World Economic Outlook, May 1995 : Global Saving

International Monetary Fund. Research Dept.

• Publisher: INTERNATIONAL MONETARY FUND
• eBook ISBN:
  9781557754684
• Year: 1995

NONE

I Economic Prospects and Policies

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

Chart 1. World Indicators¹

(In percent)

¹Blue shaded areas indicate IMF staff projections.

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

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

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

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

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

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

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

Industrial Countries

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

Table 1. Overview of the World Economic Outlook Projections

(Annual percent change, unless otherwise noted)

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

¹ Fifteen current members of the European Union.

² Information on 1993 trade may understate trade volume because of reduced data coverage associated with the abandonment of customs clearance of trade within the European Union. Similarly, the strong rebound in trade volumes in 1994 may partly reflect improved data coverage.

³ Simple average of the U.S. dollar spot prices of U.K. Brent, Dubai, and Alaska North Slope crude oil; assumptions for 1995 and 1996.

⁴ Average, based on world commodity export weights, of U.S. dollar prices.

⁵ London interbank offered rate.

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

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

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

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

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

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

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

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

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

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

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

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Content Page
• Assumptions and Conventions
• Preface
• Chapter I. Economic Prospects and Policies
• Chapter II. Policies for Sustained Growth in Industrial Countries
• Chapter III. Policy Challenges Facing Developing Countries
• Chapter IV. Disinflation, Growth, and Foreign Direct Investment in Transition Countries
• Chapter V. Saving in a Growing World Economy
• Annexes
• Boxes Chapter
• Annex
• Box
• Annex
• Box
• Footnotes