected Countries in Transition: Indicators of Capital Flows 9430. Countries in Transition: Indicators of External Viability, 1995 9531. Countries in Transition: Broad Money 9632. Selected Countries in Transition: Problem Loans 9633. Selected Countries in Transition: Bank Interest Rate Spreads 97

VI 34. Exchange Rate Regime and Inflation 10535. Importance of Seigniorage in Developing Countries 10636. Inflation and Output Growth Before and After Stabilization 11237. Probability of Being Above 100 Percent in Next Year at Different Rates

of Inflation in Current Year 114

Annex

III 38. Consumption of Petroleum by Groups of Countries 13739. Crude Oil Production 14140. Average Growth Rates in Consumption of Petroleum, by Groups of Countries 143

III 41. Discrepancies on World Current Account 145IV 42. Potential Indicators for Analyzing Causes of Capital Inflows in

Developing and Transition Countries 14943. Symptoms of Causes of Capital Inflows 15044. Macroeconomic Policy Matrix for a Country with Balanced Policies

Experiencing Capital Inflows 152

Box

2 Number of Quarters Between Changes in the Yield Gap and the Maximum Impact on the Growth of Output, Unemployment, and Inflation 49

5 Developing Countries: Financial Repression and Economic Performance 738 Inflation Targets in Selected Countries 110

Contents

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CONTENTS

Charts

Chapter

III 1. World Indicators 32. European Union: General Government Budget Positions 63. Industrial Countries: Real Interest Rates 9

III 4. Commodity Price Indices 145. Major Industrial Countries: Output Gaps 166. Three Major Industrial Countries: Policy-Related Interest Rates and

Ten-Year Government Bond Yields 177. European Union and the United States: Indicators of Consumer Confidence 188. Major Industrial Countries: Monetary Conditions Indices 199. Selected Countries More Advanced in Transition: Inflation 30

10. Selected Countries Less Advanced in Transition: Inflation 3111. Major Industrial Countries: Nominal Interest Rates 3212. Major Industrial Countries: Effective Exchange Rates 3313. United States and Japan: Equity Yield Gap and Stock Market Prices 3514. Selected Emerging Market Countries: Equity Prices 3615. Emerging Market Countries: Equity Prices 3716. Elasticity of World Trade with Respect to World Output 3717. Developing Countries and Countries in Transition: External Debt and

Debt Service 40III 18. Major Industrial Countries: Real Short-Term Interest Rate Differential

Versus Real Exchange Rates 4619. Major Industrial Countries: Simulated Response of Real Output to a

Monetary Policy Tightening 4720. Japan: Investment Spending Over Recovery Cycles, Small and

Medium-Sized Enterprises 5121. European Union and the United States: Output, Capital, Employment,

and Compensation 53IV 22. Developing Countries: Net Private Capital Flows, 1990–95 58

23. Developing, Industrial, and Transition Countries: Current Account Convertibility 59

24. Developing Countries: Openness 6025. Selected Emerging Market Countries: Indicators of Demand Pressure 6426. Developing Countries: Foreign Direct Investment in Selected Countries 6727. Developing Countries: Financial Development and Economic Growth,

1976–94 6828. Developing Countries: Real Interest Rates and Financial Intermediation,

1976–94 7229. Developing Countries: Debt-Export Ratios of Heavily Indebted Poor

Countries, Average 1992–94 7530. Developing Countries: Net Resource Transfers to Heavily Indebted Poor

Countries, 1990–94 76IV 31. Economies in Transition: Inflation and Real Output Growth, 1992–95 80

32. Economies in Transition: Index of Reform Progress (IRP) and Real Output Growth 80

33. Economies in Transition: Unemployment and Real Output Growth 81VI 34. Inflation 100

35. Price Level in the United States and the United Kingdom 10136. Industrial Countries: Inflation and Real Output Growth 10237. Selected Industrial Countries: Inflation 10338. Developing Countries: Inflation Across Regions 10739. Selected Industrial and Developing Countries: Inflation and

Money Growth, 1960–95 11540. Influences of Various Factors on Inflation 115

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41. Response of Inflation to Various Shocks 11642. Industrial Countries: Inflation and Inflation Variability, 1960–95 12043. Industrial Countries: Variability in Inflation and Real Output Growth,

1960–95 12044. Inflation and Real Output Growth, 1965–95 12245. Asymmetric and Symmetric Model Responses to Overheating 124

Annex

III 46. Industrial Country Real Output Growth: World Economic OutlookForecast Compared with Actual 133

47. Major Industrial Countries: Comparison of World Economic Outlookand Consensus Forecasts Errors 134

III 48. Crude Petroluem Price in Current and Real Terms 13549. Commercial Stocks of Petroleum 13650. West Texas Oil Prices: Spot and Futures Contracts 13651. Industrial Countries: Consumption of Petroleum 13852. Global Oil Reserves and Consumption 13953. Distribution of Crude Oil Reserves in 1990 140

III 54. Global Discrepancies on World Current Account and on World Financial Flows 144

Box

3 Selected Emerging Market Countries: Impact of the Output Gap on Inflation, 1975–95 63

6 Countries in Transition: Trade Volume and Output Growth 8411 Industrial Countries: Central Bank Independence and Inflation 128

Selected Developing Countries: Central Bank Independence and Inflation 129

Contents

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A number of assumptions have been adopted for the projections presented in the WorldEconomic Outlook. It has been assumed that real effective exchange rates will remain constantat their average levels during July 25–August 21, 1996 except for the bilateral rates among theEuropean exchange rate mechanism (ERM) currencies, which are assumed to remain constantin nominal terms; that established policies of national authorities will be maintained (forspecific assumptions about fiscal and monetary policies in industrial countries, see Box 1); thatthe average price of oil will be $19.42 a barrel in 1996 and $17.94 a barrel in 1997, and remainunchanged in real terms over the medium term; and that the six-month London interbankoffered rate (LIBOR) on U.S. dollar deposits will average 5.6 percent in 1996 and 6.0 percentin 1997. These are, of course, working hypotheses rather than forecasts, and the uncertaintiessurrounding them add to the margin of error that would in any event be involved in theprojections. The estimates and projections are based on statistical information available onSeptember 10, 1996.

The following conventions have been used throughout the World Economic Outlook:

. . . to indicate that data are not available or not applicable;

— to indicate that the figure is zero or negligible;

– between years or months (e.g., 1994–95 or January-June) to indicate the years ormonths covered, including the beginning and ending years or months;

/ between years or months (e.g., 1994/95) to indicate a fiscal or financial year.

“Billion” means a thousand million; “trillion” means a thousand billion.

“Basis points” refer to hundredths of 1 percentage point (e.g., 25 basis points are equivalent to

!/4 of 1 percentage point).

Minor discrepancies between sums of constituent figures and totals shown are due to rounding.

* * *

As used in this report, the term “country” does not in all cases refer to a territorial entity thatis a state as understood by international law and practice. As used here, the term also covers someterritorial entities that are not states but for which statistical data are maintained on a separateand independent basis.

ix

Assumptions and Conventions

The projections and analysis contained in the World Economic Outlook are an integralelement of the IMF’s ongoing surveillance of economic developments and policies in its membercountries and of the global economic system. The IMF has published the World EconomicOutlook annually from 1980 through 1983 and biannually since 1984.

The survey of prospects and policies is the product of a comprehensive interdepartmentalreview of world economic developments, which draws primarily on information the IMF staffgathers through its consultations with member countries. These consultations are carried out inparticular by the IMF’s area departments together with the Policy Development and ReviewDepartment and the Fiscal Affairs Department.

The country projections are prepared by the IMF’s area departments on the basis of interna-tionally consistent assumptions about world activity, exchange rates, and conditions in inter-national financial and commodity markets. For approximately 50 of the largest economies—accounting for 90 percent of world output—the projections are updated for each WorldEconomic Outlook exercise. For smaller countries, the projections are based on those preparedat the time of the IMF’s regular Article IV consultations with member countries or in connec-tion with the use of IMF resources; for these countries, the projections used in the WorldEconomic Outlook are incrementally adjusted to reflect changes in assumptions and globaleconomic conditions.

The analysis in the World Economic Outlook draws extensively on the ongoing work of theIMF’s area and specialized departments, and is coordinated in the Research Department underthe general direction of Michael Mussa, Economic Counsellor and Director of Research. TheWorld Economic Outlook project is directed by Flemming Larsen, Deputy Director of theResearch Department, together with Graham Hacche, Chief of the World Economic StudiesDivision.

Primary contributors to the current issue are Francesco Caramazza, Robert F. Wescott,Staffan Gorne, Paula De Masi, James Haley, Mahmood Pradhan, Jahangir Aziz, JohnMcDermott, Phillip Swagel, and Cathy Wright. Other contributors include Guy Debell, Anne-Marie Gulde, Douglas Laxton, Ceyla Pazarbasioglu, Robert Price, and Anthony G. Turner. Theauthors of the annexes are indicated on the first page of each. The Fiscal Analysis Division ofthe Fiscal Affairs Department computed the structural budget and fiscal impulse measures.Sungcha Hong Cha, Toh Kuan, and Michelle Marquardt provided research assistance. ShamimKassam, Allen Cobler, Nicholas Dopuch, Isabella Dymarskaia, Gretchen Gallik, MandyHemmati, and Yasoma Liyanarachchi processed the data and managed the computer systems.Susan Duff, Caroline Bagworth, and Margaret Dapaah were responsible for word processing.Juanita Roushdy of the External Relations Department edited the manuscript and coordinatedproduction of the publication.

The analysis has benefited from comments and suggestions by staff from other IMF depart-ments, as well as by Executive Directors following their discussion of the World EconomicOutlook on September 4 and 6, 1996. However, both projections and policy considerations arethose of the IMF staff and should not be attributed to Executive Directors or to their nationalauthorities.

xi

Preface

Partnership for Sustainable Global GrowthThe following “Declaration on Partnership for Sustainable Global Growth” was adopted at the con-

clusion of the forty-seventh meeting of the Interim Committee of the Board of Governors of the IMF,September 29, 1996.

The Interim Committee has reviewed the “Declaration on Cooperation to Strengthen the GlobalExpansion,” which it adopted two years ago in Madrid.1 It notes that the strategy set out in theDeclaration, which emphasized sound domestic policies, international cooperation, and global integra-tion, remains valid. It reiterates the objective of promoting full participation of all economies, includingthe low-income countries, in the global economy. Favorable developments in, and prospects for, manyindustrial, developing, and transition economies owe much to the implementation of sound policies con-sistent with the common medium-term strategy.

The Interim Committee sees a need to update and broaden the Declaration, in light of the new chal-lenges of a changing global environment, and to strengthen its implementation, in a renewed spirit ofpartnership. It attaches particular importance to the following:

• Stressing that sound monetary, fiscal, and structural policies are complementary and mutually re-inforcing: steady application of consistent policies over the medium term is required to establishthe conditions for sustained noninflationary growth and job creation, which are essential for so-cial cohesion.

• Implementing sound macroeconomic policies and avoiding large imbalances are essential to pro-mote financial and exchange rate stability and avoid significant misalignments among currencies.

• Creating a favorable environment for private savings.• Consolidating the success in bringing inflation down and building on the hard-won credibility of

monetary policy.• Maintaining the impetus of trade liberalization, resisting protectionist pressures, and upholding the

multilateral trading system.• Encouraging current account convertibility and careful progress toward increased freedom of cap-

ital movements through efforts to promote stability and financial soundness.• Achieving budget balance and strengthened fiscal discipline in a multiyear framework. Continued

fiscal imbalances and excessive public indebtedness, and the upward pressures they put on globalreal interest rates, are threats to financial stability and durable growth. It is essential to enhancethe transparency of fiscal policy by persevering with efforts to reduce off-budget transactions andquasi-fiscal deficits.

• Improving the quality and composition of fiscal adjustment, by reducing unproductive spendingwhile ensuring adequate basic investment in infrastructure. Because the sustainability of economicgrowth depends on development of human resources, it is essential to improve education and train-ing; to reform public pension and health systems to ensure their long-term viability and enable theprovision of effective health care: and to alleviate poverty and provide well-targeted and afford-able social safety nets.

• Tackling structural reforms more boldly, including through labor and product market reforms, witha view to increasing employment and reducing other distortions that impede the efficient allocationof resources, so as to make our economies more dynamic and resilient to adverse developments.

• Promoting good governance in all its aspects, including by ensuring the rule of law, improving theefficiency and accountability of the public sector, and tackling corruption, as essential elements ofa framework within which economies can prosper.

• Ensuring the soundness of banking systems through strong prudential regulation and supervision,improved coordination, better assessment of credit risk, stringent capital requirements, timely dis-closure of banks’ financial conditions, action to prevent money laundering, and improved man-agement of banks.

The Committee encourages the Fund to continue to cooperate with other international organizationsin all relevant areas. It welcomes the recent strengthening of Fund surveillance of member countries’policies, which is an integral part of the strategy. It reaffirmed its commitment to strengthen the Fund’scapacity to fulfill its mandate. It will keep members’ efforts at achieving the common objectives of thisstrategy under review.

1See the October 1994 World Economic Outlook, page x.

xii

World economic and financial conditions remaingenerally encouraging, notwithstanding a dis-

appointing performance recently in continental west-ern Europe, and the global economic expansion is ex-pected to continue at a satisfactory pace in 1996–97and over the medium term (Table 1 and Chart 1). Thestrength of economic activity is particularly impres-sive in the emerging market countries of the develop-ing world, with an increasing number of them reapingthe benefits of structural reforms and strong macro-economic fundamentals. In a number of such countriesin Asia, concerns about overheating have been allevi-ated to some extent by a moderation of growth. And inmost of the transition countries, the private sector isincreasingly responding to the progress that has beenmade toward macroeconomic stability, the growing re-liance on market forces, and these countries’ integra-tion into the world economy.

Among the industrial countries, there has generallybeen continuing success in containing inflation, butgrowth and labor market performance have remaineduneven. A number of countries—most notably theUnited States—are experiencing robust growth ofoutput and employment; these economies tend to be characterized by relatively flexible and dynamiclabor and product markets and significant progress to-ward fiscal consolidation. In Japan, supportive mone-tary and fiscal policies and a correction of the earlierovervaluation of the yen have finally put the economyon the path of recovery after a protracted economicslowdown. But financial sector problems remain adownside risk and the authorities will soon have toconfront the task of restoring balance in the publicfinances.

Many industrial countries, however, are yet to sharefully in the current expansion, and continue to face theimportant policy challenges of addressing the deep-seated structural and macroeconomic weaknesses intheir economies. Some countries are also experiencingdifficulties in their banking systems with attendantdownside risks to confidence and economic activity. Inmuch of continental Europe, in response to the falter-ing of growth in the second half of 1995 and in viewof the approaching deadline for Economic and Mone-tary Union (EMU), the policy mix has shifted towardtighter budgetary policies and easier monetary condi-tions. Together with a correction of earlier exchangerate misalignments this has improved prospects for a

resumption of stronger growth in the latter part of1996. The projected strengthening of growth will fa-cilitate fiscal consolidation and lessen uncertaintiesabout the EMU timetable and the associated risk oftensions in financial markets. In addition to strongerefforts to reduce the growth of public expenditures andcontain fiscal imbalances, fundamental labor marketreforms and deregulation of product markets remainessential if Europe is to achieve greater economic dy-namism and be able to meet future challenges.

In the developing world, despite the growing num-ber of success stories, many countries continue tostruggle with macroeconomic imbalances and struc-tural impediments that keep their living standards wellbelow what they are potentially capable of achieving.The role of market forces is generally increasing, buthigh degrees of government intervention in the econ-omy and large claims on financial resources by thepublic sector and quasi-public entities continue tohamper the development of the private sector in manycountries. These problems also often limit countries’ability to take advantage of their improving access toforeign markets. Reforming the public sector, remov-ing price distortions, liberalizing foreign trade andpayments, opening up to foreign direct investment,and strengthening the capacity of the financial systemto mobilize domestic saving and allocate financial re-sources to productive uses are all essential elements ofa comprehensive growth strategy. Such reforms needto be supported by prudent macroeconomic policiesaimed at containing fiscal deficits, controlling infla-tion, and maintaining external viability.

In the transition countries, where there have beenconsiderable improvements in inflation performance,there is still a need to continue the reform process andto achieve and safeguard greater macroeconomic sta-bility. In many countries, including some that are rela-tively advanced in the transition process, fiscal deficitsremain excessive and contribute to continued pricepressures. Transformation of the enterprise sector isoften being impeded by acquiescence to tax and wagearrears and by growing portfolios of nonperformingbank loans, which undermine the ability of pricemechanisms and of the financial system to allocate re-sources more efficiently. The inadequacy of socialsafety nets also hampers the needed restructuring ofloss-making enterprises. Without adequate progress inthese areas the economic and social costs of the tran-

1

IGlobal Economic Prospects and Policies

I GLOBAL ECONOMIC PROSPECTS AND POLICIES

2

Table 1. Overview of the

World Economic Outlook Projections (Annual percent change unless otherwise noted)

Differences fromCurrent May 1996

Projections Projections______________ ______________1994 1995 1996 1997 1996 1997

World output 3.7 3.5 3.8 4.1 — –0.1Industrial countries 2.8 2.1 2.3 2.5 0.3 –0.1

Major industrial countries 2.8 2.0 2.2 2.5 0.3 –0.1United States 3.5 2.0 2.4 2.3 0.6 0.2Japan 0.5 0.9 3.5 2.7 0.8 –0.3Germany 2.9 1.9 1.3 2.4 0.3 –0.6France 2.8 2.2 1.3 2.4 — –0.3Italy 2.2 3.0 1.1 2.2 –1.3 –0.5United Kingdom 3.9 2.5 2.2 3.0 — 0.3Canada 4.1 2.3 1.4 3.2 –0.5 0.3

Other industrial countries 3.0 2.8 2.3 2.6 –0.1 —

MemorandumEuropean Union 2.8 2.5 1.6 2.5 –0.2 –0.2

Developing countries 6.6 5.9 6.3 6.2 –0.1 –0.3Africa 2.9 3.0 5.0 5.0 –0.3 0.5Asia 9.1 8.6 8.0 7.5 –0.2 –0.2Middle East and Europe 0.5 3.6 3.9 3.3 0.9 –0.5Western Hemisphere 4.7 0.9 3.0 4.0 –0.2 –0.7

Countries in transition –8.8 –1.3 0.4 4.0 –2.1 0.2Central and eastern Europe –2.9 1.2 1.6 4.2 –1.4 —

Excluding Belarus and Ukraine 3.4 4.9 4.2 4.7 –0.3 0.2Russia, Transcaucasus, and central Asia –14.8 –4.1 –0.9 3.8 –2.9 0.5

World trade volume (goods and services) 8.8 8.9 6.7 7.2 0.3 0.1Imports

Industrial countries 9.3 7.8 5.3 5.5 0.4 0.5Developing countries 8.1 11.6 11.3 10.1 1.2 –1.5Countries in transition 3.5 13.3 12.3 8.5 0.7 –1.6

ExportsIndustrial countries 8.3 7.3 4.3 6.0 –0.5 0.6Developing countries 11.1 11.5 10.3 10.7 0.2 –0.5Countries in transition 4.6 12.2 10.7 6.2 1.8 –1.1

Commodity pricesOil1

In SDRs –7.8 1.9 17.8 –7.6 13.0 –0.4In U.S. dollars –5.5 8.0 13.2 –7.6 11.8 –0.3

Nonfuel2In SDRs 10.8 2.1 4.8 –2.4 2.9 –0.9In U.S. dollars 13.6 8.2 0.7 –2.5 2.1 –0.8

Consumer pricesIndustrial countries 2.3 2.4 2.3 2.4 — –0.1Developing countries 46.8 19.8 13.3 10.8 0.7 1.0Countries in transition 264.8 128.0 41.3 16.8 3.2 3.2

Six-month LIBOR (in percent)3

On U.S. dollar deposits 5.1 6.1 5.6 6.0 0.2 0.4On Japanese yen deposits 2.4 1.3 1.0 2.4 — —On deutsche mark deposits 5.3 4.6 3.3 3.8 — –0.7

Note: Real effective exchange rates are assumed to remain constant at the levels prevailing during July 25–August 21, 1996, except for the bilateral rates among ERM currencies, which are assumed to re-main constant in nominal terms.

1 Simple average of spot prices of U.K. Brent, Dubai, and West Texas Intermediate crude oil.2 Average, based on world commodity export weights.3 London interbank offered rate.

sition will be considerably higher, the benefits will besmaller and slower to materialize, and the risks of re-versal of the economic and political reform processwill remain.

The achievements of recent years underscore the va-lidity of the cooperative strategy to strengthen theglobal expansion set out by the Interim Committee in1993 and reaffirmed in its October 1994 MadridDeclaration. At the same time, the continuing prob-lems affecting many countries suggests a need tobroaden the strategy in several areas and to strengthenits implementation. Experience in recent years hasconfirmed that economic success requires sustainedefforts at both structural reform and macroeconomicstabilization and that efforts over a broad range ofpolicies are mutually reinforcing. It has become par-ticularly apparent that a failure to tackle serious weak-nesses in some areas may increase the short-termcosts, and delay the positive effects, of those policiesthat go in the right direction. More comprehensive andbetter balanced policy approaches are necessary if agreater number of countries are to realize their fullgrowth potential.

Industrial Countries

In the industrial countries, there are promising signsthat economic activity will turn out to be stronger in1997 than during the past year, when growth slowedsharply in many countries.1 At the same time, inflationis likely to remain subdued while external imbalancesare expected to diminish further in a number of cases.For the United States, the slowdown in 1995 wasneeded to reduce the risk of overheating after thestrong performance of 1994, which brought the econ-omy to a high rate of resource utilization. More re-cently, activity has again picked up, partly in responseto the easing of monetary conditions that began inmid-1995. In Europe—with the main exception of theUnited Kingdom, where growth had also been abovetrend—the slowdown in growth was decidedly unwel-come as recoveries from the trough of the 1992–93 re-cession were incomplete and unemployment had re-mained high. Since the beginning of 1996, however,conditions for a renewed strengthening of activityhave improved as monetary conditions have generallyeased, as long-term interest rates remain well belowtheir levels in late 1994 and the first half of 1995, andas overstocking appears to have been corrected some-what. Moreover, with greater convergence of eco-


3

1The average annual growth rate for the industrial countriesshown in Table 1 of about 2 percent in 1995 masks the extent of last year’s slowdown. On a fourth-quarter-to-fourth-quarter basis,growth in the major seven countries slowed to only 1.5 percent in1995 (from 3.1 percent in 1994) but is projected to pick up to 2.5percent in 1996.

Chart 1. World Indicators1

(In percent)

1Shaded areas indicate IMF staff projections.2Goods and services, volume.3GDP-weighted average of ten-year (or nearest maturity) government

bond yields less inflation rates for the United States, Japan, Germany,France, Italy, United Kingdom, and Canada. Excluding Italy prior to1972.

-4

0

4

8

12

-4

0

4

8

12

0

5

10

15

20

-6

-4

-2

0

2

4

6

8

1970 75 80 85 90 95 2000 1970 75 80 85 90 95 2000

1970 75 80 85 90 95 2000 1970 75 80 85 90 95 2000

Growth of World Real GDP Growth of World Trade2

Inflation (Consumer prices) World Real Long-Term Interest Rate3

Average, 1970–95

Developing countries (median)

Industrial countries

Average, 1970–95

The global expansion is expected to continue with the growth ofworld output and trade above trend, while inflation should remaincontained in industrial countries and slow further in developingcountries.


nomic and policy fundamentals within Europe, ex-change rates have returned to levels more consistentwith balanced growth following the misalignmentsthat arose in the spring of 1995 when the deutschemark (together with the yen) appreciated sharplyagainst the U.S. dollar and several other currencies. InJapan, in contrast to the moderation of growth else-where in 1995, the recovery has gained momentum,with confidence gradually recovering as the yen de-preciated from the excessively high values reached inthe early part of last year.

Inflation in the industrial world has been generallywell contained in recent years and is no immediatethreat to sustained growth in most countries. But asdiscussed further below, monetary authorities will, of

course, need to remain vigilant to incipient price pres-sures as growth continues or strengthens. (The mone-tary and fiscal policy assumptions underlying the pro-jections are summarized in Box 1.) Of continuingconcern, however, is the need shared by most indus-trial countries to make further progress toward sub-stantially reducing their fiscal imbalances over themedium term. Structural (i.e., cyclically adjusted)deficits have only been brought down from 3!/2 percentof GDP in 1992 to 2!/2 percent of GDP in 1995 for theindustrial countries as a group, and the financing offiscal deficits remains a source of pressure on worldreal interest rates, keeping the level of private invest-ment and potential future growth below what other-wise could be achieved. A growing number of coun-

4

Fiscal policy assumptions for the short term are basedon official budgets adjusted for any deviations in outturnas estimated by IMF staff and also for differences in eco-nomic assumptions between IMF staff and national au-thorities. The assumptions for the medium term take intoaccount announced future policy measures that arejudged likely to be implemented. In cases where futurebudget intentions have not been announced with suffi-cient specificity to permit a judgment about the feasibilityof their implementation, an unchanged structural primarybalance is assumed. For selected industrial countries, thespecific assumptions adopted are as follows.

United States: For the period through FY1999, fiscal rev-enues and outlays at the federal level are based on the ad-ministration’s March 1996 budget proposal (as updated inthe July 1996 Mid-Session Review of the 1997 Budget),after adjusting for differences between the IMF staff’smacroeconomic assumptions and those of the administra-tion. From FY 2000 onward, the federal government pri-mary balance as a proportion of GDP is assumed to re-main unchanged from its projected FY 1999 level.

Japan: Measures that have already been announced areassumed to be implemented over the medium term. Thesemeasures include an increase in the consumption tax ratefrom 3 percent to 5 percent in 1997 and a simultaneousend to the temporary income tax cut, implementation ofthe 1994 pension reform plan, and the medium-term pub-lic investment plan.

Germany: The 1996 projection for the general govern-ment is based on the 1996 federal budget and recent offi-cial estimates for the other levels of government, adjustedfor differences in macroeconomic projections. The 1997projections are based on official tax estimates and envis-age implementation of most of the government’s pro-posed fiscal package. Elements of the package that havegained the requisite agreement (e.g., from the unions andthe Bundestag) have been incorporated, while measuresthat still need Bundesrat approval or lack specificity atthe Länder level have not been fully taken into account.

Projections for 1998 and beyond are predicated on an un-changed structural primary balance.

France: The projections for both 1996 and 1997 take intoaccount policy measures that have already been imple-mented. In addition, it is assumed that the government’splans for the 1997 budget of the state (a freeze in nomi-nal expenditure yielding an adjustment of about !/2 of1 percent of GDP) will be fully achieved, given the strongcommitment to meeting the criteria for EuropeanEconomic and Monetary Unit (EMU). As regards socialsecurity spending in 1997, the projections assume thatParliament (using the new powers conferred by theconstitutional amendment adopted earlier this year) willset a ceiling consistent with the government’s overallobjectives.

Italy: The projections take into account policy measuresthat have already been implemented, including the June1996 supplementary package. In addition, it is assumedthat the measures announced in the 1997–99 plan arefully implemented and yield the officially estimatedamounts. Projections beyond 1999 assume an unchangedstructural balance.

United Kingdom: The budgeted three-year spending ceil-ings are assumed to be observed. Thereafter, noncyclicalspending is assumed to grow in line with potential GDP.For revenues, the projections incorporate, through thethree-year budget horizon, the announced commitment toraise excises on tobacco and road fuels each year in realterms; thereafter, real tax rates are assumed to remainconstant.

Canada: Federal government outlays for departmentalspending and business subsidies conform to the medium-term commitments announced in the March 1996 budget.Other outlays and revenues are assumed to evolve in linewith projected macroeconomic developments. The unem-ployment insurance premium, however, is assumed to fallin 1998/99 to a level that is consistent with an unchangedsurplus in the unemployment insurance account. The fis-

Box 1. Policy Assumptions Underlying the Projections

tries, however, are setting targets for substantiallyeliminating their fiscal shortfalls over the mediumterm. These consolidation efforts appropriately are fo-cused on the need to contain the level and growth ofpublic expenditure, which may ultimately permitreductions in tax burdens. There is also increasedawareness of the need to address early on the problemof unfunded pension liabilities, which threaten to ex-acerbate pressures on public finances as populationsage in coming decades (see Chapter III of the May1996 World Economic Outlook). In many countries,however, the debate about pension reform and thesearch for solutions has only just begun.

Most of the largest fiscal imbalances are suffered bymembers of the European Union (EU), including some

of those countries that have experienced the highestunemployment rates and the weakest growth perfor-mance in recent years. It is generally recognized thatprogressive elimination of fiscal imbalances is neces-sary for an improvement in growth performance overthe medium term. The priority that has now been givento fiscal consolidation has already begun to yield ben-efits in reducing risk premiums in long-term interestrates, in improving confidence, and in strengtheningmedium-term growth prospects, particularly in thosecountries where financial markets previously indicatedsome lack of confidence in government policies. Theattention being given to fiscal consolidation also re-flects the desire to meet the objective of keeping fiscaldeficits within the Maastricht Treaty reference value of


5

cal situation of the provinces is assumed to be consistentwith their stated medium-term deficit targets.

Spain: Projections for 1996–97 incorporate the multiyearexpenditure control agreements in the areas of public sec-tor wages and employment, health care, and regional andlocal governments; additional cuts announced in May;and the economic liberalization, tax measures, and wagefreeze announced in June and July. For 1997, the incometax schedule and excise taxes are assumed to be adjustedin line with inflation. The projections do not take into ac-count the implications for 1996–97 of the recently dis-covered large public expenditure overruns in 1995.

Netherlands: Projections assume continued adherence tothe government’s medium-term expenditure path for thecentral government and social security. While the author-ities have not specified a general government deficit tar-get for 1997, their 1997 expenditure ceilings for centralgovernment and social security that were decided in thespring of 1996 provide scope for a deficit well under 3percent of GDP.

Belgium: Projections for 1996 are based on the budgetand the spring budget control exercise. For 1997, IMFstaff estimates reflect the general government deficit ceil-ing of 3 percent of GDP included in the framework lawpassed by Parliament in July 1996 that gives the govern-ment broad powers to achieve participation in EMU (re-cent pronouncements by the authorities have signaled adesire for a deficit of 2.8 percent of GDP).

Sweden: The medium-term projections are based on thegovernment’s multiyear consolidation program approvedby Parliament in 1995 and additional measures taken inApril 1996.

Greece: Projections for 1996 reflect the IMF staff’s as-sessment of the outcome of the official budget. Measuresto meet the targets of the convergence plan are still beingdefined in the 1997 budget under preparation, and theprojections at this stage are based on IMF staff estimatesof current services.

Portugal: Projections for 1996 are based on implementa-tion to date of the official budget. Preparation of the 1997budget (which will aim at a deficit of not more than 3 per-cent of GDP) is currently under way, and the projectionsfor 1997 and beyond are at this stage based on an un-changed structural primary balance.

Switzerland: Projections for 1996–99 are based on offi-cial estimates for current services. Thereafter, the generalgovernment structural primary balance is assumed to re-main constant.

Australia: Projections for the Commonwealth govern-ment are based on the 1996/97 budget, adjusted for anydifferences between the economic projections of the staffand the authorities. Unchanged policies are assumed forthe state and local government sector from 1996.

* * *

Monetary policy assumptions are based on the estab-lished framework for monetary policy in each country,which in most cases implies a nonaccommodative stanceover the business cycle. Hence, it is generally assumedthat official interest rates will firm when economic indi-cators, including monetary aggregates, suggest that infla-tion will rise above its acceptable rate or range and easewhen the indicators suggest that prospective inflationdoes not exceed the acceptable rate or range and thatprospective output growth is below its potential rate. Forthe exchange rate mechanism (ERM) countries, whichuse monetary policy to adhere to exchange rate anchors,official interest rates are assumed to move in line withthose in Germany, except that progress on fiscal consoli-dation may influence interest differentials relative toGermany. On this basis, it is assumed that the London in-terbank offered rate (LIBOR) on six-month U.S. dollardeposits will average 5.6 percent in 1996 and 6 percent in1997; that the six-month LIBOR rate in Japan will aver-age 1 percent in 1996 and 2.4 percent in 1997; and thatthe three-month interbank deposit rate in Germany willaverage 3.3 percent in 1996 and 3.8 percent in 1997.


3 percent of GDP by 1997, the test year for decidingwhich member countries meet the criteria for partici-pation in the third and final stage of EMU beginning in1999.

While the weakness of activity in early 1996 wouldappear to militate against the pursuit of specific fiscaltargets defined in actual rather than cyclically adjustedor structural terms, the legacy of excessive fiscal im-balances in many European countries suggests thatany significant backsliding from announced consoli-dation efforts could have severe implications for inter-est rates and financial market confidence, especiallysince it might derail the EMU process. Not only doesthe maintenance of an adequate pace of consolidationoffer the best prospect for a sustained improvement ineconomic performance over the medium term, but alsothe short-term costs may be smaller than those arisingfrom failure to address adequately the persistentlylarge deficits. At the same time, it is important to avoidaggravating a difficult situation through unduly pro-cyclical fiscal policies. If recent economic weaknesswere to be prolonged, it would be necessary to allowfiscal policy to provide automatic stabilizers for activ-ity, but only in those countries that are making con-vincing and adequate progress in reducing structuralimbalances (Chart 2). To foster greater fiscal disci-pline in Stage 3 of EMU, it is encouraging that the EUis considering an agreement whereby countries wouldaim for a budgetary position close to balance over themedium term. This should provide a basis for allowingautomatic stabilizers to operate without budget deficitsexceeding 3 percent of GDP during a normal businesscycle.

For many countries, particularly in Europe, fiscalimbalances are related to shortcomings in the func-tioning of labor markets, which have resulted in a dra-matic upward trend in unemployment over the pasttwenty-five years. As much as 8 to 9 percentage pointsof the EU’s current unemployment rate of over 11 per-cent is widely considered to be structural in the sensethat it is unlikely that it could be absorbed throughcyclical recovery alone, without significant inflation-ary risks. Together with discouraged job seekers andheavy resort to early retirement, these high rates of un-employment represent a considerable underutilizationof labor resources, which has reduced potential outputand exacerbated budgetary pressures through revenuelosses and outlays for income support. Clearly, a sub-stantial reduction in this underutilization through ap-propriate labor market reforms would go a long waytoward addressing Europe’s fiscal shortfalls.

Many economists and policymakers agree on theroot causes of rising structural unemployment and onthe types of reform that are needed to reverse it. Muchremains to be done to tackle the problem, however,and it has proved extremely difficult to mobilize pub-lic support for the necessary reforms. In many coun-tries, there is great reluctance to modify labor market

6

Chart 2. European Union: General GovernmentBudget Positions1

(In percent of GDP)

1IMF staff estimates and projections. The ordering of countries isbased on the projected unadjusted budget positions in 1997, except thatwhere the differences between projections are not significant the order-ing is alphabetical.

2The estimates differ from those of national authorities (shown inTable 3) at least in part because sufficient information on the measuresto be proposed in the 1997 budgets is not yet available. See Box 1 fordetails regarding the IMF staff’s fiscal assumptions.

3The unadjusted budget position for Ireland in 1996 is not shown sep-arately because it is about equal to the structural balance, reflecting thefact that output is close to potential.

4Structural budget positions are unavailable and unadjusted budgetpositions are expected to be in approximate balance in 1996–97.

5Excludes Luxembourg.

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

1995 96 97

Greece2

Italy

Portugal2

Spain2

United Kingdom

Austria

Belgium

France

Germany

Sweden

Netherlands

Ireland3

Finland

Denmark

Luxembourg4

European Union (Average) 5

Unadjusted

Structural

Maastricht Treaty reference value

1 0 -1 -2 -3 -4 -5 -6 -7 -8 -9 -10

Expected progress toward reducing underlying budgetary imbalances ismasked to some extent by large cyclical components in fiscal deficits.

regulations, benefits, and privileges that are widelyperceived to be social achievements, but which con-tribute to persistently high unemployment and socialexclusion by keeping labor costs above warranted lev-els for low-productivity workers and by reducing in-centives to work and to create jobs. New Zealand andthe United Kingdom are the most prominent examplesof countries that have begun to reduce their structuralunemployment rates. Most other countries have intro-duced some reforms aimed at reducing overly gener-ous levels of unemployment compensation, tighteningeligibility criteria, reducing taxes on employment, re-straining increases in minimum wages, or facilitatingrestructurings and layoffs—and thereby hirings. Thereforms in many countries, however, have been mostlypiecemeal, and the beneficial effects of progress in onearea have often been hampered by new or deeply in-grained distortions in other areas.

The essential aim of labor market reforms must beto allow market forces a greater role in helping to clearthe labor market at much lower levels of unemploy-ment. Since this may well result in lower real wagesfor some skill categories, governments, in Europe andCanada, in particular, are faced with the challenge ofalso reforming tax and transfer systems so that theymay better meet equity objectives and safeguard a rea-sonable level of social protection without the negativeimplications for incentives and employment that areassociated with present arrangements. Enhanced train-ing and education are also needed in all countries to al-leviate poverty and social exclusion. In Europe, as em-phasized in earlier issues of the World EconomicOutlook, labor market reforms are not only needed toaddress the problems of unemployment and fiscal im-balances, but are also essential for the success of theplanned monetary union: increased labor market flex-ibility will be needed to substitute for the loss of theexchange rate instrument when countries are facedwith exceptional adjustment needs.

In contrast to the continued difficulties in the fiscalarea and in labor markets, monetary authorities in theindustrial countries have been highly successful inachieving reasonable price stability, the primary ob-jective for monetary policy. The industrial countriesare now enjoying the lowest inflation rates in thirtyyears with price increases well within official targetranges and generally at very low levels in most cases.It is through the achievement and maintenance of ahigh degree of price stability that monetary policy canmake its most important contribution to both sup-porting the highest sustainable growth paths for out-put and employment and minimizing cyclical fluc-tuations around these growth paths. When monetarypolicy fails to contain inflationary pressure, therebynecessitating stronger tightening at a later date, theeventual effects on the stability of output and employ-ment and on the sustainable growth rate are likely tobe negative.

Success on the inflation front has enhanced thecredibility of the anti-inflationary commitment ofmonetary authorities and thereby reduced inflationpremiums in interest rates in many countries, as indi-cated by the trend declines in nominal and real long-term interest rates since the early 1980s. Credibilityhas also provided some room for monetary policies torespond to other macroeconomic concerns, such as thestability of output, without raising doubts in financialmarkets about the commitment and ability to containinflation. This is fully consistent with the normalcyclical movement of monetary conditions needed toachieve and maintain reasonable price stability. Thus,in situations when inflation objectives would not bejeopardized, it is appropriate to guide short-term inter-est rates lower to help counter recessionary forces or tofacilitate the absorption of slack. But it is essential thatsuch a posture be consistent with the overriding needfor monetary policy to safeguard a high degree of pricestability. And, because of the lags with which changesin monetary conditions affect the economy, monetarypolicy must necessarily be forward looking: this im-plies that preemptive tightening is needed when infla-tionary pressures are in prospect and before they be-come apparent.

A complication in the conduct of monetary policy,at least for countries that are not using the exchangerate as an intermediate target, is the need to rely on abroad set of indicators to judge the appropriate stanceof monetary conditions. This became clear followingthe unsatisfactory experiences with monetary targetsin many countries. Greater reliance on broader indica-tors does not appear to have been an obstacle toachieving and maintaining reasonable price stabilityand seems if anything to have enhanced the credibilityof monetary authorities. Still, in a number of cases,credibility has not yet been fully established and willrequire a solid track record over a long period. In thiscontext, the emphasis on meeting explicit inflation tar-gets in many countries should be helpful, even thoughit will be difficult in practice to keep inflation withinthe narrow ranges defined by these targets in allcircumstances.

The United States has been particularly successfulin recent years in achieving a high level of employ-ment and maintaining growth at close to its potentialrate with low inflation. These achievements can bepartly attributed to an exceptionally dynamic and flex-ible labor market that has accommodated a growinglabor force and facilitated macroeconomic manage-ment. The authorities have also made good progresson the fiscal front—after more than a decade of exces-sive deficits—while the soft landing achieved in 1995testifies to the success of monetary policy in preempt-ing inflationary pressures at a mature stage of theexpansion.

Despite these achievements, significant challengesremain in both the monetary and fiscal areas. Follow-


7


ing the moderation of growth in 1995, the U.S. econ-omy rebounded in early 1996 and is now again threat-ening to exceed the level of output consistent with lowand stable inflation. So far, the underlying inflationrate has remained fairly stable at about 3 percent orless throughout this expansion. However, margins ofunused resources in the economy appear to be virtu-ally exhausted and the unemployment rate has fallen toa level that in the past has been associated with risingwage and price pressures. In these circumstances,some tightening of monetary conditions would seemappropriate to reduce the risk of a pickup in inflationthat would require more severe and potentially moredisruptive policy actions at a later stage, the effects ofwhich would be felt beyond the United States. In thefiscal area, further efforts are needed to progressivelybalance the budget over the medium term and to averta renewed deterioration in the fiscal situation in thelong run due to the rapid growth expected in spendingon pensions and medical care for the elderly.

Japan’s economic recovery has gained momentumsince mid-1995 after a protracted slowdown. A broadrange of supportive policy actions have helped tocounteract the deflationary forces stemming fromfalling asset prices and difficulties in the banking sec-tor and to correct the excessive appreciation of the yenin the early part of 1995. The authorities are now facedwith the challenge of gradually withdrawing stimuluswithout undermining prospects for continued recov-ery. Eventually, short-term interest rates will need tobe raised from the low levels seen recently, but thelarge output gap, a virtually stationary price level,exchange market considerations, and the need to facil-itate the workout from the nonperforming loan prob-lems all underscore the appropriateness of maintainingthe current supportive monetary stance for the timebeing. Fiscal consolidation will need to proceed at asustained pace as the recovery gains momentum andthe authorities appropriately are planning to unwindthe recent stimulus packages and to increase revenues.Over the medium term, the need to prepare for futurebudgetary outlays associated with the aging of thepopulation suggests that Japan should aim at reestab-lishing a surplus in its overall budgetary position (forgeneral government), although perhaps not as large asin the early 1990s when it reached almost 3 percent ofGDP. Further deregulation to strengthen the role ofmarket forces is essential to support the recovery.

Although Germany has already made progress in re-ducing the large unification-related structural budgetdeficit that emerged in 1990–91, the actual deficit isprojected to widen to about 4 percent in 1996 partly asa result of the renewed cyclical slowdown during thepast year. The latest fiscal consolidation package,which also contains important measures to enhancelabor market flexibility, is projected to reduce thedeficit to 3 percent of GDP in 1997, provided activitycontinues to pick up as expected during the period

ahead, following the rebound in the second quarter.But major fiscal challenges remain to be addressed, in-cluding the need to ensure the financial sustainabilityof public pension plans and to reduce the easternLänder’s dependence on transfers and subsidies.

Inflation in Germany is well under control, and thisallowed short-term interest rates to be lowered signif-icantly in late 1995 and early 1996 in response togrowing signs that the recovery was faltering. InAugust, short-term market rates were eased further,triggering corresponding reductions in many ofGermany’s partner countries (Chart 3). Real long-terminterest rates increased somewhat in the openingmonths of 1996, partly under the influence of higherbond yields in the United States, but more recentlyexchange market developments and the slack in theeconomy have allowed German rates to decouple to alarge extent from U.S. rates. The growth of M3, theprincipal monetary aggregate monitored by theBundesbank, has decelerated in recent months al-though it is still above its target range; the rise in M3in 1996 follows very subdued money growth in 1995.The easing of monetary conditions over the past yearshould help to secure the prospective recovery and wasappropriate in view of the absence of inflationary pres-sure, the continuing efforts at fiscal consolidation, andthe strength of the exchange rate. However, it is stilltoo early to conclude that the recent round of interestrate reductions has fully run its course.

In France, growth has also been weak since early1995, raising doubts, as in many other countries, aboutthe ability to meet fiscal targets. The authorities havestood firm, however, on their intention to meet by1997 the 3 percent fiscal deficit criterion stipulated inthe Maastricht Treaty. This firm approach and the sub-dued inflation picture have contributed to a significantnarrowing of interest differentials vis-à-vis Germany;the easing of monetary conditions over the past yearshould also assist recovery. The 3 percent deficit goalseems within reach provided activity strengthens dur-ing the period ahead as envisaged in the staff’s projec-tions. But it will be difficult to restore adequate bal-ance in the public finances over the medium term andlower the tax burden without fundamental reformsaimed at better containing public expenditures and atenhancing incentives to create and seek jobs in orderto reduce the high level of unemployment. Recentmeasures to lower social security contributions forworkers at or near the minimum wage and to stimulatepart-time work are welcome steps but should be fol-lowed up by more far-reaching measures that addressthe root causes of high and persistent unemployment.A comprehensive program of fiscal and labor marketreform is necessary to create a basis for robust nonin-flationary growth over the medium term, which wouldfacilitate other reforms, including measures to addressthe problem of unfunded liabilities in the public pen-sion system.

8

In the United Kingdom, where the recent economicslowdown has been much less severe than in Germanyand France, underlying inflation has been runningslightly above the 2!/2 percent ceiling of the authori-ties’ inflation target range, but is expected to dropbelow the ceiling by early 1997. Unemployment hasdeclined steadily since the start of the recovery in 1993and there may still be room for some further reductionwithout undue inflationary risks. On the fiscal side, re-cent revenue shortfalls suggest that government bor-rowing will be higher than expected in lastNovember’s budget and that corrective measures areneeded to put the public finances back on track towardthe authorities’ goal of balance over the medium term.Growth is expected to pick up in the second half of1996 and to be sustained at a pace higher than thegrowth of potential next year. There is some risk, how-ever, that financial market confidence and long-terminterest rates, which already appear to reflect concernsover the fiscal outlook, could be more adversely af-fected by continuing fiscal slippage, especially if theauthorities were to introduce significant tax cuts be-fore the next general election.

Following a relatively strong performance in 1995,Italy’s recovery lost momentum in the first half of1996 as growth in key export markets slowed, as thecorrection of the earlier undervaluation of the lira con-tinued, and as domestic demand remained subdued.Progress in reducing the large fiscal deficit and in low-ering inflation has helped to reduce interest differen-tials further vis-à-vis Germany, but real interest ratesremain among the highest in Europe. Despite the slow-down in growth, the new government’s three-year pro-gram confirms the previous plan’s targets, centered onachieving the Maastricht objectives by 1998.Furthermore, it does not rule out accelerating adjust-ment later this year, if growth and interest rate devel-opments turn out better than currently expected.Achievement of the plan’s targets is essential forsafeguarding stability in financial markets and achiev-ing better balanced economic growth. It is, however,likely to require action in sensitive areas, including thepublic payroll, health expenditures, and pensions. The1997 budget will constitute an important test of thegovernment’s resolve in this respect.

In Canada, efforts at fiscal consolidation since 1993have reduced the fiscal deficit from over 7 percent ofGDP to an estimated 2!/2 percent of GDP in 1996,which has helped to narrow the long-term interest ratedifferential vis-à-vis the United States in recentmonths. Meanwhile, weak growth, subdued inflation-ary pressures, and a firmer exchange rate have led to adecline in short-term rates well below U.S. levels.Lower domestic interest rates, combined with thestrength of the U.S. expansion in 1996, should lead toa significant pickup in growth this year. Achievementof the official objective of balancing the budget iswithin reach, which would help to reduce real long-


9

Chart 3. Industrial Countries: Real Interest Rates1

(In percent a year)

Sources: WEFA, Inc.; and Bloomberg Financial Markets.1Real rates are nominal rates minus percent change of consumer

prices from a year ago. Price data for January and February 1996 arepartly estimated.

2Data prior to January 1990 exclude Luxembourg.3Excludes Greece and data prior to June 1993 exclude Finland.

-2

0

2

4

6

8

10

-2

0

2

4

6

8

10

Real Short-Term Interest Rates

Real Long-Term Interest Rates

European Union 2

Germany

Japan

Japan

United States

United States Germany

European Union 3

1989 1990 1991 1992 1993 1994 1995 Aug. 1996

Real interest rates in Europe have remained considerably abovethose in the United States and Japan.


term interest rates further and strengthen the basis forsustained economic expansion. With substantial gainsof export market shares in recent years, the externalcurrent account, which has been in significant deficitduring the past decade, is expected to be close to bal-ance in 1996.

Among the smaller industrial countries, economicconditions vary considerably. Australia and NewZealand have experienced buoyant growth in recentyears with emerging inflationary pressures being metby monetary tightening. Norway and Ireland also con-tinue to enjoy robust growth, so far with low inflation.While activity has been relatively strong in theNetherlands, growth in Austria and Belgium moder-ated in 1995 but should gradually firm as their mainexport markets in Germany and France begin to re-cover; Spain, Sweden, and Finland have experienced aslowing of their export-led recoveries but with infla-tion remaining well within official targets and fiscalconsolidation proceeding, interest differentials vis-à-vis Germany have narrowed considerably, and confi-dence is improving. All of these countries are pursuingrelatively tight fiscal policies aimed at fulfilling by1997 the conditions for participation in the final stageof EMU. (Denmark, Ireland, and Luxembourg are theonly countries that are currently considered to meetthe Maastricht fiscal criterion.) Economic activity inSwitzerland remains sluggish, in large part because ofthe persistent strength of its currency. Relatively easymonetary conditions, deregulation, and other struc-tural reforms are needed to facilitate recovery, to re-duce the large external surplus, and to promote furtherrealignment of the exchange rate.

Developing Countries

Growth in the developing countries remained closeto 6 percent in 1995 despite a marked slowdown inLatin America in the wake of the Mexican financialcrisis. In 1996 and 1997, aggregate growth seemslikely to remain in the 6 percent region as Mexico andArgentina recover, growth in Africa strengthens, andthe expansion moderates in a number of Asian emerg-ing market countries. Activity in emerging marketcountries is generally expected to remain buoyant onthe basis of strong domestic fundamentals and contin-ued large capital inflows, especially of foreign directinvestment. In parallel with their remarkable successin expanding exports—both to developed economiesand to each other—these countries have become themost dynamic markets for exports from the industrialcountries. This has helped to offset the recent weak-ness in economic activity in many industrial countries,at the same time as strengthened international compe-tition has contributed to the alleviation of global infla-tionary pressures and to the improvement of livingstandards worldwide, particularly in those countries

that have adjusted quickly and flexibly to changes inrelative prices and in their comparative advantages.

The role of domestic policies in fostering conditionsconducive to rapid growth in the successful developingcountries carries important lessons for those countrieswhere progress has been more limited and that con-tinue to fall behind in relative income positions.Among the strong performers, fiscal imbalances havegenerally been well contained and the role of the pub-lic sector has been mainly geared toward promotingprivate sector development. Disciplined fiscal policiesin turn have reduced the need for monetary financingof budget deficits and facilitated the maintenance oflow inflation, which is in single digits in many of thesecountries. And a stable, predictable macroeconomicenvironment has provided incentives to save and investwhile heavy reliance on market forces, includingthrough the pursuit of outward-oriented trade policies,has helped channel resources toward their most pro-ductive uses.

In contrast, although situations differ considerablyand it is difficult to generalize, the less successfulcountries are often characterized by persistent fiscalimbalances exacerbated by loss-making public enter-prises; by extensive government intervention in theeconomy through regulations and restrictions on theprivate sector and on foreign trade; by poor control ofinflation; and by financial repression and the struc-turally negative real interest rates associated with it,which discourage saving and distort resource alloca-tion. Experience shows that the sustained implementa-tion of policies to address such shortcomings does,over time, lead to substantial improvements in eco-nomic performance.

One of the most pressing issues in many emergingmarket countries has been the question of how theyshould deal with the risk of overheating, which can re-sult in unsustainable macroeconomic imbalances, ris-ing inflation, and strains in financial markets, and ulti-mately affect the confidence of domestic and foreigninvestors. The importance of addressing such problemsat an early stage is underscored by concerns about thevulnerability of banking systems to foreign exchangeand financial market crises and domestic policy rever-sals, particularly when corrective policy actions areimplemented belatedly. In the past several years, anumber of emerging market countries have experi-enced disruptive and costly banking crises, and thefragility of banking systems in many other countriessuggests that similar difficulties may occur in the fu-ture. To reduce such risks, the emerging market coun-tries need to enhance the soundness of their financialsectors through strong prudential standards and super-vision. Appropriate measures and early action will helpto limit the risk of contagion from difficulties originat-ing in the banking systems of other countries.

So far, standard price indicators suggest that infla-tion is relatively well under control in most of the

10

emerging market countries. But the combination ofwidening deficits on current account and rapid growthtestifies to excess demand pressures—as opposed toproblems of external competitiveness—in countriessuch as Indonesia, Malaysia, and Thailand. Moreover,preliminary staff work to assess the level and growthrate of output that appear to be consistent with stableinflation suggests that the current levels of activity inthese countries may be above their sustainable long-term trends. These countries have already taken mea-sures to restrain demand, but further action may beneeded to avoid the emergence of excessive pressureson capacity and to contain external imbalances. Koreahas also been facing a risk of overheating, althoughgrowth has been moderating toward a more sustainablepace and pressures on resources appear to be easing.

In China, growth has slowed from the unsustainablepace of the early 1990s and inflation has fallen to lessthan half the rate seen in 1994. Money and credit,however, have continued to expand at a rapid rate andmore restrained financial policies, supported by ahardening of budget constraints in state enterprises,are required to sustain the favorable inflation perfor-mance. An intensification of state enterprise reform to-gether with further trade liberalization and the removalof the few remaining restrictions on current accountpayments will help strengthen the role of marketforces in resource allocation. Vietnam has made sub-stantial efforts to move toward a market-based econ-omy, and has achieved robust growth for the last fiveyears and more recently, single-digit inflation. To sus-tain this performance, structural reforms need to bedeepened, including through restructuring of state en-terprises, and macroeconomic policies need to remaincautious, especially in view of the widening deficit oncurrent account.

For India, while recent economic performance hasbeen quite favorable, high real interest rates stemmingfrom excessive fiscal deficits and supply-side bottle-necks are likely to slow long-term growth. Moreover,there are risks of rising inflation and external vulnera-bility unless these issues are forcefully addressed. Aslong as the fiscal deficit remains high—the overallpublic sector deficit is still close to 9 percent of GDPeven with the modest adjustment planned for thisyear—it will be necessary to maintain a tight monetarypolicy stance. But the key to sustained strong perfor-mance is ambitious fiscal consolidation that would re-lieve pressures on prices and the balance of payments,free resources for productive investment, and providea more conducive environment for needed structuralreforms. In Pakistan, the recent deterioration in thecurrent account and continued double-digit inflationpose a threat to the medium-term outlook. Fiscal ad-justment and financial sector reform are critical to theenhancement of longer-term prospects.

In Latin America, Chile remains the most successfuleconomy. With a moderation of growth in 1996 from

the unsustainable pace of 8!/2 percent in 1995, con-cerns about overheating have abated, but pressures oncapacity continue to warrant some degree of monetaryrestraint. Brazil also has been successful in reining ininflation thanks to the Real Plan: in fact, inflation inthe year to August 1996, at only 8!/2 percent, was thelowest 12-month rate since 1973. Fiscal consolidationand structural reforms, especially trade liberalization,are essential to safeguard this progress on the inflationfront and to permit stronger growth on a sustainedbasis. In Mexico, activity is now recovering followingdeclines in output in the wake of last year’s financialcrisis, and there has been progress in containing infla-tion following the sharp depreciation of the peso.Sustained adjustment efforts should help to strengthenmarket confidence further and permit growth to be-come firmly established in the period ahead. Growthhas also resumed in Argentina, which is currently en-joying the lowest inflation rate in more than fiftyyears. Following several years of political instability,financial market crises, accelerating inflation, and de-clining output, Venezuela has now begun to implementan economic program designed to restore confidence,reduce inflation, and set the stage for a resumption ofgrowth in 1997.

The recent strengthening of growth in many Africancountries is promising and the implementation ofstronger macroeconomic and structural policies shouldallow average growth to continue to improve and theoverall inflation rate to decline further. Nevertheless,the region continues to face important policy chal-lenges to enhance resource allocation and strengthensaving and investment. It is particularly encouragingthat Benin, Côte d’Ivoire, Togo, and other CFA franczone countries are seeing continued recovery follow-ing the strengthening of incentives and restoration ofexternal competitiveness brought about by the 1994devaluation and accompanying policies. Ghana, Kenya,and especially Malawi and Uganda are also experi-encing gains in living standards on the basis of contin-ued progress in domestic policies and notwithstandingthe adverse effects of volatile commodity prices. InSouth Africa, economic policies have begun to set thestage for a gradual strengthening of growth perfor-mance although unemployment will remain relativelyhigh for some time. Several other countries, however,including Nigeria, Sudan, and Zaïre, have made littleprogress in the formulation and implementation ofappropriate stabilization and structural adjustmentpolicies.

In the Middle East and Europe region, economicperformance also remains uneven. Israel and Jordanare experiencing strong expansions—with Israel re-cently taking further action to avert overheating—as aresult of strengthened policies and capital inflowsstimulated in part by progress toward improved re-gional stability. Turkey experienced a strong recoveryin 1995, but the sustainability of the economic expan-

Developing Countries

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sion is threatened by widening fiscal deficits and ris-ing inflation. Saudi Arabia and many other oil produc-ing countries are making progress in adjusting tolower oil prices; fiscal deficits have been reduced sub-stantially, but further efforts are needed to containpublic expenditures and reverse the rising trend in lev-els of public debt. Egypt has made progress in deregu-lating the economy and liberalizing foreign trade. Asemphasized in the policy program the authorities haveput forward for Fund support, privatization of publicenterprises, the strengthening of the financial sector,and reforms to further improve the tax system areneeded to allow the country to grow at a faster pace.Morocco’s economy has rebounded from last year’sdrought. The needed strengthening of stabilizationpolicies will have to be complemented by stronger ef-forts at structural reform. In Algeria, where greatermacroeconomic stability has been achieved, furtherstructural reforms are needed to achieve sustained eco-nomic growth over the medium term.

Economies in Transition

As in other parts of the world, the rewards for com-prehensive reform and stabilization efforts are verystriking among the transition countries, where the re-sults of economic transformation are increasingly vis-ible. While the declines in output during the initialphase of transition were considerably larger than mostobservers had expected, the countries that are the mostadvanced in the transition are now clearly experienc-ing substantial economic growth. Although strong do-mestic demand has recently been the main factor be-hind growth in some cases, rapid expansion of exportshas continued to play an important role in the recov-ery, especially given the powerful signals exports pro-vide for investment and restructuring decisions. In ad-dition, many of the advanced transition economies arereceiving substantial inflows of foreign direct invest-ment, which complement domestic resources andoften bring invaluable transfers of technology andmanagement know-how. The relative success of manyof the countries in central and eastern Europe in ex-panding their exports and attracting foreign investmentwould not have been possible without determined sta-bilization and structural reform efforts. Among thecentral Asian countries, Mongolia’s economic perfor-mance has also shown the results of considerable re-form efforts.

A turnaround in economic activity is expected tomaterialize relatively soon in many of the countriesthat started the reform process later, or have only re-cently succeeded in reducing the high inflation ratesthat have plagued all of these countries. In Russia,strengthened budgetary policies have been essential tosupport an anti-inflationary monetary stance that hasbrought down inflation to an annual rate of 22 percent

in the first eight months of 1996. Although output isreported to have contracted further in the first half of1996, conditions appear to be in place for activity tobegin to pick up next year. Containment of fiscal im-balances, especially through greater efforts to collecttax revenues, and further deepening of the reformprocess are essential if the expected recovery is to be-come firmly established. Progress in structural reformis expected to stabilize output in Kazakstan in 1996and permit moderate growth in coming years. InUkraine, output is expected to contract further in 1996but progress in implementing the needed reforms andin stabilizing the economy should begin to reverse theeconomic decline next year. Bulgaria has experienceda particularly serious setback in its stabilization effortsas a result of large quasi-fiscal deficits that have un-dermined confidence in the banking system. The situ-ation is being addressed within the framework of aFund-supported stabilization program that places astrong emphasis on structural reform.

The experience of the transition countries over thepast five years suggests a number of important lessons.First, the reduction of inflation from high levels is crit-ical for halting and reversing the sharp contractions inoutput that have been an inevitable feature of the firstphase of the transformation process. Second, growth isunlikely to resume unless there is substantial progresswith structural reform in a broad range of areas. Andthird, restructuring the enterprise sector and increasingproductivity in existing enterprises may result in rela-tively high levels of open unemployment, at least for aperiod. Rather than allowing enterprises to maintainsoft budget constraints, governments need to supportthe transformation process by fostering greater labormobility and flexibility of wages, by establishing re-training schemes to satisfy skill requirements in ex-panding sectors of the economy, and also by establish-ing affordable, well-targeted social safety nets tolessen the hardship associated with unemployment.Sustained progress in all of these areas should permitthose countries that have been lagging behind to beginto catch up with the early reformers in the periodahead.

Despite the generally positive outlook for the transi-tion countries, considerable uncertainty attaches totheir long-term growth potential. Based on the experi-ence of other groups of countries that have experi-enced relatively rapid growth over extended periods, itis clear that some, but not all, of the conditions are inplace for a significant convergence toward income lev-els in the industrial countries. One of the most encour-aging characteristics of the transition countries is thehigh level and quality of education, which suggests anadvantage in terms of human capital, notwithstandinga considerable need for retraining. The transitioncountries are also characterized, however, by relativelyunfavorable demographic trends that imply a progres-sive aging of their populations and stagnant or even

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declining labor forces. Rising dependency ratios sug-gest that their saving performance, which is currentlyquite weak, may not improve sufficiently in comingyears as to reach the levels of many rapidly growingcountries. Since this will constitute an important con-straint on the level of investment, increases in produc-tivity will need to make a significant contribution ifhigh growth rates are to be sustained. On the basis ofpreliminary staff analysis, the various factors that in-fluence productivity growth seem to imply potentiallong-term growth rates on the order of 4 to 5 percent ayear, although the margin of uncertainty that attachesto such estimates is obviously very large.

Government policies will clearly have a significantinfluence on the outcome. In particular, long-term fis-cal strategies will need to ensure that social objectives

are met without recourse to persistent budget deficits.It is also essential to establish economic and financialconditions that are conducive to private saving and in-vestment. Capital imports may help to complementdomestic saving and it is particularly important to fos-ter high levels of foreign direct investment, which doesnot add to external indebtedness. Transparent legalframeworks and property rights, further progress withprivatization (including of land), and facilitating entryfor new enterprises are critical in this regard. But ex-perience from other countries suggests that large-scalereliance on foreign saving may not be sustainable.Therefore, major efforts are also needed in most tran-sition countries to put the banking system on a soundfooting; this is essential for the mobilization and ef-fective allocation of domestic saving.

Economies in Transition

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Documents

IMF World Economic Outlook Fall 1996 - Chapter 1 · World economic outlook: a survey by the staff of the International ... Partnership for Sustainable Global Growth xii Chapter I